<PAGE>
 
                       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 October 3, 1998 or
[_]  Transition Report Pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the transition period from                 to
 
 
COMMISSION FILE NUMBER 0-18623
 
                               ----------------
 
                               IKOS SYSTEMS, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                       <C>
                Delaware                                    77-0100318
    (STATE OR OTHER JURISDICTION OF                       (IRS EMPLOYER
     INCORPORATION OR ORGANIZATION)                    IDENTIFICATION NO.)
 
 
 19050 Pruneridge Avenue, Cupertino, CA                       95014
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                    (ZIP CODE)
</TABLE>
 
              REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
                                 (408) 255-4567
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
                                      NONE
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                          COMMON STOCK $.01 PAR VALUE
                        PREFERRED STOCK PURCHASE RIGHTS
                                (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 such shorter period that the registrant
was required to file such report), and (2) has been subject to such filing
requirements for the past 90 days.  Yes X    No
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
 
  The approximate aggregate market value of the registrant's Common Stock held
by non-affiliates as of November 11, 1998, was approximately $27,886,982.
 
  As of November 11, 1998, approximately 8,748,857 shares of the registrant's
Common Stock were outstanding.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Portions of the Proxy Statement for the 1999 Annual Meeting of Stockholders
are incorporated by reference in Part III hereof.
 
  This report (excluding exhibits) contains 51 pages. The Index to Exhibits
begins on Page 21 of this report.
<PAGE>
 
                                    PART I
 
ITEM 1. BUSINESS
 
  FORWARD-LOOKING STATEMENTS IN THIS REPORT ARE MADE PURSUANT TO THE SAFE
HARBOR PROVISIONS OF SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934. IN
THIS REPORT, THE WORDS, "ANTICIPATES," "BELIEVES," "EXPECTS," "FUTURE,"
"INTENDS" AND SIMILAR EXPRESSIONS IDENTIFY FORWARD-LOOKING STATEMENTS.
STOCKHOLDERS ARE CAUTIONED THAT ALL FORWARD-LOOKING STATEMENTS PERTAINING TO
THE COMPANY INVOLVE RISKS AND UNCERTAINTIES, INCLUDING, WITHOUT LIMITATION,
THOSE CONTAINED UNDER THE CAPTION, "FACTORS THAT MAY AFFECT FUTURE RESULTS OF
OPERATIONS" AND OTHER RISKS DETAILED FROM TIME TO TIME IN THE COMPANY'S
PERIODIC REPORTS AND OTHER INFORMATION FILED WITH THE SECURITIES AND EXCHANGE
COMMISSION. ACTUAL EVENTS AND RESULTS MAY DIFFER MATERIALLY FROM THE COMPANY'S
CURRENT EXPECTATIONS AND BELIEFS.
 
GENERAL
 
  IKOS Systems, Inc. (IKOS or the Company) develops, manufactures, markets,
and supports hardware and software systems for the verification of integrated
circuits (ICs). IKOS' mission is to help customers realize their high
complexity electronic systems through innovative design verification
solutions. IKOS differentiates its verification solutions with three
technologies: hardware acceleration, emulation hardware, and software for
compilation and integration of both emulation and acceleration hardware into
the design flow. IKOS also provides services to customers to assist in the
integration and deployment of IKOS solutions.
 
  The Company sells its products and services to a broad range of customers,
including telecommunications, multimedia, semiconductor, computer, consumer
electronics, and aerospace application segments. The Company's customers
include Lucent Technologies, Motorola, NEC, STMicroelectronics, Siemens, LSI
Logic, and Texas Instruments. Headquartered in Cupertino, California, IKOS has
3 development centers worldwide: Cupertino California, Waltham Massachusetts,
and Noida India; in addition IKOS supports direct sales operations in North
America, the United Kingdom, Scandinavia, France, Germany, and Japan. The
Company has a distributor network covering the remainder of Europe and parts
of Asia. IKOS is publicly traded on the Nasdaq National Market under the
symbol IKOS. IKOS was incorporated in Delaware in May 1990.
 
BACKGROUND
 
  The electronic design automation (EDA) industry provides design automation
tools and technology to the semiconductor industry. Verification and
implementation are the largest segments in the EDA market and the Company is
focused on the verification segment. The demand for design automation tools in
this segment continues to grow at a faster rate than the EDA industry has been
able to match. The fundamental drivers in this arena are the continuing trend
toward increased design complexity, the inability of design engineering
productivity to keep pace, and the resulting productivity gap. Using Moore's
law, the Company expects a 58% compounded annual growth rate in design
complexity while, under the same assumptions, the Company expects design
engineering productivity to grow at only 21% annually. This creates an ever-
widening productivity gap that EDA tool vendors seek to address.
 
                                       1
<PAGE>
 
 
 
 
  Design verification, which includes module verification, chip-level
verification, system-level verification, and sign-off verification, is the
assessment of the functionality and timing of a design prior to fabrication.
It is a critical part of the design process with significant impact upon the
design engineer's productivity. Customers estimate that up to 70% of their
total design cycle time is spent in the verification phases. The Company is
focused on selling products and solutions for the three of the four
verification phases: chip level, system level and sign-off. As design sizes
increase, the amount of testing required to thoroughly verify functionality
also grows. As design size and time to market pressures increase, the
throughput required for thorough verification of these high-complexity designs
can exceed the performance capability of software simulators running on
general purpose workstations. It is for this group of customers that the
Company's accelerator and emulation products provide increased throughput that
enables them to meet project schedules with a high degree of confidence in
their designs.
 
COMPANY SOLUTIONS
 
  IKOS offers two different hardware technologies for verification: emulation
and hardware accelerated simulation. The emulation technology is utilized
primarily for system-level verification where simulation and hardware
accelerated simulation fall short of meeting customers' verification
requirements.
 
  The Company's emulation solutions are differentiated from the competition
through the Company's patented VirtualWires technology. VirtualWires allows
the Company to deliver the lowest cost, high capacity solution available in
emulation today. The Company's VirtuaLogic and Avatar emulation products
leverage the rapidly growing system-level verification requirements created by
the growth in silicon complexity.
 
  The hardware accelerated simulation technology is used for chip-level and
sign-off level verification and provides one to two orders of magnitude more
performance than software simulation. These two hardware technologies are
augmented with software technologies: compilation software and integration
software and interfaces to support customer design flows with high performance
verification.
 
  The Company further augments its simulation and emulation products with
consulting services for on-site support and design verification expertise to
help customers achieve project goals. Verification services allow the customer
to outsource the work needed to integrate new verification products into their
design flow or deliver new verification capabilities to the design team. These
services allow the customer to invest and focus on what differentiates them
while benefiting from the custom integration of high performance verification
to their design flow.
 
                                       2
<PAGE>
 
MAINTENANCE AND SUPPORT
 
  The Company provides hardware and software maintenance and support on a
contractual basis after the initial product warranty has expired. Hardware
maintenance is provided on an on-site or on a return and repair basis. The
Company also provides application support via a toll-free telephone line.
Customers with software maintenance coverage also receive software releases,
if any, from the Company. Foreign distributors generally provide customer
training, service and support for the products they sell. Maintenance
revenues, as a percent of total revenues, represented 32% in fiscal 1998 and
17%, in fiscal 1997 and 1996.
 
COMPETITION
 
  In emulation mainly used for system-level verification, the Company's main
competitors are Quickturn Design Systems, Inc. ("Quickturn") and Mentor
Graphics Corporation ("Mentor"). Quickturn continues to be the market leader.
Mentor Graphics offers emulation solutions in Europe and Asia but is currently
enjoined from selling in the United States as a result of litigation initiated
by Quickturn. The Quickturn and Mentor Graphics legal procedures have
continued and now include Mentor's hostile takeover bid for Quickturn. In
addition to its legal matters, Quickturn is also facing the difficult task of
transitioning customers to new hardware. Quickturn announced their next
generation emulator "Mercury" and the end of life of their current System
Realizer product.
 
  Competitors in the chip-level and sign-off level verification market include
software simulation providers such as Synopsys, Inc. ("Synopsys"), Mentor
Graphics, and Cadence Design Systems, Inc. ("Cadence"). Hardware accelerated
simulation providers include a new company entering the market this year, Axis
Systems. For sign-off level verification the Company's strongest competition
comes from static tools from providers such as: Chrysalis, Synopsys, and
Cadence.
 
  The Company expects competition in the verification market to continue to
expand and change. Moreover, the Company competes, and expects that it will
continue to compete, with established EDA companies. A number of these
companies have longer operating histories, significantly greater financial,
technical and marketing resources, greater name recognition and larger
installed customer bases than the Company. In addition, many of these
competitors and potential competitors have established relationships with
current and potential customers of the Company and offer a broader and more
comprehensive product line. Increased competition could result in price
reductions, reduced margins and loss of market share, all of which could
materially adversely affect the Company. In addition, current competitors or
other entities may develop other products that have significant advantages
over the Company's products. There can be no assurance that the Company will
be able to compete successfully against current and future competitors or that
competitive pressures faced by the Company will not materially adversely
affect its operating results.
 
  The Company competes on the basis of certain factors, including product
performance, price, support of industry standards, technical support and
customer service, timely introduction of new products, ease of use and
reputation. The Company believes that it currently competes favorably overall
with respect to these factors.
 
CUSTOMERS, MARKETING AND SALES
 
  IKOS sells its products to a broad range of companies including those in the
communications, multimedia/graphics, semiconductor, computer, aerospace and
consumer electronics industries. The Company markets its products and services
primarily through its direct sales and service organization. The Company
employs a technically-oriented sales force and application engineering team to
serve the needs of existing and prospective customers. The Company's
consulting services provide customers with a comprehensive solution that is
tailored specifically to the needs of the design team. These services include
education, application services, interface software support, custom library
development and other on-site support through customized consulting
partnerships to assist the customer in accomplishing key verification
milestones.
 
  IKOS' direct sales strategy concentrates on those companies that it believes
are key users and designers of complex ICs and IC-based systems for high-
performance applications. For the fiscal year ended October 3, 1998,
 
                                       3
<PAGE>
 
one customer Lucent Technologies, Inc., accounted for approximately 13% of net
revenues. For the fiscal year ended September 27, 1997, one customer Lucent
Technologies, Inc., accounted for approximately 11% of net revenues. For the
year ended September 28, 1996, one distributor, Itochu & Co., Ltd. (Itochu) in
Japan, accounted for approximately 12% of net revenues and one customer, S3
Inc., accounted for approximately 14% of net revenues.
 
  Direct Sales. IKOS currently maintains direct sales and support offices in
the following states: Arizona, California, Illinois, Massachusetts, New Jersey
and Texas. IKOS makes direct sales internationally in Canada, in Japan through
its wholly-owned subsidiary, IKOS K.K. and in central Europe through its
wholly-owned subsidiary, ICOS Systems GmbH, and through its sales offices in
France and England. Direct sales, including maintenance fees, accounted for
over 95% of the Company's net revenues in fiscal 1998. Direct sales for fiscal
1997 and 1996 as a percentage of net revenues were 90% and 86%, respectively.
 
  Distributors. IKOS believes that international markets are an important
source of the Company's revenues and while the bulk of its sales is through
direct channels, the Company has developed distributor relationships in ten
foreign countries in Europe and Asia. In fiscal 1997, the Company terminated
its distributor relationship in Japan and began selling directly in that
market. Revenues to distributors were less than 5% of the Company's net
revenues for the fiscal year 1998. Distributor revenues for fiscal 1997 and
1996 as a percentage of net revenues were 10% and 14%, respectively.
 
  International Sales. International sales, including export sales and foreign
operation net revenues, accounted for approximately 36%, 34% and 33% of the
Company's net revenues in fiscal 1998, 1997 and 1996, respectively.
International revenues decreased as a result of decreases in Voyager sales and
limited availability of emulation product for shipment during fiscal 1998.
During fiscal 1997, the Company terminated its Japan distributor relationship
and completed its transition to a direct sales channel in Japan. This
transition resulted in less than expected revenues in Japan during the fiscal
year. Although the Company has attempted to reduce the risk of fluctuations in
exchange rates associated with international revenues by selling its systems
denominated in U.S. dollars only, the Company pays the expenses of its
international operations in local currencies and has not engaged in hedging
transactions with respect to such obligations. With the exception of sales to
customers through the Japan subsidiary, sales in all foreign countries are
denominated in U.S. dollars. Sales through the Japan subsidiary are
denominated in Japanese Yen. For those sales made in Japanese Yen, the Company
periodically enters into foreign exchange contracts to minimize foreign
exchange risk relating to the Japanese subsidiary's sales.
 
  Conducting business in international markets requires compliance with
applicable laws and regulations, such as safety and telecommunication laws and
regulations of foreign jurisdictions and import duties and quotas. To date,
the Company has not experienced any difficulty in obtaining export licenses
from the U.S. Department of Commerce for foreign sales; however, there can be
no assurance that the Company will not experience difficulties in the future.
 
MANUFACTURING AND SUPPLIERS
 
  The Company performs final assembly and test of all its products in its
Cupertino, California facility. The Company utilizes third parties for all
major subassembly manufacturing, including printed circuit boards and custom
ICs. The Company has a testing and qualification program to ensure that all
subassemblies meet the Company's specifications before going into final
assembly and test.
 
  The capacity and speed of IKOS' hardware results from its basic design and
architecture, and includes certain proprietary components and components that
are required to perform near technological limits. Certain key components used
in the Company's products are presently available from sole or limited
sources. The Company believes that it could obtain alternative sources in a
short period of time, although the inability to develop alternative sources
for these sole or limited source components or to obtain sufficient quantities
of these components could result in delays or reductions in product shipments
which could adversely affect the
 
                                       4
<PAGE>
 
Company's operating results. The Company's simulation and emulation systems
use proprietary ASICs, FPGAs and certain subassemblies that are currently
available from single sources. The Company generally purchases these
components, including semiconductor memories used in the Company's hardware
simulators, pursuant to purchase orders placed from time to time in the
ordinary course of business and has no supply arrangements with any of these
source suppliers that require the suppliers to provide components in
guaranteed quantities or at set prices. The Company endeavors to maintain an
ample supply of such components at all times through order generation based on
tracking of sales projections, production and inventories, and by ordering
critical components for delivery over an extended period.
 
PRODUCT DEVELOPMENT
 
  The Company's ongoing product development activities include the enhancement
of current products, such as the ability to simulate, emulate and verify the
design of higher gate count ICs and to offer a greater degree of integration
with EDA tools. Furthermore these product development activities include the
development of new product options and features, such as new library tools and
the research and development of new technologies for use in future products.
 
  The Company's research and product development organization included 100
engineers at October 3, 1998, of whom 80 were engaged principally in software
development. During fiscal 1998, 1997 and 1996, the Company spent
approximately $14.4 million, $10.7 million and $8.1 million, respectively, on
research and development. During fiscal 1998, the Company also spent
approximately $9.0 million acquiring technology from Interra, Inc. In addition
to acquiring this technology, the Company also obtained the services of
approximately 52 software engineers in establishing a research and development
subsidiary in India. During 1997, the Company spent approximately $7.3
million, related to acquiring technology purchased from Zycad Corporation
("Zycad"). In 1996, the Company spent $9.6 million on in-process research and
development in connection with the its acquisition of Virtual Machine Works,
Inc. The Company's research and development costs, including costs of software
development before technological feasibility, are expensed as incurred.
 
PROPRIETARY RIGHTS
 
  Due to the rapid pace of technological advancement, the Company believes it
is less dependent on the protection of proprietary product information than on
its ability to develop and market new products. The Company protects its
proprietary product information through the use of employee nondisclosure
agreements and by limiting access to confidential information. The Company
presently has three United States patents, two of which expire on November 22,
2005, and the third expiring on June 30, 2009, that cover various aspects and
features of its products, including its overall system architecture and
certain features in the systems hardware. The Company has licensed rights
under certain patent applications relating to VirtualWires from MIT and has
filed additional patent applications. This license is through December 2004,
and thereafter becomes nonexclusive. MIT may terminate this license if the
Company fails to meet certain minimum net sales milestones or upon certain
other material breaches of the license agreement that remain uncured after 90
days' notice of such breach. Although the Company may file additional patent
applications in the future, it does not expect to rely extensively on patents
to protect its products.
 
  The Company also relies on certain software which it licenses from third
parties, including software which is integrated with internally developed
software and used in the Company's systems to perform key functions.
 
  From time to time the Company has received, and may receive in the future,
notice of claims of infringement of other parties' proprietary rights.
Although the Company does not believe that its products infringe the
proprietary rights of any third parties, there can be no assurance that
infringement or invalidity claims (or claims for indemnification resulting
from infringement claims) will not be asserted against the Company or that any
such assertions will not materially adversely affect the Company's business,
financial condition or results of operations. Irrespective of the validity or
the successful assertion of such claims, the Company could incur significant
costs and diversion of management efforts with respect to the defense thereof
 
                                       5
<PAGE>
 
which could have a material adverse effect on the Company' business, financial
condition or results of operations. If any claims or actions are asserted
against the Company, the Company may seek to obtain a license under a third
party's intellectual property rights. There can be no assurance, however, that
under such circumstances, a license would be available under reasonable terms
or at all.
 
  The Company's tradename, "IKOS," its facing parrots logo and its product
series named "Voyager" are registered trademarks of the Company.
 
EMPLOYEES
 
  As of October 3, 1998, the Company employed a total of 256 persons,
consisting of 119 in marketing, sales and support, 11 in manufacturing, 100 in
research, development and engineering, and 26 in finance, administration and
other capacities. The Company has never had a work stoppage. None of its
employees is represented by a labor organization, and the Company considers
its relations with its employees to be good.
 
ITEM 2. PROPERTIES
 
  The Company's principal executive offices, as well as its principal
manufacturing, marketing, research and development, and engineering facility,
are located on approximately 57,000 square feet of leased office building
space in Cupertino, California. The lease on this facility expires September
2000, with options to extend the lease for up to nine years. In addition, the
Company leases research and development and sales office space domestically in
Arizona, California, Illinois, Massachusetts, New Hampshire, New Jersey and
Texas and internationally in England, France, Germany and Japan. The Company
believes that its existing facilities are adequate for its current needs and
that additional space will be available as needed.
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company is party to third party subpoenas of certain information by both
Mentor Graphics and Quickturn in Quickturn's patent infringement dispute with
Mentor Graphics.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this report.
 
                                       6
<PAGE>
 
EXECUTIVE OFFICERS OF THE REGISTRANT
 
  Set forth below is certain information with respect to age and background
for each of the officers of the Company.
 
<TABLE>
<CAPTION>
NAME                                  AGE       POSITION WITH THE COMPANY
----                                  ---       -------------------------
<S>                                   <C> <C>
Gerald S. Casilli....................  59 Chairman of the Board
 
 
Ramon A. Nunez.......................  44 Chief Executive Officer, President and
                                          Director
 
 
Joseph W. Rockom.....................  59 Chief Financial Officer, Vice
                                          President of Finance and
                                          Administration, and Secretary
 
 
Daniel R. Hafeman....................  49 Vice President of Advanced Research
                                          and Chief Technical Officer
 
 
Stephen M. McLaughlin................  51 Vice President of Manufacturing
 
 
Lawrence A. Melling..................  41 Vice President of Business Development
                                          and Strategic Marketing
 
 
Robert Hum...........................  46 Senior Vice President of Product
                                          Operations
 
 
Nader Fathi..........................  39 Vice President of International Sales
 
 
Tom Gardner..........................  50 Vice President of North American Sales
</TABLE>
 
  Mr. Casilli has served as Chairman of the Board of Directors of the Company
since July 1989 and served as Chief Executive Officer from April 1989 to
August 1995. He has served as a director since 1986. Mr. Casilli is also
currently a Director for Evans and Sutherland Computer Corporation. From
January 1986 to December 1989, he was a general partner of Trinity Ventures,
Ltd., a venture capital firm that was a former investor in the Company. Mr.
Casilli was a general partner of Genesis Capital, a venture capital firm, from
February 1982 to 1990. Mr. Casilli founded Millennium Systems, a manufacturer
of microprocessor development systems, in 1973 and served as its President and
Chief Executive Officer until 1982.
 
  Mr. Nunez was appointed Chief Executive Officer in August 1995. Mr. Nunez
had been President, Chief Operating Officer and Director of the Company since
October 1994. He had served as Vice President of Worldwide Sales since July
1993. Mr. Nunez joined the Company in April 1990 as Vice President of North
American Sales after five years in sales management with Zycad Corporation.
Earlier he was branch sales manager for Cadnetix (now part of Intergraph) in
Southern California.
 
  Mr. Rockom has served as Chief Financial Officer and Vice President of
Finance and Administration since September 1986. Mr. Rockom has also served as
the Company's Secretary since April 1995. Before joining the Company, Mr.
Rockom spent seventeen years at American Microsystems, Inc. (AMI), a
semiconductor manufacturer, where he held a variety of administrative,
operating and management positions, including Vice President of Finance.
 
  Mr. Hafeman, a founder of the Company, has served as Vice President of
Advance Research and Chief Technical Officer since March 1996. Mr. Hafeman
served as Vice President of Engineering from August 1989 to March 1996. From
December 1984 to August 1989, he served in various positions of engineering
management with the Company. Mr. Hafeman was an engineering manager at
Scientific Micro Systems, Inc. for eight years prior to his employment with
the Company.
 
  Mr. McLaughlin has served as Vice President of Manufacturing since November
1986. From July 1977 to November 1986, he served as Director of Manufacturing
of Scientific Micro Systems, Inc.
 
                                       7
<PAGE>
 
  Mr. Melling has served as Vice President of Business Development and
Strategic Marketing since December 1997. Prior to this, he was Vice President
of Marketing from July 1993 to December 1997. From August 1990 to July 1993,
Mr. Melling was Vice President of Technical Support. From 1983 until joining
IKOS in 1985, Mr. Melling had been a system design engineer at Corvus Systems,
a manufacturer of computer networking equipment. Prior to his relationship
with Corvus Systems, he was a production and circuit engineer with Hewlett-
Packard for four years.
 
  Mr. Hum was promoted to Senior Vice President of Product Operations in
January of 1998. He came to IKOS as Vice President of Engineering in May of
1997 from Cadence Design Systems where he served in several senior business
and technical management positions. Prior to joining Cadence, Mr. Hum held a
variety of technical and business management roles during an 18-year tenure at
Bell-Northern Research (NORTEL).
 
  Mr. Fathi was promoted to Vice President of International Sales in June
1998. Prior to joining IKOS, Mr. Fathi served in several sales, marketing,
program management and customer support management positions at Cadence, Daisy
(now part of Intergraph), Silicon General and Xerox Microelectronics Center.
 
  Mr. Gardner was promoted to Vice President of North American Sales in June
1998. Earlier, he held senior sales management positions in the eastern and
central US regions during the last two years. Most recently he held the
position of director of sales for the central region. Prior to joining IKOS,
Mr. Gardner held sales and sales management positions with Mentor Graphics,
Quickturn, Cadence and Zycad.
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
  The Company's Common Stock is currently traded on the Nasdaq National Market
under the symbol IKOS. The following table sets forth, for the fiscal period
indicated, the high and low closing sales prices for the Common Stock as
reported by Nasdaq.
 
<TABLE>
<CAPTION>
                                                                  HIGH     LOW
                                                                 ------- -------
       <S>                                                       <C>     <C>
       FISCAL 1997
         First Quarter.......................................... $23.875 $16.375
         Second Quarter.........................................  25.250  17.688
         Third Quarter..........................................  25.125  16.375
         Fourth Quarter.........................................  21.375  11.563
       FISCAL 1998
         First Quarter.......................................... $12.688 $ 5.688
         Second Quarter.........................................   8.750   6.500
         Third Quarter..........................................   7.625   3.500
         Fourth Quarter.........................................   3.656   1.313
</TABLE>
 
  The approximate number of record holders of IKOS stock as of November 11,
1998 was 157. The approximate number of beneficial holders is estimated to be
4,000 as of that same date.
 
  The Company has never declared or paid cash dividends on its stock. The
Company currently anticipates that it will retain all future earnings for use
in the operation and expansion of its business and does not anticipate paying
any cash dividends in the foreseeable future.
 
  During fiscal 1998, the Company announced its intention to repurchase up to
1,000,000 shares of its outstanding common stock on the open market. Through
December 5, 1998, the Company had repurchased 516,500 shares at a weighted-
average per share price of $5.96.
 
                                       8
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                              FISCAL YEARS ENDED
                                -----------------------------------------------
                                OCT. 3,   SEPT. 27, SEPT. 28, SEPT. 30, OCT. 1,
                                  1998      1997      1996      1995     1994
                                --------  --------- --------- --------- -------
<S>                             <C>       <C>       <C>       <C>       <C>
CONSOLIDATED STATEMENT OF
 OPERATIONS DATA:
Net revenues..................  $ 40,893   $56,096   $45,341   $28,600  $21,636
Cost of revenues..............    14,734    12,452     9,852     7,139    5,930
                                --------   -------   -------   -------  -------
    Gross profit..............    26,159    43,644    35,489    21,461   15,706
Operating expenses............    49,516    42,495    36,070    18,063   14,904
                                --------   -------   -------   -------  -------
Income (loss) from
 operations...................   (23,357)    1,149      (581)    3,398      802
Other income..................     1,031     1,269     1,140       169      134
                                --------   -------   -------   -------  -------
Income (loss) before provision
 for income taxes and
 extraordinary credit.........   (22,326)    2,418       559     3,567      936
Provision (benefit)for income
 taxes........................     4,928     1,023    (1,892)      411       95
                                --------   -------   -------   -------  -------
Income (loss) before
 extraordinary credit.........   (27,254)    1,395     2,451     3,156      841
Extraordinary credit
 forgiveness of debt..........       --        --        --        --       664
                                --------   -------   -------   -------  -------
    Net income (loss).........  $(27,254)  $ 1,395   $ 2,451   $ 3,156  $ 1,505
                                ========   =======   =======   =======  =======
Basic net income (loss) per
 share:
  Income(loss) before
   extraordinary credit.......  $  (3.24)  $  0.17   $  0.33   $  0.56  $  0.16
  Extraordinary credit........       --        --        --        --      0.12
                                --------   -------   -------   -------  -------
    Basic net income (loss)
     per share................  $  (3.24)  $  0.17   $  0.33   $  0.56  $  0.28
                                ========   =======   =======   =======  =======
Weighted-average shares used
 in computing basic per share
 amounts......................     8,418     8,408     7,383     5,611    5,455
                                ========   =======   =======   =======  =======
Dilutive net income loss per
 share:
  Income (loss) before
   extraordinary credit.......  $  (3.24)  $  0.16   $  0.30   $  0.51  $  0.15
  Extraordinary credit........       --        --        --        --      0.12
                                --------   -------   -------   -------  -------
    Dilutive net income (loss)
     per share................  $  (3.24)  $  0.16   $  0.30   $  0.51  $  0.27
                                ========   =======   =======   =======  =======
Weighted-average shares used
 in computing dilutive per
 share amounts................     8,418     8,927     8,114     6,151    5,651
                                ========   =======   =======   =======  =======
CONSOLIDATED BALANCE SHEET
 DATA:
Working capital...............  $  5,492   $31,608   $27,919   $ 7,509  $ 3,850
Total assets..................    33,344    56,550    53,471    17,152   12,129
Long-term, debt, less current
 portion......................       --        --        350     1,300    2,151
Total stockholders' equity....    12,613    41,990    38,144     7,710    3,476
</TABLE>
 
  Note: The net income (loss) per common share amounts have been restated to
comply with Statement of Financial Accounting Standards No. 128, "Earnings Per
Share"
 
  See notes to consolidated financial statements, management discussion and
analysis of financial condition and results of operations.
 
                                       9
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
CAUTIONARY STATEMENT
 
  The statements in the Management's Discussion and Analysis of Financial
Condition and Results of Operations that are forward looking involve numerous
risks and uncertainties and are based on current expectations. Actual results
may differ materially from those projected. Such risks and uncertainties may
be more fully described in other reports and information filed by the Company
with the Securities and Exchange Commission. Certain of these risks and
uncertainties are discussed under the caption "Factors That May Affect Future
Results of Operations."
 
NATURE OF OPERATIONS
 
  The Company develops, manufactures, markets and supports hardware and
software systems for the verification of integrated circuit designs. IKOS'
mission is to help customers realize their high complexity products through
innovative design verification solutions. The Company's products are designed
to enable its customers to verify their designs more rapidly and accurately
than existing software-based simulation tools. In 1996, the Company broadened
its spectrum of verification solutions to extend from the design concept stage
to the prototype stage by introducing its first emulation system. The Company
commercially released its first emulation system in 1997 and has completely
redesigned its original emulation product to the current two million gate
emulation solution. The Company sells it products to a broad range of
customers in the communications, multimedia/graphics, semiconductor, computer,
aerospace and consumer electronics industries. The Company markets its
products and services primarily through its direct sales and service
organization as the Company has direct sales operations throughout the United
States and in the United Kingdom, France, Germany and Japan. The Company also
has a distribution network covering the remainder of Europe and in parts of
Asia. The Company recently opened a research and development operation in
India.
 
NET REVENUES
 
  For the fiscal year ended October 3, 1998, net revenues decreased 27% from
$56,096,000 in fiscal 1997 to $40,893,000 in fiscal 1998. The decrease was
primarily the result of the decline in the sales of the Company's Voyager
simulation product line which decreased approximately 52% from the previous
year. The decrease in simulation revenues was due in part to delays in the
introduction of new simulation products and increased focus on the Company's
emulation product line and consulting services. In addition, the Company
encountered a lengthy beta test program for its second-generation emulation
product. Due to the extended length of the Company's beta program, emulation
revenues were lower than expected for fiscal 1998 and flat with the previous
year. The unexpected length of the beta program limited the Company's
shipments of revenue producing units during the third quarter and fourth
quarter of fiscal 1998. The Company completed its beta program and began to
ship commercial product during the fourth quarter. Consulting services revenue
increased from approximately $2,792,000 during the year ended September 27,
1997 to over $4,132,000 for fiscal 1998. The Company's aggressive pursuit of
providing value added consulting services to new and existing customers is the
main reason for the increase. However, while the Company has seen growth in
this market segment, the Company has consolidated the services group with its
technical support organization to better leverage the Company's higher margin
product business. As a result, the growth realized in prior periods may not be
indicative of revenue levels in future periods. Maintenance revenues continue
to grow, increasing 35% over the previous year. The growth is primarily
attributable to the current Voyager systems installed base and the beta
release of the new emulation systems. In addition the Company has announced
certain new products for its simulation system business which are expected to
extend the life of current Voyager products, resulting in several customers
who no longer had maintenance contracts with the Company, to renew such
maintenance agreements.
 
  For the fiscal year ended September 27, 1997, net revenues increased 24%
from $45,341,000 to $56,096,000. The increase was primarily due to increasing
sales of the Company's Voyager systems (NSIM product), emulation products and
increased consulting and maintenance revenues.
 
                                      10
<PAGE>
 
  International sales (export sales and sales shipped by the Company's Japan
and European operations) were $14,532,000, $19,194,000 and $14,890,000 for
fiscal years 1998, 1997 and 1996, respectively. These sales represent 36%, 34%
and 33% of net revenues, respectively. International revenues decreased in
absolute dollars by 25% in 1998 as a result of the decreases in Voyager sales
and the limited availability of emulation products for shipment during fiscal
1998. The increases in international sales in 1997 were a result of the
increasing sales of the Company's Voyager product offerings and increased
economic demand, particularly in Europe. While the Company's international
revenues were down for 1998, the Company believes this decline was primarily
the result of its late commercial release of the latest emulation offering
combined with the failure to release other new products during the fiscal
year. The Company will continue to focus its efforts on the international
market and expects that international sales will increase in 1999. There can
be no assurances that international sales will increase to the extent
anticipated.
 
  The Company first released its Voyager Series product, the VHDL software
simulator (VS) in 1992 and has since released its mixed level simulator, its
next generation hardware accelerator and its software gate level simulator.
The Company entered the Verilog market with its Gemini product during 1995 and
in early 1996 released its Voyager fault simulator (Voyager FS). The Company
began commercial shipments of its new emulator product in the first quarter of
fiscal 1997 and commercially released its second-generation emulator in the
fourth quarter of fiscal 1998. While the Company has seen declines in its
simulation business, the Company believes that its current new product
offerings and future product offerings will result in simulation sales
remaining flat in 1999 when compared to 1998. In addition, the commercial
release of the Company's second-generation emulator is expected to result in
increasing sales of emulation product. Although the Company believes its
product offerings have been accepted very favorably, there can be no
assurances that there will not be any new product offerings by competitors or
changes in the marketplace that could have a materially adverse affect on the
Company's sales and profits.
 
GROSS PROFIT
 
  Gross profit was $26,159,000, $43,644,000 and $35,489,000 or 64%, 78% and
78% of total net revenues for fiscal years 1998, 1997 and 1996, respectively.
Gross margins during the year were lower as the Company recorded charges to
operations of approximately $3,100,000 for the write-off of obsolete inventory
related to the Company's emulation and simulation products. In addition to the
impact from the inventory write-offs, the decrease in margins are a result of
the lower than expected revenues resulting in less coverage of fixed
manufacturing costs which include increased consulting services personnel
costs. These decreases were offset by higher margins on maintenance revenues
as maintenance costs did not grow at the same rate as the related revenues.
The margins for fiscal 1997 were comparable with the previous year as the
Company realized a slight increase in product margins as a result of continued
sales of the higher margin products offset by a slightly lower margin on
maintenance revenues. The Company expects margins to increase from the current
year as the Company believes it will realize higher revenue levels, including
sales of products with higher margins and recognize greater manufacturing
efficiencies.
 
RESEARCH AND DEVELOPMENT EXPENSES
 
  Research and development expenses were $14,381,000, $10,740,000 and
$8,146,000 in fiscal 1998, 1997 and 1996, respectively. As a percentage of net
revenues, research and development expenses were 35%, 19% and 18% for fiscal
1998, 1997 and 1996, respectively. The increase as a percentage of net
revenues in 1998 was a result of an increase in absolute dollars spent on
research and development projects coupled with the reduction in net revenues.
The increase in absolute dollars spent on research and development projects
was primarily the result of increased spending on prototypes as the company
executed on the completion of various new product projects, including its
revamping of the original emulation technology. Also research and development
spending increased due to increased consulting costs for various research and
development projects, depreciation expenses and to a lesser degree salary and
headcount increases. Overall spending also increased as a result of the
establishment of the research and development facility in India. Research and
development expenses increased in 1997 as a result of increased headcount and
consulting fees for various research and development projects
 
                                      11
<PAGE>
 
over the course of the entire year. The Company expects research and
development expenses to increase in absolute dollars as the Company expects to
continue its on-going research and development efforts for completion of its
current and future product development projects. In addition, fiscal 1999 will
have a full year of expenses from its new India facility as compared to a
partial year in fiscal 1998.
 
SALES AND MARKETING EXPENSES
 
  Sales and marketing expenses were $18,609,000, $17,516,000 and $14,483,000
in fiscal 1998, 1997 and 1996, or 46%, 31% and 32% of net revenues,
respectively. The increase as a percentage of net revenues in fiscal 1998 was
primarily the result of the reduction in net revenues. In addition, sales and
marketing expenses increased approximately $1,100,000 as a result of increased
salaries and commissions as well as increased spending, depreciation and
travel expenses. The increased sales and marketing expenses in fiscal 1997
were primarily the result of increased headcount, commissions and
international operations. The Company expects sales and marketing expenses to
increase in absolute dollars in fiscal 1999 as the Company continues to expand
its field application engineering resources and to support increased
activities at its foreign locations.
 
GENERAL AND ADMINISTRATIVE EXPENSES
 
  General and administrative expenses were $4,247,000, $3,777,000 and
$3,420,000 for fiscal 1998, 1997 and 1996, or 10%, 7% and 8%, respectively.
General and administrative costs increased as a percentage of net revenues in
1998 primarily as a result of the reduction in net revenues. In addition,
general and administrative expenses increased approximately $500,000 as a
result of increased consulting expenses associated with the Company's
recruiting efforts and new information systems implementation. General and
administrative expenses for fiscal 1997 increased slightly over 1996 as a
result of increased headcount and related expenses, annual focal increases and
profit sharing expenses. General and administrative expenses are expected to
increase in absolute dollars in fiscal 1999.
 
OTHER INCOME (EXPENSE)
 
  Net interest income in fiscal 1998 was $1,031,000, representing a 14%
decrease from the $1,198,000 earned in 1997. The decrease was the result of
the reduction of cash, cash equivalents, and short-term investments from
$24,815,000 in fiscal 1997 to $15,682,000. The primary use of the interest
income generating funds was the payment of approximately $6,490,000 to Interra
in connection with the Company's acquisition of technology and the repurchase
of approximately 387,000 shares of common stock for approximately $2,673,000.
Net interest income in fiscal 1997 increased 18% over fiscal 1996 primarily as
the result of higher average cash balances during fiscal 1997. In fiscal 1996,
the Company completed two stock offerings netting proceeds of approximately
$20,177,000.
 
PROVISION FOR INCOME TAXES
 
  For fiscal 1998, the Company did not recognize the tax benefit of its
operating loss and recorded a tax provision of $4,928,000. The provision
primarily consisted of the write down of the Company's net deferred tax assets
because these deferred tax assets are not realizable on a more likely than not
basis, as a result of the losses incurred in the current fiscal year. During
fiscal 1997, the Company recorded a tax provision of $1,023,000, which
primarily consisted of federal tax, state taxes, foreign taxes, and the impact
of goodwill amortization. These were offset by research and development
credits and the foreign sales corporation benefit. The $1,892,000 tax benefit
recorded in fiscal 1996 was primarily attributable to the recognition of
deferred tax assets for which no benefit was previously recognized, net
operating losses utilized during fiscal 1996 and acquired research and
development expenditures for which no tax benefit was available.
 
OTHER
 
  The Company has experienced minimal gains or losses on foreign currency
translation since substantially all of its international sales to date have
been billed and collected in U.S. dollars. The Company pays the
 
                                      12
<PAGE>
 
expenses of its international operations in local currencies and to date the
Company has not engaged in hedging transactions with respect to such
obligations. The Company has reorganized its operations at its Japan
subsidiary and is engaging in transactions in the Japanese local currency. As
such, the Company periodically enters into foreign exchange contracts to
minimize foreign exchange risk relating to the Japanese subsidiary's sales
that are denominated in yen. A forward exchange contract obligates the Company
to exchange predetermined amounts of a specified foreign currency at a
specified exchange rate on a specified date or to make an equivalent US dollar
payment equal to the value of such exchange. These contracts are accounted for
as hedges of identifiable receivables denominated in Japanese yen. Realized
gains or losses are recognized upon maturity of the contracts and offset the
underlying asset or liability. Through October 3, 1998, such hedging
arrangements have been immaterial to the Company operations.
 
FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
 
  Potential Fluctuations in Quarterly Results--The Company's quarterly
operating results have in the past and may in the future vary significantly
depending on factors including the timing of customer development projects and
purchase orders, new product announcements and releases by the Company and
other companies, gain or loss of significant customers, price discounting of
the Company's products, the timing of expenditures, customer product delivery
requirements, availability and cost of components or labor and economic
conditions generally and in the electronics industry specifically. Any
unfavorable change in these or other factors could have a material adverse
effect on the Company's operating results for a particular quarter. Many of
the Company's customers order on an as-needed basis and often delay issuance
of firm purchase orders until their project commencement dates are determined.
Quarterly revenue and operating results will therefore depend on the volume
and timing of orders received during the quarter, which are difficult to
forecast accurately. Moreover, a significant portion of the Company's revenue
may result from shipments during the last few weeks of the quarter from orders
generally received in the last month of the quarter. Any concentration of
sales at the end of the quarter may limit the Company's ability to plan or
adjust operating expenses and production and inventory levels. Therefore, if
anticipated shipments in any quarter do not occur or are delayed, expenditure
levels could be disproportionately high as a percentage of revenue, and the
Company's operating results for that quarter would be adversely affected. In
addition, sales of individual systems with high average sales prices can
constitute a significant percentage of the Company's quarterly revenue.
Operating results in any period should not be considered indicative of the
results to be expected for any future period, and there can be no assurance
that the Company's net revenues will increase or that the Company will remain
profitable in any future period.
 
  Increased Sales and Development of the Company's Products--Substantially all
of the Company's product revenues since fiscal 1993 have been derived from the
sale of its Voyager and Gemini simulation systems. The Company has seen a
decline in such revenues and there can be no assurance the decline in these
product's revenues will reverse. Increased sales of the Company's hardware-
assisted simulation products for the verification of IC and system designs are
expected to depend on the introduction of new simulation products and
methodologies. Furthermore, increased sales will also depend on an increasing
number of complex ICs designed for electronic systems, integration of the
Company's products with other tools for IC design and simulation, the ability
of hardware-assisted simulation systems to shorten the time of simulation of
IC designs and continued industry acceptance of mixed-level hardware-assisted
simulation. Because the market for hardware-assisted simulation products is
evolving, it is difficult to predict with any assurance whether the market for
hardware-assisted simulation products will continue to expand. There can be no
assurances that such market will expand, or even if such market expands that
the Company's products will achieve the market acceptance required to maintain
revenue growth and profitability in the future.
 
  In addition to the Company's simulation product line, the Company has
focused certain of its resources on its emulation product line. The Company's
initial emulation product was commercially released in the first quarter of
fiscal 1997. The Company encountered several hardware and software design
issues with its initial emulation product, and in addition, the EDA
marketplace for emulation products continued to evolve, impacting the original
design. During 1998, the Company addressed its hardware and software design
issues by completely redesigning
 
                                      13
<PAGE>
 
the emulation product and has recently commercially released its second-
generation emulation product. While the Company has seen favorable results
with its latest release, there can be no assurance that the product will
adequately meet the requirements of the marketplace. There continues to be
further development of the emulation product, and as the Company continues to
develop emulation products which are based on the new technology concept,
there can be no assurance that the enhanced products or other developed
products resulting from this development will provide the necessary solutions
to customer design verification needs, be of acceptable quality or achieve
further market acceptance. The success of the Company in developing,
introducing, selling and supporting emulation products will depend on a
variety of factors, including but not limited to, the timely and successful
enhancement of current products, completion of product design and development
of future products, the timely and efficient implementation of manufacturing
processes, effective sales, marketing and customer service, and the absence of
performance problems or other difficulties that may require design
modifications and related expenses and may hinder or damage market acceptance
of the products. While the Company's emulation systems are designed to provide
cost and ease of use advantages intended to broaden the market for logic
emulation, there can be no assurance that its products will be able to achieve
such goals. Moreover, there can be no assurance that the market for logic
emulation will broaden beyond the current set of emulation systems users. The
adoption of any emulation products the Company has or may develop will also
depend on the continued increasing complexity of ICs designed for electronic
systems, integration of such products with other tools for IC design and
verification, importance of the time to market benefits of emulation systems
and industry acceptance of the need to close the gap between high level design
and silicon production. Because the market for emulation products is new and
evolving, it is difficult to predict with any assurance whether the market for
emulation products will continue to expand, or even if such market expands,
that the Company's products will achieve the market acceptance required to
maintain revenue growth and continued profitability.
 
  In May 1998, the Company completed its acquisition of certain technology and
research and development expertise from Interra, Inc., and its affiliate,
Delsoft India Pvt. Limited. While the Company expects that the technology
acquired and the resources obtained in this transaction will assist the
Company in meeting its new product introduction goals and deadlines, the
Company has significant development risk with respect to incorporating the
acquired technology into current products or generating new products from such
technology. Such effort will result in increased spending on research and
development as the Company attempts to meet these goals and deadlines. There
can be no assurances that such goals or deadlines will be achieved in a timely
manner. Furthermore, should such goals and deadlines for the introduction of
new products be attained, there can be no assurances that the resulting new
products will adequately meet the requirements of the marketplace.
 
  Competition--The EDA industry is highly competitive and rapidly changing.
The Company's products are specifically targeted at the emerging portion of
the industry relating to complex designs that the Company believes benefit
from simulation and emulation products. The Company currently competes with
traditional software verification methodologies, including product offerings
sold by Cadence, Synopsis and Mentor Graphics. The Company's main competition
for the sale of emulation systems is Quickturn. The Company expects
competition in the market for verification tools to increase as other
companies attempt to introduce new products, such as cycle-based software
simulation products and product enhancements. Moreover, the Company competes,
and expects that it will continue to compete, with established EDA companies.
A number of these companies have longer operating histories, significantly
greater financial, technical and marketing resources, greater name recognition
and larger installed customer bases than the Company. In addition, many of
these competitors and potential competitors have established relationships
with current and potential customers of the Company and offer a broader and
more comprehensive product line. Increased competition could result in price
reductions, reduced margins and loss of market share, all of which could
materially adversely affect the Company. In addition, current competitors or
other entities may develop other products that have significant advantages
over the Company's products. There can be no assurance that the Company will
be able to compete successfully against current and future competitors or that
competitive pressures faced by the Company will not materially adversely
affect its operating results.
 
  New Products and Technological Change--The EDA industry is characterized by
extremely rapid technological change in both hardware and software
development, frequent new product introductions, evolving
 
                                      14
<PAGE>
 
industry standards and changing customer requirements. The introduction of
products embodying new technologies and the emergence of new industry
standards can render existing products obsolete and unmarketable. The
Company's future success will depend upon its ability to enhance its current
series of simulation and emulation systems and to design, develop and support
its future simulation and emulation products on a timely basis. These efforts
require a high level of expenditures for research and development by the
Company to address the increasingly sophisticated needs of the customers. For
example, all of the Company's current products operate in, and planned future
products will operate in, the Unix operating environment, an industry standard
in the EDA market. In the event that another operating system, such as Windows
NT, becomes an industry standard, the Company may be required to port its
products to such new standard. In addition, the Company's simulation systems
generally accept designs in the broadly accepted hardware description
language, Verilog-XL, which Cadence has developed and made available to the
Company. In the event Cadence adopts a less cooperative stance toward the
Company in the future, the Company's systems may not be able to accept designs
based on Verilog-XL and the Company may be required to develop software to
accept designs of other hardware description languages. The inability to
accept designs in Verilog-XL may materially adversely affect the Company's
results of operations. There can be no assurance that the Company will be
successful in developing and marketing product enhancements or new products
that respond to technological change or evolving industry standards or
changing customer requirements, that the Company will not experience
difficulties that could delay or prevent the successful development,
introduction and marketing of these products, or that its new products and
product enhancements will adequately meet the requirements of the marketplace,
will be of acceptable quality or will achieve market acceptance. If the
Company is unable, for technological or other reasons, to develop and
introduce products in a timely manner in response to changing market
conditions or customer requirements, the Company's business, operating results
and financial condition will be materially and adversely affected. Moreover,
from time to time, the Company may announce new products or technologies that
have the potential to replace the Company's existing product offerings. There
can be no assurance that the announcement of new product offerings will not
cause customers to defer purchases of existing Company products, which could
adversely affect the Company's results of operations for any particular
quarter.
 
  Dependence on Electronics Industry--The Company is dependent upon the
electronics industry and, in particular, new system and IC design projects.
The electronics industry is characterized by rapid technological change, short
product life cycles, fluctuations in manufacturing capacity and pricing and
margin pressures, all of which cause it to be volatile. As a result, the
electronics industry has historically experienced sudden and unexpected
downturns, at which time the number of new system and IC design projects
decrease. Because most of the Company's sales occur upon the commencement of
new projects for system and IC products, the Company is dependent upon the
rate of commencement of new system and IC design projects. Accordingly,
negative factors affecting the electronics industry could have a material
adverse effect on the Company's results of operations.
 
  Dependence Upon Certain Suppliers--Certain key components used in the
Company's products are presently available from sole or limited sources. The
inability to develop alternative sources for these sole or limited source
components or to obtain sufficient quantities of these components could result
in delays or reductions in product shipments which could adversely affect the
Company's operating results. The Company's systems use proprietary ASICs and
FPGAs that are currently manufactured solely by American Microsystems, Inc.
("AMI") and Xilinx, Inc. ("Xilinx"), respectively.
 
  The Company generally purchases these components, including semiconductor
memories used in the Company's simulator and emulator hardware, pursuant to
purchase orders placed from time to time in the ordinary course of business
and has no supply arrangements with any of its source suppliers that require
the suppliers to provide components in guaranteed quantities or at set prices.
Moreover, the manufacture of these components can be extremely complex, and
the Company's reliance on the suppliers of these components exposes the
Company to production difficulties and quality variations that may be
experienced by these suppliers. Therefore, the Company's reliance on its sole
and limited source suppliers involves several risks, including a potential
inability to obtain an adequate supply of required components, reduced control
over pricing and timely
 
                                      15
<PAGE>
 
delivery and quality of acceptable components. While the timeliness and
quality of deliveries to date from such suppliers have been acceptable, there
can be no assurance that problems will not occur in the future. Any prolonged
inability to obtain components or subassemblies in sufficient quantities or
quality or on favorable pricing or delivery terms, or any other circumstances
that would require the Company to seek alternative sources of supply, could
have a material adverse effect on the Company's operating results and could
damage the Company's relationships with its customers.
 
  Customer Concentration--A relatively limited number of customers have
historically accounted for a substantial portion of the Company's net
revenues. During fiscal 1998, 1997 and 1996, sales to the Company's top ten
customers accounted for approximately 45%, 52% and 65%, respectively, of the
Company's net revenues. The Company expects that sales of its products to a
limited number of customers will continue to account for a high percentage of
net revenues for the foreseeable future. The loss of a major customer or any
reduction in orders by such customers, including reductions due to market or
competitive conditions in the electronics or EDA industries, would have an
adverse effect on the Company's results of operations. Moreover, the Company's
ability to increase its sales will depend in part upon its ability to obtain
orders from new customers, as well as the financial condition and success of
its existing customers and the general economy. There can be no assurance that
such increases will occur.
 
  Year 2000 Considerations--The Year 2000 issue is the result of computer
programs being written using two digits rather than four to define the
applicable year. As such there is the risk that computer programs or hardware
that have date-sensitive software or embedded chips may recognize a date using
"00" as the year 1900 rather than the year 2000. Such recognition, could
result in miscalculations, classifications errors or system failures. The
Company has taken steps to review, update or confirm such update of all of the
systems (IT and Non IT) which use date-sensitive computerized information used
in its operations, including its current products, vendor and customer
systems. The Company has completed its assessment and testing for Year 2000
compliance within its current product lines and all future products are being
designed and tested to be Year 2000 compliant. The costs associated with this
assessment and testing have been immaterial and have not materially impacted
other non-Year 2000 IT projects. The Company has completed its assessments of
its significant third party systems, including its IT systems and other vendor
systems and believe such systems are in compliance. The Company is currently
in the process of performing its testing of such systems to confirm
compliance. The Company does not believe that the costs incurred to date or
expected to be incurred in the future in addressing this matter are material
to the Company's operating results. However, if the Company has failed to
adequately address any of its systems or if its vendor or customer systems
fail to adequately address this risk, the Company's financial condition and
results of operations could be adversely affected. The Company currently does
not have a contingency plan completed and is currently reviewing initial
drafts of such plans. Accordingly, the Company will continue to devote the
necessary resources to the issue.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  Since inception, the Company has financed its operations, including
increases in accounts receivable and inventory and capital equipment
acquisitions, primarily through private and public sales of equity securities
and a loan secured by capital equipment. The Company's cash, cash equivalents
and short-term investments decreased to $15,682,000 at October 3, 1998 from
$24,815,000 at September 27, 1997. The decrease was a result of $3,482,000
cash provided by operating activities offset by $10,225,000 used in investing
activities (excluding short-term investment activities) and $2,390,000 of cash
used in financing activities.
 
  Operating Activities--The Company's operating activities provided cash of
$3,482,000 during fiscal 1998, $7,161,000 during fiscal 1997, and $10,411,000
in fiscal 1996. The $3,482,000 cash provided by operations was primarily due
to net loss adjusted for special charges, depreciation and amortization,
deferred tax assets adjustments, a decrease in accounts receivable and
inventory and increases in accounts payable, income taxes payable and deferred
revenues offset by payments on accrued payroll. For fiscal 1997, the net cash
provided by operating activities primarily resulted from the net income
adjusted for special charges related to the Zycad
 
                                      16
<PAGE>
 
technology purchase plus depreciation and amortization offset by increases in
accounts receivable, inventory and a decrease in accounts payable. For fiscal
1996, net cash provided by operating activities resulted primarily from net
income adjusted for the purchase of in-process research and development
related to the purchase of VMW plus depreciation and amortization partially
offset by the adjustment for deferred tax assets. In addition, the increase
was impacted by increases in accounts payable, accrued payroll and related
expenses, income taxes, and deferred revenues offset by increases in accounts
receivable and inventories.
 
  Investing Activities--Net cash used in investing activities for fiscal 1998,
1997 and 1996 was $2,413,000, $10,172,000 and $28,042,000, respectively. The
primary use of cash during fiscal 1998 consisted of approximately $3,235,000
in capital expenditures, $500,000 related to the acquisition of Deerbrook
Systems, Inc. and $6,490,000 related to the acquisition of technology from
Interra, Inc. This use of cash for investment activities was offset by the net
maturities of short-term investments totaling $7,812,000. The primary uses of
cash during fiscal 1997, was the $7,289,000 paid for the acquisition of
technology from Zycad and capital expenditures of approximately $2,192,000.
For fiscal 1996, a significant use of cash resulted from the acquisition of
VMW which totaled $10,712,000 and capital expenditures totaling $3,142,000.
The purchases and maturities of short-term investments resulted in a net use
of cash in the amount $14,188,000 for investment purposes in fiscal 1996. For
each period presented, capital expenditures were primarily for evaluation
equipment and engineering workstations. The Company expects continued capital
expenditures during fiscal 1999 as expected headcount additions will require
additional computers and engineering workstations.
 
  Financing Activities--Net cash used in financing activities for the year
ended October 3, 1998, was $2,390,000 and was primarily related to the net
purchases of stock during the year. During fiscal 1998, the Company announced
its intention to repurchase up to 1,000,000 shares of its outstanding common
stock on the open market. Through October 3, 1998, the Company had repurchased
approximately 386,500 shares at a weighted-average per share price of $6.92.
In addition, the Company repaid its remaining principal debt obligations
totaling $350,000. During fiscal 1997 and 1996, the Company's financing
activities provided cash of $1,907,000 and $20,916,000, respectively. Cash
provided from financing activities during fiscal 1997 were primarily related
to proceeds of $2,451,000 from the exercise of options to purchase common
stock under the Company's stock option and purchase plans. Such proceeds were
offset by the payment of $750,000 on outstanding debt obligations. During
fiscal 1996, the Company completed two public stock offerings, issuing
approximately 1,743,000 shares of common stock while receiving net proceeds of
approximately $20,177,000.
 
  The Company's primary unused sources of funds at October 3, 1998 consisted
of $8,165,000 of cash and cash equivalents, in addition to $7,517,000 of
short-term investments. The Company is in the process of obtaining a general
working line of credit and equipment line of credit. While these arrangements
are not yet in place, the Company believes that its current cash, cash
equivalents and short-term investments, together with cash and cash
equivalents generated from operations will be sufficient to finance its
operations for at least the next twelve months and such financing arrangement
will further assist the Company in funding its operating, investing and
financing activities. There can be no assurances that such financing will be
available on terms favorable or acceptable to the Company.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  As of October 3, 1998, the Company's investment portfolio consists of money
market funds, certificates of deposits, U.S. corporate overnight securities,
commercial paper and other corporate obligations generally due within one
year. The Company's primary objective with its investment portfolio is to
invest available cash while preserving principal and meeting liquidity needs.
In accordance with the Company's investment policy, the Company places
investments with high credit quality issues and limits the amount of credit
exposure to any one issuer. These securities, which approximate $12,720,000
and have an average interest rate of approximately 5%, are subject to interest
rate risks. However, based on the investment portfolio contents and the
ability of the Company to hold these investments until maturity, the Company
believes that if a significant change in interest rates were to occur, it
would not have a material effect on the Company's financial condition,
although there can be no assurance of this.
 
                                      17
<PAGE>
 
  In addition to its cash equivalents and short-term investments, the Company
enters into derivative financial instruments such as forward exchange
contracts to hedge certain identifiable receivables denominated in Japanese
yen. The Company's accounting policies for these contracts are based on the
Company's designation of the contracts as hedging transactions. The criteria
the Company uses for designating a contract as a hedge includes the contract's
effectiveness in risk reduction and one-to-one matching of derivative
instruments to underlying transactions. As such, the impact of exchange rate
changes on these contracts is offset by the impact of the changes in the rate
on the underlying transactions. Therefore, any market risks associated with
these contracts and related underlying transactions are deemed minimal. As of
October 3, 1998, the Company had six foreign forward contract outstanding
covering approximately $865,000 of the Company's yen designated receivables
maturing within a year.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The Company's Financial Statements and Schedules, and the report of the
independent auditors appear on pages F-1 through F-17 and S-1 of this Form
10-K.
 
  The Company's Supplementary Data--Unaudited Selected Quarterly Financial
Data appears on F-17 of this Form 10-K.
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
  Not applicable.
 
                                   PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The information contained on pages 4 and 5 of the Company's Definitive Proxy
Statement related to the Annual Meeting of Stockholders to be held January 22,
1999, to be filed by the Company with the Securities and Exchange Commission
(the "Proxy Statement") with respect to the directors of the Company is
incorporated herein by reference. Information with respect to executive
officers of the Company is contained in Part I of this report.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  The information required by this Item is incorporated by reference to the
section captioned "EXECUTIVE COMPENSATION AND OTHER MATTERS" contained in the
Proxy Statement.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information required by this Item is incorporated by reference to the
section captioned "GENERAL INFORMATION--Security Ownership of Certain
Beneficial Owners and Management" contained in the Proxy Statement.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  Not applicable.
 
                                      18
<PAGE>
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
  (a) The following financial documents of the Registrant are filed as part of
this report:
 
    (1) Financial Statements:
 
<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
<S>                                                                         <C>
Report of Ernst & Young LLP, Independent Auditors.........................  F-1
 
Consolidated Balance Sheets, October 3, 1998 and September 27, 1997.......  F-2
 
Consolidated Statements of Operations for the fiscal years ended October
 3, 1998, September 27, 1997 and September 28, 1996.......................  F-3
 
Consolidated Statements of Stockholders' Equity for the fiscal years ended
 October 3, 1998,
 September 27, 1997 and September 28, 1996................................  F-4
 
Consolidated Statements of Cash Flows for the fiscal years ended October
 3, 1998, September 27, 1997 and September 28, 1996.......................  F-5
 
Notes to Consolidated Financial Statements................................  F-6
</TABLE>
 
    (2) Financial Statement Schedule:
 
<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
<S>                                                                         <C>
Schedule II--Valuation and Qualifying Accounts............................. S-1
</TABLE>
 
  All other schedules are omitted because they are not applicable or the
required information is shown in the Financial Statements or notes thereto
which are included herein.
 
    (3) Exhibits:
 
      See Index to Exhibits beginning on Page 21 of this report.
 
  (b) The Company filed no reports on Form 8-K during the fourth quarter ended
October 3, 1998.
 
                                      19
<PAGE>
 
                                  SIGNATURES
 
  PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED
ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
 
                                          IKOS Systems, Inc.
 
                                                     /s/ Ramon Nunez
                                          _____________________________________
                                                      Ramon Nunez,
                                           Chief Executive Officer, President
                                                      and Director
                                                    December 16, 1998
 
                               POWER OF ATTORNEY
 
  Each of the officers and directors of IKOS Systems, Inc. whose signature
appears below hereby constitutes and appoints Ramon A. Nunez and Joseph W.
Rockom and each of them, their true and lawful attorneys and agents, with full
power of substitution, each with power to act alone, to sign and execute on
behalf of the undersigned any amendment or amendments to this Report on Form
10-K and to perform any acts necessary in order to file such amendment or
amendments and each of the undersigned does hereby ratify and confirm all that
said attorneys and agents or their or his substitutes, shall do or cause to be
done by virtue hereof.
 
  PURSUANT TO REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT
HAS BEEN SIGNED ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE
DATE INDICATED.
 
<TABLE>
<CAPTION>
             SIGNATURE                           TITLE                    DATE
             ---------                           -----                    ----
 
<S>                                  <C>                           <C>
  /s/ Ramon Nunez                    Chief Executive Officer,      December 16, 1998
____________________________________  President and Director
   (Ramon Nunez)
 
  /s/ Gerald S. Casilli              Chairman of the Board         December 16, 1998
____________________________________
   (Gerald S. Casilli)
 
  /s/ Joseph W. Rockom               Vice President of Finance     December 16, 1998
____________________________________  and Administration and
   (Joseph W. Rockom)                 Chief Finance Officer
                                      (Principal Accounting and
                                      Financial Officer) and
                                      Secretary
 
  /s/ James R. Oyler                 Director                      December 16, 1998
____________________________________
   (James R. Oyler)
 
  /s/ Glenn E. Penisten              Director                      December 16, 1998
____________________________________
   (Glenn E. Penisten)
</TABLE>
 
                                      20
<PAGE>
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
 EXH. NO.                   DOCUMENTATION DESCRIPTION                     PAGE
 --------                   -------------------------                     ----
 <C>      <S>                                                             <C>
    2.1   Agreement and Plan of Reorganization among the Company, VMW
          Acquisition Corporation and VMW dated May 14, 1996
          (Incorporated by reference to Exhibit 2.1 of the Company's
          registration statement on Form S-3 effective June 26, 1996).
 
 
    2.2   Technology Purchase Agreement dated May 12, 1998 by and
          between the Company and Interra, Inc. (Incorporated by
          reference to Exhibit 2.1 of the Company's Current Report on
          Form 8-K filed May 20, 1998).
 
 
    3.1   Certificate of Incorporation (Incorporated by reference to
          Exhibit 3.1 of the Company's registration statement on Form
          S-1 effective July 25, 1990).
 
 
    3.2   Certificate of Amendment of Certificate of Incorporation
          filed May 5, 1994 (Incorporated by reference to Exhibit 4.1
          of the Company's registration statement on Form S-2 effective
          October 12, 1995).
 
 
    3.3   Certificate of Amendment of Certificate of Incorporation
          filed April 24, 1995 (Incorporated by reference to Exhibit
          4.2 of the Company's registration statement on Form S-2
          effective October 12, 1995).
 
 
    3.4   Certificate of Amendment of Certificate of Incorporation
          filed February 3. 1997 (Incorporated by reference to Exhibit
          3.4 of the Company's quarterly report on Form 10-Q for the
          quarter ending March 29, 1997).
 
 
    3.5   By laws (Incorporated by reference to Exhibit 3.2 of the
          Company's registration statement on Form S-1 effective July
          25, 1990).
 
 
    4.1   Rights agreement dated as of January 27, 1992 between the
          Company and Manufacturers Hanover Trust Company of
          California, Rights Agent. (Incorporated by reference to
          Exhibit (C)1, in the Company's report on Form 8-K filed
          February 10, 1992).
 
 
   10.1   Lease Agreement for the Company's principal facility dated
          March 20, 1992, between Ames Avenue Associates and the
          Company, as amended. (Incorporated by reference to Exhibit
          10.1 of the Company's annual report on 10-K for the year
          ending September 26, 1992).
 
 
   10.2   Form of Director and Officer Indemnity Agreement.
          (Incorporated by reference to Exhibit 10.6 of the Company's
          registration statement on Form S-1 effective July 25, 1990).
 
 
   10.3   1988 Stock Option Plan. (Incorporated by reference to Exhibit
          10.14 of the Company's registration statement on Form S-1
          effective July 25, 1990).
 
 
   10.4   Patent Cross License Agreement dated May 17, 1989 with Zycad
          Corporation (Incorporated by reference to Exhibit 10.20 of
          the Company's registration statement on Form S-1 effective
          July 25, 1990).
 
 
   10.5   International Distributorship Agreement dated April 11, 1988,
          with C. Itoh & Co., Ltd. (Incorporated by reference to
          Exhibit 10.24 of the Company's registration statement on Form
          S-1 effective July 25, 1990). Confidential Treatment has been
          granted as to certain portions of this Exhibit.
 
 
   10.6   OEM Software License Agreement between CAD Language Systems,
          Inc. and IKOS Systems, Inc. dated June 22, 1989 and amendment
          dated September 1991 (Incorporated by reference to Exhibit
          10.18 of the Company's Annual Report for the year ended
          September 28, 1991).
</TABLE>
 
                                       21
<PAGE>
 
<TABLE>
<CAPTION>
 EXH. NO.                   DOCUMENTATION DESCRIPTION                     PAGE
 --------                   -------------------------                     ----
 <C>      <S>                                                             <C>
  10.7    Technology Transfer and Joint Development Agreement with
          Racal-Redac, Inc. dated July 1, 1993 (Incorporated by
          reference to Exhibit 10.19 of the Company's quarterly report
          on Form 10-Q for the quarter ended July 3, 1993).
          Confidential Treatment has been granted as to certain
          portions of this Exhibit.
 
 
  10.8    Settlement Agreement and Release dated March 31, 1994 between
          Racal Redac, Inc. and the Company (Incorporated by reference
          to Exhibit 10.13 of the Company's registration statement on
          Form S-2 effective October 12, 1995).
 
 
  10.9    Software License Agreement with Compass Design Automation
          dated December 31, 1993 (Incorporated by reference to Exhibit
          10.17 of the Company's quarterly report on Form 10-Q for the
          quarter ended January 1, 1994).
 
 
  10.10   Agreement dated June 2, 1994, by and between the Company and
          Gerald S. Casilli (Incorporated by reference to Exhibit 10.18
          of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
 
 
  10.11   Agreement dated June 2, 1994, by and between the Company and
          Daniel R. Hafeman (Incorporated by reference to Exhibit 10.18
          of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
 
 
  10.12   Agreement dated June 2, 1994, by and between the Company and
          Stephen McLaughlin. (Incorporated by reference to Exhibit
          10.18 of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
 
 
  10.13   Agreement dated June 2, 1994, by and between the Company and
          Larry A. Melling (Incorporated by reference to Exhibit 10.18
          of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
 
 
  10.14   Agreement dated June 2, 1994, by and between the Company and
          Ramon A. Nunez (Incorporated by reference to Exhibit 10.18 of
          the Company's quarterly report on Form 10-Q for the quarter
          ended July 2, 1994).
 
 
  10.15   Agreement dated June 2, 1994, by and between the Company and
          Joseph W. Rockom (Incorporated by reference to Exhibit 10.18
          of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
 
 
  10.16   The Company's 1995 Outside Directors Stock Option Plan
          (Incorporated by reference to Exhibit 10.22 of the Company's
          registration statement on Form S-2 effective October 12,
          1995).
 
 
  10.17   Development and OEM Agreement for Verilog/IKOS Co-simulation
          Interface dated August 26, 1994 by and between the Company
          and Precedence Incorporated (Incorporated by reference to
          Exhibit 10.24 of the Company's registration statement on Form
          S-2 effective October 12, 1995).
 
 
  10.18   Amendment to OEM Agreement for the acquisition of certain
          software technology, by and between Compass Design
          Automation, Inc. and the Company dated December 27, 1995
          (Incorporated by reference to Exhibit 10.20 of the Company's
          quarterly report on Form 10-Q for the quarter ended December
          30, 1995).
 
 
  10.19   Amended and Restated Employment Agreement dated August 1,
          1995 by and between the Company and Ramon Nunez (Incorporated
          by reference to Exhibit 10.21 of the Company's quarterly
          report on Form 10-Q for the quarter ended December 30, 1995).
</TABLE>
 
                                       22
<PAGE>
 
<TABLE>
<CAPTION>
 EXH. NO.                   DOCUMENTATION DESCRIPTION                    PAGE
 --------                   -------------------------                    ----
 <C>      <S>                                                            <C>
  10.20   Patent License Agreement dated December 22, 1993 between
          Massachusetts Institute of Technology and the Company
          (Incorporated by reference to Exhibit 10.20 of the Company's
          quarterly report on Form 10-Q for the quarter ended June 29,
          1996). Confidential treatment has be granted as to certain
          portions of this Exhibit.
 
 
  10.21   The Company's 1995 Stock Option Plan, as amended
          (Incorporated by reference to Exhibit 10.21 of the Company's
          Quarterly Report on Form 10-Q for the quarter ended April 4,
          1998).
 
 
  10.22   The Company's 1996 Employee Stock Purchase Plan, as amended
          (Incorporated by reference to Exhibit 10.22 of the Company's
          Quarterly Report on Form 10-Q for the quarter ended April 4,
          1998).
 
 
  21.1    List of Subsidiaries
 
 
  23.1    Consent of Ernst & Young LLP, Independent Auditors
 
 
  24.1    Power of Attorney (Included on page 20 of this report)
 
 
  27.1    Financial Data Schedule
</TABLE>
 
                                       23
<PAGE>
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
 
Board of Directors and Stockholders
IKOS Systems, Inc.
 
  We have audited the accompanying consolidated balance sheets of IKOS
Systems, Inc., as of October 3, 1998 and September 27, 1997 and the related
consolidated statements of operations, stockholders' equity, and cash flows
for each of the three fiscal years in the period ended October 3, 1998. Our
audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of IKOS Systems, Inc., at October 3, 1998 and September 27, 1997, and the
consolidated results of its operations and its cash flows for each of the
three fiscal years in the period ended October 3, 1998, in conformity with
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material
respects the information set forth therein.
 
                                          Ernst & Young LLP
 
San Jose, California
October 27, 1998
 
                                      F-1
<PAGE>
 
                               IKOS SYSTEMS, INC.
 
                          CONSOLIDATED BALANCE SHEETS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                       OCTOBER 3, SEPTEMBER 27,
                                                          1998        1997
                                                       ---------- -------------
<S>                                                    <C>        <C>
                        ASSETS
Current assets:
  Cash and cash equivalents...........................  $  8,165    $  9,486
  Short-term investments..............................     7,517      15,329
  Accounts receivable (net of allowances for doubtful
   accounts of $801 and $501, respectively)...........     6,033      12,228
  Inventories.........................................     3,816       4,804
  Deferred income taxes...............................       --        3,450
  Prepaid expenses and other assets...................       536         659
                                                        --------    --------
    Total current assets..............................    26,067      45,956
Equipment and leasehold improvements
  Office and evaluation equipment.....................     4,876       3,684
  Machinery and equipment.............................     9,201       7,328
  Leasehold improvements..............................       587         337
                                                        --------    --------
                                                          14,664      11,349
    Less allowances for depreciation and
     amortization.....................................    (9,342)     (7,080)
                                                        --------    --------
                                                           5,322       4,269
Intangible assets (net of amortization of $303 and
 $1,681, respectively)................................     1,559       4,626
Deferred income taxes.................................       --        1,127
Other assets..........................................       396         572
                                                        --------    --------
                                                        $ 33,344    $ 56,550
                                                        ========    ========
         LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable....................................  $  4,789    $  3,073
  Accrued payroll and related expenses................     1,854       2,437
  Accrued commissions.................................       801         742
  Income taxes payable................................     1,185       1,072
  Other accrued liabilities...........................     4,350       1,551
  Deferred revenues...................................     7,596       5,123
  Other...............................................       --          350
                                                        --------    --------
    Total current liabilities.........................    20,575      14,348
Accrued rent..........................................       156         212
 
Commitments
 
Stockholders' equity:
  Preferred stock, $.01 par value; 10,000 shares
   authorized, none issued and outstanding............       --          --
  Common stock, $.01 par value; 50,000 shares
   authorized, 8,797 and 8,611 shares issued and 8,361
   and 8,579 outstanding, respectively................        87          85
  Additional paid-in capital..........................    58,775      58,014
  Treasury stock, at cost, 436 shares in 1998 and 32
   in 1997............................................    (3,144)       (341)
  Accumulated translation adjustment..................      (314)       (231)
  Accumulated deficit.................................   (42,791)    (15,537)
                                                        --------    --------
    Total stockholders' equity........................    12,613      41,990
                                                        --------    --------
                                                        $ 33,344    $ 56,550
                                                        ========    ========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-2
<PAGE>
 
                               IKOS SYSTEMS INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                   FISCAL YEARS ENDED
                                         --------------------------------------
                                         OCTOBER 3, SEPTEMBER 27, SEPTEMBER 28,
                                            1998        1997          1996
                                         ---------- ------------- -------------
<S>                                      <C>        <C>           <C>
Net revenues
  Product..............................   $ 27,724     $46,350       $37,619
  Maintenance..........................     13,169       9,746         7,722
                                          --------     -------       -------
    Total net revenues.................     40,893      56,096        45,341
Cost of revenues
  Product..............................     12,952      10,745         8,422
  Maintenance..........................      1,782       1,707         1,430
                                          --------     -------       -------
    Total cost of revenues.............     14,734      12,452         9,852
                                          --------     -------       -------
    Gross profit.......................     26,159      43,644        35,489
Operating expenses:
  Research and development.............     14,381      10,740         8,146
  Sales and marketing..................     18,609      17,516        14,483
  General and administration...........      4,247       3,777         3,420
  Acquired in process research and
   development and special charges.....      7,600       9,202         9,600
  Amortization of intangibles..........      4,679       1,260           421
                                          --------     -------       -------
    Total operating expenses...........     49,516      42,495        36,070
                                          --------     -------       -------
Income (loss) from operations..........    (23,357)      1,149          (581)
Other income (expense):
  Interest income......................      1,031       1,198         1,058
  Interest expense.....................        --          --            (42)
  Other................................        --           71           124
                                          --------     -------       -------
    Total other income.................      1,031       1,269         1,140
                                          --------     -------       -------
Income (loss) before provision
 (benefit) for income taxes and
 extraordinary credit..................    (22,326)      2,418           559
Provision (benefit) for income taxes...      4,928       1,023        (1,892)
                                          --------     -------       -------
  Net income (loss)....................   $(27,254)    $ 1,395       $ 2,451
                                          ========     =======       =======
Earnings (loss) per share:
Basic net income (loss)................   $  (3.24)    $  0.17       $  0.33
                                          ========     =======       =======
Weighted-average shares used in
 computing basic per share amounts.....      8,418       8,408         7,383
                                          ========     =======       =======
Dilutive net income (loss).............   $  (3.24)    $  0.16       $  0.30
                                          ========     =======       =======
Weighted-average shares used in
 computing dilutive per share amounts..      8,418       8,927         8,114
                                          ========     =======       =======
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-3
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
                CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                                (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                          COMMON STOCK  TREASURY STOCK  ADDITIONAL    ACCUMULATED                     TOTAL
                          ------------- --------------   PAID-IN      TRANSLATION     ACCUMULATED STOCKHOLDERS'
                          SHARES AMOUNT SHARES AMOUNT    CAPITAL   GAINS AND (LOSSES)   DEFICIT      EQUITY
                          ------ ------ ------ -------  ---------- ------------------ ----------- -------------
<S>                       <C>    <C>    <C>    <C>      <C>        <C>                <C>         <C>
Balance at September 30,
 1995...................  5,886   $59     --     $ --    $27,025         $   9         $(19,383)    $  7,710
Issuance of stock under
 employee benefit
 plans..................    437     4     --       --      1,589           --               --         1,593
Issuance of stock in
 connection with stock
 offerings..............  1,743    18     --       --     20,159           --               --        20,177
Issuance of stock and
 warrants in connection
 with the acquisition of
 VMW....................    113     1     --       --      5,198           --               --         5,199
Income tax benefit from
 stock options
 exercised..............    --    --      --       --      1,048           --               --         1,048
Net accumulated
 translation losses.....    --    --      --       --        --            (34)             --           (34)
Net income..............    --    --      --       --        --            --             2,451        2,451
                          -----   ---    ----  -------   -------         -----         --------     --------
Balance at September 28,
 1996...................  8,179    82     --       --     55,019           (25)         (16,932)      38,144
Net issuance of stock
 under employee benefit
 plans..................    432     3     (32)    (341)    2,995           --               --         2,657
Net accumulated
 translation losses.....    --    --      --       --        --           (206)             --          (206)
Net income..............    --    --      --       --        --            --             1,395        1,395
                          -----   ---    ----  -------   -------         -----         --------     --------
Balance at September 27,
 1997...................  8,611    85     (32)    (341)   58,014          (231)         (15,537)      41,990
Net issuance of stock
 under employee benefit
 plans..................    186     2     (17)    (130)      761           --               --           633
Acquisition of treasury
 stock..................    --    --     (387)  (2,673)      --            --               --        (2,673)
Net accumlated
 translation losses.....    --    --      --       --        --            (83)             --           (83)
Net loss................    --    --      --       --        --            --           (27,254)     (27,254)
                          -----   ---    ----  -------   -------         -----         --------     --------
Balance at October 3,
 1998...................  8,797   $87    (436) $(3,144)  $58,775         $(314)        $(42,791)    $ 12,613
                          =====   ===    ====  =======   =======         =====         ========     ========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-4
<PAGE>
 
                               IKOS SYSTEMS, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
         INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS IN THOUSANDS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                   FISCAL YEARS ENDED
                                         --------------------------------------
                                         OCTOBER 3, SEPTEMBER 27, SEPTEMBER 28,
                                            1998        1997          1996
                                         ---------- ------------- -------------
<S>                                      <C>        <C>           <C>
Operating activities:
  Net income............................  $(27,254)   $  1,395      $  2,451
  Adjustments to reconcile net income to
   net cash provided by operating
   activities:
    Depreciation and amortization.......     7,189       2,775         1,583
    Accumulated translation
     adjustments........................       (83)       (206)          (34)
    Special charges.....................     7,600       9,202         9,600
    Gain (loss) on retirement of
     equipment..........................       --            4            27
    Deferred income taxes...............     4,577         735        (5,312)
    Deferred rent.......................       (56)        (25)          (14)
Changes in operating assets and
 liabilities:
  Accounts receivable...................     6,195      (3,035)       (3,147)
  Inventories...........................       988      (1,290)       (2,186)
  Prepaid expenses and other current
   assets...............................       123        (122)         (266)
  Other assets..........................       176        (367)          (92)
  Accounts payable......................     1,716      (1,702)        3,162
  Accrued payroll and other expenses....      (583)         31         1,211
  Accrued commissions...................        59          17            28
  Income taxes payable..................       113        (673)        2,571
  Other accrued liabilities.............       249         254            16
  Deferred revenues.....................     2,473         168           813
                                          --------    --------      --------
    Net cash provided by operating
     activities.........................     3,482       7,161        10,411
Investing activities:
  Purchases of equipment and leasehold
   improvements.........................    (3,235)     (2,192)       (3,142)
  Purchase of Deerbrook Systems, Inc....      (500)        --            --
  Purchase of Interra, Inc. technology..    (6,490)        --            --
  Purchase of Zycad technology..........       --       (7,289)          --
  Purchase of Virtual Machine Works,
   Inc..................................       --          --        (10,712)
  Purchase of short-term investments....   (14,047)    (30,347)      (25,393)
  Maturities of short-term investments..    21,859      29,656        11,205
                                          --------    --------      --------
    Net cash used in investment
     activities.........................    (2,413)    (10,172)      (28,042)
Financing activities:
  Principal payments on long-term
   borrowings...........................      (350)       (750)         (888)
  Net sale of common stock..............       633       2,657        21,804
  Acquisition of treasury stock.........    (2,673)        --            --
                                          --------    --------      --------
    Net cash provided by (used in)
     financing activities...............    (2,390)      1,907        20,916
                                          --------    --------      --------
Increase (decrease) in cash and cash
 equivalents............................    (1,321)     (1,104)        3,285
Cash and cash equivalents at beginning
 of period..............................     9,486      10,590         7,305
                                          --------    --------      --------
Cash and cash equivalents at end of
 period.................................  $  8,165    $  9,486      $ 10,590
                                          ========    ========      ========
Supplemental disclosures of cash flow
 information:
  Cash paid for income taxes............  $    337    $    311      $    704
  Cash paid for interest................       --          --       $     42
Supplemental disclosure of noncash
 financing activities:
  Issuance of commons stock under
   employee benefit plans in exchange
   for common stock.....................  $    130    $    341           --
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-5
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                                OCTOBER 3, 1998
 
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  Nature of operations: The Company develops, manufactures, markets and
supports hardware and software systems for the verification of integrated
circuit designs. The Company's strategy is to serve the needs of a growing
universe of IC designers for fast, accurate verification of complex IC designs
through its family of hardware and software simulation and emulation systems.
The Company performs final assembly and test of all of its products in its
Cupertino, California facility and utilizes third parties for all major
subassembly manufacturing. Certain key components used in the Company's
products are presently available from sole or limited sources. The Company is
dependent upon these suppliers to provide these components on a timely basis.
The Company sells its products to a broad range of customers in the
communications, multimedia/graphics, semiconductor, computer, aerospace and
consumer electronics industries.
 
  Basis of presentation: The accompanying consolidated financial statements
include the Company and its wholly owned subsidiaries after elimination of all
significant inter-company accounts and transactions.
 
  Fiscal year: The Company is on a 52-53 week fiscal year. Accordingly,
October 3, 1998, September 27, 1997 and September 28, 1996 are the fiscal
year-ends for 1998, 1997 and 1996, respectively. Fiscal year 1998 is a 53 week
fiscal year.
 
  Cash equivalents and short-term investments: All liquid investments with
original maturities of three months or less when purchased are considered to
be cash equivalents and are stated at cost, which approximates their fair
value. At October 3, 1998, cash equivalents consisted of money market funds,
certificates of deposits and U.S. corporate overnight securities. Short-term
investments are stated at cost, which approximates market, and consist
primarily of commercial paper and other corporate obligations all due within
one year. The Company is exposed to credit risks in the event of default by
the financial institutions or issuers of investments to the extent of amounts
recorded on the balance sheet.
 
  Under Statements of Financial Accounting Standards No. 115 (FAS 115),
"Accounting for Certain Investments in Debt and Equity Securities," debt
securities that the Company has both positive intent and ability to hold to
maturity are carried at amortized cost. Debt securities that the Company does
not have the positive intent and ability to hold to maturity and all
marketable equity securities are classified as available-for-sale or trading
and carried at fair value. Unrealized holding gains and losses on securities
classified as available-for-sale are reported as part of equity while
unrealized holding gains and losses on securities classified as trading are
reported in earnings. At October 3, 1998, all securities are designated as
held to maturity.
 
  The fair values for marketable debt securities are based on quoted market
prices. The fair value of marketable securities is substantially equal to
their carrying values as of October 3, 1998 and September 27, 1997.
 
  The following is a summary of held-to-maturity securities at October 3, 1998
and September 27, 1997 (in thousands):
 
<TABLE>
<CAPTION>
                                                       OCTOBER 3, SEPTEMBER 27,
                                                          1998        1997
                                                       ---------- -------------
     <S>                                               <C>        <C>
     U.S. Treasury Securities.........................   $  982      $   167
     U.S. Corporate Securities........................    2,910       14,481
     Mortgage-Backed Securities.......................    3,625        2,417
                                                         ------      -------
                                                         $7,517      $17,065
                                                         ======      =======
     Amounts included in short-term investments.......   $7,517      $15,329
                                                         ======      =======
     Amounts included in cash and cash equivalents....   $  --       $ 1,736
                                                         ======      =======
</TABLE>
 
 
                                      F-6
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
  Inventories: Inventories are stated at the lower of cost (first-in, first-
out method) or market (estimated net realizable value). Inventories consist of
the following (in thousands):
 
<TABLE>
<CAPTION>
                                                        OCTOBER 3, SEPTEMBER 27,
                                                           1998        1997
                                                        ---------- -------------
     <S>                                                <C>        <C>
     Raw materials.....................................   $1,520      $1,979
     Work-in-process...................................    1,163       1,385
     Finished goods....................................    1,133       1,440
                                                          ------      ------
                                                          $3,816      $4,804
                                                          ======      ======
</TABLE>
 
  Equipment and leasehold improvements: Equipment and leasehold improvements
are stated at cost and are depreciated or amortized using the straight-line
method over the estimated useful life (generally two to five years) of the
related asset, or in the case of leasehold improvements, the term of the
lease, if shorter.
 
  Goodwill and software development costs and other long-lived assets: The
Company periodically reviews and evaluates its recorded goodwill and other
long-lived assets for proper valuation of the intangible asset. During the
fourth quarter of 1998, the Company evaluated and concluded that based on the
strategic changes and the current form of the emulation technology, the
original technology acquired from Virtual Machine Works, Inc. (VMW) would no
longer be used, and thus, the unamortized intangibles associated with the
original transaction were written off. The Company recorded a charge to
operations of approximately $3,200,000. There were no write-downs of
intangibles in fiscal 1997 or 1996.
 
  The Company capitalizes software development costs upon achievement of
technological feasibility, subject to net realizable value considerations in
accordance with Statement of Financial Accounting Standards No. 86. The
Company has defined technological feasibility as completion of a working
model. Such capitalized costs are amortized upon product release on a
straight-line basis over the estimated useful life of two years or the ratio
of current revenue to the total of current and anticipated future revenues,
whichever is greater. For the three fiscal years ended October 3, 1998
capitalizable costs were insignificant and thus charged to research and
development expenses for the respective periods in the accompanying financial
statements. For fiscal 1998, 1997 and 1996, all previously capitalized costs
had been amortized.
 
  Revenue recognition: Product revenues, which include licensing and software
revenues, are generally recognized on shipment, provided that no significant
vendor or post-contract support obligations remain outstanding and collection
of the resulting receivable is deemed probable. Insignificant vendor and post-
support obligations are accrued upon shipment. Revenue under maintenance
contracts is recognized ratably over the term of the related contract,
generally twelve months. Revenue recognized under consulting arrangements are
generally recognized upon the achievement of agreed upon milestones.
 
  Warranty: The Company warrants products sold to customers for ninety days
from shipment. A provision for the estimated future cost of warranty is
recorded upon shipment.
 
  Employee stock plans: The Company accounts for its stock option and employee
stock purchase plans in accordance with provisions of the Accounting
Principles Board's Opinion No. 25 (APB 25), "Accounting for Stock Issued to
Employees." Accordingly, no compensation expense has been recognized for its
fixed cost stock option plans or its associated stock purchase plan when the
exercise price is equal to the fair value on the date of grant. The Company
provides additional pro forma disclosures as required under Statement of
Financial Accounting Standard No. 123 "Accounting for Stock Based
Compensation."
 
                                      F-7
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
 
  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 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.
Such estimates related to the useful lives of fixed assets, allowances for
doubtful accounts and customer returns, inventory write-downs, other reserves
and income tax valuation allowances. Actual results inevitably will differ
from those estimates, and such differences may be material to the financial
statements.
 
  Translation of foreign currencies: For foreign operations with the local
currency as the functional currency, the translation of the applicable foreign
currencies into U.S. dollars is performed for balance sheet accounts using
current exchange rates in effect at the balance sheet date and for revenue and
expense accounts using an average exchange rate during the period. The gains
or losses resulting from translation are included in stockholders' equity in
the accompanying balance sheets. The Company also recognizes foreign currency
transaction gains and losses at a result its international operations. Such
gains or losses are charged to operations and have been immaterial to the
Company's operating results.
 
  Derivative Financial Instruments: The Company enters into derivative
financial instruments such as forward exchange contracts to hedge certain
identifiable receivables denominated in Japanese yen against fluctuations in
exchange rates until such receivables are collected. The Company does not
enter into forward foreign contracts for speculative or trading purposes. The
Company's accounting policies for these contracts are based on the Company's
designation of the contracts as hedging transactions. The criteria the Company
uses for designating a contract as a hedge includes the contract's
effectiveness in risk reduction and one-to-one matching of derivative
instruments to underlying transactions. As such, the impact of exchange rate
changes on these contracts is offset by the impact of the changes in the rate
on the underlying transactions. Therefore, any market risks associated with
these contracts and related underlying transactions are deemed minimal. As of
October 3, 1998, the Company had six foreign forward contract outstanding
covering approximately $865,000 of the Company's yen designated receivables
maturing within one year.
 
                                      F-8
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
 
  Net income per share: During fiscal 1998, the Company adopted the Financial
Accounting Standards Board "(FASB) Statement of Financial Accounting Standards
No. 128, Earnings Per Share." The overall objective of the Statement No. 128
is to simplify the calculation of earnings per share by excluding the dilutive
effect of stock options and warrants from the "basic" earnings per share
calculation. Dilutive per share data is computed using the weighted-average
common and dilutive common equivalent shares outstanding. All earnings (loss)
per share data for all periods have been presented, and where appropriate,
restated to conform to the Statement 128 requirements. The following table
sets forth the computation of basic and dilutive per share data:
 
<TABLE>
<CAPTION>
                                                   FISCAL YEARS ENDED
                                         --------------------------------------
                                         OCTOBER 3, SEPTEMBER 27, SEPTEMBER 28,
                                            1998        1997          1996
                                         ---------- ------------- -------------
<S>                                      <C>        <C>           <C>
BASIC EARNINGS (LOSS) PER SHARE:
 Net Income (loss)......................  $(27,254)    $1,395        $2,451
                                          ========     ======        ======
 Weighted-average common shares
  outstanding...........................     8,418      8,408         7,383
                                          ========     ======        ======
 Basic net income (loss) per share......  $  (3.24)    $ 0.17        $ 0.33
                                          ========     ======        ======
DILUTIVE EARNINGS (LOSS) PER SHARE:
 Net Income (loss)......................  $(27,254)    $1,395        $2,451
                                          ========     ======        ======
 Weighted-average common shares
  outstanding...........................     8,418      8,408         7,383
 Common equivalent shares attributable
  to options (treasury stock method)....       --         519           731
                                          --------     ------        ------
 Total weighted-average common shares
  outstanding...........................     8,418      8,927         8,114
                                          ========     ======        ======
 Dilutive net income (loss) per share...  $  (3.24)    $ 0.16        $ 0.30
                                          ========     ======        ======
</TABLE>
 
  Outstanding options to purchase approximately 1,681,000, 779,000, and
655,000 shares, for the fiscal years 1998, 1997 and 1996, respectively, under
the Company's Stock Option Plan were not included in the treasury stock
calculation to derive diluted income per share as their inclusion would have
had an anti-dilutive effect.
 
  Impact of recently Issued Accounting Standards: In June 1997, the Financial
Accounting Standards Boards issued Statement of Financial Accounting Standards
No. 130, "Reporting Comprehensive Income" ("SFAS 130"), which establishes
standards for reporting and displaying comprehensive income and its components
in a full set of general purpose statements and is expected to be first
reflected in the Company's first quarter 1999 interim financial statements.
The adoption of SFAS 130 is not expected to materially impact the Company's
results of operation or financial position.
 
  In June 1997, the Financial Accounting Standards Board also issued Statement
of Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131"), which established standards
for the way public enterprises report information in annual statements and
financial reports regarding operating segments, products, services, geographic
areas, and major customers. SFAS 131 will be first reflected in the Company's
1999 Annual Report. The adoption of SFAS 131 is not expected to materially
impact the Company's results of operation or financial position.
 
  In March 1998, the American Institute of Certified Public Accounts issued
Statement of Position 98-1, "Accounting for the Costs of Computer Software
Developed for Obtained for Internal Use" ("SOP 98-1"), which provides
guidelines for accounting for costs of computer software developed for
internal use. SOP 98-1 is effective for financial statements for fiscal years
beginning after December 15, 1998. The adoption of SO 98-1 is not expected to
materially impact the Company's results of operation or financial position.
 
                                      F-9
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
 
  In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"), which is required to be adopted in years
beginning after June 15, 1999. The adoption of SFAS 133 is not expected to
materially impact the Company's results of operations or its financial
position.
 
  Reclassifications: Certain items in the fiscal 1997 and 1996 financial
statements have been reclassified to conform to the fiscal 1998 presentation.
 
2. ACQUISITIONS
 
  Virtual Machine Works, Inc.: In May 1996, the Company completed the
acquisition of VMW, a development stage company and a developer of logic
emulation systems. Under the terms of the acquisition, the Company paid
approximately $10,712,000 in cash and issued approximately 113,000 shares of
common stock to the former stockholders of VMW. The transaction was treated as
a purchase; accordingly the purchase price was allocated to the tangible
assets acquired, goodwill and liabilities assumed at their fair market values
using a risk adjusted discounted cash flows approach. In connection, with the
acquisition, the Company recorded a charge of approximately $9,600,000 for the
acquisition of in-process research and development during the third quarter of
fiscal 1996. During 1998, the Company abandoned the original technology. As
such, the Company recorded a charge to operations to write-off the remaining
unamortized value of the intangible. Prior to the write-off, the Company
recorded amortization of $977,000 relating to capitalized intangible assets in
fiscal 1998 amortization of $1,260,000 and $421,000 in fiscal 1997 and 1996,
respectively.
 
  Zycad Corporation: In April and August 1997, the Company completed the
purchase of certain software and hardware simulation technology from Zycad
Corporation for approximately $7,600,000 in cash. The technology acquisition
was charged to operations.
 
  Interra, Inc.: In May 1998, the Company acquired certain technology and
research and development expertise from Interra, Inc. and its affiliate,
Delsoft India Pvt. Limited. The purchase price paid, including costs of the
transaction, was approximately $9,000,000. Through November 30, 1998, the
Company has paid approximately $7,340,000 with the remaining $1,700,000 to be
paid in two equal installments through November 1999. The Company recorded a
charge of approximately $7,600,000 related to the acquired technology to in-
process research and development. The evaluation of the underlying technology
acquired considered the inherent difficulties and uncertainties in completing
the development of the technology, and thereby achieving technological
feasibility, and the risks related to the viability of and potential changes
in future target markets. The underlying technology had no alternative use (in
other research and development projects or otherwise) since the technology was
acquired for the sole purpose of developing simulation and emulation products.
In connection with the technology acquisition, the Company recorded as an
asset approximately $1,400,000 for the acquired workforce and other
intangibles, which are to be amortized over 8 years.
 
3. LONG-TERM DEBT
 
  Racal-Redac Agreement--In July 1993, the Company and Racal-Redac, Inc.
("Racal") amended the May 1991 Technology Transfer and Joint Development
Agreement which provided for the exchange of certain VHDL technologies and for
the joint ownership in certain Racal technology for cash, common stock and
future payments based on future sales. Under the terms of the July agreement
the original agreement was amended to require payments of $3,600,000 (payable
over four years) in lieu of the future payments based on product sales. As of
October 3, 1998 all amounts had been paid in full.
 
                                     F-10
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
 
4. COMMITMENTS
 
  Non-cancelable operating leases include building leases, which expire in
September 2000. The Company has the option to renew its building lease at its
principal offices for up to an additional nine years, commencing in September
2000, at the fair market value at the time of renewal. The Company subleased
certain facilities through April of fiscal 1997. Sublease rental income was
approximately $67,000 and $122,000 in fiscal 1997, and 1996, respectively.
 
  Rent expense approximated $1,633,000, $1,153,000, and $975,000 in fiscal
1998, 1997 and 1996, respectively.
 
4. COMMITMENTS
 
  Future minimum payments under non cancelable operating leases at October 3,
1998 are as follows (in thousands):
 
<TABLE>
<CAPTION>
     FISCAL YEAR                                                          AMOUNT
     -----------                                                          ------
     <S>                                                                  <C>
     1999................................................................  1,163
     2000................................................................    816
     Total............................................................... $1,979
</TABLE>
 
5. STOCKHOLDERS' EQUITY
 
  Common stock: In October 1995, the Company sold 1,150,000 shares of common
stock in a public offering resulting in net proceeds to the Company of
approximately $10,450,000. In July 1996, the Company completed a second
offering of common stock whereby approximately 593,000 shares of common stock
were sold resulting in net proceeds to the Company of approximately
$9,727,000.
 
  Preferred Stock Purchase Rights Plan: The Company has a Preferred Stock
Purchase Rights Plan (the "Rights Plan") which provides existing shareholders
with the right to purchase 1/100 preferred share for each common share held in
the event of certain changes in the Company's ownership. The Rights Plan may
serve as a deterrent to takeover tactics, which are not in the best interests
of shareholders. The Board of Directors of the Company has designated 500,000
shares of Series G Preferred Stock, $0.01 par value per share, and has
reserved such shares for issuance pursuant to the Company's Rights Plan.
 
  Stock Repurchase: During fiscal 1998, the Company announced its intention to
repurchase up to 1,000,000 shares of its outstanding common stock on the open
market. Through December 5, 1998, the Company had repurchased 516,500 shares
at a weighted-average per share price of $5.96.
 
  VMW Acquisition: In connection with the acquisition of VMW, the Company
granted options to purchase approximately 84,000 shares of common stock in
exchange for VMW options. The option prices range from $0.85--$2.54 and are
included in the grants in the table below. In connection with the acquisition,
the Company also issued warrants to purchase 25,000 shares of common stock at
$23.50 per share in return for professional services rendered. These warrants,
which were valued at approximately $200,000, are included as consideration in
connection with the acquisition. These warrants expire on April 19, 2001.
 
  At October 3, 1998, options to purchase approximately 16,000 shares of
common stock and warrants to purchase 25,000 shares of common stock remain
outstanding. The Company has reserved approximately 41,000 shares of common
stock for issuance in connection with these options and warrants.
 
                                     F-11
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
 
  Stock option plans: In 1988, the Company established a Stock Option Plan
(the Plan) which provides for the granting of options to employees or
directors to purchase shares of the Company's common stock. During fiscal
1996, the Company replaced the 1988 Stock Option Plan by establishing the 1995
Stock Option Plan (the "1995 Plan"). The terms of the 1995 Plan are similar to
the 1988 Plan. Any shares remaining available for grant under the 1988 Plan
were converted to the 1995 Plan, and an additional 750,000 shares were
reserved for future grants under the 1995 Plan. During 1997 and 1998, an
additional 450,000 and 430,000 shares were reserved for future grants under
the 1995 Plan, respectively. In connection with its 1997 Annual Shareholders
meeting, the Company obtained approval whereby on the first day of each fiscal
year of the Company beginning after October 4, 1998, the maximum aggregate
number of shares of common stock issuable under the Company's 1995 plan will
increase automatically by that number of shares of common stock of the Company
equal to 4.9% of the number of shares of the Company issued and outstanding on
the last day of the preceding fiscal year.
 
  In December 1997, the Board of Directors authorized the Company to offer all
employees the opportunity to cancel certain previously granted options in
exchange for new options with new vesting and expiration terms at the then
fair market value prices of $5.75 per share. In connection with this offer,
options to purchase 891,035 shares of common stock with a weighted-average
price of $15.68 were exchanged for new options.
 
  In September 1998, the Board of Directors authorized the Company to offer
all employees the opportunity to cancel certain previously granted options in
exchange for new options with three year cliff vesting and a three year
expiration term at the then fair market value prices of $1.78 per share. In
connection with this offer, options to purchase 531,022 shares of common stock
with a weighted-average price of $6.93 were exchanged for new options.
 
  The following table summarizes the activity for the stock option plans (in
thousands, except per share data):
 
<TABLE>
<CAPTION>
                                            OPTIONS AND RIGHTS OUTSTANDING
                                        (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                       ----------------------------------------
                                        NUMBER     AGGREGATE         PRICE
                                       OF SHARES EXERCISE PRICE    PER SHARE
                                       --------- -------------- ---------------
<S>                                    <C>       <C>            <C>
Balance at September 30, 1995.........   1,206      $  5,386    $ 0.350- 13.250
  Granted.............................     863        11,115      0.850- 28.375
  Exercised...........................    (419)       (1,424)     0.350- 11.125
  Forfeitures.........................     (85)         (580)     0.850- 18.500
                                        ------      --------
Balance at September 28, 1996.........   1,565        14,497      0.850- 28.375
  Granted.............................     658        12,912     12.500- 25.125
  Exercised...........................    (339)       (1,756)     0.850- 19.125
  Forfeitures.........................    (400)       (8,018)     0.850- 28.375
                                        ------      --------
Balance at September 27, 1997.........   1,484        17,635      0.850- 28.375
  Granted.............................   2,232        10,329      1.438- 12.688
  Exercised...........................     (88)         (359)     0.850-  6.000
  Forfeitures.........................  (1,707)      (19,748)     0.850- 28.375
                                        ------      --------
Balance at October 3, 1998............   1,921      $  7,857    $ 0.850-$28.375
                                        ======      ========
</TABLE>
 
                                     F-12
<PAGE>
 
                               IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
 
  The following table summarizes information about options outstanding at
October 3, 1998:
 
<TABLE>
<CAPTION>
                                  OPTIONS OUTSTANDING                OPTIONS EXERCISABLE
                       ----------------------------------------- ----------------------------
                                      WEIGHTED-
                          NUMBER       AVERAGE                      NUMBER
                        OUTSTANDING   REMAINING     WEIGHTED-     EXERCISABLE    WEIGHTED-
       RANGE OF        AT OCTOBER 3, CONTRACTUAL     AVERAGE     AT OCTOBER 3,    AVERAGE
    EXERCISE PRICES        1998      LIFE (YEARS) EXERCISE PRICE     1998      EXERCISE PRICE
   -----------------   ------------- ------------ -------------- ------------- --------------
   <S>                 <C>           <C>          <C>            <C>           <C>
   $ 0.8500-$ 1.7500       282,757       9.77         $ 1.72          8,177        $ 0.85
     1.7813-  1.7813       529,772       9.94           1.78            --            --
     1.8125-  5.5000       334,884       6.61           3.91        262,105          3.94
     5.7500-  5.8750       576,067       9.21           5.75        154,069          5.75
     6.0000-  9.2500       178,799       8.48           8.20         62,295          8.66
    11.1250- 25.0000        19,450       7.84          17.59          2,402         13.28
                         ---------                                  -------
   $ 0.8500-$25.0000     1,921,729       8.96         $ 4.09        489,048        $ 5.11
                         =========                                  =======
</TABLE>
 
  Exercisable options were approximately 489,000, 593,000 and 544,000 at fiscal
year end for 1998, 1997 and 1996, respectively. At October 3, 1998, there were
no shares that were exercised and subject to repurchase.
 
  Vesting provisions with respect to the Stock Option Plans are determined by
the Board of Directors at the date of grant. Generally, shares issued pursuant
to the Plan vest at 12 1/2% upon an employee's six-month employment date and
ratably thereafter in monthly installments over three and one-half years. At
October 3, 1998, options to purchase approximately 489,000 shares of common
stock were vested.
 
  Included in the table above are options to purchase approximately 73,000
shares of common stock which were granted outside of the Plans during fiscal
1995. These options were granted to various employees and have rights and
vesting provisions which are the same as those granted pursuant to the plan. At
October 3, 1998, options to purchase approximately 13,000 shares of common
stock remain outstanding.
 
  Total shares reserved for grant under option plans total 3,773,000 (excluding
options subject to grant under the Outside Directors Stock Option Plan), of
which approximately 3,578,000 shares were granted, leaving approximately
195,000 shares available for grant at October 3, 1998.
 
  The Company has reserved 2,150,000 shares of common stock for future issuance
under the stock option plans for outstanding options and options available for
grant at October 3, 1998 and 13,000 shares of common stock for future issuance
of shares granted outside of the option plan.
 
  1995 Outside Directors Stock Plan: The Company's 1995 Directors Stock Option
Plan (the "Directors Plan") was adopted by the Company's Board of Directors in
June 1995 and approved in February 1996. A total of 100,000 shares of Common
Stock has been reserved for issuance under the Directors Plan. As of October 3,
1998, 52,500 shares had been granted to Directors under the plan and are
included in the table presented above.
 
  1996 Stock Purchase Plan: In fiscal 1996, the 1996 Employee Stock Purchase
Plan (ESPP) was approved and 100,000 shares of common stock was reserved for
issuance under this plan. The ESPP provides that substantially all employees
may purchase stock at 85% of its fair value on certain specified dates via a
payroll deduction plan. During 1998, the maximum aggregate number of shares of
common stock issuable under the Company's ESPP was increased by 150,000.
Through October 3, 1998, approximately 180,680 shares have been
 
                                      F-13
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
issued under this plan. A summary of stock purchased under the plan is shown
below (in thousands, except employee participants).
 
<TABLE>
<CAPTION>
                                                       1998     1997     1996
                                                     -------- -------- --------
     <S>                                             <C>      <C>      <C>
     Aggregate purchase price....................... $475,659 $961,294 $197,479
     Shares purchased...............................   97,768   64,138   18,774
     Employee participants..........................      132      146       59
</TABLE>
 
  Pro forma information regarding net income (loss) and net income (loss) per
share is required by SFAS 123 for awards granted after October 1, 1995 as if
the Company had accounted for its stock-based awards to employees under the
fair value method of SFAS 123. The fair value of the Company's stock-based
awards to employees was estimated using a Black-Scholes option pricing model.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, the Black-Scholes model requires the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's stock-based awards to employees have characteristics
significantly different from those of traded options, and because changes in
the subjective input assumptions can materially affect the fair value
estimate, in management's opinion, the existing models do not necessarily
provide a reliable single measure of the fair value of its stock-based awards
to employees. The fair value of the Company's stock-based awards to employees
was estimated assuming no expected dividends and the following weighted-
average assumptions:
 
<TABLE>
<CAPTION>
                                          OPTIONS               ESPP
                                     -------------------  -------------------
                                     1998   1997   1996   1998   1997   1996
                                     -----  -----  -----  -----  -----  -----
     <S>                             <C>    <C>    <C>    <C>    <C>    <C>
     Expected life (years)..........  3.57   2.65   2.67    0.5    0.5    0.5
     Expected stock price
      volatility.................... 70.98% 66.23% 67.04% 65.22% 68.19% 68.09%
     Risk-free interest rate........  5.47%  6.03%  5.92%  5.58%  5.82%  5.71%
</TABLE>
 
  For pro forma purposes, the estimated fair value of the Company's stock
based awards to employees is amortized over the options' vesting period (for
options) and the six month purchase period (for stock purchased under the
ESPP). The weighted-average fair value of stock options and employee stock
purchase rights granted during 1998 was $2.31 and $3.93 per share,
respectively. The weighted-average fair value of stock options and employee
stock purchase rights granted during 1997 was $8.62 and $7.53 per share,
respectively. The weighted-average fair value of stock options and employee
stock purchase rights granted during 1996 was $6.29 and $5.85 per share,
respectively.
 
  The Company's pro forma information follows (in thousands, except per share
amounts):
 
<TABLE>
<CAPTION>
                                                        1998     1997     1996
                                                      --------  -------  ------
     <S>                                              <C>       <C>      <C>
     Net income--as reported......................... $(27,254) $ 1,395  $2,451
     Net income (loss)--pro forma....................  (30,242)  (1,113)  1,480
     Net income per share--as reported...............    (3.24)    0.16    0.30
     Net income (loss) per share--pro forma..........    (3.59)   (0.13)   0.18
</TABLE>
 
  Because SFAS 123 is applicable only to awards granted subsequent to October
1, 1995, its pro forma effect will not be fully reflected until approximately
2000.
 
6. EMPLOYEE SAVINGS AND INVESTMENT PLAN
 
  During fiscal 1996, the Company amended its 401(k) savings and investment
plan in which all employees, at least 21 years of age, are eligible to
participate. The amended plan allows for the Company to make matching
 
                                     F-14
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
contributions based on an employee's elective deferrals. For fiscal 1998, the
matching contributions may not exceed $1,800 per employee, and through October
3, 1998, the matching contributions were approximately $299,000 for fiscal
1998, and $304,000 in fiscal 1997 and $62,000 in fiscal 1996.
 
7. INCOME TAXES
 
  The tax provision (benefit) for continuing operations consists of the
following (in thousands):
 
<TABLE>
<CAPTION>
                                                    FISCAL YEAR ENDED
                                          --------------------------------------
                                          OCTOBER 3, SEPTEMBER 27, SEPTEMBER 28,
                                             1998        1997          1996
                                          ---------- ------------- -------------
   <S>                                    <C>        <C>           <C>
   Federal:
     Current.............................   $  --       $ (283)       $ 2,591
     Deferred............................    3,584         740         (4,326)
                                            ------      ------        -------
                                             3,584         457         (1,735)
   State:
     Current.............................      --           35            273
     Deferred............................      993          (5)          (987)
                                            ------      ------        -------
                                               993          30           (714)
   Foreign:
     Current.............................      351         536            557
                                            ------      ------        -------
                                            $4,928      $1,023        $(1,892)
                                            ======      ======        =======
</TABLE>
 
  Pretax income (loss) from foreign operations was ($775,000) in 1998,
$1,330,000 in 1997 and $680,000 in 1996.
 
  A reconciliation between the Company's effective tax rate and the U.S.
statutory rate of 35% follows (in thousands):
 
<TABLE>
<CAPTION>
                                                  FISCAL YEAR ENDED
                                        --------------------------------------
                                        OCTOBER 3, SEPTEMBER 27, SEPTEMBER 28,
                                           1998        1997          1996
                                        ---------- ------------- -------------
   <S>                                  <C>        <C>           <C>
   Tax provision at U.S. statutory
    rate...............................  $(7,814)     $  846        $   196
   Benefit of operating loss
    carryforwards......................      --          --          (4,756)
   Change in valuation allowance.......    4,595         --             --
   Operating loss not benefited........    6,328         --             --
   Research and development credit.....      --         (229)        (1,263)
   In process research and
    development........................      --          --           3,264
   Goodwill amortization...............    1,468         442            143
   Foreign taxes.......................      351         139            261
   Foreign sales corporation benefit...      --         (181)           --
   Other individually immaterial
    items..............................      --          (13)            83
   State taxes.........................      --           19            180
                                         -------      ------        -------
                                         $ 4,928      $1,023        $(1,892)
                                         =======      ======        =======
</TABLE>
 
  As of October 3, 1998, the Company had federal and state net operating loss
carryforwards of approximately $10,400,000 and $4,223,000, respectively. The
Company also had federal and California research and
 
                                     F-15
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
development tax credit carryforwards of approximately $1,765,000 and
$1,074,000, respectively. The Company also has federal alternative minimum tax
credit carryforwards of approximately $260,000. The net operating loss and
federal research credit carryforwards will expire at various dates beginning
in 2001 through 2013, if not utilized. The California research credit
carryforwards and alternative minimum tax credit carryforwards have no
expiration date.
 
  Utilization of the net operating losses and credits may be subject to an
annual limitation due to the ownership change limitations provided by the
Internal Revenue Code of 1986, as amended, and similar state provisions. The
annual limitation could result in the expiration of net operating losses and
credits before utilization.
 
  Significant components of the Company's deferred tax assets and liabilities
are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                      OCTOBER 3, SEPTEMBER 27,
                                                         1998        1997
                                                      ---------- -------------
   <S>                                                <C>        <C>
   Deferred tax assets:
     Net operating loss carryforwards................  $  3,964     $ 2,079
     Research credits and alternative minimum tax
      credit.........................................     2,711         965
     Capitalized software............................       250         500
     Deferred revenue................................     2,209       1,655
     Purchased technology............................     6,073       3,073
     Accrued expenses and reserves...................     3,698       1,931
                                                       --------     -------
       Total deferred tax assets.....................    18,905      10,203
       Valuation allowance for deferred tax assets...   (18,905)     (5,626)
                                                       --------     -------
   Net deferred tax assets...........................  $    --      $ 4,577
                                                       ========     =======
</TABLE>
 
  As of October 3, 1998, the Company had fully offset deferred tax assets by a
valuation allowance. Management believes that such net deferred tax assets are
not realizable on a more likely than not basis. The valuation allowance
increased by $13,279,000 and $2,096,000 for the years ended October 3, 1998
and September 27, 1997, respectively. Approximately $4,500,000 of the
valuation is attributable to stock options which will be credited to equity
when realized.
 
8. GEOGRAPHIC, MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISKS
 
  The Company and its subsidiaries operate in one segment, principally the
development, manufacture, sale and service of high performance hardware-
assisted systems for simulation and emulation of integrated circuits (ICs) and
IC-based electronic systems. The Company sells its products to a broad range
of customers in the communications, multimedia/graphics, semiconductor,
computer, aerospace and consumer electronics industries. The Company performs
ongoing credit evaluations of its customers and generally does not require
collateral.
 
  The Company maintains reserves for potential credit losses and such losses
have been within management's expectations.
 
                                     F-16
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                OCTOBER 3, 1998
 
 
  Total international sales by geographic region, including export sales and
foreign net revenues, are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                    FISCAL YEAR ENDED
                                          --------------------------------------
                                          OCTOBER 3, SEPTEMBER 27, SEPTEMBER 28,
                                             1998        1997          1996
                                          ---------- ------------- -------------
     <S>                                  <C>        <C>           <C>
     Far East............................  $ 4,912      $ 6,228       $ 7,012
     Europe..............................    9,620       12,966         7,878
                                           -------      -------       -------
                                           $14,532      $19,194       $14,890
                                           =======      =======       =======
</TABLE>
 
  In fiscal 1998, one customer, Lucent Technologies, accounted for
approximately 13% of net revenues. In fiscal 1997, one customer, Lucent
Technologies, Inc., accounted for approximately 11% of net revenues. For the
fiscal year ended September 28, 1996, one customer, S3, Inc., and one
distributor, Itochu & Co. Ltd., accounted for 14% and 12% of net revenues,
respectively.
 
9. UNAUDITED QUARTERLY CONSOLIDATED FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                                  FISCAL QUARTERS ENDED
                                          --------------------------------------
                                          JAN. 3,  APRIL 4,  JULY 4,    OCT. 3,
                                            1998     1998      1998      1998
                                          -------- --------- --------  ---------
<S>                                       <C>      <C>       <C>       <C>
Net revenues............................  $12,065   $12,319  $  8,424  $  8,085
Gross profit............................    9,052     9,146     3,531     4,430
Total operating expenses................    8,620     8,793    18,574    13,529
Income (loss) from operations...........      432       353   (15,043)   (9,099)
Net income (loss).......................      467       404   (14,583)  (13,541)
 
Basic income (loss) per share...........  $  0.05   $  0.05  $  (1.74) $  (1.62)
                                          =======   =======  ========  ========
Weighted-average sharesused in computing
 per share amounts......................    8,501     8,435     8,392     8,346
                                          =======   =======  ========  ========
Dilutive income (loss) per share........  $  0.05   $  0.05  $  (1.74) $  (1.62)
                                          =======   =======  ========  ========
Common and common equivalent Weighted-
 average shares used in computing per
 share amounts..........................    8,713     8,695     8,392     8,346
                                          =======   =======  ========  ========
<CAPTION>
                                                  FISCAL QUARTERS ENDED
                                          --------------------------------------
                                          DEC. 28, MARCH 29, JUNE 28,  SEPT. 27,
                                            1996     1997      1997      1997
                                          -------- --------- --------  ---------
<S>                                       <C>      <C>       <C>       <C>
Net revenues............................  $14,189   $14,475  $ 14,429  $ 13,003
Gross profit............................   11,076    11,331    11,166    10,071
Total operating expenses................    7,894     7,657    15,267    11,677
Income (loss) from operations...........    3,182     3,674    (4,101)   (1,606)
Net income..............................    2,175     2,515    (2,344)     (951)
 
Basic income per share..................  $  0.26   $  0.30  $  (0.28) $  (0.11)
                                          =======   =======  ========  ========
Weighted-average shares used in
 computing per share amounts............    8,241     8,378     8,457     8,553
                                          =======   =======  ========  ========
Dilutive income per share...............  $  0.25   $  0.28  $  (0.28) $  (0.11)
                                          =======   =======  ========  ========
Weighted-average shares used in
 computing per share amounts............    8,856     8,984     8,457     8,553
                                          =======   =======  ========  ========
</TABLE>
 
                                     F-17
<PAGE>
 
                                                                     SCHEDULE II
 
                               IKOS SYSTEMS, INC.
 
                       VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                     BALANCE AT CHARGED TO            BALANCE AT
                                     BEGINNING  COSTS AND  DEDUCTIONS    END
                                     OF PERIOD   EXPENSES  WRITE-OFFS OF PERIOD
                                     ---------- ---------- ---------- ----------
<S>                                  <C>        <C>        <C>        <C>
Allowance for doubtful accounts:
  Year ended September 28, 1996.....    $171       $100      $ --        $271
                                        ====       ====      =====       ====
  Year ended September 27, 1997.....    $271       $230      $ --        $501
                                        ====       ====      =====       ====
  Year ended October 3, 1998........    $501       $300      $ --        $801
                                        ====       ====      =====       ====
</TABLE>
 
                                      S-1
<PAGE>
 
 
 
 
 
 
3920-AR-98