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                        SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, D.C. 20549
 
                                    FORM 10-K
 
     [X]          ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                      OF THE SECURITIES EXCHANGE ACT OF 1934
 
                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
 
                                        OR
 
     [ ]        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
                      OF THE SECURITIES EXCHANGE ACT OF 1934
 
                          COMMISSION FILE NUMBER 1-9434
 
                              PICTURETEL CORPORATION
              (Exact name of Registrant as specified in its Charter)
 
<TABLE>
<S>                                        <C>
                DELAWARE                                  04-2835972
     (State or other jurisdiction of                   (I.R.S. Employer
     incorporation or organization)                   Identification No.)
 
     100 MINUTEMAN ROAD, ANDOVER, MA                         01810
(Address of Principal Executive Offices)                  (Zip Code)
</TABLE>
 
                 Registrant's telephone number: (978) 292-5000
 
          Securities registered pursuant to Section 12(b) of the Act:
 
                                      None
 
          Securities registered pursuant to Section 12(g) of the Act:
                                  Common Stock
                               (Title and Class)
 
     Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the last 90 days. Yes X     No __.
 
     Indicate by check mark if disclosure of delinquent filings pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K, or any
amendment to this Form 10-K. [X]
 
     The aggregate market value of the Registrant's Common Stock held by
non-affiliates of the Registrant as of March 12, 1999 was $332,760,236. On such
date, the average of the high and low price of the Common Stock was $8.25 per
share. The Registrant has 40,334,574 shares of Common Stock outstanding as of
March 12, 1999.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
     Portions of the definitive 1999 Proxy Statement in connection with the
Annual Meeting of Stockholders to be held June 17, 1999 are incorporated by
reference into Part III.
 
     A list of all Exhibits to this Annual Report on Form 10-K is located at
pages 52 through 55.
 
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ITEM 1.  BUSINESS
 
     PictureTel Corporation (the "Company" or "PictureTel") is the world leader
in developing, manufacturing and marketing a full-range of visual and audio
collaboration solutions. Visual collaboration employs videoconferencing, video
streaming and data collaboration technologies to facilitate productive meeting
environments that may incorporate video, audio, and real-time and archived
multimedia data. The Company's products and services enable businesses, schools,
medical facilities, government and other organizations to eliminate the barrier
of distance so they can work together more effectively. PictureTel markets a
complete line of videoconferencing systems, multi-location servers, peripheral
equipment and a full suite of enterprise-wide services.
 
     PictureTel is organized into three distinct business segments, each
responsible for its own profitability. The business segments are
videoconferencing products, videoconferencing services and audioconferencing,
which consists of its MultiLink, Inc. subsidiary. PictureTel's direct sales
organization and its worldwide indirect sales channels sell the Company's entire
range of video and audio products and services.
 
     PictureTel is a Delaware corporation organized in 1984, with executive
offices at 100 Minuteman Road, Andover, Massachusetts 01810 (telephone:
978-292-5000).
 
VIDEOCONFERENCING PRODUCTS
 
     The core of PictureTel's business since the Company's inception in 1984 has
been the development, manufacture and marketing of a complete line of
full-featured videoconferencing systems. PictureTel's videoconferencing systems
deliver full-color video and high-fidelity, FM radio-caliber audio so customers
can enjoy a natural, productive meeting environment whether they are in the same
office complex or halfway around the world from each other. The video and audio
signals are transmitted over digital telephone lines, most often ISDN
(Integrated Services Digital Network) lines, which are part of the public
switched telephone network. More than twelve thousand organizations around the
world use PictureTel systems to conduct face-to-face meetings with colleagues,
partners, suppliers, customers and others. The Company's videoconferencing
systems consist of three categories: group, desktop/personal and network server
systems.
 
     PictureTel group videoconferencing systems, the performance line Concorde
4500(TM) and the value line Venue 2000(TM) families of products, are dedicated
conference-room systems that deliver high-quality video and audio performance at
a variety of price points. Units include all equipment necessary to
videoconference. PictureTel created the compact category of videoconferencing in
1996 with the introduction of SwiftSite(TM), the world's first compact
videoconferencing system. SwiftSite -- and its successor, SwiftSite II, which
debuted in February 1999 -- deliver high-quality performance in a simple,
portable and affordable package. SwiftSite, which sits on top of the monitor to
which it is connected, is optimized for use in smaller offices. It has proven
popular in field sales offices, franchises and other similar locations where it
can complement the larger group systems deployed at headquarters and other
larger sites.
 
     PictureTel also has a complete line of personal or desktop
videoconferencing systems. These systems, which add videoconferencing
capabilities to standard personal computers, are suited for use by individuals
who not only need to videoconference with one or more sites, but also share any
number of PC documents through the systems' data-conferencing capabilities.
PictureTel's desktop systems run on the most popular Microsoft(R) operating
systems. PictureTel introduced its first PC-based personal systems in 1994, when
that segment of the market was emerging. PictureTel's personal systems operate
in much the same way as the Company's group systems. PictureTel markets several
different models of personal videoconferencing systems. The PictureTel Live200
(TM) is an ISDN-based system. PictureTel, through a technology alliance, also
markets two Zydacron, Inc. desktop videoconferencing systems -- the OnWAN 250
and OnWAN 350 -- which are entry-level ISDN-based systems. The PictureTel
550(TM) operates over both ISDN lines and networks that use the Internet
Protocol (IP). Using IP network capabilities enables the systems to operate over
many different types of IP-based networks, including Ethernet local area
networks (LANs). These IP-based systems, which are becoming an increasingly
significant part of PictureTel's product line, are expected to play an even more
prominent role in the future of PictureTel and the videoconferencing industry in
general. PictureTel LiveLAN(TM) is designed exclusively for use over IP
networks.
 
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     All of PictureTel's group, desktop/personal and network server
videoconferencing systems deliver 15 frames-per-second of video performance at
128 Kbps (Kilobits per second) over ISDN lines. Many PictureTel systems in all
three categories also have the ability to deliver up to 30 frames per second of
video performance -- the same frame rate as broadcast television -- at 384 Kbps.
PictureTel IP-based systems also can deliver up to 30 frames per second of video
performance.
 
     When business people need to collaborate with colleagues across a city or
halfway around the world, they often require network products that enable more
than two systems to participate in the same conference. PictureTel markets two
ISDN-based multi-location conferencing server lines - Montage(TM) and Prism(TM).
Montage is designed for large, reservation-based videoconferencing networks.
Prism is a smaller system designed for use with personal videoconferencing
systems and in situations where users want to conduct multi-location conferences
more spontaneously. In the IP-conferencing market, PictureTel provides
PictureTel 330(TM) NetConference multipoint server software. With the PictureTel
330, organizations can create virtual conference rooms on a variety of local
area networks and the Internet for videoconferencing and data conferencing. In
addition to multi-location servers, PictureTel's complete network products line
includes scheduling software, gateway products that enable users to conduct
conferences between ISDN- and IP-based videoconferencing systems, and management
software that enables the user to control videoconference network traffic on
their local area network.
 
     PictureTel systems support international standards for videoconferencing.
H.320 is the international standard for ISDN-based videoconferencing and H.323
is the standard for IP-based videoconferencing. PictureTel products also support
T.120, the international standard for data collaboration. PictureTel has been a
staunch supporter of and contributor to worldwide videoconferencing standards.
PictureTel co-authored the H.323 standard and has contributed portions of the
H.320 and T.120 standards as well. PictureTel's commitment to industry standards
gives its customers the peace of mind that their PictureTel systems will
interoperate with any other manufacturer's standards-based systems. In a
PictureTel-to-PictureTel operating environment, PictureTel systems are built to
function in an above-standards mode using proprietary technology to deliver the
highest possible video and audio performance.
 
     One of the key new technologies behind visual collaboration is streaming
video. In 1998, PictureTel acquired Starlight Networks, Inc., a provider of
streaming-media solutions for enterprise communications. PictureTel sees
tremendous synergy between its traditional videoconferencing technologies and
video-streaming technology. When businesses add video-streaming technology to
their existing videoconferencing capabilities, they will be able to take some of
their important intellectual capital - meetings involving technical, marketing,
sales and other experts - and enable employees, suppliers, partners and
customers anywhere in the world to experience these meetings first hand by
viewing the streamed content over IP-based networks. They also can extend the
reach of that information by providing on-demand access at a later time. The
acquisition of Starlight is expected to enable the Company to address a wider
set of customers' visual-collaboration needs with solutions for enterprise
briefings, distance-learning applications, and business television. The
acquisition also provides the Company with a knowledge base of streaming
technology, which is a natural extension of PictureTel's interactive
visual-collaboration leadership and complements PictureTel's IP-based
videoconferencing technology. The first new product resulting from this
acquisition is expected in the second half of 1999.
 
INTEL RELATIONSHIP
 
     In January 1999, PictureTel entered into a distribution and joint product
development agreement to accelerate growth of videoconferencing worldwide. Intel
invested $30.5 million in the Company, acquiring approximately 10% of the
Company's equity through convertible preferred stock.
 
     Under terms of the distribution and development agreement, Intel provided
PictureTel with distribution rights to sell the Intel(R)ProShare(R) Video System
500, and exclusive worldwide distribution rights to sell and support the
Intel(R) TeamStation(TM) System. In addition to its expertise in
videoconferencing distribution, sales and marketing, PictureTel will provide its
complete line of professional, managed and maintenance support services for both
products. Intel TeamStation System is a conference room workstation that
combines
 
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videoconferencing, Internet access, corporate network access and PC applications
in one convenient system. Based on the Intel Pentium(R) II processor, the Intel
TeamStation is a turnkey, high-performance system that brings increased
productivity to conference rooms. Intel ProShare Video System 500 is an add-in
kit for desktop PCs. It operates over both ISDN and LAN networks and offers
fully integrated data-sharing capabilities. These Intel products augment
PictureTel's existing product line of group, desktop/personal and network server
systems.
 
     Intel and PictureTel also agreed to begin joint development of
videoconferencing and collaboration products based on a common PC-based
technology platform. The common platform will be the foundation for future
products that will feature communication and multimedia capabilities such as
collaboration over LANs, streaming audio and video, and real-time conferencing.
The full effects of this joint development agreement can be expected in the year
2000. These future products -- which will operate over multiple networks,
including IP, ISDN and asynchronous transfer mode (ATM) -- are expected to
complement PictureTel's existing product line and will be marketed under the
PictureTel brand name. Intel plans to market the resulting building-block
components to other manufacturers and integrators. Both PictureTel and Intel
will receive compensation for the sale of products or components featuring
either company's technology.
 
VIDEOCONFERENCING SERVICES
 
     PictureTel assists customers in implementing and managing their technology
on a global basis through a comprehensive portfolio of maintenance, professional
and conference services, which together address each phase of the product life
cycle. Professional services include consulting, design and project management
services. Consulting services provide planning and needs analysis to customers.
Design services, such as room design and custom solutions, provide customized
videoconferencing solutions to meet each customer's unique requirements. Project
management, installation and training provide customers with effective
implementation of videoconferencing systems. For the on-going operation of
customers' videoconferencing environment, PictureTel provides conference
services and maintenance services. Conference services facilitate the customer's
use of the videoconferencing technology by providing conference room scheduling,
call launching, bridging and end-to-end problem resolution during conferences.
These services are delivered for point-to-point, as well as multipoint
conferences on a global basis. All services are sold both directly to customers
and through PictureTel's distributors. Service programs for local and
international distributors range from reselling PictureTel's service offerings
to providing back-end support for servicing end-users.
 
     All maintenance services are delivered on a worldwide basis from several
integrated global support centers located in the United States, United Kingdom,
Singapore and Japan. Spare parts are stocked around the world to meet response
time commitments to customers and distributors. PictureTel utilizes direct field
service staff as well as distributors and third party service providers to
perform installation and on-site repairs. Conference services are delivered from
geographically distributed Network Operations Centers located in the United
States, United Kingdom, and Singapore. PictureTel delivers professional services
and training through consultants, project managers and instructors. In addition,
PictureTel offers electronic support via the World Wide Web.
 
     PictureTel believes that the quality and reliability of its systems and
services is important to customer satisfaction. Accordingly, PictureTel's
videoconferencing services are ISO9002 registered and PictureTel expects to
continue to maintain its certification. PictureTel also regularly measures
customer satisfaction and strives to implement corrective actions to improve the
quality of its service. The delivery of service is backed by PictureTel's
certification program, which tests and certifies the technical abilities of all
support personnel dealing with videoconferencing products. PictureTel provides
warranty support for parts and software media on the majority of its products.
The warranty period is generally one year for hardware, ninety days for software
media, and ninety days for repaired parts.
 
AUDIOCONFERENCING BUSINESS
 
     In addition to its core visual collaboration products and services,
PictureTel, through its MultiLink business unit, also is a leading provider of
audioconferencing solutions. MultiLink(R), which PictureTel acquired
 
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in 1997, develops, manufactures and markets audioconferencing systems that allow
multiple parties to participate in a telephone call simultaneously -- commonly
known as bridges. Many of the world's leading telecommunications service
providers use MultiLink audioconferencing technology to support their multi-
location audio conference call services. Corporate customers use MultiLink
systems throughout their enterprise to conduct multi-location audio conference
calls for a variety of business purposes, including but not limited to business
meetings, shareholder services, public relations, project management, focus
groups, teletraining, distance learning and crisis management. MultiLink also
provides maintenance and other customer support services for its installed base.
 
RESEARCH AND DEVELOPMENT
 
     PictureTel continues to invest a significant percentage of its annual
revenue in its research and development activities. A strong investment in
research and development since the Company's inception has enabled PictureTel to
become the world leader in videoconferencing and is the basis for the Company's
new visual collaboration strategy. PictureTel's historic investments in research
and development have earned the Company patents for its video and audio
technologies.
 
     The overall Company investment in research and development has been reduced
and will continue at reduced levels in 1999 and beyond. While spending fewer
dollars on research and development programs, PictureTel believes that effective
management will result in the same level -- if not a higher level -- of
productivity from its research and development investment.
 
SALES
 
     The Company and its subsidiaries currently distribute PictureTel products
worldwide by direct sales and indirect channels of distribution. In 1998, the
Company derived approximately 25% of its worldwide product revenues from direct
selling activities, and 75% from indirect channels.
 
     Direct Sales Organization.  The Company directly markets its
videoconferencing products, videoconferencing services and audioconferencing
principally to the Fortune 500(R) (the largest product and service businesses in
the United States as published annually by Fortune magazine). These large
companies typically have multiple locations in the United States as well as
internationally and typically specify a single vendor to supply equipment on a
world-wide basis. The Company believes that it is important to maintain a close
working relationship with these customers in order to meet their demands for
sales and support on a multinational basis.
 
     The Company maintains five regional sales and support offices and twenty
additional branch sales and support offices. Regional offices typically include
demonstration equipment as well as a number of customer and technical sales
representatives and field support personnel.
 
     Indirect Channels.  To address the market below the Fortune 500 and expand
the Company's presence in the Fortune 500 market, the Company utilizes
telecommunication equipment distributors, regional Bell Operating Companies
("RBOCs"), value-added resellers ("VARs") and dedicated dealers who sell the
Company's videoconferencing products and videoconferencing services.
 
     International Distribution.  Outside of the United States the Company
relies on a network of foreign market distributors and its own international
subsidiaries. Agreements with the Company's foreign market distributors
generally provide for pricing, volume discounts, order lead times, a specific
geographic territory and other terms and conditions and are typically for terms
of one to three years with options to extend such terms by mutual agreement.
 
COMPETITION
 
     The visual collaboration industry is intensely competitive and is
characterized by extensive research and development efforts that continue to
introduce technologically advanced products on an accelerated basis. In order
for PictureTel to maintain its market leadership in the visual collaboration
industry, it must continue to develop, market and sell innovative,
technologically advanced and cost-competitive products through internal
 
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development or by acquisition. For example, PictureTel and its competitors have
recently begun exploring new technologies and networks, such as the Internet and
corporate intranets or LANs, for delivering visual collaboration products and
services. There can be no assurance that PictureTel will be successful in
selecting, developing, manufacturing and marketing new products with attractive
margins for these new technologies and networks or enhancing its existing
products for these and other applications. Further, there can be no assurance
that PictureTel will be able to respond effectively, if at all, to technological
changes, new standards or product announcements by competitors. The failure to
do any of the foregoing may have a material adverse effect on PictureTel's
business financial condition and results of operations. Moreover, unforeseen
technical or other difficulties may interfere with the development or production
of new or enhanced products, or prevent or create delays in marketing such
products.
 
     In its established businesses of group systems and desktop systems,
PictureTel competes with a number of larger corporations. In the developing
businesses of network-based visual collaboration systems and compact systems, a
number of new corporations have begun to offer competitive products. In
addition, a number of PictureTel's competitors have pursued and are continuing
to pursue a strategy of partnering with or acquiring corporations which develop
and market network-based visual collaboration products. The partnering with or
acquisition of such corporations allows PictureTel's competitors to offer new
products without the lengthy time delays associated with internal product
development. As a consequence, competitors are able to more quickly meet the
demand for advanced network-based visual collaboration products. The greater
resources of the competitors engaged in these partnerships and acquisitions may
permit them to accelerate the development and commercialization of new
competitive products and the marketing of existing competitive products to their
larger installed bases. There is significant competition among PictureTel and
its competitors for the partnering and/or acquisition of corporations possessing
such advanced technologies. The greater resources of PictureTel's current and
potential competitors will enable them to compete more effectively for the
partnering and/or acquisition of such corporations. Further, the industry
standards for such network-based technology are still in the early stages of
development, which PictureTel believes has led to customer uncertainty and,
accordingly, a slowdown in the growth of the general market for visual
collaboration products.
 
     This increased competition resulting from such partnerships and
acquisitions, together with mergers among competitors and a slowdown in the
growth of the general market for visual collaboration products, has led and may
continue to lead to increases in the defection or dilution of PictureTel's
distribution channel partners to competitors, decreases in average selling
prices and margins in both group and desktop visual collaboration systems, and a
lower segment market share by PictureTel for products and services in the
emerging area of network-based visual collaboration. In some cases, PictureTel
competes with its channel partners for various services, which increases the
complexity of channel management. In addition, competitors may offer
network-based visual collaboration software solutions or incorporate standard
algorithms into processor chips free of additional charge, which may reduce the
value PictureTel Technology provides to the market, especially in its lower end
visual collaboration products. In addition, the prices which PictureTel is able
to charge for its visual collaboration products and services may further
decrease from historical levels as a result of new product introductions by
competitors, price competition, technological advances, or otherwise. Any of
these factors could have a material adverse effect on PictureTel's business,
financial condition and results of operations.
 
     PictureTel competes primarily on the basis of video and audio quality and
data collaboration, as well as on favorable features, support services and the
pricing of those systems and services. PictureTel believes that its products are
competitive in each of these areas.
 
MANUFACTURING
 
     The Company has developed a supply chain that encompasses the Company's
subassemblies and products supplied by vendors to the delivery of finished goods
to the customer. This effort has resulted in a cost
 
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effective and timely delivery of products to the Company's customers. This
strategy allows the Company to reduce costly investment in manufacturing capital
and to leverage the expertise of its vendors.
 
     The Company's manufacturing operation consists of final assembly and
testing of complete video and audioconferencing systems. Subassemblies of large
systems, including tested printed circuit boards, are assembled into complete
systems. These final systems are tested to ensure they meet all functional
requirements.
 
     Desktop/personal hardware products are purchased in final form from various
vendors. The products have been subjected to PictureTel's quality testing at the
vendor site. These products are placed into inventory, and are shipped according
to demand.
 
     The Company utilizes a European Distribution Center (EDC) in Holland to
centralize videoconferencing product shipments to its customer base in Europe.
PictureTel has sourced components from local vendors in Europe to support proper
stocking levels in Holland and maintain timely customer shipments. The EDC
incorporates the same working relationships and policies with vendors in Europe
as the Company currently does in the United States.
 
PATENTS
 
     The Company's principal technology consists primarily of certain advances
in video and audio compression algorithms, echo cancellation and audio signal
processing, camera positioning, and automatic speaker location technology,
implemented in software and hardware configurations for use in PictureTel
products and unique product designs. The Company has been issued a number of
United States patents relating to the above described technology, which expire
at various dates from 2004 to 2017. The Company has a number of additional
patent applications issued and pending in various countries including the United
States, Canada, Europe and Japan, and will continue to file additional
applications. However, there can be no assurance that its current patents (or
any additional patents that may be issued in the future) provide broad
protection from the development of similar product technology by competitors of
the Company. In the absence of broad patent protection, and despite the
Company's reliance upon its proprietary confidential information, competitors of
the Company may be able to use algorithms similar to those used by the Company
to design and manufacture products that are directly competitive with the
Company's products.
 
EMPLOYEES
 
     At December 31, 1998, the Company had 1,466 full-time employees, of whom
718 were employed in sales, marketing and customer support, 388 in product
development and engineering, 130 in manufacturing and 230 in administration and
finance. The Company had 314 employees in foreign countries at December 31,
1998.
 
     The Company's continued success will depend in part on its ability to
attract and retain highly skilled and motivated personnel who are in great
demand throughout the industry.
 
     None of the Company's employees are represented by a labor union. The
Company believes its relations with its employees to be good.
 
ITEM 2.  PROPERTIES
 
     PictureTel's corporate offices and research, development and manufacturing
facilities are located in five leased facilities in Andover, Massachusetts, one
facility in Chelmsford, Massachusetts, and one facility in Mountain View,
California, aggregating approximately 903,200, 51,200, and 30,000 square feet,
respectively. The lease at 100 Brickstone in Andover, Massachusetts expires in
June, 1999, and the Company does not intend to renew it. The lease at 6
Riverside Drive in Andover, Massachusetts expires in July, 2007. The lease at
100 Minuteman Road in Andover, Massachusetts expires in July, 2014. The lease at
50 Minuteman Road in Andover, Massachusetts expires in October, 2015. In June of
1998, the property at 50 Minuteman Road was subleased for a period of ten years.
The lease is accounted for as a capital lease. PictureTel leased an additional
facility at 200 Minuteman Road in Andover, Massachusetts beginning on October 2,
1998. The
 
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lease is accounted for as a capital lease and expires in December, 2016. The
lease for the product distribution facility in Chelmsford, Massachusetts expires
in December, 2002. The lease in Mountain View, California expires in May, 2003.
The videoconferencing products and videoconferencing services segments share
common office space, and the audioconferencing segment is primarily at the
Riverside Drive property.
 
     PictureTel also leases office space for its regional and branch sales and
support offices in the United States and for similar offices of its subsidiary
and branch operations worldwide.
 
ITEM 3.  LEGAL PROCEEDINGS
 
     A.  Datapoint Litigation
 
     In December 1993, PictureTel was sued by Datapoint Corporation in the
United States District Court for the Northern District of Texas. Datapoint
alleged that certain of PictureTel's products infringed patent rights allegedly
owned by Datapoint. On April 9, 1998 a jury returned a verdict in favor of
PictureTel finding that PictureTel did not infringe the Datapoint patents and
that the Datapoint patent claims raised against PictureTel were invalid.
Datapoint has appealed these findings, and there can be no assurance that the
outcome of the appeal will be in favor of PictureTel, however, the Company
believes that it has meritorious defenses to the appeal.
 
     B.  Shareholder Litigation
 
     Since September 23, 1997, seven class action shareholders' complaints have
been filed against the Company, Norman E. Gaut, Director and former Chairman of
the Board and Chief Executive Officer, and Les Strauss, the former Vice
President and Chief Financial Officer, in the United States District Court for
the District of Massachusetts. The plaintiffs filed a consolidated complaint on
February 11, 1998.
 
     The original complaints were filed following the Company's announcement on
September 19, 1997 that it would restate its financial results for the first
quarter of the fiscal year ending December 31, 1997 and the last two quarters of
the fiscal year ending December 31, 1996 and were amended when the Company
announced on November 13, 1997 that it would also restate the second quarter of
the fiscal year ending December 31, 1997. The consolidated complaint alleges
that PictureTel and Messrs. Gaut and Strauss violated Sections 10(b) and 20(a)
of the Exchange Act and Rule 10b-5 promulgated thereunder, during the period
from October 17, 1996 through November 13, 1997, through the alleged preparation
and dissemination of materially false and misleading financial statements which
artificially inflated the price of PictureTel Common Stock. The consolidated
complaint seeks to recover an unspecified amount of damages, including
attorneys' and experts' fees and expenses.
 
     On April 7, 1998, the Company filed a motion to dismiss the complaint. On
October 28, 1998, the motion to dismiss Norman E. Gaut was granted and the
motion to dismiss PictureTel and Les Strauss was denied. Limited discovery has
occurred, and the Company expresses no opinion as to the likely outcome. This
litigation may have a material impact on the Company's financial position,
results of operations and cash flows.
 
     C.  Revnet, Inc.
 
     On June 2, 1998, the Company was served with a complaint from a former
distribution channel customer, Revnet, Inc., which has ceased operations.
(Revnet, Inc., v. PictureTel Corporation. Civil Action 98092039, filed April 2,
1998, in the Circuit Court for Baltimore City, Maryland.) The complaint alleges
that the Company breached an oral contract. Revnet is seeking $200,000,000 in
damages. Discovery has recently begun. The Company believes that the complaint
and the claim for damages are without merit and intends to vigorously defend
against them.
 
     In addition to the above, the Company has also been and is from time to
time subject to claims and suits incidental to the conduct of business. There
can be no assurance that the Company's insurance will be adequate to cover all
liabilities that may arise out of such claims. Further, although the Company
intends to defend itself vigorously against all such claims, the ultimate
outcome of the claims cannot be accurately predicted. The Company does not
believe that any claim of which it is aware, other than the claims listed
 
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above, could result in an outcome that will have a material adverse affect to
its business, financial condition, results of operations or cash flows.
 
ITEM 4.  SUBMISSION OF VOTES
 
     There were no items submitted to the shareholders during the fourth quarter
of 1998.
 
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                                    PART II
 
ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
                          PRICE RANGE OF COMMON STOCK
 
     The following table sets forth the high and low sale prices for the
Company's Common Stock for the periods indicated as reported by NASDAQ under the
symbol PCTL.
 
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                                                             HIGH        LOW
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1997
     First Quarter........................................  $26.875    $11.875
     Second Quarter.......................................  $14.125    $ 8.250
     Third Quarter........................................  $13.500    $ 8.813
     Fourth Quarter.......................................  $11.625    $ 5.625
1998
     First Quarter........................................  $ 8.250    $ 5.750
     Second Quarter.......................................  $11.938    $ 6.000
     Third Quarter........................................  $11.125    $ 5.375
     Fourth Quarter.......................................  $ 7.938    $ 4.750
1999
     First Quarter (through March 12, 1999)...............  $11.000    $ 5.875
</TABLE>
 
     As of March 12, 1999 there were approximately 1,907 holders of record of
the Company's Common Stock.
 
                                DIVIDEND POLICY
 
     The Company has not paid any dividends on its Common Stock since its
inception. The Board of Directors does not anticipate declaring any cash
dividends in the foreseeable future.
 
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ITEM 6.  SELECTED FINANCIAL DATA
 
                            SELECTED FINANCIAL DATA
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
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                                        1998        1997        1996        1995        1994
                                      --------    --------    --------    --------    --------
<S>                                   <C>         <C>         <C>         <C>         <C>
STATEMENT OF OPERATIONS DATA:
     Revenues.......................  $406,152    $466,425    $490,225    $363,799    $272,841
     Net income (loss)..............  $(55,679)   $(39,398)   $ 32,172    $ 21,859    $  7,669
     Net income (loss) per common
       share -- basic(1)(2)(3)......  $  (1.45)   $  (1.04)   $   0.89    $   0.64    $   0.24
     Net income (loss) per common
       share -- diluted(1)(2)(3)....  $  (1.45)   $  (1.04)   $   0.81    $   0.57    $   0.22
     Weighted average shares
       outstanding -- basic(1)(2)...    38,527      37,760      36,097      34,178      32,254
                                      ========    ========    ========    ========    ========
     Weighted average shares
       outstanding --
       diluted(1)(2)................    38,527      37,760      39,598      38,428      34,739
                                      ========    ========    ========    ========    ========
BALANCE SHEET DATA:
     Working capital................  $112,322    $152,973    $202,063    $143,130    $123,962
     Total assets...................   352,994     355,051     386,254     300,613     227,238
     Total short-term debt..........     4,418       3,612       3,942       4,383      10,452
     Total long-term debt...........    56,411      22,000      14,202      12,804       3,758
     Stockholders' equity...........  $190,242    $227,965    $264,846    $208,384    $156,842
</TABLE>
 
---------------
 
(1) All common and per share amounts in 1995 and years prior have been
    retroactively restated to reflect the two-for-one common stock split
    effected by a 100% common stock dividend paid during the fourth quarter of
    1995. The effect of the MultiLink acquisition accounted for as a
    pooling-of-interests is included in all numbers presented. See Note 2 of
    "Notes to Consolidated Financial Statements".
 
(2) The Company has not paid dividends on its Common Stock since its inception.
    The Board of Directors does not anticipate declaring any cash dividends in
    the foreseeable future.
 
(3) Includes other charges totaling $9,957 and $42,664 before income tax benefit
    in 1998 and 1997, respectively. Also includes tax expense of $35,141 in 1998
    to record a full valuation allowance against the deferred tax assets. See
    Note 15 of "Notes to Consolidated Financial Statements".
 
                                       11
<PAGE>   12
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS
 
        MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
                             RESULTS OF OPERATIONS
 
     The following table sets forth, for the periods indicated, the percentage
of Revenues for certain items in the Company's Statement of Operations for each
period. The table and the following discussion reflect the other charges
described in Note 15 of the Notes to Consolidated Statements:
 
<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                              -------------------------------
                                                              1998         1997         1996
                                                              -----        -----        -----
<S>                                                           <C>          <C>          <C>
Revenues....................................................  100.0%       100.0%       100.0%
Cost of revenues............................................   57.4         59.2         51.2
Gross margin................................................   42.6         40.8         48.8
Selling, general and administrative.........................   32.2         36.0         27.1
Research and development....................................   16.2         17.0         13.3
Total operating expenses....................................   48.4         53.0         40.4
Operating income (loss).....................................   (5.8)       (12.2)         8.4
Interest income, net........................................    0.5          0.5          0.8
Other income (expense), net.................................    0.4         (0.2)         0.6
Income (loss) before income tax expense (benefit)...........   (4.9)       (11.9)         9.8
Income tax expense (benefit)................................    8.8         (3.5)         3.2
Net income (loss)...........................................  (13.7)        (8.4)         6.6
</TABLE>
 
FORWARD-LOOKING STATEMENTS
 
     This document includes forward-looking statements about the Company's
business, revenues and expenses, effective tax rate, and operating and capital
requirements. Forward-looking statements made or incorporated by reference
herein are not guarantees of future performance. In addition, forward-looking
statements may be included in various other PictureTel documents to be issued in
the future and in various oral statements by PictureTel representatives to
security analysts and investors from time to time. Any forward-looking
statements are subject to risks that could cause the actual results to vary
materially. Such risks are discussed in "Risk Factors Which May Affect Future
Results" and in other related portions of this document.
 
BUSINESS DEVELOPMENTS
 
     On November 10, 1998, the Company acquired all of the common stock of
Starlight Networks, Inc. ("Starlight") in a transaction accounted for using the
purchase method of accounting. Starlight develops, manufactures and markets
streaming video software that enables live, interactive multicast video and
video-on-demand. Total consideration of $17,798,000 consisted of 1,509,266
shares of common stock and 2,723 warrants with a total value of $14,679,000 and
$3,119,000 in cash. The total purchase price of $22,252,000 included the
consideration as well as assumed debt of $3,544,000, which was paid off at
closing, and acquisition costs of $910,000 related to legal, accounting and
financial advisory fees and was allocated to the fair value of the assets as
follows: completed technology of $12,781,000; in-process technology of
$4,442,000, which was charged to research and development expense in the fourth
quarter of 1998; goodwill, tradename and workforce intangible assets of
$6,837,000; and net liabilities of $1,808,000. (See Note 3 to Notes to
Consolidated Financial Statements.) The Company expects to invest an additional
$2,500,000, approximately, to complete the technology in 1999. If the product is
not completed within the expected timeframe, the Company may incur additional
costs and experience lower revenues which are not expected to be material to the
Company's results of operations or liquidity.
 
     On January 19, 1999, the Company announced it had entered into a
distribution and joint development agreement with Intel Corporation. On February
18, 1999, Intel invested $30.5 million in the Company, acquiring approximately
10% of the Company's equity through convertible preferred stock. The two
 
                                       12
<PAGE>   13
 
companies will develop videoconferencing and collaborative products based on a
common PC-based technology platform. Under terms of the agreement, Intel will
provide the Company with distribution rights to sell the Intel ProShare(R) Video
System 500 and exclusive worldwide distribution rights to sell and support the
Intel(R) TeamStation(TM) System.
 
YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31, 1997
 
     Revenues.  The Company's revenues decreased $60,273,000, or 13%, in 1998
from 1997. The decrease in revenue was primarily a result of decreased unit
shipments of videoconferencing products offset by an increase in
videoconferencing services revenues. The Company's revenues from sales to
foreign markets were approximately 43% of total revenues in both 1998 and 1997.
The Company expects that international revenues will continue to account for a
significant portion of total revenues. Revenues from sales to foreign markets in
1998 were principally comprised of sales made from the United States of
$35,618,000, the United Kingdom of $79,396,000 and Japan of $24,747,000.
Revenues from sales to foreign markets in 1997 were principally comprised of
sales made from the United States of $41,667,000, the United Kingdom of
$76,318,000 and Japan of $36,689,000.
 
     Gross Margin.  The Company's gross margin decreased $17,448,000 or 9%, in
1998 compared to 1997. Gross margin as a percentage of revenues was 43% in 1998
compared to 41% in 1997. Gross margin as a percentage of revenues increased due
to the decrease in significant charges included in cost of revenues for the
videoconferencing products segment in 1998 versus 1997 as discussed below.
 
     Operating Expenses.  Selling, general and administrative expenses decreased
$37,179,000 or 22% from 1997 and decreased as a percentage of revenues to 32%
from 36%. Research and development expenses decreased $13,469,000, or 17% in
1998 from 1997 and were 16% and 17% of revenues for 1998 and 1997, respectively.
Research and development expenditures, prior to the capitalization of software
costs, were $73,500,000 in 1998 and $86,775,000 in 1997 or 18% and 19% of
revenues, respectively. The Company capitalized software costs of $7,446,000 in
1998, excluding completed Starlight technology, and $7,252,000 in 1997
representing 10% and 8% of aggregate research and development expenditures for
1998 and 1997, respectively. As discussed below, total operating expenses
decreased by $50,648,000 year over year due to a decrease in significant charges
included in videoconferencing products and audioconferencing segment results as
well as efforts by management to reduce the Company's overall cost structure
through headcount and program reductions.
 
     Videoconferencing Products.  The videoconferencing products segment
develops, manufactures and markets visual communications systems and
collaboration software. Segment revenues fell $69,603,000, or 18%, to
$324,984,000 in 1998 compared to 1997, with a 16% decline in overall unit volume
primarily responsible for the decrease. Group system shipments were down 22%,
mainly in the Concorde and Swiftsite lines, while desktop/personal system
shipments decreased 12%. Network server product volume, which is driven largely
by group and desktop/personal shipments, also declined. Average selling prices
were generally lower across all products compared to 1997, but a shift in mix
towards higher priced group and associated network products kept overall average
selling prices nearly flat. Delayed introduction of Swiftsite II, the Company's
successor compact system to Swiftsite I, from the fourth quarter of 1998 to the
first quarter of 1999 accounted for much of the group systems volume decline and
the favorable mix as higher priced systems made up a larger proportion of
revenues. However, the general trend toward lower selling prices is expected to
continue as the Company lowers its prices to compete with new products in the
market with features and functionality previously available in only higher
priced models.
 
     The videoconferencing products segment generated a $17,387,000 operating
loss during 1998 compared to a $32,667,000 loss the previous year. The losses
for both years include significant charges, with $11,394,000 of the $15,280,000
operating loss reduction from 1997 to 1998 resulting from lower charges in 1998.
In addition to the $4,442,000 charge for incomplete technology acquired in
connections with the Starlight acquisition, the 1998 loss includes charges of
$6,808,000 related to the write-down of inventory and capitalized software to
their net realizable value plus other costs associated with discontinuance of a
video network server product line. Charges of $22,644,000 are included in the
1997 loss and include $4,940,000 for various write-
 
                                       13
<PAGE>   14
 
downs of excess and obsolete inventory, $9,881,000 for capitalized software
costs impaired as a result of canceled development projects, $1,122,000 for
product retrofit accruals, $4,037,000 for severance charges and office closings,
$1,880,000 for advances to vertical partners written off to reflect changing
business conditions and shifts in distribution channels and $784,000 to write
off other assets associated with the canceled development projects.
 
     Absent these significant charges, the videoconferencing product segment
operating loss would have been $6,137,000 in 1998 compared to a $10,023,000 loss
the previous year. For 1998, an 18% reduction in research and development
expenditures along with an 18% reduction in other operating expenses due to
management's efforts to reduce the Company's overall cost structure more than
offset a gross margin decline caused by the lower segment revenues. Gross margin
as a percent of revenue was approximately 46% in both years excluding charges.
 
     Videoconferencing Services.  The videoconferencing services segment
provides maintenance as well as professional consulting and management services
for videoconferencing products sold by the Company and its competitors. Segment
revenues increased 23% from $47,313,000 in 1997 to $58,263,000 in 1998. Growth
in professional service revenue, particularly from managing multipoint
videoconferences for customers, is primarily responsible for the increase.
 
     Operating profits were $12,071,000 in 1998, which represents a 25% increase
over the prior year's $9,642,000 figure. The higher revenue accounts for the
improvement.
 
     Audioconferencing. The audioconferencing segment develops, manufactures,
markets and services multipoint audio control units. Segment revenues decreased
$1,620,000, or 7%, from prior year levels to $22,905,000 in 1998. A decrease in
average selling prices that was partially offset by an increase in unit
shipments was responsible for the decrease.
 
     The segment generated $7,555,000 of operating profit during 1998 compared
to a $6,384,000 operating loss the previous year. Operating expenses in 1997
included $2,561,000 for investment banking and other advisory fees recorded when
the Company acquired MultiLink as well as $3,431,000 to establish accruals for
severance, sales tax and benefit liabilities. The 1997 loss would have been
$392,000 without these charges. The year-over-year profitability improvement
between 1997 and 1998 was driven largely by reductions in research and
development and sales expenses due to lower headcount. Gross margin improved
versus 1997, despite lower revenues, as a result of improved service
profitability.
 
YEAR ENDED DECEMBER 31, 1997 COMPARED TO THE YEAR ENDED DECEMBER 31, 1996
 
     Revenues. The Company's revenues decreased $23,800,000, or 5%, in 1997 from
1996. The decrease in revenue was primarily a result of decreased unit volumes
and decreased average selling prices of videoconferencing products due to
increased competition. This decrease was partially offset by increased
videoconferencing services revenues. The Company's revenues from sales to
foreign markets were approximately 43% and 44% of total revenues, in 1997 and
1996, respectively. Revenues from sales to foreign markets in 1997 were
principally comprised of sales made from the United States of $41,667,000, the
United Kingdom of $76,318,000 and Japan of $36,689,000. Revenues from sales to
foreign markets in 1996 were principally comprised of sales made from the United
States of $48,215,000, the United Kingdom of $78,645,000 and Japan of
$40,008,000.
 
     Gross Margin. The Company's gross margin decreased $48,662,000, or 20%, in
1997 compared to 1996. Gross margin as a percentage of revenues was 41% in 1997
compared to 49% in 1996. Gross margin as a percentage of revenues decreased as a
result of significant other charges discussed in the videoconferencing products
section below.
 
     Operating Expenses. Selling, general and administrative expenses increased
$34,813,000 or 26% from 1997 and increased as a percentage of revenues to 36%
from 27%. Research and development expenses increased $14,389,000, or 22% in
1997 from 1996 and were 17% and 13% of revenues for 1997 and 1996, respectively.
Research and development expenditures, prior to the capitalization of software
costs, were $86,775,000 in 1997 and $72,900,000 in 1996 or 19% and 15% of
revenues, respectively. Total operating
 
                                       14
<PAGE>   15
 
expenses increased $49,202,000 due to the increased expenditure on research and
development and the increases in administrative expenses as discussed below.
 
     Videoconferencing Products. Videoconferencing product revenue of
$394,587,000 in 1997 decreased $34,112,000, or 8%, compared with 1996. A 27%
decline in desktop/personal system unit volume coupled with lower average
desktop/personal selling prices accounted for virtually the entire decrease. The
average group system price also declined in response to competitive pressures,
but additional volume from sales of the newly introduced Swiftsite I line kept
overall group system revenue slightly above 1996 levels. Network server revenues
declined as higher shipments were offset by lower average selling prices.
 
     Segment operating income fell from a $38,459,000 profit in 1996 to a
$32,667,000 loss in 1997. The significant charges discussed earlier account for
$22,644,000 of the decrease. Additionally, gross margin decreased $26,486,000
excluding charges because of lower revenue and lower average selling prices.
Gross margin as a percent of revenues decreased 2.5 percentage points from 1996
to approximately 46% in 1997. Continued investment in new product and software
development for existing and future products resulted in a 21% increase in
research and development expense. Other operating expenses increased 9% because
of added personnel and facilities costs.
 
     Videoconferencing Services. Videoconferencing service revenue grew
$8,207,000, or 21%, in 1997 from 1996's $39,106,000 total. Increased
professional service revenue provided over 90% of this growth. Operating
profitability, however, declined from $11,846,000 in 1996 to $9,642,000, due to
cost increases in anticipation of continued revenue growth.
 
     Audioconferencing. Audioconferencing revenue increased $2,105,000, or 9%,
to $24,525,000 during 1997 because of increased unit shipments partially offset
by lower average selling prices. Operating income fell $2,930,000 between 1996
and 1997 excluding the 1997 charges discussed previously. Lower gross margin as
a percent of revenue is primarily responsible for the decrease.
 
OTHER
 
     Net Interest Income. Net interest income was $1,948,000, $2,518,000 and
$4,287,000 in 1998, 1997 and 1996, respectively. The $570,000 decrease from 1998
to 1997 was primarily the result of higher interest expense resulting from
capital lease obligations. The $1,769,000 decrease from 1997 to 1996 was
primarily the result of lower marketable securities portfolio balances and
higher interest expense.
 
     Other Income (Expense). Other income of $1,804,000 in 1998 consists
primarily of net gains on foreign currency transactions. Other expenses of
$1,158,000 in 1997 consists primarily of a $3 million write-off of an equity
investment offset by net gains on foreign currency transactions and net gains on
sales of securities. Other income of $2,794,000 in 1996 consists primarily of
net gains on sales of securities.
 
     Income Taxes. The Company's effective tax rate for 1998, 1997 and 1996 was
180%, 29% and 33%, respectively. The 1998 rate differs from the federal
statutory rate due to state and foreign taxes and an increase in the valuation
allowance for deferred taxes. Management believes it is unlikely that the
Company will fully realize the deferred tax assets and accordingly has
established a full valuation allowance against the deferred tax assets. The 1997
rate differs from the federal statutory rate due to state and foreign taxes
offset by research and development tax credits and an increase in the valuation
allowance related to certain current year tax credits and net operating losses
whose benefits are uncertain. The 1996 rate was lower than the federal statutory
rate primarily due to the benefits of the research and development credits, the
foreign sales corporation, and a decrease in the valuation allowance.
 
                        LIQUIDITY AND CAPITAL RESOURCES
 
     At December 31, 1998, the Company had $62,642,000 in cash and cash
equivalents and $38,078,000 in short-term marketable securities. The primary
uses of cash during 1998 were for capital expenditures, primarily leasehold
improvements, internal development of software, certain intangible and other
assets
 
                                       15
<PAGE>   16
 
associated with the Starlight Networks, Inc. acquisition and the purchase of
marketable securities. The principal sources of cash were the decrease in trade
receivables and inventories of $35,325,000.
 
     At December 31, 1998 there were no borrowed amounts outstanding under the
Company's revolving credit agreement which expires October 4, 1999 and
$28,762,000 in standby letters of credit outstanding. The revolving credit
agreement is collateralized by cash and marketable securities and contains
certain financial covenants, including the maintenance of certain financial
ratios, and minimum net income (loss) requirements. At December 31, 1998, the
Company was out of compliance with substantially all of the debt covenants. The
Company received waivers from the bank regarding those covenants and is
retroactively in compliance. The Company's quarterly operating results for 1999
are likely to be out of compliance with the credit line's financial covenants.
Accordingly, the respective banks have informed the Company that while they
anticipate providing continued short-term lending up to $4,000,000 under the
credit line, they will not renew the Company's outstanding letters of credit as
they come due. The letters of credit come due as follows: $12,500,000 on June
24, 1999, $9,012,000 on July 31, 1999 and $7,250,000 on September 12, 1999. The
Company expects to find alternative issuers for the letters of credit or to
renegotiate the lease terms requiring such letters of credit. In the event such
efforts are unsuccessful, the Company's cash could be reduced by the amount of
the letters of credit.
 
     The Company has available up to approximately $5,300,000 under local
foreign guaranteed lines of credit to certain of its foreign subsidiaries. At
December 31, 1998, there was $881,000 outstanding under the foreign lines of
credit.
 
     At December 31, 1998, the Company had $59,948,000 outstanding under various
leasing lines including the obligations for the leases of the facilities at 50
Minuteman Road and 200 Minuteman Road in Andover, Massachusetts, which were
$20,277,000 and $37,737,000, respectively, at December 31, 1998. The lease at 50
Minuteman Road was subleased in June 1998 for a ten-year term.
 
     In October 1998, the Board of Directors authorized a plan to repurchase up
to 1,000,000 shares of the Company's Common Stock in open market, privately
negotiated or other transactions. No shares were repurchased during 1998.
 
     The Company believes that funds from operations, equipment lease financing
and existing cash, cash equivalents and marketable securities will be sufficient
to meet the Company's operating, investing and financing requirements for the
forseeable future.
 
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
 
     In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS 133 is
effective for all fiscal quarters of all fiscal years beginning after June 15,
1999. SFAS 133 requires that all derivative instruments be recorded on the
balance sheet at their fair value. Changes in the fair value of derivatives are
recorded each period in current earnings or other comprehensive income,
depending on whether a derivative is designated as part of a hedge transaction
and, if it is, the type of hedge transaction. The Company is currently
evaluating the effects of this change but anticipates that the adoption of SFAS
133 will not have a significant effect on the Company's results of operations or
its financial position.
 
     In March 1998, the Accounting Standards Board issued SOP 98-1, "Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use." The
Company adopted the SOP on January 1, 1999. The SOP will require the
capitalization of certain costs incurred after the date of adoption in
connection with developing or obtaining software for internal use. Management
does not expect its adoption will have a material impact on the Company's
financial position or results of operations.
 
     SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition, With
Respect to Certain Transactions," was issued in December, 1998 and addresses
software revenue recognition as it applies to certain multiple-element
arrangements. SOP 98-9 also amends SOP 98-4, "Deferral of the Effective Date of
a Provision of SOP 97-2," to extend the deferral of application of certain
passages of SOP 97-2 through fiscal years beginning on or before March 15, 1999.
All other provisions of SOP 98-9 are effective for transactions entered into in
fiscal years beginning after March 15, 1999. The Company will comply with the
requirements
 
                                       16
<PAGE>   17
 
of this SOP as appropriate as they become effective and this is not expected to
have a material effect on the Company's result of operations.
 
RISK FACTORS WHICH MAY AFFECT FUTURE RESULTS
 
     The following risk factors relating to the business of PictureTel and
certain forward looking statements contained herein, should be considered by
current and prospective investors of PictureTel common stock. These factors
should be considered in conjunction with other information contained in this
document.
 
     NEW PRODUCTS, COST REDUCTIONS, TECHNOLOGICAL CHANGE, AND EVOLVING
MARKETS.  The Company is engaged in an industry that is still emerging as a
result of extensive research and development efforts and which continues to
bring to market new, more technologically advanced products introduced on an
accelerated basis. Simultaneously, the larger telecommunications market is in a
heightened competitive state due to deregulation throughout the world. In order
to maintain its market share leadership role in this fast-paced emerging market,
the Company must continue to introduce, through internal development or by
acquisition, significant innovative, technologically leading and
cost-competitive products. There can be no assurance that such new products will
be introduced by the Company, or if introduced, will be accepted by the market
and its customers. In November 1998, the Company acquired all of the common
stock of Starlight Networks, Inc. Starlight develops, manufactures and markets
streaming video that enables live, interactive multicast video-on-demand. There
can be no assurance that the integration of Starlight will be successful or
produce products which will be accretive to the Company's results of operations
and financial condition. In January 1999, the Company entered into a
distribution and joint product development agreement with Intel Corporation. The
two companies will develop videoconferencing and collaborative products based on
a common PC-based technology platform. There can be no assurance that the
partnership will be successful or produce products which will be accretive to
the Company's results of operations and financial condition. In addition to
offering products that operate in an integrated service digital network (ISDN)
environment, the Company and its competitors are exploring new technologies and
networks, such as the Internet and corporate intranets or LANs, for delivering
videoconferencing and data collaboration services. The industry standards for
such new technologies and networks, however, are still in the early stages of
development, which the Company believes has led to customer uncertainty and,
accordingly, a slowdown in the growth of the general market for
videoconferencing products. As a result of customer preferences, the Company has
also experienced over the past year a shift in its sales model to
videoconferencing systems with lower average selling prices. There can be no
assurance that the Company will be successful in implementing cost reductions
for all of its products or in developing and marketing suitable new products and
related services with attractive margins for these new technologies and
networks. The possible transition, migration and/or convergence of technologies
is difficult to predict and could have profound implications for the industry
and the business of the Company. Further, there is significant risk that
existing products could be rendered obsolete due to changing technology. The
failure of the Company to develop and market new products on a timely basis or
to enhance its existing products or to respond effectively to technological
changes, new industry standards or product announcements by competitors could
have a material adverse effect on the Company's business, financial condition
and results of operations.
 
     COMPETITION.  In its established businesses of group systems and desktop
systems, the Company competes with a number of larger corporations, which have
greater financial and marketing resources than the Company. In the developing
businesses of network-based videoconferencing systems and compact systems, a
number of corporations have begun to offer competitive products. In addition,
partnerships between corporations which compete with the Company and
corporations which develop and market network products, as well as mergers among
competitors, are intensifying competition in the marketplace. This increased
competition, together with a slowdown in the growth of the general market for
videoconferencing products, has led and may continue to lead to increases in the
defection or dilution of the Company's distribution channel partners to
competitors, decreases in average selling prices and margins in both group and
desktop videoconferencing systems, and a lower segment market share by the
Company for products and services in the emerging area of network-based visual
collaboration. In some cases, the Company competes with its channel partners for
various services, which increases the complexity of channel management. In
addition, competitors may offer network visual collaboration software solutions
or incorporate standard algorithms into
 
                                       17
<PAGE>   18
 
processor chips free of additional charge, which may reduce the value the
Company's technology provides to the market, especially in its lower end
videoconferencing products. In addition, the prices which the Company is able to
charge for its videoconferencing products and services may further decrease from
historical levels as a result of new product introductions by competitors, price
competition, technological advances, or otherwise. Any of these factors could
have a material adverse effect on the Company's business, financial condition
and results of operations.
 
     MANUFACTURING. Certain key subassemblies and products are currently
available only from one vendor and several vendors are smaller corporations with
limited financial resources that could prove to be inadequate. In some cases
components are sourced from only one vendor, even where multiple sources are
available, to maintain quality control and enhance the working relationship with
the vendor. In addition, the Company from time to time enters into development
arrangements with third parties to develop and incorporate new features and
functions into the Company's products. Failure of these third parties to fulfill
their respective obligations under these development arrangements could have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company's business could also be adversely affected
by delays or interruptions in delivery, and poor quality of supplies,
subassemblies or products from key vendors. In addition, the Company designs and
procures certain circuits, components and subassemblies from
non-videoconferencing divisions of its competitors, such as Sony and Panasonic
Corporation. The failure to obtain adequate supplies or the requirement to
redesign and source supplies from another manufacturer may take substantial time
and result in significant expense, each of which could impact product shipments
and materially and adversely affect the Company's business, financial condition
or results of operations.
 
     RECENT HISTORY OF LOSSES. The Company reported a thirteen percent (13%)
decrease in revenues for the year ended December 31, 1998 as compared to
revenues for the year ended December 31, 1997, and an increase in net loss from
$39,398,000 for the year ended December 31, 1997 to $55,679,000 for the year
ended December 31, 1998. This compares to net income of $32,172,000 in 1996.
Included in the results for the year ended December 31, 1998 were charges
totaling $9,957,000 related to discontinuing a video network server product line
and the write-down of certain inventory and fixed assets and a valuation
allowance for deferred taxes of $35,141,000. The Company recorded other charges
in the year ended December 31, 1997 to bring expenses into line with its lower
level of revenues and a lower expected rate of growth. Revenues and prospects
for growth have been impacted by, among other things, the decline in the average
selling price for several PictureTel products, a decline in the profitability of
the industry, and by a slowdown in the general market for videoconferencing
products, in part resulting from the perceived uncertainty of customers with
respect to the compatibility of existing products of the Company and its
competitors with expected new multimedia videoconferencing products utilizing
the Internet and LAN systems. Continued lower operating results could impact the
Company's ability to remain in compliance with covenants under its existing
revolving credit agreement. Further, there can be no assurance that the Company
can return to the level of revenues or profits in relation to net sales
experienced in years prior to the year ended December 31, 1997.
 
     PRODUCT PROTECTION AND INTELLECTUAL PROPERTY. The Company's success depends
in part on its proprietary technology. The Company attempts to protect its
proprietary technology through patents, copyrights, trademarks, trade secrets
and license agreements. In absence of broad patent protection, which is not
likely, and despite the Company's reliance upon its proprietary confidential
information, competitors of the Company have been able to use algorithms or
other features similar to those used by the Company to design and manufacture
products that are directly competitive with the Company's products. The Company
believes that due to the rapid pace of technological change in the visual
collaboration industry, legal protection for its products is less significant
than factors such as the Company's use, implementation and enhancement of
standards-based open architecture and the Company's ongoing efforts in product
innovation.
 
     Although the Company does not believe that its products infringe the
proprietary rights of any third parties, third parties have asserted
infringement and other claims against the Company from time to time. There can
be no assurance that third parties will not assert such claims against the
Company in the future or that such claims will not be successful. The Company
could incur substantial costs and diversion of management resources with respect
to the defense of any claims relating to proprietary rights, which in turn could
have a material adverse effect on the Company's business, financial condition
and result of operations. See "Litigation."
 
                                       18
<PAGE>   19
 
     POTENTIAL FLUCTUATIONS OF QUARTERLY OPERATING RESULTS.  The majority of the
Company's revenues in each quarter result from orders booked in that quarter,
and a substantial portion of the Company's orders and shipments typically occur
during the last weeks of each quarter such that forecasting of revenue and
product mix is both complex and difficult. Unanticipated variations in the
timing of receipt of customer orders in any quarter may produce significant
fluctuations in quarterly revenues. As a result, a shortfall in revenue compared
to internal expectations may not evidence itself until late in the quarter and
any resulting impact on earnings may not be determinable until several weeks
after the end of the quarter. The Company's ability to maintain or increase net
revenues depends upon its ability to increase unit volume sales. There can be no
assurance that the Company will be able to increase or to maintain the current
level of unit volume sales. Other factors which may cause period-to-period
fluctuations in operational results include the timing of new product
announcements and introductions by the Company and its competitors, market
acceptance of new or enhanced versions of the Company's products, changes in the
product mix of sales, changes in the relative proportions of sales among
distribution channels or among customers within each distribution channel,
changes in manufacturing costs, and general economic factors such as the recent
decline of currency values in the Asian markets.
 
     INTERNATIONAL OPERATIONS. Revenues related to international operations of
the Company totaled approximately 43%, 43% and 44% of total revenues for the
three years ended December 31, 1998, 1997 and 1996, respectively. Management of
the Company expects international revenues to continue to constitute a
significant portion of total revenues in future periods. However, there can be
no assurance that the Company will be able to maintain or increase international
market demand for its products and, to the extent the Company is unable to do
so, its business, financial condition, results of operations or cash flows could
be materially adversely affected. The Company's sales to international
distributors are denominated in U.S. dollars in order to minimize risks
associated with fluctuating foreign currency rates. An increase in the value of
the U.S. dollar relative to other currencies, however, could make the Company's
product more expensive and, therefore, potentially less competitive in foreign
markets. Sales by the Company's foreign subsidiaries are generally made in the
foreign subsidiary's local currency, in which case fluctuations in the value of
the U.S. dollar relative to such other currencies could have a material adverse
effect on the operating results of the Company. Currently, the Company employs
various currency hedging strategies to reduce these risks. In addition, a
significant portion of the Company's revenue is derived from Asian markets.
Given the current general weakness in the Asian markets, there can be no
assurance that the Company will be able to sustain current revenue levels or
growth in such markets. There can be no assurance that the above factors will
not have a material adverse effect on the Company's future international sales
and, consequently, on its business, financial condition, results of operations
or cash flows.
 
     VOLATILITY OF STOCK PRICE. As is frequently the case with the stocks of
high technology corporations, the market price of PictureTel Common Stock has
been, and may continue to be, volatile. Factors such as quarterly fluctuations
in results of operations, increased competition, the introduction of new
products by the Company and by its competitors, changes in the mix of products
and sales channels, the timing of significant customer orders, and macroeconomic
conditions generally, may have a significant adverse effect on the market price
of the Company's stock in any given period. In addition, the stock market has,
from time to time, experienced extreme price and volume fluctuations, which have
particularly affected the market price for many high technology corporations and
which, on occasion, have appeared to be unrelated to the operating performance
of such corporations. Past financial performance should not be considered a
reliable indicator of future performance and investors should not use historical
trends to anticipate results or trends in future periods. Any shortfall in
revenue or earnings from the levels anticipated by securities analysts could
have an immediate and significant adverse effect on the market price of
PictureTel Common Stock in any given period.
 
     DEPENDENCE ON KEY PERSONNEL. In February 1998, Bruce R. Bond succeeded Dr.
Norman Gaut as Chief Executive Officer and President. In June, 1998, Bruce Bond
was elected Chairman of the Board and Dr. Gaut retired as an active employee
while remaining a member of the Board of Directors. There can be no assurance
that the transition from Dr. Gaut to Bruce Bond will be successful. On October
15, 1998, the Company announced the appointment of Gary Bond as Group Vice
President and General Manager of Products. On October 21, 1998, Arthur Fatum was
appointed as Vice President and Chief Financial Officer. The Company
 
                                       19
<PAGE>   20
 
depends on a limited number of key senior management personnel, including Bruce
Bond; David Grainger, Group Vice President and General Manager of Services;
David Goselin, Vice President, Operations; Lawrence Bornstein, Vice President,
Human Resources; Gary Bond; Arthur Fatum; Frazer Hamilton, Group Vice President
of Worldwide Sales; and John Nye, Vice President, MultiLink. There has been
considerable turnover in the Company's senior management team over the past
several years, and the loss of the services of one or more of the Company's
senior management team or the inability to attract, retain, motivate and manage
additional key personnel could have a material adverse effect on the business,
financial condition or operating results of the Company. In addition, over the
past year, the Company has experienced an increase in voluntary employee
attrition from engineering and other departments. There is no assurance, given
the competitive nature of the current job market, that the Company will be able
to adequately fill the open positions.
 
     YEAR 2000 COMPLIANCE. The Company has formed an internal compliance team to
evaluate its internal information technology infrastructure and application
systems ("IT Systems") and other non-IT infrastructure systems ("Non-IT
Systems") to determine whether such systems will operate correctly with regard
to the import, export, and processing of date information, including correct
handling of leap years, in connection with the change in the calendar year from
1999 to 2000 (the "Year 2000 Issue"), and to evaluate the Year 2000 Issue with
respect to the systems of third party partners and suppliers with which the
Company has a material relationship ("Third Party Systems").
 
     The Company has completed a comprehensive IT Systems inventory analysis and
risk assessment. As previously planned and budgeted, the Company completed the
upgrade of its core domestic IT Systems to incorporate additional desired
features and functionality and is now testing the Year 2000 compliance of the
customizations to the software. The Company expects to complete this process as
planned by June 30, 1999. IT systems at several foreign subsidiaries will be
converted to the IT systems used domestically by the end of July. Systems
supporting MultiLink will likely be replaced in 1999 in order to achieve Year
2000 compliance. The Company currently estimates an additional $1,200,000 of
1999 IT system remediation costs based on its assessment to date. To the extent,
however, that such upgrades are not completed in a timely manner, the Company's
operations, financial condition, results of operations or cash flows could be
materially adversely affected.
 
     The Company also expects to complete a Non-IT Systems inventory analysis
and risk assessment by May 15, 1999. The costs of any remediation actions
required in order to be Year 2000 compliant have not been identified at this
time. As the Company believes the number of mission critical Non-IT Systems is
relatively small, the Company does not expect that any additional costs of
addressing the Year 2000 Issue for Non-IT Systems will have a material adverse
impact on its operations or its financial position, results of operations or
cash flows.
 
     With the assistance of an independent Year 2000 solution provider, the
Company is in the process of creating a plan to complete a Third Party Systems
inventory and risk assessment. The Company expects to verify Year 2000
compliance of Third Party Systems using this independent Year 2000 solution
provider. As the Company believes the number of mission critical Third Party
Systems is relatively small, the Company expects to be in a position to evaluate
the risks in a timely manner. Until Year 2000 compliance of all Third Party
Systems is ascertained and written assurances are received, the risk to the
Company's operations and any additional costs relating to such Third Party
Systems is unknown.
 
     The Company estimates it will spend a total of $433,000 on inventory
analysis and risk assessment. To date, the Company has incurred $269,000 of
expense relating to inventory analysis and risk assessment. These Year 2000
expenditures are within the Company's planned organizational budgets and include
the cost of independent Year 2000 solution providers. Year 2000 expenditures for
IT Systems, Non-IT Systems and Third Party Systems do not reflect the cost to
the Company of internal resources working on the Year 2000 Issue and do not
reflect planned upgrades or planned replacement systems which may have a
positive impact on resolving the Year 2000 Issue. The Company expects to
complete its risk assessment and cost estimate relating to the Year 2000 Issue
no later than the end of May, 1999 and to develop a high-level contingency plan
relating to the remediation and prioritization of its IT Systems, Non-IT Systems
and Third Party
 
                                       20
<PAGE>   21
 
Systems shortly thereafter. As of March 1, 1999, no IT Systems projects have
been deferred due to problems associated with the Year 2000 Issue.
 
     The Company has also tested its products for Year 2000 compliance and had
determined that all PictureTel products currently available for sale have either
successfully passed Year 2000 compliance testing or are not subject to Year 2000
compliance because such products do not import, export or process date
information in any manner. Recently, it has come to the Company's attention that
two of its newly released products, which are supplied by a third party and
whose prior versions passed the Year 2000 compliance tests, are not Year 2000
compliant. The Company is actively pursuing the third party supplier to provide
fixes to these products. A small number of the Company's installed base products
do not meet Year 2000 compliance testing. For these older, non-compliant
versions of products, the Company has, with one exception, developed adequate
workarounds that will be made available to customers and that will permit the
products to continue to operate with full functionality.
 
     EURO. On January 1, 1999, eleven of the fifteen member countries of the
European Union established fixed conversion rates between their existing
sovereign currencies and established the euro, making the euro their common
legal currency on that date. Based on a recent assessment, the euro conversion
is not anticipated to have a material impact on the Company's business.
 
ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
     The Company and its subsidiaries face exposures to financial market risks,
including adverse movements in foreign currency exchange rates and changes in
interest rates. The Company's primary currency exposure has been related to
foreign currency denominated receivables and receivables denominated in a
currency other than the functional currency. Historically, the Company has
hedged currency exposures associated with foreign currency denominated
receivables by entering into foreign currency forward contracts as a hedge
against the foreign currency receivable transaction. Forward contracts generally
have a maturity date within four to six months of the contract date. The goal of
the Company's hedging activity is to minimize the exposures inherent in these
transactions. The Company's hedging activities minimizes the Company's exchange
rate risk because the gains and losses on these contracts offset the losses and
gains on the transactions being hedged. The criteria the Company uses for
designating a forward contract as a hedge include the instrument's effectiveness
in risk reduction and one-to-one matching of the forward contract to the
underlying transaction.
 
     The following table represents hypothetical changes in fair value in the
Company's foreign currency forward contracts. The modeling technique measures
the fair value of the forward contract by currency type arising from potential
changes in foreign currency rates. Movements in foreign currency rates of plus
or minus 3% and 6% reflect hypothetical shifts in fair value of these forward
contracts. "No change in currency rates" represents the market value of each
market-rate sensitive currency as of December 31, 1998. All values are
represented in U.S. Dollar equivalents (in thousands):
 
<TABLE>
<CAPTION>
                                VALUATION OF FORWARD GIVEN                          VALUATION OF FORWARD GIVEN
                                A CURRENCY FLUCTUATION OF                           A CURRENCY FLUCTUATION OF
       FORWARD CONTRACT         --------------------------       NO CHANGE IN       --------------------------
        CURRENCY TYPE              3%               6%          CURRENCY RATES        (3%)             (6%)
       ----------------            --               --          --------------        ----             ----
<S>                             <C>              <C>            <C>                 <C>              <C>
FUNCTIONAL CURRENCY-USD
British Pound.................   $1,884           $1,938            $1,829           $1,774           $1,719
Swedish Krona.................      566              583               550              533              517
Swiss Franc...................      124              128               120              117              113
Japanese Yen..................    8,564            8,813             8,315            8,065            7,816
Germany Demark................    2,060            2,120             2,000            1,940            1,880
Australian Dollar.............    1,754            1,805             1,703            1,652            1,601
FUNCTIONAL CURRENCY -- L
U.S. Dollar...................   $2,639           $2,558            $2,721           $2,803           $2,884
French Franc..................      127              123               131              135              139
FUNCTIONAL CURRENCY -- DEM
U.S. Dollar...................   $  226           $  258            $  274           $  282           $  290
</TABLE>
 
                                       21
<PAGE>   22
 
     The Company's investments include corporate obligations with various
issuers and maturities. The Company's primary market risk exposure for its
investments relates to fluctuations in interest rates. Given the short
maturities and investment grade quality of the portfolio holdings at December
31, 1998, a sharp rise in interest rates is not expected to have a material
adverse impact on the fair value of the Company's investment portfolio. As a
result, the Company does not hedge these interest rate exposures.
 
     The following table represents hypothetical changes in fair value in the
Company's investment portfolio at December 31, 1998 that are sensitive to
changes in interest rates. The modeling technique measures the change in fair
value arising from selected potential changes in interest rates. Movements in
interest rates of plus or minus 50 basis points ("BP") and 100 BP reflect
hypothetical shifts in the fair value of these investments. Fair value
represents the market principal plus accrued interest and dividends of certain
interest-rate-sensitive securities. "No change in interest rates" represents
fair value at December 31, 1998. All dollars are presented in thousands:
 
<TABLE>
<CAPTION>
                                    VALUATION OF                                       VALUATION OF
                                SECURITIES GIVEN AN                                 SECURITIES GIVEN AN
                               INTEREST RATE INCREASE                             INTEREST RATE DECREASE
                               ----------------------          NO CHANGE          -----------------------
TYPE OF SECURITY                50 BP         100 BP       IN INTEREST RATES      (50 BP)       (100 BP)
----------------                -----         ------       -----------------      -------       --------
<S>                            <C>           <C>           <C>                    <C>           <C>
Corporate Obligations........  $58,167       $58,132            $58,200           $58,237        $58,272
</TABLE>
 
                                       22
<PAGE>   23
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                             PICTURETEL CORPORATION
 
              INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
<TABLE>
<CAPTION>
                                                              PAGE
                                                              ----
<S>                                                           <C>
Financial Statements:
     Report of Independent Accountants......................   24
     Consolidated Balance Sheets............................   25
     Consolidated Statements of Operations..................   26
     Consolidated Statements of Stockholders' Equity........   27
     Consolidated Statements of Cash Flows..................   28
     Notes to Consolidated Financial Statements.............   29
 
Supplementary Data:
     Report of Independent Accountants......................   49
     Schedule II Valuation and Qualifying Accounts..........   50
</TABLE>
 
                                       23
<PAGE>   24
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors and Stockholders of
  PICTURETEL CORPORATION:
 
     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, stockholders' equity and cash
flows present fairly, in all material respects, the financial position of
PictureTel Corporation and its subsidiaries at December 31, 1998 and 1997, and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 1998, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
 
PRICEWATERHOUSECOOPERS LLP
 
Boston, Massachusetts
February 12, 1999
 
                                       24
<PAGE>   25
 
                             PICTURETEL CORPORATION
 
                          CONSOLIDATED BALANCE SHEETS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              --------------------
                                                                1998        1997
                                                              --------    --------
<S>                                                           <C>         <C>
                                      ASSETS
Current assets:
     Cash and cash equivalents..............................  $ 62,642    $ 49,859
     Marketable securities..................................    38,078      32,152
     Accounts receivable, less allowances for doubtful
      accounts of $5,392 and $3,890 at December 31, 1998 and
      1997, respectively....................................    78,995     108,729
     Inventories, net.......................................    30,256      44,901
     Deferred taxes, net....................................        --      15,615
     Other current assets...................................     8,692       6,803
                                                              --------    --------
     Total current assets...................................   218,663     258,059
Deferred taxes, net.........................................        --      16,106
Property and equipment, net.................................    95,655      69,103
Capitalized software costs, net.............................    20,484       2,368
Goodwill, net...............................................     5,336          --
Other assets................................................    12,856       9,415
                                                              --------    --------
     Total assets...........................................  $352,994    $355,051
                                                              ========    ========
 
                       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
     Short-term borrowings..................................  $    881    $    186
     Accounts payable.......................................    32,777      30,169
     Accrued compensation and benefits......................    11,214      10,551
     Accrued expenses.......................................    35,316      37,207
     Current portion of capital lease obligations...........     3,537       3,426
     Deferred revenue.......................................    22,616      23,547
                                                              --------    --------
     Total current liabilities..............................   106,341     105,086
     Capital lease obligations, net of current portion......    56,411      22,000
Commitments and contingencies (Notes 7, 8 and 16)
Stockholders' equity:
     Preference stock, $.01 par value; 15,000,000 shares
      authorized; none issued...............................        --          --
     Common stock, $.01 par value; 80,000,000 shares
      authorized; 40,067,771 and 38,040,363 shares issued
      and outstanding at December 31, 1998 and 1997.........       400         380
     Additional paid-in capital.............................   222,230     204,242
     (Accumulated deficit)/retained earnings................   (30,254)     25,425
     Accumulated other comprehensive income.................    (2,134)     (2,082)
                                                              --------    --------
     Total stockholders' equity.............................   190,242     227,965
                                                              --------    --------
     Total liabilities and stockholders' equity.............  $352,994    $355,051
                                                              ========    ========
</TABLE>
 
   The accompanying notes are an integral part of the consolidated financial
                                  statements.
                                       25
<PAGE>   26
 
                             PICTURETEL CORPORATION
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                YEARS ENDED DECEMBER 31,
                                                           ----------------------------------
                                                             1998         1997         1996
                                                           --------     --------     --------
<S>                                                        <C>          <C>          <C>
Revenues:
     Product revenues....................................  $345,076     $417,115     $451,119
     Service revenues....................................    61,076       49,310       39,106
                                                           --------     --------     --------
          Total revenues.................................   406,152      466,425      490,225
Cost of revenues:
     Product cost of revenues............................   184,734      234,953      223,680
     Service cost of revenues............................    48,352       40,958       27,369
                                                           --------     --------     --------
          Total cost of revenues.........................   233,086      275,911      251,049
Gross margin.............................................   173,066      190,514      239,176
Operating expenses:
     Selling, general and administrative.................   130,662      167,841      133,028
     Research and development............................    66,054       79,523       65,134
                                                           --------     --------     --------
          Total operating expenses.......................   196,716      247,364      198,162
                                                           --------     --------     --------
Income (loss) from operations............................   (23,650)     (56,850)      41,014
Interest income..........................................     4,857        4,339        5,337
Interest expense.........................................     2,909        1,821        1,050
Other income (expense), net..............................     1,804       (1,158)       2,794
                                                           --------     --------     --------
Income (loss) before income tax expense (benefit)........   (19,898)     (55,490)      48,095
Income tax expense (benefit).............................    35,781      (16,092)      15,923
                                                           --------     --------     --------
Net income (loss)........................................  $(55,679)    $(39,398)    $ 32,172
                                                           ========     ========     ========
Net income (loss) per common share -- basic..............  $  (1.45)    $  (1.04)    $   0.89
                                                           ========     ========     ========
Net income (loss) per common share -- diluted............  $  (1.45)    $  (1.04)    $   0.81
                                                           ========     ========     ========
Weighted average common shares outstanding -- basic......    38,527       37,760       36,097
                                                           ========     ========     ========
Weighted average common shares outstanding -- diluted....    38,527       37,760       39,598
                                                           ========     ========     ========
</TABLE>
 
   The accompanying notes are an integral part of the consolidated financial
                                  statements.
                                       26
<PAGE>   27
 
                             PICTURETEL CORPORATION
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                             (DOLLARS IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                                     ACCUMULATED
                                                                                        OTHER
                                        COMMON STOCK        ADDITIONAL              COMPREHENSIVE   COMPREHENSIVE       TOTAL
                                   ----------------------    PAID-IN     RETAINED      INCOME          INCOME       STOCKHOLDERS'
                                     SHARES     PAR VALUE    CAPITAL     EARNINGS      (LOSS)          (LOSS)          EQUITY
                                   ----------   ---------   ----------   --------   -------------   -------------   -------------
<S>                                <C>          <C>         <C>          <C>        <C>             <C>             <C>
Balance, December 31, 1995.......  35,600,129     $357       $176,077    $32,257       $  (307)             --        $208,384
Exercise of employee stock
  options and related tax
  benefit........................   1,300,155       13         21,061         --            --              --          21,074
Employee stock purchase plan
  shares.........................      73,827        1          1,878         --            --              --           1,879
Conversion of subordinated debt
  to common stock................     525,000        5            739         --            --              --             744
    Net income...................          --       --             --     32,172            --        $ 32,172          32,172
    Other comprehensive
      income/(loss), net of tax
        Foreign currency
          translation
          adjustment.............          --       --             --         --            --             (71)            (71)
        Unrealized gain on
          marketable securities,
          net of tax of $478.....          --       --             --         --            --             664             664
    Other comprehensive income...          --       --             --         --           593             593
                                                                                                      --------
Comprehensive income.............          --       --             --         --                        32,765
                                                                                                      ========
                                   ----------     ----       --------    --------      -------                        --------
Balance, December 31, 1996.......  37,499,111      376        199,755     64,429           286                         264,846
Exercise of employee stock
  options and related tax
  benefit........................     358,235        3          1,196         --            --              --           1,199
Employee stock purchase plan
  shares.........................     183,017        1          3,291         --            --              --           3,292
    Net loss.....................          --       --             --    (39,398)                      (39,398)        (39,398)
    Other comprehensive losses,
      net of tax
        Foreign currency
          translation
          adjustment.............          --       --             --         --                        (1,475)         (1,475)
        Unrealized loss on
          marketable securities,
          net of tax of $(3).....          --       --             --         --            --            (893)           (893)
    Other comprehensive losses...          --       --             --         --        (2,368)         (2,368)
                                                                                                      --------
Comprehensive loss...............          --       --             --         --                       (41,766)
                                                                                                      ========
Adjustment to conform MultiLink's
  fiscal year....................                                            394                                           394
                                   ----------     ----       --------    --------      -------                        --------
Balance, December 31, 1997.......  38,040,363      380        204,242     25,425        (2,082)                        227,965
Exercise of employee stock
  options and related tax
  benefit........................     232,068        2            979                                                      981
Employee stock purchase plan
  shares.........................     286,074        3          2,345                                                    2,348
Issuance of shares -- Starlight
  acquisition....................   1,509,266       15         14,664                                                   14,679
    Net loss.....................          --       --             --    (55,679)                      (55,679)        (55,679)
    Other comprehensive losses,
      net of tax
        Foreign currency
          translation
          adjustment.............          --       --             --         --                           (63)            (63)
        Unrealized gain on
          marketable securities,
          net of tax of $4.......          --       --             --         --            --              11              11
    Other comprehensive losses...          --       --             --         --           (52)            (52)
                                                                                                      --------
Comprehensive loss...............          --       --             --         --                      $(55,731)
                                                                                                      ========
                                   ----------     ----       --------    --------      -------                        --------
Balance, December 31, 1998.......  40,067,771     $400       $222,230    $(30,254)     $(2,134)                       $190,242
                                   ==========     ====       ========    ========      =======                        ========
</TABLE>
 
   The accompanying notes are an integral part of the consolidated financial
                                  statements.
                                       27
<PAGE>   28
 
                             PICTURETEL CORPORATION
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                             (DOLLARS IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                              -------------------------------
                                                                1998        1997       1996
                                                              --------    --------    -------
<S>                                                           <C>         <C>         <C>
Cash flows from operating activities:
     Net income (loss)......................................  $(55,679)   $(39,398)   $32,172
Adjustments to reconcile net income to net cash provided by
  operating activities:
     Depreciation and amortization..........................    28,183      35,221     22,744
     Deferred taxes, provision (benefit)....................    31,721     (21,314)     1,955
     Provisions to write down inventory and capitalized
       software to net realizable value.....................     7,092      14,357      3,449
     Write down of long-lived assets........................     3,149          --         --
     Bad debt provision.....................................     4,160       4,241        461
     Write-off of incomplete technology.....................     4,442
     Other non-cash items...................................       896       2,107       (225)
Changes in operating assets and liabilities, net of effects
  of purchased business:
     Accounts receivable....................................    26,513      30,267    (40,546)
     Inventories............................................     8,812       2,161     (9,403)
     Other assets...........................................    (1,086)     (1,022)      (900)
     Accounts payable.......................................     2,468     (24,124)    27,906
     Accrued compensation and benefits and accrued
       expenses.............................................    (4,035)     18,314     11,714
     Deferred revenue.......................................    (1,086)      4,020       (399)
                                                              --------    --------    -------
Net cash provided by operating activities...................    55,550      24,830     48,928
Cash flows from investing activities:
     Purchase of marketable securities......................  (126,262)    (26,392)   (20,115)
     Proceeds from marketable securities....................   120,336      42,276     25,987
     Additions to property and equipment....................   (19,421)    (21,645)   (39,877)
     Proceeds from disposals of property and equipment......       506          --        387
     Capitalized software costs.............................    (7,446)    (17,133)    (6,887)
     Cash paid to acquire business, less cash acquired......    (3,964)         --         --
     Purchase of other assets...............................    (2,851)     (5,350)      (565)
     Proceeds from sale of intangible asset.................        --          --      2,050
                                                              --------    --------    -------
Net cash used in investing activities.......................   (39,102)    (28,244)   (39,020)
Cash flows from financing activities:
     Change in short-term borrowings........................    (2,955)       (333)        38
     Change in long-term borrowings.........................        --      (9,242)    (3,784)
     Principal payments under capital lease obligations.....    (3,471)     (3,895)    (3,387)
     Proceeds from sale leaseback transactions..............        --          --      8,492
     Proceeds from exercise of stock options................       981         954     10,676
     Proceeds from employee stock purchase plan.............     1,718       3,537      1,948
                                                              --------    --------    -------
Net cash provided by (used in) financing activities.........    (3,727)     (8,979)    13,983
Adjustment to conform fiscal year of MultiLink..............        --         394         --
Effect of exchange rate changes on cash.....................        62      (1,475)      (151)
                                                              --------    --------    -------
Net increase (decrease) in cash and cash equivalents........    12,783     (13,474)    23,740
Cash and cash equivalents at beginning of year..............    49,859      63,333     39,593
                                                              --------    --------    -------
Cash and cash equivalents at end of year....................  $ 62,642    $ 49,859    $63,333
                                                              ========    ========    =======
</TABLE>
 
   The accompanying notes are an integral part of the consolidated financial
                                  statements.
 
                                       28
<PAGE>   29
 
                             PICTURETEL CORPORATION
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.  NATURE OF THE BUSINESS:
 
     PictureTel Corporation (the "Company") develops, manufactures and markets
video and audio collaboration equipment and applications and services. These
products and services enable businesses, schools, medical facilities, government
and other organizations to eliminate the barrier of distance so they can work
together more effectively. The Company sells its products internationally
through both direct and indirect channels.
 
2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
 
  PRINCIPLES OF CONSOLIDATION
 
     The accompanying consolidated financial statements include the accounts of
the Company and all of its subsidiaries. All intercompany accounts and
transactions have been eliminated.
 
  USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
  FOREIGN CURRENCY
 
     The financial statements of the Company's non-U.S. subsidiaries, where the
local currency is the functional currency, are translated using exchange rates
in effect at the end of the year for assets and liabilities and average exchange
rates during the year for results of operations. Related translation adjustments
are reported in accumulated other comprehensive income. Transaction gains and
losses are recognized in the statement of operations.
 
  FOREIGN EXCHANGE CONTRACTS
 
     The Company and its subsidiaries have entered into foreign currency forward
contracts as a hedge against specific intercompany and foreign currency
receivable transactions. Forward contracts involve agreements to purchase or
sell foreign currencies at specific rates at future dates. The Company enters
into derivatives only with counterparties which are financial institutions
having credit ratings of at least A to minimize credit risk. The Company's
hedging activities do not subject the Company to exchange rate risk because the
gains and losses on these contracts offset the losses and gains on the assets,
liabilities, and transactions being hedged. The criteria the Company uses for
designating a forward contract as a hedge include the instrument's effectiveness
in risk reduction and one-to-one matching of the forward contract to the
underlying transaction. The carrying amount of the forward contracts is the fair
value, which is determined by obtaining market prices. Gains and losses on
forward contracts are deferred and recognized in the same period that the
underlying transactions are settled. The contract premiums or discounts are
amortized over the life of the foreign exchange contracts and are recognized in
other income. At December 31, 1998 and 1997 the Company had contracts maturing
through April 5, 1999 and April 6, 1998 to purchase $17,570,000 and $24,627,000,
respectively, in foreign currency (British pounds, French francs, German marks,
Japanese yen, Swiss francs, Swedish krona and Australian dollars). Cash flows
resulting from hedging contracts are classified in the same category as the cash
flows from the items being hedged.
 
                                       29
<PAGE>   30
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
  CASH EQUIVALENTS AND MARKETABLE SECURITIES
 
     The Company considers all highly liquid investments with a maturity of
three months or less at the date of purchase to be cash equivalents. Those
instruments with maturities between three months and twelve months are
considered to be short-term marketable securities and investments with
maturities of greater than one year are classified as long-term marketable
securities. At December 31, 1998 and 1997 marketable securities primarily
consist of corporate obligations.
 
     The Company classifies all marketable securities as available for sale.
They are carried at their fair value, based on quoted market prices, with the
unrealized gains and losses, net of tax, reported in accumulated other
comprehensive income. The cost of marketable securities is adjusted for the
amortization of premiums and accretion of discounts over the life of the
security. Such amortization and interest are included in interest income. For
the purpose of determining gain or loss, the specific identification of
securities method is used. Realized gains and losses are included in other
income.
 
  INVENTORIES
 
     Inventories are stated at the lower of cost or market. Cost is determined
on the first-in, first-out basis.
 
  PROPERTY AND EQUIPMENT
 
     Property and equipment are stated at cost. Depreciation and amortization
are provided using the straight-line method over the following estimated useful
lives:
 
<TABLE>
<S>                                     <C>
Buildings under capital lease.........  18 years
Equipment.............................  2-5 years
Equipment and furniture under capital   3-5 years
  leases..............................
Furniture and fixtures................  3-5 years
Leasehold improvements................  Estimated useful life or term of the
                                        lease, if shorter
</TABLE>
 
     Maintenance and repairs are charged to expense as incurred. Significant
improvements are capitalized and depreciated. Upon retirement or sale, the cost
of the assets disposed of and the related accumulated depreciation are removed
from the accounts and any resulting gain or loss is included in the
determination of net income.
 
  RESEARCH AND DEVELOPMENT AND CAPITALIZED SOFTWARE COSTS
 
     Costs incurred prior to the establishment of technological feasibility are
charged to research and development expense. Software production costs incurred
subsequent to the establishment of technological feasibility are capitalized
until the product is available for general release to customers.
 
     During the years ended December 31, 1998, 1997, and 1996, the Company
capitalized approximately $7,446,000, $7,252,000, and $6,887,000, respectively,
of internal software costs. Capitalized software for the year ended December 31,
1998 also included completed technology of $12,781,000 acquired through the
purchase of Starlight. Amortization is based on the straight-line method over
the remaining estimated life of the product. During the years ended December 31,
1998, 1997, and 1996, the Company amortized approximately $1,023,000,
$13,994,000 and $5,694,000, respectively, of software costs.
 
                                       30
<PAGE>   31
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
  OTHER ASSETS
 
     Included in other assets are intangible assets, which consist primarily of
intellectual property rights and non-compete agreements, which are amortized
over their estimated useful life, ranging from eighteen to thirty-six months.
Accumulated amortization on intangible assets was $279,000, $3,868,000 and
$3,771,000 at December 31, 1998, 1997, and 1996, respectively. Also included in
other assets are prepaid royalties, long-term notes receivable and investments
accounted for under the cost method. The Company reviews other long-term assets
for any impairment in accordance with the Statement of Financial Accounting
Standard No. 121 "Accounting for Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of" (SFAS 121).
 
  REVENUE RECOGNITION
 
     Beginning in fiscal 1998 the Company adopted Statement of Position (SOP)
97-2, "Software Revenue Recognition," as amended by Statement of Position 98-4.
The effect of adoption did not have a material impact on the financial position
or results of operations of the Company.
 
     Revenue from product sales is recognized upon execution of a contract and
completion of delivery obligations provided customer acceptance is reasonably
assured and collectibility is deemed probable. Revenue from maintenance
contracts is recognized ratably over the term of the contract. Allowances for
estimated future product returns and price protection under the Company's
agreements with its distributors and resellers are provided for in the same
period as the related revenues.
 
  WARRANTY
 
     The Company provides a warranty for parts and labor on its products.
Hardware warranty periods are generally one year from installation date on sales
to end-users and one year from delivery date on sales to distributors. In
addition, warranty periods for certain software products, repairs, and upgraded
parts are 90 days upon receipt. Estimated warranty costs are recorded at the
time of revenue recognition.
 
  INCOME TAXES
 
     The Company provides for the recognition of deferred tax liabilities and
assets for the expected future tax consequences of events that have been
included in the financial statements or tax returns. Under this method, deferred
tax liabilities and assets are determined based on the difference between the
financial statement and tax bases of assets and liabilities using enacted tax
rates in effect for the year in which the differences are expected to reverse.
The measurement of deferred tax assets is reduced by a valuation allowance if,
based upon the weighted available evidence, it is more likely than not that some
or all of the deferred tax assets will not be realized. (See Note 10)
 
  EARNINGS PER SHARE
 
     Basic earnings per share ("EPS") excludes the effect of any dilutive
options, warrants or convertible securities and is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted EPS reflects the potential dilution that
could occur if securities or other contracts to issue common stock were issued,
exercised or converted into common stock. Dilutive common share equivalents
consist of stock options and warrants calculated using the treasury stock
method. The following table reconciles the numerator and the denominators of the
basic and diluted
 
                                       31
<PAGE>   32
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
EPS computations shown on the Consolidated Statements of Operations (in
thousands, except per share data):
 
<TABLE>
<CAPTION>
                                                      FOR THE YEARS ENDED DECEMBER 31,
                                                     ----------------------------------
                                                       1998         1997         1996
                                                     ---------    ---------    --------
<S>                                                  <C>          <C>          <C>
BASIC EPS COMPUTATION:
Numerator:
     Net income (loss).............................  $(55,679)    $(39,398)    $32,172
                                                     ========     ========     =======
DENOMINATOR:
     Weighted average common shares outstanding....    38,527       37,760      36,097
                                                     ========     ========     =======
Basic EPS..........................................  $  (1.45)    $  (1.04)    $  0.89
                                                     ========     ========     =======
DILUTED EPS COMPUTATION:
Numerator:
     Net income (loss).............................  $(55,679)    $(39,398)    $32,172
                                                     ========     ========     =======
DENOMINATOR:
     Weighted average common shares outstanding....    38,527       37,760      36,097
     Common share equivalents......................        --           --       3,501
                                                     --------     --------     -------
          Total Shares.............................    38,527       37,760      39,598
                                                     ========     ========     =======
Diluted EPS........................................  $  (1.45)    $  (1.04)    $  0.81
                                                     ========     ========     =======
</TABLE>
 
     Options to purchase shares of the Company's common stock of 6,686,832 and
4,728,190 were outstanding at December 31, 1998 and 1997, respectively, but were
not included in the computation of diluted EPS because they were antidilutive
due to the net losses sustained in 1998 and in 1997. Warrants for the Company's
common stock of 2,723 were outstanding at December 31, 1998 but were not
included in the computation of diluted EPS because they were antidilutive to the
loss sustained in 1998.
 
  CONCENTRATIONS
 
  Credit Risk
 
     Financial instruments, which potentially subject the Company to
concentration of credit risk, include cash, cash equivalents, marketable
securities and trade receivables. With respect to its cash, cash equivalents and
marketable securities, the Company invests its excess cash primarily in deposits
with a commercial bank and corporate obligations and has established guidelines
relative to credit ratings, diversification and maturities that maintain safety
and liquidity. The Company sells its products to a variety of customers,
including end users, dealers and distributors, in a variety of different
industries and geographic regions. The Company performs ongoing credit
evaluations of its customers and maintains reserves for potential credit losses.
 
  Suppliers
 
     Certain components and parts used in the Company's products are procured
from a single source. The Company obtains parts from one vendor only, even where
multiple sources are available, to maintain quality control and enhance the
working relationship with suppliers. These purchases are made under existing
contracts or purchase orders. The failure of a supplier, including a
subcontractor, to deliver on schedule could delay or interrupt the Company's
delivery of products and thereby adversely affect the Company's revenues and
profits.
 
                                       32
<PAGE>   33
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
  OTHER COMPREHENSIVE INCOME
 
     The Company adopted Statement of Financial Accounting Standards No. 130,
"Reporting Comprehensive Income" for the year ended December 31, 1998. This
statement requires that changes in comprehensive income be shown in a financial
statement that is displayed with the same prominence as other financial
statements. The Company has presented accumulated other comprehensive income and
other comprehensive income in the Consolidated Balance Sheets and Consolidated
Statements of Stockholders' Equity.
 
  SEGMENT INFORMATION
 
     The Company has adopted Statement of Financial Accounting Standards No.
131, "Disclosure about Segments of an Enterprise and Related Information," for
the year ended December 31, 1998 which requires companies to report selected
information about operating segments, as well as enterprise-wide disclosures
about products, services, geographic areas, and major customers. Operating
segments are determined based on the way that management organizes its business
for making operating decisions and assessing performance.
 
  NEWLY ISSUED ACCOUNTING STANDARDS
 
     In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS 133 is
effective for all fiscal quarters of all fiscal years beginning after June 15,
1999. SFAS 133 requires that all derivative instruments be recorded on the
balance sheet at their fair value. Changes in the fair value of derivatives are
recorded each period in current earnings or other comprehensive income,
depending on whether a derivative is designated as part of a hedge transaction
and, if it is, the type of hedge transaction. The Company is currently
evaluating the effects of this change but anticipates that the adoption of SFAS
133 will not have a significant effect on the Company's results of operations or
its financial position.
 
     In March, 1998 the Accounting Standards Board issued SOP 98-1, "Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use." The
Company plans to adopt the SOP on January 1, 1999. The SOP will require the
capitalization of certain costs incurred after the date of adoption in
connection with developing or obtaining software for internal use. Management
does not expect its adoption will have a material impact on the Company's
financial position or results of operations.
 
     SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition, With
Respect to Certain Transactions," was issued in December, 1998 and addresses
software revenue recognition as it applies to certain multiple-element
arrangements. SOP 98-9 also amends SOP 98-4, "Deferral of the Effective Date of
a Provision of SOP 97-2," to extend the deferral of application of certain
passages of SOP 97-2 through fiscal years beginning on or before March 15, 1999.
All other provisions of SOP 98-9 are effective for transactions entered into in
fiscal years beginning after March 15, 1999. The Company will comply with the
requirements of this SOP as appropriate as they become effective and this is not
expected to have a material effect on the Company's result of operations.
 
  RECLASSIFICATIONS
 
     Certain reclassifications of prior year amounts have been made to conform
with current year presentation. There is no impact of these reclassifications on
shareholders' equity.
 
                                       33
<PAGE>   34
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
3.  ACQUISITIONS:
 
  STARLIGHT NETWORKS, INC.
 
     On November 10, 1998, the Company acquired all of the common stock of
Starlight Networks, Inc. ("Starlight") in a transaction accounted for using the
purchase method of accounting. Starlight develops, manufactures and markets
streaming video software that enables live, interactive multicast video and
video-on-demand. Total consideration of $17,798,000 consisted of 1,509,266
shares of common stock and 2,723 warrants which totaled $14,679,000 and cash of
$3,119,000. The total purchase price of $22,252,000 included the consideration
as well as assumed debt of $3,544,000 and acquisition costs of $910,000 which
related to legal, accounting and financial advisory fees and was allocated to
the fair value of the assets acquired as follows (in thousands):
 
<TABLE>
<S>                                                             <C>
Completed technology........................................    $12,781
In-process technology.......................................      4,442
Long-term liabilities.......................................     (1,853)
Fixed assets................................................        555
Net working capital.........................................       (510)
Goodwill....................................................      5,473
Workforce...................................................        778
Tradename...................................................        586
                                                                -------
Total assets acquired.......................................    $22,252
                                                                =======
</TABLE>
 
     Goodwill is being amortized on a straight line basis over five years and
the fair value of the workforce and tradename are being amortized on a straight
line basis over three years. Completed technology is being amortized over a
period of two to five years based upon the expected life of the products using
the technology.
 
     The fair value of the in-process technology was determined using the stage
of completion methodology. Under this technique, expected net cash flows from
the resulting product are discounted at a risk-adjusted discount rate to arrive
at the project's expected present value and then the percentage of project
completion as of the acquisition date is applied to arrive at a fair value. The
Company used a 30% risk-adjusted discount rate for the Starlight project. The
project was intended to seamlessly integrate several prototype streaming media
applications into one, customer-supportable and distribution channel ready
product suitable for managing high quality streaming events such as business
briefings, distance learning and business television. As such, the Company
believes it has no alternative use, and the in-process technology was charged to
research and development expense in the fourth quarter of 1998. The project was
54% complete as of the acquisition date. The new product is expected to be
introduced in the second half of 1999. Significant risks involved with the
development effort include potential inability to retain key software engineers
and contractors, the possibility of major architectural design oversights, the
possibility of major problems with the development tools created for the
project, potential integration issues with individual software modules and
external software products with which the product must interoperate, and beta
testing of the product. If the product is not completed within the expected
timeframe, the Company may incur additional costs and experience lower revenues
which are not expected to be material to the Company's results of operations or
liquidity.
 
                                       34
<PAGE>   35
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     The following information presents certain statement of operations data for
1998 and 1997 as though the acquisition had occurred on January 1, 1997 (in
thousands):
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31,
                                                     ------------------------
                                                        1998          1997
                                                     ----------    ----------
                                                           (UNAUDITED)
<S>                                                  <C>           <C>
Revenues...........................................   $408,083      $474,499
Net loss...........................................   $(63,372)     $(53,572)
Net loss per common share -- basic.................   $  (1.59)     $  (1.36)
Net loss per common share -- diluted...............   $  (1.59)     $  (1.36)
</TABLE>
 
  MULTILINK, INC.
 
     On July 22, 1997, the Company acquired all of the common stock of
MultiLink, Inc. (MultiLink) in a transaction accounted for as a pooling of
interests. MultiLink develops, manufactures and markets software and hardware
that enable users at two or more sites to participate in audio meetings. The
Company issued 3,578,026 shares of common stock in exchange for 6,389,332 shares
of MultiLink common stock at a ratio of one share of MultiLink common stock to
0.56 shares of the Company's common stock. The accompanying consolidated
financial statements for all periods prior to the acquisition have been restated
to include the results of operations, financial position and cash flows of
MultiLink. Intercompany sales between MultiLink and the Company were
insignificant and have been eliminated in consolidation. Costs associated with
the acquisition of $2,561,000 were charged to operations for the year ended
December 31, 1997. These costs principally relate to investment banking,
accounting and legal advisory fees and severance expense.
 
     The following information presents certain statement of operations data of
the separate companies for the periods prior to the acquisition which for these
purposes has been assumed to occur on June 29, 1997.
 
<TABLE>
<CAPTION>
                                               SIX MONTHS ENDED       YEAR ENDED
                                                   JUNE 29,          DECEMBER 31,
                                             --------------------    ------------
                                               1997        1996          1996
                                             --------    --------    ------------
<S>                                          <C>         <C>         <C>
Revenues
     PictureTel............................  $227,439    $221,083      $467,805
     MultiLink.............................    12,462       9,662        22,420
Net income (loss)
     PictureTel............................  $ (1,513)   $ 15,957      $ 30,598
     MultiLink.............................    (1,376)        651         1,574
</TABLE>
 
     In conjunction with the acquisition, MultiLink's fiscal year end has been
changed from September 30 to December 31 to conform to the Company's fiscal year
end. As a result, the financial statements for the years ended December 31, 1996
and 1997 include the results of operations and financial position of MultiLink
for the year ended September 30, 1996 and the year ended December 31, 1997,
respectively. Accordingly, MultiLink's results of operations and financial
position for the quarter ended December 31, 1996 excluded from the financial
statements are as follows (in thousands):
 
<TABLE>
<S>                                                           <C>
Revenues....................................................  $6,613
                                                              ======
Total cost of sales and operating expenses..................  $5,918
                                                              ======
Net income..................................................  $  394
                                                              ======
</TABLE>
 
     The net income of $394,000 for the quarter ended December 31, 1996 has been
credited directly to retained earnings.
 
                                       35
<PAGE>   36
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
4.  INVENTORIES:
 
     Inventories consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                       ------------------
                                                        1998       1997
                                                       -------    -------
<S>                                                    <C>        <C>
Purchased parts......................................  $ 2,609    $ 2,983
Work in process......................................    1,399      2,128
Finished goods.......................................   26,248     39,790
                                                       -------    -------
                                                       $30,256    $44,901
                                                       =======    =======
</TABLE>
 
5.  MARKETABLE SECURITIES:
 
     At December 31, 1998 and 1997, marketable securities, including those
reported in cash equivalents, were as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                   1998                    1997
                                           --------------------    --------------------
                                           AMORTIZED     FAIR      AMORTIZED     FAIR
                                             COST        VALUE       COST        VALUE
                                           ---------    -------    ---------    -------
<S>                                        <C>          <C>        <C>          <C>
U.S. Government and its agencies.........        --          --     $16,296     $16,291
Corporate obligations....................   $58,192     $58,200      38,957      38,954
                                            -------     -------     -------     -------
     Total debt securities...............   $58,192     $58,200     $55,253     $55,245
                                            =======     =======     =======     =======
</TABLE>
 
     Net unrealized holding gains (losses) of $6,000 and ($5,000) for 1998 and
1997, respectively, are included in other comprehensive income, net of tax.
Gross unrealized holding gains (losses) were $10,000 and ($7,000) for 1998 and
1997, respectively. Realized losses of approximately $1,000 and realized gains
of approximately $1,500,000 and $3,000,000 from the sales of available for sale
securities are included in other income for the years ended December 31, 1998,
1997 and 1996, respectively.
 
     At December 31, 1998, all of the Company's marketable securities have
stated maturity dates within one year of the balance sheet date.
 
6.  PROPERTY AND EQUIPMENT:
 
     Property and equipment consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           -------------------
                                                            1998        1997
                                                           -------    --------
<S>                                                        <C>        <C>
Buildings under capital lease............................  $38,000    $     --
Buildings under capital lease held for sublease..........   20,938      20,938
Equipment................................................  103,274      96,589
Equipment and furniture under capital leases.............   11,268       9,665
Furniture and fixtures...................................   13,922      10,831
Leasehold improvements...................................   15,077      11,442
                                                           -------    --------
                                                           202,479     149,465
Less: Accumulated depreciation and amortization..........  106,824      80,362
                                                           -------    --------
                                                           $95,655    $ 69,103
                                                           =======    ========
</TABLE>
 
     At December 31, 1998 and 1997, accumulated amortization amounted to
$9,134,332 and $4,865,000 on equipment and furniture under capital leases. At
December 31, 1998 and 1997, accumulated amortization amounted to $2,079,000 and
$388,000 on the buildings under capital leases. Depreciation expense for the
years ended December 31, 1998, 1997, and 1996 was $26,967,000, $21,227,000 and
$17,741,000, respectively.
 
                                       36
<PAGE>   37
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
Depreciation expense of $291,000 related to the building under capital lease
held for sublease and the related sublease income of $588,000 for 1998 was
included in other income.
 
7.  DEBT:
 
     On August 12, 1998 and March 31, 1999, the Company amended certain
provisions of the amended and restated credit agreement which expires on October
4, 1999. This agreement requires interest payable at either the bank's base
rate, or the adjusted eurocurrency rate plus an applicable margin of two
percent. The commitment fees were also amended and are payable quarterly on any
unused portion at a rate per annum equal to 0.25%. The amended agreement
contains no demand feature and provides that the principal portion of the
borrowings be paid by the expiration date. At December 31, 1998 and 1997, no
borrowings were outstanding under this credit agreement. In addition, the
Company has $28,762,000 of outstanding standby letters of credit under this
agreement. Fees for letters of credit outstanding against this revolving credit
line were payable at one percent per annum of the face amount. The revolving
credit agreement is collateralized by cash and cash equivalents and contains
certain financial covenants, including the maintenance of certain financial
ratios and minimum net income (loss) requirements. At December 31, 1998, the
Company was out of compliance with substantially all of the debt covenants. The
Company received waivers from the bank regarding those covenants and is
retroactively in compliance. The Company's quarterly operating results for 1999
are likely to be out of compliance with the credit line's financial covenants.
Accordingly, the respective banks have informed the Company that while they
anticipate providing continued short-term lending up to $4,000,000 under the
credit line, they will not renew the Company's outstanding letters of credit as
they come due. The letters of credit come due as follows: $12,500,000 on June
24, 1999, $9,012,000 on July 31, 1999 and $7,250,000 on September 12, 1999.
 
     The Company expects to find alternative issuers for the letters of credit
or to renegotiate the lease terms requiring such letters of credit. In the event
such efforts are unsuccessful, the Company's cash could be reduced by the amount
of the letters of credit.
 
     Local lines of credit are available for short-term advances of up to
$5,300,000 to certain of the Company's foreign subsidiaries. Two of these lines
are guaranteed by the Company. The agreements require interest payable ranging
from the bank's prime lending rate plus up to one quarter of one percent per
annum. A total of $881,000 was outstanding under the local lines of credit at
December 31, 1998. No borrowings were outstanding against these local lines of
credit at December 31, 1997. At December 31, 1998, the weighted average interest
rate on outstanding short-term borrowings was 1.7%.
 
8.  COMMITMENTS:
 
     The Company has commitments under capital and non-cancelable operating
leases for office and manufacturing space. The facility leases are for terms
ranging from one to eighteen years. The leases generally contain provisions that
allow for expansion, extension and termination. In August of 1997, the Company
entered into an eighteen-year lease agreement for the building at 50 Minuteman
Road in Andover, Massachusetts. In June of 1998, the property was subleased for
a period of ten years. The lease is accounted for as a capital lease. In March
of 1997, the Company entered into another eighteen-year lease agreement for an
additional building at 200 Minuteman Road in Andover, Massachusetts. The lease,
which commenced in October 1998, is accounted for as a capital lease.
 
     The Company is the lessee under several capital lease and sale-leaseback
agreements with third parties for certain leasehold improvements, equipment and
furniture.
 
                                       37
<PAGE>   38
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     Future minimum lease payments under capital and operating leases with
initial or remaining terms of one year or more are (in thousands):
 
<TABLE>
<CAPTION>
                                                           CAPITAL     OPERATING
                                                            LEASES      LEASES
                                                           --------    ---------
<S>                                                        <C>         <C>
1999.....................................................  $  8,047     $10,083
2000.....................................................     6,151       7,850
2001.....................................................     6,103       7,479
2002.....................................................     6,103       7,005
2003.....................................................     6,103       6,427
Thereafter...............................................    75,261      41,798
                                                           --------     -------
Total future minimum lease payments......................   107,768     $80,642
                                                                        =======
Less amount representing interest........................    47,820
Present value of net future minimum lease payments.......    59,948
Less current portion.....................................     3,537
                                                           --------
Long-term obligation under capital leases................  $ 56,411
                                                           ========
</TABLE>
 
     Total future minimum lease payments have not been reduced by future minimum
sublease payments under non-cancelable sublease agreements. Income from future
minimum sublease agreements with initial or remaining terms of one year or more
are (in thousands):
 
<TABLE>
<CAPTION>
                                                            CAPITAL    OPERATING
                                                            LEASES      LEASES
                                                            -------    ---------
<S>                                                         <C>        <C>
1999......................................................  $ 2,353      $108
2000......................................................    2,353       110
2001......................................................    2,353        55
2002......................................................    2,388        --
2003......................................................    2,414        --
Thereafter................................................   10,660        --
                                                            -------      ----
          Total future minimum lease payments.............  $22,521      $273
                                                            =======      ====
</TABLE>
 
     Net rental expense for operating leases was $10,787,000, $11,600,000 and
$9,619,000 for 1998, 1997 and 1996, respectively.
 
9.  CAPITAL STOCK:
 
  PREFERENCE STOCK
 
     The Company's Board of Directors is empowered to fix the terms and rights
of the Preference Stock. Issuance of the Preference Stock limits the rights of
the Common Stockholders. On February 18, 1999, Intel invested $30,500,000 in the
Company, acquiring approximately 10% of the Company's equity through convertible
preferred stock.
 
  WARRANTS
 
     As part of the acquisition of Starlight Networks, Inc., the Company assumed
warrants to purchase 2,723 shares of Common Stock. The warrants are exercisable
at an average price of $27.83 per share and have expiration dates ranging from
February, 2002 through February, 2007.
 
  STOCKHOLDERS' RIGHTS AGREEMENT
 
     On March 25, 1992, the Board of Directors of the Company declared a
dividend of one purchase right (a "Right") for every outstanding share of the
Company's Common Stock. After giving effect to the split, each
 
                                       38
<PAGE>   39
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
Right entitles the holder to purchase from the Company one two-hundredths of a
share of Junior Preference Stock at a price of $90 per one two-hundredths of a
share, subject to adjustment. The Rights will become exercisable on the
fifteenth business day following the date of a public announcement that an
acquiring person (as defined in the Rights Agreement, the definition of which
provides for certain limited exclusions) has acquired, or obtained the right to
acquire, beneficial ownership of 15% or more of the Company's outstanding Common
Stock or on the fifteenth business day following the commencement of a tender
offer or exchange offer that would result in an acquiring person owning 15% or
more of the Company's outstanding Common Stock.
 
     If the Company were acquired in a merger or other business combination, or
more than 25% of its assets or earning power were sold, each holder of a Right
would be entitled to exercise such Right and thereby receive common stock of the
acquiring company with a market value of two times the exercise price of the
Right. If an acquiring person has acquired or obtained the right to acquire 15%
of the Company's Common Stock, each holder of a Right, other than the acquiring
person, will be entitled to receive shares of the Company's Common Stock having
a market value of two times the exercise price of the Right. At any time the
Company may redeem the Rights at a redemption price of $0.005 per Right. The
Rights expire March 25, 2002.
 
  STOCK-BASED COMPENSATION PLANS
 
     The Company has adopted the disclosure requirements of Statement of
Financial Accounting Standard (SFAS) No. 123, "Accounting for Stock-Based
Compensation." The Company continues to recognize compensation costs using the
intrinsic value based method described in Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees." No compensation costs were
recognized in 1998, 1997, and 1996.
 
     Net income (loss) and net income (loss) per share as reported in these
consolidated financial statements and on a pro forma basis, as if the fair value
based method described in SFAS No. 123 had been adopted, are as follows (in
thousands, except per share amounts):
 
<TABLE>
<CAPTION>
                                                                   YEAR ENDED DECEMBER 31,
                                                               -------------------------------
                                                                 1998        1997       1996
                                                               --------    --------    -------
<S>                                             <C>            <C>         <C>         <C>
Net income (loss).............................  As reported    $(55,679)   $(39,398)   $32,172
                                                Pro forma       (66,224)    (46,554)    25,812
Net income (loss) per share -- Basic..........  As reported    $  (1.45)   $  (1.04)   $  0.89
                                                Pro forma         (1.72)      (1.23)      0.72
Net income (loss) per share -- Diluted........  As reported    $  (1.45)   $  (1.04)   $  0.81
                                                Pro forma         (1.72)      (1.23)      0.65
</TABLE>
 
     The effects of applying SFAS No. 123 for the purpose of providing pro forma
disclosures may not be indicative of the effects on reported net income and net
income per share for future years, as the pro forma disclosures include the
effects of only those awards granted after January 1, 1995 and additional awards
are anticipated in future years.
 
  EMPLOYEE STOCK PURCHASE PLAN
 
     Under terms of an Employee Stock Purchase Plan (the "ESPP") adopted in 1994
and amended in 1996, eligible employees are able to purchase shares of the
Company's Common Stock at 85% of the average market value as of the start of
each six month option period or the end of such period, whichever is lower. Up
to 1,000,000 shares are authorized under the ESPP. Shares purchased under the
ESPP in 1998, 1997 and 1996 totaled 286,074, 183,017 and 73,827, respectively.
The weighted average grant date fair value of the shares
 
                                       39
<PAGE>   40
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
purchased was $2.64, $5.43 and $9.37 in 1998, 1997 and 1996, respectively. There
are 325,088 shares available under the ESPP at December 31, 1998.
 
     For the purpose of providing pro forma disclosures, the fair values of
shares purchased were estimated using the Black-Scholes option-pricing model
with the following weighted-average assumptions used for purchases in 1998, 1997
and 1996, respectively: a risk-free interest rate of 5.11%, 6.07% and 5.35%, an
expected life of 6 months, expected volatility of 65%, 56% and 50%, and no
expected dividends.
 
  STOCK OPTION PLANS
 
     On February 18, 1997, the Compensation Committee of the Board of Directors
granted replacement options, at an exercise price of $16.875 per share, to all
employees other than the executive officers and directors (and other than those
few who did not consent) holding outstanding options exercisable at a price of
$20.00 or more. The replacement options become exercisable (unless accelerated
by the Compensation Committee) over a four-year period, and to the extent the
canceled option had already become exercisable, such portion of the new option
became exercisable in six months from the date of re-grant and the remaining
options became exercisable over a four-year period commencing in February, 1998.
 
     On November 5, 1997, the Compensation Committee of the Board of Directors
granted replacement options at the rate of four replacement options for every
five outstanding options (including replacement options granted in February,
1997) returned, at an exercise price of $9.187 per share, to all employees other
than the executive officers and directors (and other than those few who did not
consent) holding outstanding options exercisable at a price of $10.00 or more.
The replacement options become exercisable (unless accelerated by the committee)
over a four-year period, and to the extent the canceled options had already
become exercisable, such portion of the new option became exercisable in six
months from the date of re-grant and the remaining options became exercisable
over a four-year period commencing in November, 1998.
 
     On November 14, 1989, the Company's shareholders approved the PictureTel
Equity Incentive Plan. As of December 31, 1998 shareholders have authorized the
issuance of up to 9,000,000 shares of post Stock Split Common Stock under the
Plan. The Equity Incentive Plan permits the granting of non-statutory and
incentive stock options, a variety of stock and stock-based awards and related
benefits, and cash performance awards, which are in addition to option grants
under the 1984 Amended and Restated Stock Option Plan, to employees and other
persons who are in a position to make significant contributions to the success
of the Company.
 
     Effective October 23, 1992, the Board of Directors adopted the 1992
Non-Employee Directors' Stock Option Plan. As of December 31, 1998 shareholders
have authorized the issuance of up to 430,000 shares of Common Stock under the
Plan to eligible non-employee directors. Under this Plan each non-employee
director at October 23, 1992 and each non-employee director subsequently elected
receives, at October 23, 1992 or the director's first election date, a
non-statutory option to purchase 40,000 shares of post Stock Split Common Stock
at an exercise price equal to the fair market value of the stock on the
effective date of grant. The Plan was amended at the Annual Meeting on June 17,
1996 so as to increase the aggregate number of shares available for issuance
under the Plan from 280,000 to 430,000, and to further provide, as of August 1,
1996, for the automatic grant of a non-statutory option to purchase 20,000
shares of Common Stock to directors who have been directors for more than two
years on August 1, 1996, and on the later date of first election of any other
director and thereafter, for the annual grant of stock options to purchase 5,000
shares of the Company's Common Stock on August first of each year, commencing on
August 1, 1997, so long as such individual is serving as a director on the
applicable August first date, provided that no such annual option for 5,000
shares shall be granted to a director who first became a director of the Company
within six months prior to August first of said year. The Plan was further
amended by the Board of Directors on February 27, 1998 to provide for
non-automatic grants of non-statutory options not to exceed 60,000 shares in the
aggregate for all directors. All options expire ten years after the effective
date of grant, and such options become exercisable
 
                                       40
<PAGE>   41
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
over a four-year period. At December 31, 1998 there were 1,328,289 shares
available for future grant under these plans.
 
     Effective upon the consummation of the acquisition of MultiLink, Inc. on
July 22, 1997, the Board of Directors voted to assume the 1984, 1986, 1987 and
1996 MultiLink, Inc. Stock Options Plans and renamed the 1984, 1986, 1987 and
1996 PictureTel (MultiLink) Option Plans (the "Plans"), as appropriate, and
provided for the issuance of shares of Common Stock in replacement for MultiLink
Common Stock upon the exercise thereof. The Compensation Committee of the Board
of Directors administers the MultiLink Option Plans assumed (and renamed) by
PictureTel. There is reserved for issuance under the Plans 655,419 shares of
Common Stock of PictureTel Corporation to be issued upon exercise of the options
outstanding under the Plans. No additional options will be issued under the
Plans. All options expire ten years after the effective date of the grant, and
such options become exercisable over a four-year period.
 
     Effective upon the consummation of the acquisition of Starlight Networks,
Inc. on November 10, 1998, the Board of Directors voted to approve the 1998
Acquisition Stock Option Plan (the "Acquisition Plan"). The Acquisition Plan
permits the grant of non-qualified options to purchase shares of Common Stock of
PictureTel Corporation to Starlight employees who are in a position to make
significant contributions to the success of the Company. The Compensation
Committee of the Board of Directors administers the Acquisition Plan. There is
reserved for issuance under the Plan 400,000 shares of Common Stock to be issued
upon exercise of the options granted under the Plan. All options expire ten
years after the effective date of the grant, and such options become exercisable
over a four-year period.
 
     The following table summarizes the Company's stock option plans at December
31, 1998, 1997, and 1996, and changes during the years then ended:
 
<TABLE>
<CAPTION>
                                      1998                     1997                     1996
                             ----------------------   ----------------------   ----------------------
                                          WEIGHTED-                WEIGHTED-                WEIGHTED-
                                           AVERAGE                  AVERAGE                  AVERAGE
                                          EXERCISE                 EXERCISE                 EXERCISE
                               SHARES       PRICE       SHARES       PRICE       SHARES       PRICE
                             ----------   ---------   ----------   ---------   ----------   ---------
<S>                          <C>          <C>         <C>          <C>         <C>          <C>
Outstanding at beginning of
  year.....................   4,728,190    $11.21      5,252,627    $17.82      5,296,989    $10.93
Granted at fair market
  value....................   3,627,100      7.01      4,356,743     13.17      1,608,889     31.94
Exercised..................    (232,068)     4.23       (342,222)     4.95     (1,314,188)     8.18
Forfeited..................  (1,436,390)    11.26     (4,538,958)    21.22       (339,063)    14.50
                             ----------               ----------               ----------
Outstanding at end of
  year.....................   6,686,832    $ 9.16      4,728,190    $11.21      5,252,627    $17.82
                             ==========               ==========               ==========
Options exercisable at
  year-end.................   2,328,993     11.52      2,034,527    $10.05      2,067,035    $ 9.59
Weighted-average grant date
  fair value of options
  granted during the year
  at fair market value.....                $ 4.38                   $ 7.62                   $16.80
</TABLE>
 
                                       41
<PAGE>   42
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     The following table summarizes information about stock options outstanding
at December 31, 1998:
 
<TABLE>
<CAPTION>
                                 OPTIONS OUTSTANDING                     OPTIONS EXERCISABLE
                   -----------------------------------------------   ----------------------------
                                 WEIGHTED-AVERAGE                      NUMBER
                     NUMBER         REMAINING         WEIGHTED-      EXERCISABLE      WEIGHTED
    RANGE OF       OUTSTANDING   CONTRACTUAL LIFE      AVERAGE           AT           AVERAGE
EXERCISE PRICES    AT 12/31/98      (IN YEARS)      EXERCISE PRICE    12/31/98     EXERCISE PRICE
---------------    -----------   ----------------   --------------   -----------   --------------
<S>                <C>           <C>                <C>              <C>           <C>
$ 0.268 -  6.250      741,013          8.14             $ 5.42          160,476        $ 4.51
  6.500 -  6.937    1,606,317          9.03               6.92           12,017          6.77
  6.938 -  7.938    1,178,834          9.43               7.25           25,434          7.38
  8.000 -  9.187    1,431,301          7.18               8.97        1,011,480          8.91
  9.188 - 10.440    1,026,192          5.80               9.72          662,891          9.73
 10.938 - 35.130      596,769          7.97              17.53          362,008         18.05
 40.500 - 40.500      106,406          7.07              40.50           94,688        $40.50
                    ---------                                         ---------
$ 0.268 - 40.500    6,686,832          7.99             $ 9.16        2,328,994        $11.52
                    =========                                         =========
</TABLE>
 
     For the purpose of providing pro forma disclosures, the fair values of
options granted were estimated using the Black-Scholes option pricing model with
the following weighted-average assumptions used for grants in 1998, 1997 and
1996, respectively: a risk-free interest rate of 5.10%, 6.06% and 5.95%, an
expected life of 5.5, 5.5 and 4 years, expected volatility of 67%, 57% and 50%
(No volatility assumption was used for MultiLink options) and no expected
dividends.
 
10.  INCOME TAXES:
 
     Significant items making up total net deferred tax assets are as follows
(in thousands):
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                            ------------------
                                                             1998       1997
                                                            -------    -------
<S>                                                         <C>        <C>
Net operating loss and tax credit carryforwards...........  $39,441    $23,825
Inventory reserves........................................    3,578      3,553
Depreciation and amortization.............................   (5,357)       753
Other temporary differences...............................   13,880     11,870
Valuation allowance.......................................  (51,542)    (8,280)
                                                            -------    -------
Total net deferred tax assets.............................  $    --    $31,721
                                                            =======    =======
</TABLE>
 
     Other temporary differences principally represent bad debt and warranty
reserves, depreciation and vacation and other payroll related differences. In
1997, the valuation allowance primarily offset the deferred benefit of certain
federal and state tax credit carryforwards whose benefit was uncertain. Included
in the deferred tax assets is $7,230,000 reflecting the benefit of deductions
from the exercise of stock options. The benefit will be recorded as a credit to
additional paid in capital when realized. Management believes the Company is
unlikely to fully realize the deferred tax assets and accordingly has
established a full valuation allowance on the deferred tax assets in the fourth
quarter of 1998.
 
                                       42
<PAGE>   43
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     The provision (benefit) for income taxes consisted of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                    YEARS ENDED DECEMBER 31,
                                                 ------------------------------
                                                  1998        1997       1996
                                                 -------    --------    -------
<S>                                              <C>        <C>         <C>
Federal income taxes:
     Currently payable.........................  $   253    $  2,742    $ 8,509
     Deferred..................................   24,634     (18,161)     3,098
State income taxes:
     Currently payable.........................       75          --        377
     Deferred..................................    7,011      (3,134)     1,375
Foreign taxes:
     Currently payable.........................    3,732       2,002      3,368
     Deferred..................................       76         459       (804)
                                                 -------    --------    -------
Total..........................................  $35,781    $(16,092)   $15,923
                                                 =======    ========    =======
</TABLE>
 
     The differences between the statutory federal income tax rate and the
Company's effective income tax rate were as follows:
 
<TABLE>
<CAPTION>
                                                      YEARS ENDED DECEMBER 31,
                                                     --------------------------
                                                     1998       1997       1996
                                                     -----      -----      ----
<S>                                                  <C>        <C>        <C>
Statutory federal income tax rate..................  (35.0)%    (35.0)%    35.0%
State income tax, net of federal tax benefit.......    0.2       (4.7)      3.0
Federal and state tax credits from research and
  development......................................     --       (0.9)     (1.4)
Difference between foreign and US tax rates and the
  benefit of the foreign sales corporation.........    3.1        0.7      (2.1)
Change in deferred asset valuation allowance.......  207.6        5.0      (2.8)
Other..............................................    3.9        5.9       1.4
                                                     -----      -----      ----
Effective tax rate.................................  179.8%     (29.0)%    33.1%
                                                     =====      =====      ====
</TABLE>
 
     At December 31, 1998 the Company had remaining net operating loss ("NOL")
carryforwards available of approximately $73,416,000 to offset future federal
and state taxable income. The Company also has unused federal research and
development tax credits of approximately $3,427,000. The NOL and tax credit
carryforwards expire at various dates through the year 2009 and 2018,
respectively. As a result of prior equity issuances, the Company's use of NOL
carryforwards incurred prior to July 1988 is subject to certain annual
limitations. At December 31, 1998, approximately $3,975,000 of the available NOL
carryforwards have an annual limitation amount of approximately $662,000 that
may be used to reduce the Company's taxable income in the future.
 
11.  EMPLOYEE BENEFIT PLANS:
 
     The Company has a defined contribution profit sharing plan incorporating
features under Section 401(k) of the Internal Revenue Code designed to provide
retirement benefits to its employees. The Plan covers substantially all
employees of the Company, and eligible participants may contribute up to 15% of
their pay on a pretax basis subject to annual dollar limits established by the
Internal Revenue Code and plan limitations. The Plan document states that the
Company will provide at least 33.3% matching contribution up to the first 3% of
each participant's eligible compensation. For the years ended December 31, 1998,
1997 and 1996 the Company's matching contribution was 50%, 50% and 33.3%
respectively or $780,000, $929,000 and $857,000, respectively.
 
                                       43
<PAGE>   44
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     The Company assumed the MultiLink, Inc. 401K Plan as a result of the
acquisition in July 1997. However, the Company has filed a Plan termination with
the Internal Revenue Service. The final termination of the Plan is pending. No
Company contributions were made to the MultiLink Plan in 1997 or 1996.
 
12.  SEGMENT INFORMATION:
 
     The Company has determined that its reportable segments are those that are
based on the Company's method of internal reporting, which disaggregates its
business into three reportable operating segments: videoconferencing products,
videoconferencing services and audioconferencing. The videoconferencing products
segment develops, manufactures and markets visual communications systems and
collaboration software. The videoconferencing services segment provides services
for the videoconferencing products. The audioconferencing segment develops,
manufactures, markets and services multipoint control units.
 
     In 1998, 1997 and 1996 no customer accounted for 10% or more of total
revenues. Solectron Corporation accounted for 32% and 19%, respectively, of the
Company's purchases from outside vendors in 1998 and 1997. VideoServer, Inc.
accounted for 10% of the Company's purchases from outside vendors in 1998.
 
<TABLE>
<CAPTION>
                                      VIDEO-          VIDEO-
                                   CONFERENCING    CONFERENCING       AUDIO-
                                     PRODUCTS        SERVICES      CONFERENCING     OTHER       TOTAL
                                   ------------    ------------    ------------    --------    --------
<S>                                <C>             <C>             <C>             <C>         <C>
YEAR ENDED DECEMBER 31, 1998:
Revenues from external
  customers......................    $324,984        $58,263         $22,905       $     --    $406,152
Operating income (loss)..........    $(17,387)       $12,071         $ 7,555       $(25,889)   $(23,650)
YEAR ENDED DECEMBER 31, 1997:
Revenues from external
  customers......................    $394,587        $47,313         $24,525       $     --    $466,425
Operating income (loss)..........    $(32,667)       $ 9,642         $(6,384)      $(27,441)   $(56,850)
YEAR ENDED DECEMBER 31, 1996:
Revenues from external
  customers......................    $428,699        $39,106         $22,420       $     --    $490,225
Operating income (loss)..........    $ 38,459        $11,846         $ 2,538       $(11,829)   $ 41,014
</TABLE>
 
     Other consists of corporate administrative functions which are excluded
from the videoconferencing products, videoconferencing services and
audioconferencing segments for management decision making.
 
     The Company evaluates the performance of its segments based upon operating
income. There are no material intersegment revenues. Transfers of
videoconferencing products to the videoconferencing services segment are
recorded at standard cost and are not tracked for management reporting purposes.
Asset information by reportable segment has not been disclosed since the Company
does not produce such information internally.
 
     Videoconferencing products consist of three categories: group,
desktop/personal and network server systems. Revenues for the videoconferencing
products segment are detailed below (in thousands):
 
<TABLE>
<CAPTION>
                                                   YEAR ENDED DECEMBER 31,
                                               --------------------------------
                                                 1998        1997        1996
                                               --------    --------    --------
<S>                                            <C>         <C>         <C>
Group Systems................................  $267,451    $320,124    $314,273
Desktop/Personal Systems.....................    29,859      41,057      75,324
Network Server Systems.......................    27,674      33,406      39,102
                                               --------    --------    --------
     Total Videoconferencing Products........  $324,984    $394,587    $428,699
                                               ========    ========    ========
</TABLE>
 
                                       44
<PAGE>   45
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     Videoconferencing services relate to maintenance revenues and professional
services as detailed below (in thousands):
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31,
                                                  -----------------------------
                                                   1998       1997       1996
                                                  -------    -------    -------
<S>                                               <C>        <C>        <C>
Maintenance Services............................  $39,436    $36,729    $36,114
Professional Services...........................   18,827     10,584      2,992
                                                  -------    -------    -------
     Total Videoconferencing Services...........  $58,263    $47,313    $39,106
                                                  =======    =======    =======
</TABLE>
 
GEOGRAPHIC DATA
 
     In addition to its direct and indirect sales channels in the United States,
the Company has subsidiaries in various foreign countries which, through direct
and indirect sales channels, sell and service the Company's products in their
respective geographic area. Revenues from external customers represent sales
made from those countries. The Company's revenues and long-lived asset financial
information is detailed as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                        UNITED
                                       UNITED STATES    KINGDOM     JAPAN     ALL OTHER     TOTAL
                                       -------------    -------    -------    ---------    --------
<S>                                    <C>              <C>        <C>        <C>          <C>
YEAR ENDED DECEMBER 31, 1998
Revenues from external customers.....    $267,111       $79,396    $24,747     $34,898     $406,152
Long-lived assets....................    $125,997       $ 3,804    $ 2,295     $ 2,235     $134,331
YEAR ENDED DECEMBER 31, 1997
Revenues from external customers.....    $307,450       $76,318    $36,689     $45,968     $466,425
Long-lived assets....................    $ 88,445       $ 4,341    $ 2,086     $ 2,120     $ 96,992
YEAR ENDED DECEMBER 31, 1996
Revenues from external customers.....    $325,580       $78,645    $40,008     $45,992     $490,225
Long-lived assets....................    $ 72,119       $ 1,966    $ 1,263     $ 1,637     $ 76,985
</TABLE>
 
                                       45
<PAGE>   46
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
13.  UNAUDITED INTERIM FINANCIAL INFORMATION:
 
     Quarterly financial information is as follows (in thousands, except per
share data):
 
<TABLE>
<CAPTION>
                                         FIRST       SECOND      THIRD       FOURTH
                                        QUARTER     QUARTER     QUARTER     QUARTER
                                        --------    --------    --------    --------
<S>                                     <C>         <C>         <C>         <C>
1998
Revenues..............................  $101,045    $104,582    $102,058    $ 98,467
Gross margin..........................    45,887      40,273      45,761      41,145
Net income (loss).....................    (2,165)     (6,688)      1,624     (48,450)
Net income (loss) per common share --
  basic...............................  $  (0.06)   $  (0.17)   $   0.04    $  (1.23)
Net income (loss) per common share --
  diluted.............................  $  (0.06)   $  (0.17)   $   0.04    $  (1.23)
1997
Revenues..............................  $121,935    $117,966    $109,689    $116,835
Gross margin..........................    58,737      51,695      42,816      37,266
Net income (loss).....................     2,011      (4,900)    (16,715)    (19,794)
Net income (loss) per common share --
  basic...............................  $   0.05    $  (0.13)   $  (0.44)   $  (0.52)
Net income (loss) per common share --
  diluted.............................  $   0.05    $  (0.13)   $  (0.44)   $  (0.52)
</TABLE>
 
14.  SUPPLEMENTAL CASH FLOW INFORMATION:
 
<TABLE>
<CAPTION>
                                                    1998       1997       1996
                                                   -------    -------    ------
<S>                                                <C>        <C>        <C>
Supplemental cash flow information:
     Interest paid...............................  $ 2,903    $ 1,722    $1,036
     Income taxes paid...........................  $ 1,245    $ 4,237    $2,676
Supplemental disclosure of non-cash investing
  activity:
     Building acquired under capital lease.......  $38,000    $20,938    $   --
     Issuance of stock for acquisition...........  $14,679    $    --    $   --
     Assumption of debt for acquisition..........  $ 3,544    $    --    $   --
</TABLE>
 
15.  OTHER CHARGES:
 
     During the year ended December 31, 1998, the Company recorded charges of
$9,957,000. Charges of $6,808,000 reported as part of cost of goods sold include
$5,457,000 related to the write down of inventory and capitalized software to
their net realizable value and other costs associated with the discontinuation
of one of the Company's product lines and $1,351,000 to record inventory
provisions for the write down of certain inventories to their net realizable
value. Charges of $3,149,000 included in operating expenses relate to the write
down of leasehold improvements related to the facility at 50 Minuteman Road in
Andover. The Company subleased this facility in June, 1998, and the sublessee
did not utilize the leasehold improvements in the facility.
 
     During the year ended December 31, 1997, the Company recorded other charges
of $42,664,000. Other charges of $16,096,000 reported as part of cost of goods
sold include $4,940,000 for various write-downs of excess and obsolete inventory
to their net realizable value as a result of lower than forecasted demand,
$9,881,000 to record impairment charges associated with software development
projects canceled as a result of a realignment in the Company's planned product
offerings, $1,122,000 for product retrofit accruals, and $153,000 related to
work-force reductions and organizational realignment as a result of activities
undertaken to reduce the Company's cost structure to bring it in line with
lower-than-expected revenues.
 
                                       46
<PAGE>   47
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     Other charges of $21,568,000 in 1997 reported as part of operating expenses
include $2,561,000 recorded in connection with the acquisition of MultiLink,
$4,373,000 related to severance expense and sales office closings associated
with the acquisition of MultiLink and PictureTel related work-force reductions
as a result of activities undertaken to reduce the Company's cost structure to
bring it in line with lower-than-expected revenues, $6,475,000 in specific
accounts and notes receivable write-offs and provisions for allowances for
doubtful accounts, $3,900,000 in provisions for sales taxes primarily related to
MultiLink, $1,880,000 in advances written-off to reflect current business
conditions and shifts in distribution channels, and $2,379,000 in charges
related to other miscellaneous matters.
 
     Additionally in 1997, the Company established a $1,500,000 provision
recorded against revenue to accrue for estimated sales returns and allowances.
Other charges of $3,500,000 included in other income/expense include the
write-off of certain equity investments to reflect current business conditions.
 
16.  LITIGATION:
 
     A.  Datapoint Litigation
 
     In December 1993, PictureTel was sued by Datapoint Corporation in the
United States District Court for the Northern District of Texas. Datapoint
alleged that certain of PictureTel's products infringed patent rights allegedly
owned by Datapoint. On April 9, 1998 a jury returned a verdict in favor of
PictureTel finding that PictureTel did not infringe the Datapoint patents and
that the Datapoint patent claims raised against PictureTel were invalid.
Datapoint has appealed these findings, and there can be no assurance that the
outcome of the appeal will be in favor of PictureTel, however, the Company
believes that it has meritorious defenses to the appeal.
 
     B.  Shareholder Litigation
 
     Since September 23, 1997, seven class action shareholders' complaints have
been filed against the Company, Norman E. Gaut, Director and former Chairman of
the Board and Chief Executive Officer, and Les Strauss, the former Vice
President and Chief Financial Officer, in the United States District Court for
the District of Massachusetts. The plaintiffs filed a consolidated complaint on
February 11, 1998.
 
     The original complaints were filed following the Company's announcement on
September 19, 1997 that it would restate its financial results for the first
quarter of the fiscal year ending December 31, 1997 and the last two quarters of
the fiscal year ending December 31, 1996 and were amended when the Company
announced on November 13, 1997 that it would also restate the second quarter of
the fiscal year ending December 31, 1997. The consolidated complaint alleges
that PictureTel and Messrs. Gaut and Strauss violated Sections 10(b) and 20(a)
of the Exchange Act and Rule 10b-5 promulgated thereunder, during the period
from October 17, 1996 through November 13, 1997, through the alleged preparation
and dissemination of materially false and misleading financial statements which
artificially inflated the price of PictureTel Common Stock. The consolidated
complaint seeks to recover an unspecified amount of damages, including
attorneys' and experts' fees and expenses.
 
     On April 7, 1998, the Company filed a motion to dismiss the complaint. On
October 28, 1998, the motion to dismiss Norman E. Gaut was granted and the
motion to dismiss PictureTel and Les Strauss was denied. Limited discovery has
occurred, and the Company expresses no opinion as to the likely outcome. This
litigation may have a material impact on the Company's financial position,
results of operations and cash flows.
 
     C.  Revnet, Inc.
 
     On June 2, 1998, the Company was served with a complaint from a former
distribution channel customer, Revnet, Inc., which has ceased operations.
(Revnet, Inc., v. PictureTel Corporation. Civil Action 98092039, filed April 2,
1998, in the Circuit Court for Baltimore City, Maryland.) The complaint alleges
that the
                                       47
<PAGE>   48
                             PICTURETEL CORPORATION
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
Company breached an oral contract. Revnet is seeking $200,000,000 in damages.
Discovery has recently begun. The Company believes that the complaint and the
claim for damages are without merit and intends to vigorously defend against
them.
 
     In addition to the above, the Company has also been and is from time to
time subject to claims and suits incidental to the conduct of business. There
can be no assurance that the Company's insurance will be adequate to cover all
liabilities that may arise out of such claims. Further, although the Company
intends to defend itself vigorously against all such claims, the ultimate
outcome of the claims cannot be accurately predicted. The Company does not
believe that any claim of which it is aware, other than the claims listed above,
could result in an outcome that will have a material adverse affect to its
business, financial condition, results of operations or cash flows.
 
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
     None.
 
                                       48
<PAGE>   49
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
                        ON FINANCIAL STATEMENT SCHEDULES
 
To the Board of Directors of PictureTel Corporation
 
     Our audits of the consolidated financial statements referred to in our
report dated February 12, 1999 of PictureTel Corporation (which report and
consolidated financial statements are included in this Annual Report on Form
10-K) also included an audit of the financial statement schedule listed in Item
14(a)(2) of this Form 10-K.
 
     In our opinion, this financial statement schedule presents fairly, in all
material respects, the information set forth therein when read in conjunction
with the related consolidated financial statements.
 
PRICEWATERHOUSECOOPERS LLP
 
Boston, Massachusetts
February 12, 1999
 
                                       49
<PAGE>   50
 
                SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
 
<TABLE>
<CAPTION>
                                          BALANCE AT    CHARGE TO
                                          BEGINNING     COSTS AND                     BALANCE AT
                                           OF YEAR       EXPENSES     DEDUCTIONS      END OF YEAR
                                          ----------    ----------    ----------      -----------
<S>                                       <C>           <C>           <C>             <C>
Year Ended December 31, 1996:
Accounts receivable reserves..........    $1,323,000    $  461,000    $  261,000(a)   $1,523,000
Inventory reserves....................    $2,868,000    $3,449,000    $4,766,000(b)   $1,551,000
Warranty reserves.....................    $2,495,000    $4,348,000    $3,938,000(c)   $2,905,000
Year Ended December 31, 1997:
Accounts receivable reserves..........    $1,523,000    $4,241,000    $1,874,000(a)   $3,890,000
Inventory reserves....................    $1,551,000    $4,476,000    $  760,000(b)   $5,267,000
Warranty reserves.....................    $2,905,000    $7,396,000    $5,574,000(c)   $4,727,000
Year Ended December 31, 1998:
Accounts receivable reserves..........    $3,890,000    $4,160,000    $2,658,000(a)   $5,392,000
Inventory reserves....................    $5,267,000    $6,004,000    $6,489,000(b)   $4,782,000
Warranty reserves.....................    $4,727,000    $7,410,000    $7,289,000(c)   $4,848,000
</TABLE>
 
---------------
 
(a) Specific write-offs
 
(b) Specific dispositions
 
(c) Specific usage
 
                                       50
<PAGE>   51
 
                                    PART III
 
ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     Information with respect to this item is incorporated by reference herein
to information contained under the heading "Item 1 -- Election of Directors",
subheadings "Nominees for Election", Executive Officers" and "Section 16(a)
Beneficial Ownership Reporting Compliance" in the definitive 1999 Proxy
Statement.
 
ITEM 11.  EXECUTIVE COMPENSATION
 
     Information with respect to this item is incorporated by reference herein
to information contained under the heading "Item 1 -- Election of Directors",
subheadings "Directors Compensation", "Management Compensation" and "Employment,
Severance and Other Agreements" in the definitive 1999 Proxy Statement.
(Information in the 1999 Proxy Statement under "Report of the Compensation
Committee" and "Performance Graph" is not incorporated by reference.)
 
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     Information with respect to this item is incorporated by reference herein
to information contained under the heading "Security Ownership" in the
definitive 1999 Proxy Statement.
 
ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     Information with respect to this item is incorporated by reference herein
to information contained under the heading "Certain Relationships and Related
Transactions" [there was no such heading in 1996] in the definitive 1999 Proxy
Statement.
 
                                       51
<PAGE>   52
 
                                    PART IV
 
ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
(a) 1.  FINANCIAL STATEMENTS
 
     Report of Independent Accountants
 
     Consolidated Balance Sheets as of December 31, 1998 and 1997
 
     Consolidated Statements of Operations for the Years ended December 31,
     1998, 1997 and 1996
 
     Consolidated Statements of Stockholders' Equity for the years ended
     December 31, 1998, 1997 and 1996
 
     Consolidated Statements of Cash Flows for the years ended December 31,
     1998, 1997 and 1996
 
     Notes to Consolidated Financial Statements
 
     2.  FINANCIAL STATEMENT SCHEDULE
 
     Report of Independent Accountants
 
     Schedule II -- Valuation and Qualifying Accounts
 
     Schedules other than those listed above have been omitted since they are
     either not required, not applicable, or the information is otherwise
     included.
 
(b) REPORTS ON FORM 8-K
 
     1.  On January 18, 1999, the Company filed a report on Form 8-K to announce
that it had entered into a distribution and joint development agreement with
Intel Corporation. The two companies will develop videoconferencing and
collaborative products based on a common PC-based technology platform. Under
terms of the agreement, Intel will provide the Company with distribution rights
to sell the Intel ProShare(R) Video System 500 and exclusive worldwide
distribution rights to sell and support the Intel TeamStation(TM) System. In
addition, Intel invested $30.5 million in the Company, acquiring approximately
10% of the Company's equity through convertible preferred stock.
 
(c) EXHIBITS
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                            DESCRIPTION
-------                           -----------
<S>       <C>
 3.1      Third Restated Certificate of Incorporation (incorporated by
          reference to Exhibit 3.1.4 to Registrant's Quarterly Report
          on Form 10-Q for the quarter ended June 27, 1992).
 3.2      Amended and Restated By-laws (incorporated by reference to
          Exhibit 1 to the Registrant's Current Report on Form 8-K
          filed September 14, 1994).
 4.1      Form of Common Stock Certificate (incorporated by reference
          to Exhibit 4(b) to Registrant's Registration Statement on
          Form S-8, Registration Number 33-36315 effective August 10,
          1990).
 4.2      Shareholders' Rights Agreement between the Company and The
          First National Bank of Boston as Rights Agent, dated March
          25, 1992 (incorporated by reference to Exhibit 1 to the
          Registrant's Registration of Certain Classes of Securities
          on Form 8-A dated March 26, 1992).
 4.2.1    Form of Certificate of Designation with respect to Junior
          Preference Stock (incorporated by reference to Exhibit 2 to
          the Registrant's Registration of Certain Classes of
          Securities on Form 8-A dated March 26, 1992).
 4.2.2    Form of Rights Certificate (incorporated by reference to
          Exhibit 3 to the Registrant's Registration of Certain
          Classes of Securities on Form 8-A dated March 26, 1992).
 4.2.3    Summary of Purchase Rights (incorporated by reference to
          Exhibit 4 to the Registrant's Registration of Certain
          Classes of Securities on Form 8-A dated March 26, 1992).
 4.2.4    Amendment dated January 13, 1995 to Shareholders' Rights
          Agreement (incorporated by reference to Exhibit 4.2.4 to
          Registrant's Annual Report on Form 10-K for the year ended
          December 31, 1994).
</TABLE>
 
                                       52
<PAGE>   53
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                            DESCRIPTION
-------                           -----------
<S>       <C>
10.1*     1984 Amended and Restated Stock Option Plan as amended
          through December 13, 1988 (incorporated by reference to
          Exhibit 10.10 to Registrant's Annual Report on Form 10-K for
          the year ended December 31, 1988).
10.1.1*   Amendment to 1984 Amended and Restated Stock Option Plan
          dated October 26, 1994 (incorporated by reference to Exhibit
          10.10.1 to Registrant's Annual Report on Form 10-K for the
          year ended December 31, 1994).
10.2*     PictureTel Corporation Equity Incentive Plan as amended
          through October 26, 1994 (incorporated by reference to
          Exhibit 10.11 to Registrant's Annual Report on Form 10-K for
          the year ended December 31, 1994).
10.2.1*   Amendment to PictureTel Corporation Equity Incentive Plan
          dated June 29, 1995 (incorporated by reference to Exhibit
          10.1 to Registrant's Quarterly Report on Form 10-Q for the
          quarter ended July 1, 1995).
10.2.2    Amendment to PictureTel Corporation Equity Incentive Plan
          dated October 18, 1996 (incorporated by reference to Exhibit
          10.3 to Registrant's Quarterly Report on Form 10-Q for the
          quarter ended September 27, 1998).
10.3*     1992 Non-Employee Director Stock Option Plan as amended
          through April 10, 1996 (incorporated by reference to Exhibit
          4(a) to Registrant's Registration Statement on Form S-8,
          Registration Number 333-10163 effective September 2, 1997).
10.3.1    1992 Non-Employee Director Stock Option Plan as amended
          through February 27, 1998 (incorporated by reference to
          Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q
          for the quarter ended September 27, 1998).
10.4      PictureTel Corporation 1994 Employee Stock Purchase Plan
          (incorporated by reference to Exhibit 4 to Registrant's
          Registration Statement on Form S-8, Registration Number
          33-81848, effective July 22, 1994).
10.5      401(k) Profit Sharing Retirement Plan as amended through
          July 1, 1994 (incorporated by reference to Exhibit 10.45 to
          Registrant's Annual Report on Form 10-K for the year ended
          December 31, 1994).
10.6*     Employment Agreement between PictureTel Corporation and
          Norman E. Gaut dated July 29, 1988 (incorporated by
          reference to Exhibit 10.12 to Registrant's Annual Report on
          Form 10-K for the year ended December 31, 1988).
10.6.1*   Amendment dated January 15, 1995 to the Employment Agreement
          between PictureTel Corporation and Norman E. Gaut
          (incorporated by reference to Exhibit 10.1 to Registrant's
          Quarterly Report on Form 10-Q for the quarter ended April 1,
          1995).
10.7*     Agreement between PictureTel Corporation and Les Strauss as
          amended through January 15, 1995 (incorporated by reference
          to Exhibit 10.2 to Registrant's Quarterly Report on Form
          10-Q for the quarter ended April 1, 1995).
10.8*     Agreement between PictureTel Corporation and Domenic J.
          LaCava as amended through January 17, 1995 (incorporated by
          reference to Exhibit 10.4 to Registrant's Quarterly Report
          on Form 10-Q for the quarter ended April 1, 1995).
10.9*     Agreement between PictureTel Corporation and Lawrence
          Bornstein as amended through January 16, 1995 (incorporated
          by reference to Exhibit 10.5 to Registrant's Quarterly
          Report on Form 10-Q for the quarter ended April 1, 1995).
10.9.1    Employment agreement between PictureTel Corporation and
          Lawrence Bornstein dated December 5, 1997 (incorporated by
          reference to Exhibit 10.9.1 to Registrant's Annual Report on
          Form 10-K for the year ended December 31, 1997).
10.9.2    Change in control agreement between PictureTel Corporation
          and Lawrence Bornstein dated December 5, 1997 (incorporated
          by reference to Exhibit 10.9.2 to Registrant's Annual Report
          on Form 10-K for the year ended December 31, 1997).
10.9.3    Amendment to employment agreement between PictureTel
          Corporation and Lawrence Bornstein dated January 20, 1999
          (filed herewith).
</TABLE>
 
                                       53
<PAGE>   54
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                            DESCRIPTION
-------                           -----------
<S>       <C>
10.10     Employment agreement between PictureTel Corporation and
          Richard B. Goldman dated June 11, 1997 (incorporated by
          reference to Exhibit 10.2 to Registrant's Quarterly Report
          on Form 10-Q for the quarter ended June 29, 1997).
10.10.1   Employment agreement between PictureTel Corporation and
          Richard B. Goldman dated December 5, 1997 (incorporated by
          reference to Exhibit 10.10.1 to Registrant's Annual Report
          on Form 10-K for the year ended December 31, 1997).
10.10.2   Change in control agreement between PictureTel Corporation
          and Richard B. Goldman dated December 5, 1997 (incorporated
          by reference to Exhibit 10.10.2 to Registrant's Annual
          Report on Form 10-K for the year ended December 31, 1997).
10.11*    Employment agreement between PictureTel Corporation and
          David Grainger dated August 10, 1994 (incorporated by
          reference to Exhibit 10.10 to Registrant's Quarterly Report
          on Form 10-Q for the quarter ended March 29, 1997).
10.11.1   Employment agreement between PictureTel Corporation and
          David Grainger dated December 5, 1997 (incorporated by
          reference to Exhibit 10.11.1 to Registrant's Annual Report
          on Form 10-K for the year ended December 31, 1997).
10.11.2   Change in control agreement between PictureTel Corporation
          and David Grainger dated December 5, 1997 (incorporated by
          reference to Exhibit 10.11.2 to Registrant's Annual Report
          on Form 10-K for the year ended December 31, 1997).
10.12     Form of Indemnification Agreement for directors and officers
          (incorporated by reference to Exhibit 10.34 to Registrant's
          Registration Statement on Form S-1, Registration No.
          33-6368, effective August 12, 1986).
10.13*    Agreement between PictureTel Corporation and Khoa Nguyen as
          amended through March 6, 1995 (incorporated by reference to
          Exhibit 10.3 to Registrant's Quarterly Report on Form 10-Q
          for the quarter ended April 1, 1995).
10.13.1   Separation agreement between PictureTel Corporation and Khoa
          Nguyen dated September 13, 1996 (incorporated by reference
          to Exhibit 10.13.1 to Registrant's Quarterly Report on Form
          10-Q for the quarter ended March 29, 1997).
10.14     Lease Agreement between PictureTel Corporation and 100
          Minuteman Limited Partnership dated October 7, 1995
          (incorporated by reference to Exhibit 10.47 to Annual Report
          on Form 10-K for the year ended December 31, 1995).
10.14.1   Amendment No. 1 To Lease for 100 Minuteman, dated July 10,
          1996 (incorporated by reference to Exhibit 10.14.1 to
          Registrant's Quarterly Report on Form 10-Q for the quarter
          ended March 29, 1997).
10.14.2   Amendment No. 2. To Lease for 100 Minuteman, dated August
          19, 1996 (incorporated by reference to Exhibit 10.14.2 to
          Registrant's Quarterly Report on Form 10-Q for the quarter
          ended March 29, 1997).
10.15     Lease Agreement between PictureTel Corporation and Andover
          Mills Realty Limited Partnership dated February 10, 1994
          (incorporated by reference to Exhibit 10.51 to Registrant's
          Annual Report on Form 10-K for the year ended December 31,
          1994).
10.15.1   Amendment No. 1. to lease with Andover Mills Realty Limited
          Partnership dated October 10, 1995 (incorporated by
          reference to Exhibit 10.15.1 to Registrant's Quarterly
          Report on Form 10-Q for the quarter ended March 29, 1997).
10.15.2   Amendment No. 2 to lease with Andover Mills Realty Limited
          Partnership dated May 28, 1996 (incorporated by reference to
          Exhibit 10.15.2 to Registrant's Quarterly Report on Form
          10-Q for the quarter ended March 29, 1997).
10.16     Lease Agreement between PictureTel Corporation and 50
          Minuteman Limited Partnership dated August 26, 1996
          (incorporated by reference to Exhibit 10.1 to Registrant's
          Quarterly Report on Form 10-Q for the quarter ended
          September 28, 1996).
10.16.1   Amendment No. 1 to 50 Minuteman Lease dated March 19, 1997
          (incorporated by reference to Exhibit 10.16.2 on Form S-4
          dated October 5, 1998).
</TABLE>
 
                                       54
<PAGE>   55
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                            DESCRIPTION
-------                           -----------
<S>       <C>
10.16.2   Sublease Agreement between PictureTel Corporation and
          Cabletron Systems, Inc. dated June 4, 1998 (incorporated by
          reference to Exhibit 10.16.3 on Form S-4 dated October 5,
          1998).
10.17     Lease Agreement between PictureTel Corporation and 200
          Minuteman Limited Partnership dated March 19, 1997
          (incorporated by reference to Exhibit 10.1 to Registrant's
          Quarterly Report on Form 10-K for the quarter ended June 29,
          1997).
10.17.1   Amendment No. 1 to 200 Minuteman Lease dated June 4, 1998
          (incorporated by reference to Exhibit 10.17.2 on Form S-4
          dated October 5, 1998).
10.18*    Employment Agreement by and between PictureTel Corporation
          and Bruce R. Bond dated March 1, 1998 (incorporated by
          Reference to Exhibit 10.1 to the Registrant's Quarterly
          Report on Form 10-Q for the quarter ended March 29, 1998).
10.18.1*  Change in Control Agreement by and between PictureTel
          Corporation and Bruce R. Bond dated February 25, 1998
          (incorporated by Reference to Exhibit 10.2 to the
          Registrant's Quarterly Report on Form 10-Q for the quarter
          ended March 29, 1998).
10.18.2*  Options to Bruce R. Bond effective January 31, 1998
          (incorporated by reference to Exhibit 10.3 to the
          Registrant's Quarterly Report on Form 10-Q for the quarter
          ended March 29, 1998).
10.19     Secured Second Amended and Restated Revolving Credit
          Agreement by and between PictureTel Corporation and
          BankBoston, N.A., as agent, dated August 12, 1998
          (incorporated by reference to Exhibit 10.19 to the
          Registrant's Form S-4 dated October 5, 1998).
10.20*    Employment agreement between PictureTel Corporation and Gary
          L. Bond dated September 1, 1998 (incorporated by reference
          to Exhibit 10.2 to the Registrant's Quarterly Report on Form
          10-Q for the quarter ended September 27, 1998).
10.20.1*  Amendment to employment agreement between PictureTel
          Corporation and Gary L. Bond dated January 20, 1999 (filed
          herewith).
10.21*    Employment agreement between PictureTel Corporation and
          Arthur L. Fatum dated October 14, 1998 (filed herewith).
10.21.1*  Amendment to employment agreement between PictureTel
          Corporation and Arthur L. Fatum dated January 20, 1999
          (filed herewith).
10.22*    Employment agreement between PictureTel Corporation and
          Richard S. Haak, Jr. dated May 14, 1998 (filed herewith).
10.22.1*  Change in Control Agreement by and between PictureTel
          Corporation and Richard S. Haak, Jr. dated November 30, 1998
          (filed herewith).
21        Subsidiaries of the Company (filed herewith)
23        Consent of PricewaterhouseCoopers LLP (filed herewith)
27        Financial Data Schedule as required by Item 601 (c) of
          Regulation S-K (filed herewith)
</TABLE>
 
---------------
* Indicates management contract or compensatory plan, contract or arrangement.
 
(d) FINANCIAL STATEMENT SCHEDULE
 
     The Company hereby files as part of this Annual Report on Form 10-K the
financial statement schedule listed on Item 14(a)2 as set forth above.
 
                                       55
<PAGE>   56
 
                                   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.
 
                                          PICTURETEL CORPORATION
 
                                          By:       /s/ BRUCE R. BOND
                                            ------------------------------------
                                                       BRUCE R. BOND
                                            CHAIRMAN AND CHIEF EXECUTIVE OFFICER
                                                           Date:  March 31, 1999
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
 
<TABLE>
<C>                                                  <S>                                    <C>
 
                 /s/ BRUCE R. BOND                   President and Chief Executive Officer  March 31, 1999
---------------------------------------------------  and Chairman of the Board (Principal
                   BRUCE R. BOND                     Executive Officer)
 
                /s/ NORMAN E. GAUT                   Director                               March 31, 1999
---------------------------------------------------
                  NORMAN E. GAUT
 
                 /s/ DAVID B. LEVI                   Director                               March 31, 1999
---------------------------------------------------
                   DAVID B. LEVI
 
               /s/ ROBERT T. KNIGHT                  Director                               March 31, 1999
---------------------------------------------------
                 ROBERT T. KNIGHT
 
                 /s/ ENZO TORRESI                    Director                               March 31, 1999
---------------------------------------------------
                   ENZO TORRESI
 
                /s/ ARTHUR L. FATUM                  Vice President, Chief Financial        March 31, 1999
---------------------------------------------------  Officer, Treasurer (Principal
                  ARTHUR L. FATUM                    Financial Officer and Principal
                                                     Accounting Officer)
</TABLE>
 
                                       56