<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ----------------
 
                                   FORM 10-K
 
(Mark One)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
    of 1934 for the Fiscal Year Ended September 27, 1997 or

[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
    Act of 1934 for the transition period from                 to
 
 
COMMISSION FILE NUMBER 0-18623
 
                               ----------------
 
                              IKOS SYSTEMS, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                            <C>
                   Delaware                                      77-0100318
       (STATE OR OTHER JURISDICTION OF                         (IRS EMPLOYER
        INCORPORATION OR ORGANIZATION)                      IDENTIFICATION NO.)
    19050 Pruneridge Avenue, Cupertino, CA                         95014
   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                      (ZIP CODE)
</TABLE>
 
              REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
                                (408) 255-4567
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
                                     NONE
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                          COMMON STOCK $.01 PAR VALUE
                        PREFERRED STOCK PURCHASE RIGHTS
                               (TITLE OF CLASS)
 
  Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the
registrant was required to file such report), and (2) has been subject to such
filing requirements for the past 90 days.  Yes X   No
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
 
  The approximate aggregate market value of the registrant's Common Stock held
by non-affiliates as of November 12, 1997, was approximately $68,716,000
 
  As of November 12, 1997, approximately 8,589,463 shares of the registrant's
Common Stock were outstanding.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Portions of the Proxy Statement for the 1998 Annual Meeting of Stockholders
are incorporated by reference in Part III hereof.
 
  This report (excluding exhibits) contains 40 pages. The Index to Exhibits
begins on Page 21 of this report.
<PAGE>
 
                                    PART I
 
ITEM 1. BUSINESS
 
GENERAL
 
  IKOS develops, manufactures, markets, and supports hardware and software
systems for the verification of integrated circuits (IC). IKOS' mission is to
help customers realize their high complexity electronic systems through
innovative design verification solutions. The Company's hardware products
include simulation acceleration for fast and accurate simulation of high
complexity ICs and emulation for early in-circuit verification of
functionality. The Company's software products include VHDL software logic and
fault simulation solutions, and modeling tools for the development of accurate
ASIC cell models. In fiscal 1997, the company created the consulting services
organization to facilitate the delivery of comprehensive design verification
solutions to our customers. This new function combines IKOS' products, people,
and verification expertise to assist customers in the verification of their
designs.
 
  The Company sells its products and services to a broad range of customers,
including telecommunications, multimedia, semiconductor, computer, consumer
electronics, and aerospace application segments. The Company's customers
include Lucent Technologies, Motorola, NEC, S3, SGS Thomson Microelectronics,
Siemens, LSI Logic, and Texas Instruments Headquartered in Cupertino,
California, IKOS supports a direct sales operations in North America, the
United Kingdom, Scandinavia, France, Germany, and Japan. In addition the
Company has a distributor network covering the remainder of Europe and in
parts Asia. IKOS is publicly traded on the Nasdaq National Market under the
symbol IKOS.
 
BACKGROUND
 
  The electronic design automation (EDA) industry provides design automation
tools and technology to the semiconductor industry. Verification and
implementation are the largest segments in the EDA market and the Company is
focused on the verification segment. The demand for design automation tools in
this segment continues to grow at a faster rate than the EDA industry has been
able to match. The fundamental drivers in this arena are the continuing trend
toward increased design complexity, the inability of design engineering
productivity to keep pace, and the resulting productivity gap. Moore's law
predicts a 58% compounded annual growth rate in design complexity while design
engineering productivity is growing at only 21% annually. This creates an ever
widening productivity gap that EDA tool vendors seek to address.
 
  Design verification, which includes timing analysis, power analysis, and
functional and timing operation, is the assessment of the functionality of a
design prior to fabrication. It is a critical part of the design process with
significant impact upon the design engineer's productivity. Customers estimate
that up to 70% of their total design cycle time is spent in the verification
phase. The Company is focused on the functional and timing operation which
dominates the verification cycle. As design sizes increase, the amount of
testing required to thoroughly verify functionality also grows. As design size
and time to market pressures increase, the throughput required for thorough
verification of these high-complexity designs can exceed the performance
capability of software simulators running on general purpose workstations. It
is for this group of customers that the Company's accelerator products provide
the increased throughput that enables them to meet project schedules with a
high degree of confidence in their designs. The company's acceleration
products provide an accurate simulation of the design at performances high
enough to run millions of test patterns to verify functionality.
 
  During fiscal 1997, the Company expanded its products with its commercial
release of its emulation product for ultra high-performance design
verification. For many customers verification demands require such large tests
that even the performance of simulation acceleration cannot adequately address
their time to market requirements. For these customers emulation is the
technology of choice. Emulation utilizes reprogrammable logic, typically field
programmable gate arrays (FPGAs), as the hardware model of an IC prior to its
fabrication. This model runs orders of magnitude faster than is possible with
software simulation and simulation acceleration
 
                                       1
<PAGE>
 
options. As more electronics are designed to connect via standard interfaces,
the need for compatibility and interoperability testing is increased, and thus
the need for ultra high-performance verification. In the multimedia arena, for
instance, a design that decodes MPEG data must have a decoder that meets the
MPEG standard. This standard is used in end-products for everything from
computers to settop boxes. Another example is companies which compete in the
processor market in the development of Pentium clones must meet the standard
defined by the Intel instruction set. These designs must be compatible with
millions of lines of application code written for this platform. From this, it
is easy to gauge the importance of design verification these and many other
applications in the semiconductor and electronic systems industries.
 
COMPANY SOLUTIONS
 
  IKOS' patented acceleration products have evolved over the years to allow
integration into the design flows that customers have adopted. Today's
preferred design methodology incorporates the use of language-based tools for
top-down design. The Company provides products that support VHDL and Verilog,
the two most widely-used design languages. These products provide a mixed-
level acceleration solution which allows software simulation running on a
workstation to take place in conjunction with hardware acceleration to
simulate the design. This solution is most useful for customers who desire to
run sign-off simulation before delivering their designs to the ASIC Vendor for
chip fabrication. The solution also benefits customers in the areas of
functional verification and regression testing by adding the power of the
accelerator to increase throughput. The company augments its hardware
accelerator products with a variety of software products that support both
VHDL and Verilog designs including logic and fault simulation and modeling
tools. The Company's emulation products are based upon patented technology
acquired from Virtual Machine Works, Inc. ("VMW"). The VirtualWires technology
is under exclusive license from Massachusetts Institute of Technology (MIT)
and the Timing Resynthesis patent is owned by the Company. These technologies
allow the Company to offer emulation solutions at a lower cost than current
competitive emulation solutions. It also enables repeatable emulation compile
processes.
 
  The Company also offers simulation and emulation services to our customers
through its consulting services organization. This groups expands the
company's product capabilities with the inclusion of support and design
verification expertise service to help customers achieve project goals.
Verification services allow the customer to outsource the work needed to
integrate new verification products into their design flow or deliver
verification capability to the design team.
 
MAINTENANCE AND SUPPORT
 
  The Company provides hardware and software maintenance and support on a
contractual basis after the initial product warranty has expired. Hardware
maintenance is provided on an on-site or on a return and repair basis. The
Company also provides application support via a toll-free telephone line.
Customers with software maintenance coverage also receive software releases,
if any, from the Company. Foreign distributors generally provide customer
training, service and support for the products they sell. Maintenance
revenues, as a percent of total revenues, represented 17%, in each of the
three fiscal years ending September 27, 1997.
 
COMPETITION
 
  Because design verification is one of the largest segments in the EDA
market, it is a competitive market. In our classic hardware acceleration
business the company's only competitor since entering the market in 1986 was
Zycad Corporation ("Zycad"). During fiscal 1997, the Company purchased Zycad's
acceleration technology and Zycad exited the market. On the emulation front,
Quickturn Design Systems, Inc. ("Quickturn") continues to be the market
leader. Mentor Graphics, Inc. ("Mentor Graphics") offers emulation solutions
in Europe and Asia but is currently enjoined from selling in the United States
as a result of litigation initiated by Quickturn. Competitors in the software
simulation market include Synopsys, Inc. ("Synopsys"), Mentor Graphics,
Cadence Design Systems, Inc. ("Cadence"), and Viewlogic Systems, Inc.
("Viewlogic"). The Company expects competition in the verification market to
continue to expand and change. Moreover, the Company competes, and expects
that it will continue to compete, with established EDA companies. A number of
these companies have
 
                                       2
<PAGE>
 
longer operating histories, significantly greater financial, technical and
marketing resources, greater name recognition and larger installed customer
bases than the Company. In addition, many of these competitors and potential
competitors have established relationships with current and potential
customers of the Company and offer a broader and more comprehensive product
line. Increased competition could result in price reductions, reduced margins
and loss of market share, all of which could materially adversely affect the
Company. In addition, current competitors or other entities may develop other
products that have significant advantages over the Company's products. There
can be no assurance that the Company will be able to compete successfully
against current and future competitors or that competitive pressures faced by
the Company will not materially adversely affect its operating results.
 
  The Company competes on the basis of certain factors, including product
performance, price, support of industry standards, technical support and
customer service, timely introduction of new products, ease of use and
reputation. The Company believes that it currently competes favorably overall
with respect to these factors.
 
CUSTOMERS, MARKETING AND SALES
 
  IKOS sells its products to a broad range of companies including those in the
communications, multimedia/graphics, semiconductor, computer, aerospace and
consumer electronics industries. The Company markets its products and services
primarily through its direct sales and service organization. The Company
employs a technically-oriented sales force and application engineering team to
serve the needs of existing and prospective customers. The Company's
consulting services organization provides its customers with a comprehensive
solution that is tailored specifically to the needs of the design team. These
services will include education, application services, interface software
support, custom library development and other on-site support through
customized consulting partnerships to assist the customer in accomplishing
successful delivery of their products to market.
 
  IKOS' direct sales strategy concentrates on those companies that it believes
are key users and designers of complex ICs and IC-based systems for high-
performance applications. For the fiscal year ended September 27, 1997, one
customer Lucent Technologies, Inc. accounted for approximately 11% of net
revenues. For the year ended September 28, 1996, one distributor, Itochu &
Co., Ltd. (Itochu) in Japan accounted for approximately 12% of net revenues
and one customer, S3 Inc., accounted for approximately 14% of net revenues. In
fiscal 1995, one distributor, Itochu accounted for approximately 15% of net
revenues.
 
  Direct Sales. IKOS currently maintains direct sales and support offices in
the following states: Arizona, California, Colorado, Florida, Illinois,
Massachusetts, New Hampshire, New Jersey and Texas. IKOS makes direct sales
internationally in Canada, in Japan through its wholly-owned subsidiary, IKOS
K.K. and in central Europe through its wholly-owned subsidiary, ICOS Systems
GmbH, and through its sales offices in France and England. Direct sales,
including maintenance fees, accounted for approximately 90% of the Company's
net revenues in fiscal 1997. Direct sales for fiscal 1996 and 1995 as a
percentage of net revenues were 86% and 79%, respectively.
 
  Distributors. IKOS believes that international markets are an important
source of the Company's revenues. The Company has developed distributor
relationships in ten foreign countries in Europe and Asia. However, during
fiscal 1997, the Company terminated its distributor relationship in Japan and
began selling directly in the Japan marketplace. Revenues to distributors were
approximately 10% of the Company's net revenues for the fiscal year 1997.
Distributor revenues for fiscal 1996 and 1995 as a percentage of net revenues
were 14% and 21%, respectively.
 
  International Sales. International sales, including export sales and foreign
operation net revenues, accounted for approximately 34%, 33% and 37% of the
Company's net revenues in fiscal 1997, 1996 and 1995, respectively. During
fiscal 1997, the Company terminated its Japan distributor relationship and
completed its transition to a direct sales channel in Japan. This transition
resulted in less than expected revenues in Japan during the fiscal year. As a
part of this transition the Company has increased its sales and sales support
 
                                       3
<PAGE>
 
organization in Japan. With the exception of sales to customers through the
Japan subsidiary, sales in all foreign countries are denominated in U.S.
dollars. Sales through the Japan subsidiary are denominated in Japanese Yen.
Although the Company has attempted to reduce the risk of fluctuations in
exchange rates associated with international revenues by selling its systems
denominated in U.S. dollars only, the Company pays the expenses of its
international operations in local currencies and has not engaged in hedging
transactions with respect to such obligations at September 27, 1997. For those
sales made in Japanese Yen, the Company may enter into hedging arrangements to
mitigate the currency risk with respect to such transactions. Currency
exchange fluctuations in those countries in which the Company sells its
systems denominated in the U.S. dollar could have a material adverse effect on
the Company by resulting in pricing that is not competitive with prices
denominated in local currencies.
 
  Conducting business in international markets requires compliance with
applicable laws and regulations, such as safety and telecommunication laws and
regulations of foreign jurisdictions and import duties and quotas. To date,
the Company has not experienced any difficulty in obtaining export licenses
from the U.S. Department of Commerce for foreign sales; however, there can be
no assurance that the Company will not experience difficulties in the future.
 
MANUFACTURING AND SUPPLIERS
 
  The Company performs final assembly and test of all its products in its
Cupertino, California facility. The Company utilizes third parties for all
major subassembly manufacturing, including printed circuit boards and custom
ICs. The Company has a testing and qualification program to ensure that all
subassemblies meet the Company's specifications before going into final
assembly and test.
 
  The capacity and speed of IKOS' hardware results from its basic design and
architecture, and includes certain proprietary components and components that
are required to perform near technological limits. Certain key components used
in the Company's products are presently available from sole or limited
sources. The Company believes that it could obtain alternative sources in a
short period of time, although the inability to develop alternative sources
for these sole or limited source components or to obtain sufficient quantities
of these components could result in delays or reductions in product shipments
which could adversely affect the Company's operating results. The Company's
simulation and emulation systems use proprietary ASICs, FPGAs and certain
subassemblies that are currently available from single sources. The Company
generally purchases these components, including semiconductor memories used in
the Company's hardware simulators, pursuant to purchase orders placed from
time to time in the ordinary course of business and has no supply arrangements
with any of these source suppliers that require the suppliers to provide
components in guaranteed quantities or at set prices. The Company endeavors to
maintain an ample supply of such components at all times through order
generation based on tracking of sales projections, production and inventories,
and by ordering critical components for delivery over an extended period.
 
PRODUCT DEVELOPMENT
 
  The Company's ongoing product development activities include the enhancement
of current products, such as the ability to simulate, emulate and verify the
design of higher gate count ICs and to offer a greater degree of integration
with EDA tools. Furthermore these product development activities include the
development of new product options and features, such as new library tools and
the research and development of new technologies for use in future products.
 
  The Company's research and product development organization included 64
engineers at September 27, 1997, of whom 17 were engaged principally in the
development of the new emulation product and 22 were engaged principally in
software development. During fiscal 1997, 1996 and 1995, the Company spent
approximately $10.7 million, $8.1 million and $4.0 million, respectively, on
research and development. In addition, the Company spent approximately $7.3
million in fiscal 1997, related to technology purchased from Zycad Corporation
("Zycad"). In 1996, in addition to the $8.1 million spent on research and
development, the
 
                                       4
<PAGE>
 
Company spent $9.6 million on in-process research and development in
connection with the VMW acquisition. The Company's research and development
costs, including costs of software development before technological
feasibility, are expensed as incurred.
 
PROPRIETARY RIGHTS
 
  Due to the rapid pace of technological advancement, the Company believes it
is less dependent on the protection of proprietary product information than on
its ability to develop and market new products. The Company protects its
proprietary product information through the use of employee nondisclosure
agreements and by limiting access to confidential information. The Company
presently has three United States patents, two of which expire on November 22,
2005, and the third expiring on June 30, 2009, that cover various aspects and
features of its products, including its overall system architecture and
certain features in the systems hardware. The Company has licensed rights
under certain patent applications relating to VirtualWires from MIT and has
filed additional patent applications. This license is through December 2004,
and thereafter becomes nonexclusive. MIT may terminate this license if the
Company fails to meet certain minimum net sales milestones or upon certain
other material breaches of the license agreement that remain uncured after 90
days' notice of such breach. Although the Company may file additional patent
applications in the future, it does not expect to rely extensively on patents
to protect its products.
 
  The Company also relies on certain software which it licenses from third
parties, including software which is integrated with internally developed
software and used in the Company's systems to perform key functions.
 
  From time to time the Company has received, and may receive in the future,
notice of claims of infringement of other parties' proprietary rights.
Although the Company does not believe that its products infringe the
proprietary rights of any third parties, there can be no assurance that
infringement or invalidity claims (or claims for indemnification resulting
from infringement claims) will not be asserted against the Company or that any
such assertions will not materially adversely affect the Company's business,
financial condition or results of operations. Irrespective of the validity or
the successful assertion of such claims, the Company could incur significant
costs and diversion of management efforts with respect to the defense thereof
which could have a material adverse effect on the Company' business, financial
condition or results of operations. If any claims or actions are asserted
against the Company, the Company may seek to obtain a license under a third
party's intellectual property rights. There can be no assurance, however, that
under such circumstances, a license would be available under reasonable terms
or at all.
 
  The Company's tradename, "IKOS," its facing parrots logo and its product
series named "Voyager" are registered trademarks of the Company.
 
EMPLOYEES
 
  As of September 27, 1997 the Company employed a total of 219 persons,
consisting of 122 in marketing, sales and support, 10 in manufacturing, 64 in
research, development and engineering, and 23 in finance, administration and
other capacities. The Company has never had a work stoppage. None of its
employees are represented by a labor organization, and the Company considers
its relations with its employees to be good.
 
ITEM 2. PROPERTIES
 
  The Company's principal executive offices, as well as its principal
manufacturing, marketing, research and development, and engineering facility,
are located in approximately 57,000 square feet of leased office building
space in Cupertino, California. The lease on this facility expires September
2000, with options to extend the lease for up to nine years. In addition, the
Company leases research and development and sales office space domestically in
Arizona, California, Colorado, Florida, Illinois, Massachusetts, New
Hampshire, New Jersey and Texas and internationally in England, France,
Germany and Japan. The Company believes that its existing facilities are
adequate for its current needs and that additional space will be available as
needed.
 
                                       5
<PAGE>
 
ITEM 3. LEGAL PROCEEDINGS
 
  Not applicable.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this report.
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
  The Company's Common Stock is currently traded on the Nasdaq National Market
under the symbol IKOS. The following table sets forth, for the fiscal period
indicated, the high and low closing sales prices for the Common Stock as
reported by Nasdaq.
 
<TABLE>
<CAPTION>
                                                                  HIGH     LOW
                                                                 ------- -------
       <S>                                                       <C>     <C>
       FISCAL 1996
         First Quarter.......................................... $14.125 $ 9.813
         Second Quarter.........................................  18.625   9.125
         Third Quarter..........................................  30.000  17.188
         Fourth Quarter.........................................  22.375  14.500
       FISCAL 1997
         First Quarter.......................................... $23.875 $16.375
         Second Quarter.........................................  25.250  17.688
         Third Quarter..........................................  25.125  16.375
         Fourth Quarter.........................................  21.375  11.563
</TABLE>
 
  The approximate number of record holders of IKOS stock as of November 12,
1997 was 149. The approximate number of beneficial holders is estimated to be
4,250 as of that same date.
 
  The Company has never declared or paid cash dividends on its stock. The
Company currently anticipates that it will retain all future earnings for use
in the operation and expansion of its business and does not anticipate paying
any cash dividends in the foreseeable future.
 
  Subsequent to September 27, 1997, the Company announced its intention to
repurchase up to 1,000,000 shares of its outstanding common stock on the open
market. Through December 15, 1997, the Company had repurchased 199,000 shares
at a weighted-average per share price of $8.14.
 
                                       6
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                             FISCAL YEARS ENDED
                                ----------------------------------------------
                                SEPT. 27, SEPT. 28, SEPT. 30, OCT. 1,  OCT. 2,
                                  1997      1996      1995     1994     1993
                                --------- --------- --------- -------  -------
<S>                             <C>       <C>       <C>       <C>      <C>
CONSOLIDATED STATEMENT OF
 OPERATIONS DATA:
Net revenues...................  $56,096   $45,341   $28,600  $21,636  $16,528
Cost of revenues...............   12,452     9,852     7,139    5,930    6,331
                                 -------   -------   -------  -------  -------
    Gross profit...............   43,644    35,489    21,461   15,706   10,197
Operating expenses:
  Research and development.....   10,740     8,146     3,999    3,861    7,896
  Sales and marketing..........   17,516    14,483    11,763    9,447    9,303
  General and administration...    3,777     3,420     2,301    1,596    1,873
  Write off of acquired in-
   process research and
   development and special
   charges.....................    9,202     9,600       --       --       --
  Amortization of goodwill.....    1,260       421       --       --       --
                                 -------   -------   -------  -------  -------
    Total operating expenses...   42,495    36,070    18,063   14,904   19,072
                                 -------   -------   -------  -------  -------
Income (loss) from operations..    1,149      (581)    3,398      802   (8,875)
Other income (expense):
  Interest income..............    1,198     1,058       159       69      130
  Interest expense.............      --        (42)     (107)     (75)     --
  Other........................       71       124       117      140       48
                                 -------   -------   -------  -------  -------
    Total other income.........    1,269     1,140       169      134      178
                                 -------   -------   -------  -------  -------
Income (loss) before provision
 for income taxes and
 extraordinary credit..........    2,418       559     3,567      936   (8,697)
Provision (benefit)for income
 taxes.........................    1,023    (1,892)      411       95       53
                                 -------   -------   -------  -------  -------
Income (loss) before
 extraordinary credit..........    1,395     2,451     3,156      841   (8,750)
Extraordinary credit--
 forgiveness of debt...........      --        --        --       664      --
                                 -------   -------   -------  -------  -------
    Net income (loss)..........  $ 1,395   $ 2,451   $ 3,156  $ 1,505  $(8,750)
                                 =======   =======   =======  =======  =======
Earnings (loss) per share:
  Income (loss) before
   extraordinary credit........  $  0.16   $  0.30   $  0.51  $  0.15  $ (1.62)
  Extraordinary credit.........      --        --        --      0.12      --
                                 -------   -------   -------  -------  -------
    Net income (loss)..........  $  0.16   $  0.30   $  0.51  $  0.27  $ (1.62)
                                 =======   =======   =======  =======  =======
Common and common equivalent
 shares used in computing per
 share amounts.................    8,927     8,114     6,151    5,651    5,415
                                 =======   =======   =======  =======  =======
CONSOLIDATED BALANCE SHEET
 DATA:
Working capital................  $31,608   $27,919   $ 7,509  $ 3,850  $ 1,805
Total assets...................   56,550    53,471    17,152   12,129   10,806
Long-term, debt, less current
 portion.......................      --        350     1,300    2,151    2,779
Total stockholders' equity.....   41,990    38,144     7,710    3,476    1,903
</TABLE>
 
  See notes to consolidated financial statements, management discussion and
analysis of financial condition and results of operations.
 
                                       7
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
CAUTIONARY STATEMENT
 
  The statements in the Management's Discussion and Analysis of Financial
Condition and Results of Operations that are forward looking involve numerous
risks and uncertainties and are based on current expectations. Actual results
may differ materially from those projected. Such risks and uncertainties may
be more fully described in other reports and information filed by the Company
with the Securities and Exchange Commission. Certain of these risks and
uncertainties are discussed under the caption "Factors That May Affect Future
Results of Operations."
 
NATURE OF OPERATIONS
 
  The Company develops, manufactures, markets and supports hardware and
software systems for the verification of integrated circuit designs. IKOS'
mission is to help customers realize their high complexity products through
innovative design verification solutions. The Company's products are designed
to enable its customers to verify their designs more rapidly and accurately
than existing software-based simulation tools. With the completion of its
acquisition of VMW in fiscal 1996, the Company broadened its spectrum of
verification solutions to extend from the design concept stage to the
prototype stage as the Company commercially introduced its emulation system in
the current year. The Company sells its products to a broad range of customers
in the communications, multimedia/graphics, semiconductor, computer, aerospace
and consumer electronics industries. The Company markets its products and
services primarily through its direct sales and service organization as the
Company has direct sales operations throughout the United States and in the
United Kingdom, France, Germany and Japan. The Company also has a distribution
network covering the remainder of Europe and in parts of Asia.
 
NET REVENUES
 
  For the fiscal year ended September 27, 1997, net revenues increased 24%
from $45,341,000 to $56,096,000. The increase was primarily due to increasing
sales of the Company's Voyager systems (NSIM product), emulation products and
increased consulting and maintenance revenues. Sales of the NSIM product, the
Company's hardware simulator, represented 57% of total revenues or an increase
of 11% over the previous year. The Company attributes this growth to the
continued acceptance of its simulation solutions. Sales of the emulation
product, which was first introduced in its beta version during fiscal 1996,
increased 425% over the previous year and represented 8.7% of net revenues for
fiscal 1997. The increase was primarily the result of the emulation product
being commercially available for all of fiscal 1997 versus its limited
availability during the fourth quarter of fiscal 1996. Consulting revenues
increased significantly as the Company has realized several successes with its
new consulting services group. As the Company has increased its emphasis on
the consulting services area, revenues have grown over eight times that of the
previous year and accounted for over 5% of the Company's revenues for the
year. Maintenance revenues continue to grow, increasing 29% over the previous
year. The growth is primarily attributable to the increasing Voyager systems
and new emulation systems entering the market. During the year the Company
discontinued its support of its older 2800/2900 product, slightly offsetting
the overall growth in maintenance revenues. International revenues increased
29%, primarily in Europe, and domestic revenues increased by 21% over the
previous year.
 
  Net revenues increased 59% to $45,341,000 for the fiscal year ended
September 28, 1996 as compared to $28,600,000 for fiscal 1995. The increase
for the year was primarily the result of continued growth in unit sales of the
Voyager systems (primarily NSIM product) and maintenance revenues.
 
  International sales (export sales and sales shipped by the Company's Japan
and European operations) were $19,194,000, $14,890,000 and $10,560,000 for the
fiscal years 1997, 1996 and 1995, respectively. These sales represent 34%, 33%
and 37% of net revenues. The increases in international sales in absolute
dollars were a result of the increased customer acceptance of the Company's
Voyager product offerings and increased economic
 
                                       8
<PAGE>
 
demand, particularly in Europe. While the Company recognized increased
international sales, the Company's Japan subsidiary, which opened in fiscal
1995, did not contribute to the revenue results as expected. The decline in
revenues from Japan was a result of the Company terminating its Japan
distribute relationship and the slower than expected transition to a fully
staffed direct sales force in Japan. The Company has increased its focus on
the Asian market and it is expected that international sales should increase
in absolute dollars in fiscal 1998, although there can be no assurances that
international sales will increase to the extent anticipated.
 
  The Company first released its Voyager Series product, the VHDL software
simulator (VS) in 1992 and has since released its mixed level simulator, its
next generation hardware accelerator and its software gate level simulator.
The Company entered the Verilog market with its Gemini product during 1995 and
in early 1996 released its Voyager fault simulator (Voyager FS). The Company
began commercial shipments of its new emulator product in the first quarter of
fiscal 1997. Although the Company believes its product offerings have been
accepted very favorably, there can be no assurances that there will not be any
new product offerings by competitors or changes in the marketplace that could
have a materially adverse affect on the Company's sales and profits.
 
GROSS PROFIT
 
  Gross profit was $43,644,000, $35,489,000 and $21,461,000 or 78%, 78% and
75% of total net revenues for fiscal years 1997, 1996 and 1995, respectively.
The margins for the current fiscal year were comparable with the previous year
as the Company realized a slight increase in product margins as a result of
continued sales of the higher margin products offset by a slightly lower
margin on maintenance revenues. The increase in fiscal 1996 as compared to
fiscal 1995 is primarily a result of increases in unit shipments of higher
margin products and increased maintenance revenues from a larger customer base
without significant increases in related maintenance costs. Also to a lesser
extent margins were favorably impacted by higher manufacturing efficiencies.
The Company expects margins to remain comparable with fiscal 1997, as the
Company believes it will continue to recognize manufacturing efficiencies and
continued sales of products with higher margins.
 
RESEARCH AND DEVELOPMENT EXPENSES
 
  Research and development expenses were $10,740,000, $8,146,000 and
$3,999,000 for fiscal 1997, 1996 and 1995, respectively. As a percentage of
net revenues, research and development expenses were 19%, 18% and 14% for
fiscal 1997, 1996 and 1995, respectively. The increase in both absolute
dollars and as a percentage of revenues in fiscal 1997 was primarily a result
of increased headcount and consulting fees for various research and
development projects over the course of the entire fiscal year. With the
acquisition of VMW during fiscal 1996, headcount and related expenses
increased significantly as these expenses were incurred for a full year in
1997 versus one quarter in fiscal 1996. The growth in headcount and the VMW
acquisition in fiscal 1996 is the primary reason for the fiscal 1996 increase
over fiscal 1995. In fiscal 1996, the Company increased its hiring to address
its on-going research and development efforts for enhancing its current
products and for new product and technology development. These efforts
continued into fiscal 1997 and are expected to continue into fiscal 1998 which
is expected to result in an increase in absolute dollars when compared to
fiscal 1997.
 
SALES AND MARKETING EXPENSES
 
  Sales and marketing expenses were $17,516,000, $14,483,000 and $11,763,000
in fiscal 1997, 1996 and 1995 or 31%, 32% and 41% of net revenues,
respectively. The primary causes of the increase over the three years in
absolute dollars have been increases in headcount, commissions and
international operations. The growth in headcount of approximately 31% is due
to the higher level of presale support and benchmarking performed by field
application engineers. Spending on international operations have increased to
support the increased activity in both Europe and Asia. During fiscal 1997,
the Company reorganized its Japan subsidiary, increasing its sales and sales
support staff. Sales and marketing expenses are expected to increase in
absolute dollars in fiscal 1998.
 
                                       9
<PAGE>
 
GENERAL AND ADMINISTRATIVE EXPENSES
 
  General and administrative expenses were $3,777,000, $3,420,000 and
$2,301,000 for fiscal 1997, 1996 and 1995, or 7%, 8% and 8% of net revenues,
respectively. General and administrative costs increased in absolute dollars
as a result of increased headcount and related expenses, annual focal
increases and profit sharing expenses. However, these increases were less than
the rate of growth in revenues resulting in a decrease as a percentage of
revenues. The increase in expenses in 1996 in absolute dollars was primarily
due to increases in headcount with related expenses, increased investor
relations expenses, and increases in professional services and profit sharing
expenses. General and administrative expenses are expected to increase in
absolute dollars in fiscal 1998.
 
OTHER INCOME (EXPENSE)
 
  Net interest income in fiscal 1997 was $1,198,000 representing an 18%
increase from the $1,016,000 earned in fiscal 1996. The increase was primarily
the result of higher average cash balances during fiscal 1997. During fiscal
1996, the Company completed two stock offerings netting proceeds of
approximately $20,177,000 generating interest income of $1,058,0000 offset by
interest paid on long-term debt borrowings of $42,000. Net interest income of
$52,000 in fiscal 1995 consisted of approximately $159,000 of interest income
offset by approximately $107,000 of interest expense on long-term borrowings.
Other income in fiscal 1997, 1996 and 1995 was $71,000, $124,000 and $117,000,
respectively, and primarily relates to rental income from property that the
Company began leasing in 1993.
 
PROVISION FOR INCOME TAXES
 
  The Company recorded a tax provision of $1,023,000, which primarily
consisted of federal tax, state taxes, foreign taxes and the impact of
nondeductible goodwill amortization. These were offset by research and
development credits and the foreign sales corporation benefit. During fiscal
1996 the Company recorded a tax benefit of $1,892,000, which was primarily
attributable to the recognition of deferred tax assets for which no benefit
was previously recognized, net operating losses utilized during fiscal 1996,
and acquired research and development expenditures for which no tax benefit is
available. The Company's tax provision for fiscal 1995 consists primarily of
federal alternative minimum tax, state taxes and foreign withholding taxes.
 
  Under Statement of Financial Accounting Standards No. 109 (FAS 109),
deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. At September 27, 1997, the Company had
deferred tax assets arising from deductible temporary differences, tax losses,
and tax credits of $4,577,000 (net of the valuation allowance). Realization of
the net deferred tax asset is dependent on the Company's ability to generate
future U.S. taxable income. Management believes that it is more likely than
not that the asset will be realized based on forecasted U.S. income. However,
there can be no assurance that the company will meet its expectations of
future U.S. income. As a result, the amount of the deferred tax assets
considered realizable could be reduced in the near and long term if estimates
of future U.S. income are reduced. Such an occurrence could materially
adversely affect the Company's financial results and condition. The Company
will continue to evaluate the realizability of the deferred tax assets
quarterly by assessing the need for a valuation allowance.
 
  The Company has established a valuation allowance covering a portion of the
gross deferred tax assets based on management's expectations of future taxable
income and the actual taxable income during the three years ended September
27, 1997. Approximately $4,446,000 of the valuation allowance at September 27,
1997 is related to stock options and will be credited to equity when realized.
The remaining valuation allowance is attributable to VMW pre-acquisition
deferred tax assets, which will be credited to goodwill when recognized.
 
OTHER
 
  The Company has experienced virtually no gains or losses on foreign currency
translation since substantially all of its international sales to date have
been billed and collected in U.S. dollars. The Company pays the
 
                                      10
<PAGE>
 
expenses of its international operations in local currencies and to date the
Company has not engaged in hedging transactions with respect to such
obligations. However, as the Company has reorganized its operations at its
Japan subsidiary, the Company will be subject to engaging in transactions in
the Japanese local currency. As such, the Company may begin entering into
hedging arrangements to mitigate the currency risk with respect to such
transactions. At September 27, 1997, the Company had not entered into any such
hedging arrangements.
 
FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
 
  Potential Fluctuations in Quarterly Results--The Company's quarterly
operating results have in the past and may in the future vary significantly
depending on factors including the timing of customer development projects and
purchase orders, new product announcements and releases by the Company and
other companies, gain or loss of significant customers, price discounting of
the Company's products, the timing of expenditures, customer product delivery
requirements, availability and cost of components or labor and economic
conditions generally and in the electronics industry specifically. Any
unfavorable change in these or other factors could have a material adverse
effect on the Company's operating results for a particular quarter. Many of
the Company's customers order on an as-needed basis and often delay issuance
of firm purchase orders until their project commencement dates are determined.
Quarterly revenue and operating results will therefore depend on the volume
and timing of orders received during the quarter, which are difficult to
forecast accurately. Moreover, a significant portion of the Company's revenue
may result, from shipments during the last few weeks of the quarter from
orders generally received in the last month of the quarter. Any concentration
of sales at the end of the quarter may limit the Company's ability to plan or
adjust operating expenses and production and inventory levels. Therefore, if
anticipated shipments in any quarter do not occur or are delayed, expenditure
levels could be disproportionately high as a percentage of revenue, and the
Company's operating results for that quarter would be adversely affected. In
addition, sales of individual systems with high average sales prices can
constitute a significant percentage of the Company's quarterly revenue.
Operating results in any period should not be considered indicative of the
results to be expected for any future period, and there can be no assurance
that the Company's net revenues will continue to increase or that the Company
will remain profitable in any future period.
 
  Continued Acceptance and Development of the Company's Products--
Substantially all of the Company's product revenues since fiscal 1993 have
been derived from the sale of its Voyager and Gemini simulation systems. There
can be no assurance that market acceptance of these products will continue.
The continued adoption of the Company's hardware-assisted simulation products
for the verification of IC and system designs is expected to depend on an
increasing number of complex ICs designed for electronic systems, integration
of the Company's products with other tools for IC design and simulation, the
ability of hardware-assisted simulation systems to shorten the time of
simulation of IC designs, continued industry acceptance of mixed-level
hardware-assisted simulation, the development and market acceptance of
alternative simulation technologies such as cycle-based software simulation,
formal proof and hybrid timing verifiers, and modular design techniques.
Because the market for hardware-assisted simulation products is evolving, it
is difficult to predict with any assurance whether the market for hardware-
assisted simulation products will continue to expand. There can be no
assurances that such market will expand, or even if such market expands, that
the Company's products will achieve the market acceptance required to maintain
revenue growth and continued profitability in the future.
 
  Prior to the acquisition of VMW, the Company had limited in-house experience
with logic emulation. The Company's initial emulation product was commercially
released in the first quarter of fiscal 1997. While the Company has released
its initial emulation product, there can be no assurance that the product will
adequately meet the requirements of the marketplace. In addition, there
continues to be further development of the emulation product. As the Company
continues to develop emulation products which are based on a new technology
concept, there can be no assurance that the enhancement of current products or
other developed products resulting from this development will provide the
necessary solutions to customer design verification needs, be of acceptable
quality or achieve further market acceptance. The success of the Company in
developing, introducing, selling and supporting emulation products will depend
on a variety of factors including but not limited to the
 
                                      11
<PAGE>
 
timely and successful enhancement of current products, completion of product
design and development of future products, the timely and efficient
implementation of manufacturing processes, effective sales, marketing and
customer service, and the absence of performance problems or other
difficulties that may require design modifications and related expenses and
may hinder or damage market acceptance of the products. While the Company's
emulation systems are designed to provide cost and ease of use advantages
intended to broaden the market for logic emulation, there can be no assurance
that its products, if successfully developed, will be able to achieve such
goals. Moreover, there can be no assurance that the market for logic emulation
will broaden beyond the current set of emulation systems users. The adoption
of any emulation products the Company has or may develop will also depend on
the continued increasing complexity of ICs designed for electronic systems,
integration of such products with other tools for IC design and verification,
importance of the time to market benefits of emulation systems and industry
acceptance of the need to close the gap between high level design and silicon
production. Because the market for emulation products is new and evolving, it
is difficult to predict with any assurance whether the market for emulation
products will continue to expand, or even if such market expands, that the
Company's products will achieve the market acceptance required to maintain
revenue growth and continued profitability.
 
  Competition--The EDA industry is highly competitive and rapidly changing.
The Company's products are specifically targeted at the emerging portion of
the industry relating to complex designs that the Company believes benefit
from simulation and emulation products. To date, substantially all of the
Company's revenue has resulted from sales of hardware-assisted simulation
products. The Company currently experiences competition from traditional
software verification methodologies, including product offerings sold by
Cadence, Synopsis and Mentor Graphics. During the current year the Company
commercially released its emulation product. The Company's main competition
for emulation systems are those sold by Quickturn and other EDA companies. The
Company expects competition in the market for verification tools to increase
as other companies attempt to introduce new products, such as cycle-based
software simulation products and product enhancements. Moreover, the Company
competes, and expects that it will continue to compete, with established EDA
companies. A number of these companies have longer operating histories,
significantly greater financial, technical and marketing resources, greater
name recognition and larger installed customer bases than the Company. In
addition, many of these competitors and potential competitors have established
relationships with current and potential customers of the Company and offer a
broader and more comprehensive product line. Increased competition could
result in price reductions, reduced margins and loss of market share, all of
which could materially adversely affect the Company. In addition, current
competitors or other entities may develop other products that have significant
advantages over the Company's products. There can be no assurance that the
Company will be able to compete successfully against current and future
competitors or that competitive pressures faced by the Company will not
materially adversely affect its operating results.
 
  New Products and Technological Change--The EDA industry is characterized by
extremely rapid technological change in both hardware and software
development, frequent new product introductions, evolving industry standards
and changing customer requirements. The introduction of products embodying new
technologies and the emergence of new industry standards can render existing
products obsolete and unmarketable. The Company's future success will depend
upon its ability to enhance its current series of simulation and emulation
systems and to design, develop and support its future simulation and emulation
products on a timely basis. Those efforts require a high level of expenditures
for research and development by the Company to address the increasingly
sophisticated needs of the customers. For example, all of the Company's
current products operate in, and planned future products will operate in, the
Unix operating environment, an industry standard in the EDA market. In the
event that another operating system, such as Windows NT, becomes an industry
standard, the Company may be required to port its products to such new
standard. In addition, the Company's simulation systems generally accept
designs in the broadly accepted hardware description language, Verilog-XL,
which Cadence has developed and made available to the Company. In the event
Cadence adopts a less cooperative stance toward the Company in the future, the
Company's systems may not be able to accept designs based on Verilog-XL and
the Company may be required to develop software to accept designs of other
hardware description languages. The inability to accept designs in Verilog-XL
may materially adversely affect
 
                                      12
<PAGE>
 
the Company's results of operations. There can be no assurance that the
Company will be successful in developing and marketing product enhancements or
new products that respond to technological change or evolving industry
standards or changing customer requirements, that the Company will not
experience difficulties that could delay or prevent the successful
development, introduction and marketing of these products, or that its new
products and product enhancements will adequately meet the requirements of the
marketplace, will be of acceptable quality or will achieve market acceptance.
If the Company is unable, for technological or other reasons, to develop and
introduce products in a timely manner in response to changing market
conditions or customer requirements, the Company's business, operating results
and financial condition will be materially and adversely affected. Moreover,
from time to time, the Company may announce new products or technologies that
have the potential to replace the Company's existing product offerings. There
can be no assurance that the announcement of new product offerings will not
cause customers to defer purchases of existing Company products, which could
adversely affect the Company's results of operations for any particular
quarter.
 
  Dependence on Electronics Industry--The Company is dependent upon the
electronics industry and, in particular, new system and IC design projects.
The electronics industry is characterized by rapid technological change, short
product life cycles, fluctuations in manufacturing capacity and pricing and
margin pressures, all of which cause it to be volatile. As a result, the
electronics industry has historically experienced sudden and unexpected
downturns, at which time the number of new system and IC design projects
decrease. Because most of the Company's sales occur upon the commencement of
new projects for system and IC products, the Company is dependent upon the
rate of commencement of new system and IC design projects. Accordingly,
negative factors affecting the electronics industry could have a material
adverse effect on the Company's results of operations.
 
  Dependence Upon Certain Suppliers--Certain key components used in the
Company's products are presently available from sole or limited sources. The
inability to develop alternative sources for these sole or limited source
components or to obtain sufficient quantities of these components could result
in delays or reductions in product shipments which could adversely affect the
Company's operating results. The Company's systems use proprietary ASICs and
FPGAs that are currently manufactured solely by American Microsystems, Inc.
("AMI") and Xilinx, Inc. ("Xilinx"), respectively.
 
  The Company generally purchases these components, including semiconductor
memories used in the Company's hardware simulators, pursuant to purchase
orders placed from time to time in the ordinary course of business and has no
supply arrangements with any of its source suppliers that require the
suppliers to provide components in guaranteed quantities or at set prices.
Moreover, the manufacture of these components can be extremely complex, and
the Company's reliance on the suppliers of these components exposes the
Company to production difficulties and quality variations that may be
experienced by these suppliers. Therefore, the Company's reliance on its sole
and limited source suppliers involves several risks, including a potential
inability to obtain an adequate supply of required components, reduced control
over pricing and timely delivery and quality of acceptable components. While
the timeliness and quality of deliveries to date from such suppliers have been
acceptable, there can be no assurance that problems will not occur in the
future. Any prolonged inability to obtain components or subassemblies in
sufficient quantities or quality or on favorable pricing or delivery terms, or
any other circumstances that would require the Company to seek alternative
sources of supply, could have a material adverse effect on the Company's
operating results and could damage the Company's relationships with its
customers.
 
  Customer Concentration--A relatively limited number of customers have
historically accounted for a substantial portion of the Company's net
revenues. During fiscal 1997 and 1996, sales to the Company's top ten
customers accounted for approximately 52% and 65%, respectively, of the
Company's net revenues. The Company expects that sales of its products to a
limited number of customers will continue to account for a high percentage of
net revenues for the foreseeable future. The loss of a major customer or any
reduction in orders by such customers, including reductions due to market or
competitive conditions in the electronics or EDA industries, would have an
adverse effect on the Company's results of operations. Moreover, the Company's
ability to increase its sales will depend in part upon its ability to obtain
orders from new customers, as well as
 
                                      13
<PAGE>
 
the financial condition and success of its existing customers and the general
economy. There can be no assurance that such increases will occur.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  Since inception, the Company has financed its operations, including
increases in accounts receivable and inventory and capital equipment
acquisitions, primarily through private and public sales of equity securities
and a loan secured by capital equipment. The Company's cash, cash equivalents
and short-term investments decreased to $24,815,000 at September 27, 1997 from
$25,228,000 at September 28, 1996. The decrease was a result of $7,367,000
cash provided by operating activities and $1,701,000 provided by financing
activities offset by $10,172,000 of cash used in investment activities.
 
  Operating Activities--The Company's operating activities provided cash of
$7,367,000 during fiscal 1997, $10,445,000 in fiscal 1996 and $4,502,000 in
fiscal 1995. For fiscal 1997, the net cash provided by operating activities
primarily resulted from the net income adjusted for special charges related to
the Zycad technology purchase plus depreciation and amortization offset by
increases in accounts receivable, inventory and a decrease in accounts
payable. For fiscal 1996, net cash provided by operating activities resulted
primarily from net income adjusted for the purchase of in-process research and
development related to the purchase of VMW plus depreciation and amortization
partially offset by the adjustment for deferred tax assets. In addition, the
increase was impacted by increases in accounts payable, accrued payroll and
related expenses, income taxes, and deferred revenues offset by increases in
accounts receivable and inventories. For fiscal 1995, net cash provided by
operating activities resulted primarily from net income adjusted for
depreciation and amortization and increased deferred revenues, which was
partially offset by increases in accounts receivable, inventories and accounts
payable associated with increases in revenue activity.
 
  Investing Activities--Net cash used in investing activities for fiscal 1997,
1996 and 1995 were $10,172,000, $28,042,000 and $943,000, respectively. The
primary uses of cash during fiscal 1997, was the $7,289,000 paid for the
acquisition of technology from Zycad and capital expenditures of approximately
$2,192,000. For fiscal 1996, a significant use of cash resulted from the
acquisition of VMW which totaled $10,712,000 and capital expenditures totaling
$3,142,000. The purchases and maturities of short-term investments resulted in
a net use of cash in the amount $14,188,000 for investment purposes in fiscal
1996. Fiscal 1995 investment activities primarily consisted of capital
expenditures of approximately $1,053,000. For each fiscal year, capital
expenditures were primarily for evaluation equipment and engineering
workstations. The Company expects continued capital expenditures during fiscal
1998 as expected headcount additions will require additional computers and
engineering workstations.
 
  Financing Activities--During fiscal 1997, 1996 and 1995, the Company's
financing activities provided cash of $1,701,000, $20,882,000 and $324,000,
respectively. Cash provided from financing activities during fiscal 1997 were
primarily related to proceeds of $2,451,000 from the exercise of options to
purchase common stock under the Company's stock option and purchase plans.
Such proceeds were offset by the payment of $750,000 on outstanding debt
obligations. During fiscal 1996, the Company completed two public stock
offerings, issuing approximately 1,743,000 shares of common stock while
receiving net proceeds of approximately $20,177,000. During fiscal 1995, the
Company realized proceeds of approximately $1,078,000 from the exercise of
options to purchase Common Stock under the Company's stock plans. In addition,
during fiscal 1996 and 1995, the Company's principal payments on long-term
borrowings were $888,000 and $754,000, respectively.
 
  The Company's primary unused sources of funds at September 27, 1997
consisted of $9,486,000 of cash and cash equivalents, in addition to
$15,329,000 of short-term investments. The Company expects to make capital
expenditures throughout fiscal 1998. The Company expects that capital
expenditures will increase during fiscal 1998 as compared to capital
expenditures incurred in fiscal 1997. The Company believes that current cash,
cash equivalents and short-term investments, together with cash and cash
equivalents generated from operations, will be sufficient to finance its
operations through at least the end of fiscal 1998. To the extent necessary,
the Company may also use bank borrowings and capital leases depending on the
terms available. The Company's
 
                                      14
<PAGE>
 
cash requirements in the future may also be financed through additional equity
or debt financing. There can be no assurance that such financing can be
obtained on favorable terms, if at all.
 
  Subsequent to September 27, 1997, the Company announced its intention to
repurchase up to 1,000,000 shares of its outstanding common stock on the open
market. Through December 15, 1997, the Company had repurchased 199,000 shares
at a weighted-average per share price of $8.14.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  Not applicable
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The Company's Financial Statements and Schedules, and the report of the
independent auditors appear on pages F-1 through F-18 and S-1 of this Form 10-
K.
 
  The Company's Supplementary Data--Unaudited Selected Quarterly Financial
Data appears on F-18 of this Form 10-K.
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
  Not applicable.
 
                                      15
<PAGE>
 
                                   PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The executive officers and directors of the Company are as follows:
 
<TABLE>
<CAPTION>
NAME                                  AGE       POSITION WITH THE COMPANY
----                                  ---       -------------------------
<S>                                   <C> <C>
Gerald S. Casilli....................  58 Chairman of the Board
Ramon A. Nunez.......................  43 Chief Executive Officer, President and
                                          Director
Joseph W. Rockom.....................  58 Chief Financial Officer, Vice
                                          President of Finance and
                                          Administration, and Secretary
Daniel R. Hafeman....................  48 Vice President of Advanced Research
                                          and Chief Technical Officer
Stephen M. McLaughlin................  50 Vice President of Manufacturing
Lawrence A. Melling (1)..............  40 Vice President of Business Development
John Stressing.......................  53 Vice President of Worldwide Sales
Lutz P. Henckels (2).................  57 Director
James R. Oyler (2)...................  51 Director
Glenn E. Penisten (2)................  66 Director
</TABLE>
--------
(1) In November 1997, Mr. Melling's position with the Company changed from
    Vice President of Marketing to Vice President of Business Development.
(2) Member of the Audit Committee and Compensation Committee
 
  Mr. Casilli has served as Chairman of the Board of Directors of the Company
since July 1989 and served as Chief Executive Officer from April 1989 to
August 1995. He has served as a director since 1986. Mr. Casilli is also
currently a Director for Evans and Sutherland Computer Corporation. From
January 1986 to December 1989, he was a general partner of Trinity Ventures,
Ltd., a venture capital firm that was a former investor in the Company. Mr.
Casilli was a general partner of Genesis Capital, a venture capital firm, from
February 1982 to 1990. Mr. Casilli founded Millennium Systems, a manufacturer
of microprocessor development systems, in 1973 and served as its President and
Chief Executive Officer until 1982.
 
  Mr. Nunez was appointed Chief Executive Officer in August 1995. Mr. Nunez
had been President, Chief Operating Officer and Director of the Company since
October 1994. He had served as Vice President of Worldwide Sales since July
1993. Mr. Nunez joined the Company in April 1990 as Vice President of North
American Sales after five years in sales management with Zycad Corporation.
Earlier he was branch sales manager for Cadnetix (now part of Intergraph) in
Southern California.
 
  Mr. Rockom has served as Chief Financial Officer and Vice President of
Finance and Administration since September 1986. Mr. Rockom has also served as
the Company's Secretary since April 1995. Before joining the Company, Mr.
Rockom spent seventeen years at American Microsystems, Inc. (AMI), a
semiconductor manufacturer, where he held a variety of administrative,
operating and management positions, including Vice President of Finance.
 
  Mr. Hafeman, a founder of the Company, has served as Vice President of
Advance Research and Chief Technical Officer since March 1996. Mr. Hafeman
served as Vice President of Engineering from August 1989 to March 1996. From
December 1984 to August 1989, he served in various positions of engineering
management with the Company. Mr. Hafeman was an engineering manager at
Scientific Micro Systems, Inc. for eight years prior to his employment with
the Company.
 
                                      16
<PAGE>
 
  Mr. McLaughlin has served as Vice President of Manufacturing since November
1986. From July 1977 to November 1986, he served as Director of Manufacturing
of Scientific Micro Systems, Inc.
 
  In November 1997, Mr. Melling's position with the Company changed from Vice
President of Marketing to Vice President of Business Development. Mr. Melling
had served as Vice President of Marketing from July 1993 to November 1997.
From August 1990 to July 1993, Mr. Melling was Vice President of Technical
Support. From 1983 until joining IKOS in 1985, Mr. Melling had been a system
design engineer at Corvus Systems, a manufacturer of computer networking
equipment. Prior to his relationship with Corvus Systems, he was a production
and circuit engineer with Hewlett-Packard for four years.
 
  Mr. Stressing has served as Vice President of Worldwide Sales since August
1995. From October 1993 to August 1995 he served as European Sales Director
and Vice President, International Sales. From January 1989 to November 1993,
he was the proprietor of Premier Consultants, a recruitment and sales agency
for IKOS' products in Scandinavia. Prior to founding Premier Consultants, Mr.
Stressing was employed in various sales capacities by Zycad Corporation for
four years, by Daisy Systems for one year, by Teradyne for four years, and by
British Aerospace for thirteen years.
 
  Mr. Henckels has served as a member of the Board since February 1994. Mr.
Henckels has been President of LeCroy Corporation, a supplier of test and
measurement equipment, since 1993 and Chief Executive Officer since 1994. Mr.
Henckels is also a director of LeCroy Corporation. Before joining LeCroy
Corporation he was President of U.S. Operations for Racal-Redac, Inc. from
1989 to 1993. From 1983 to 1989, Mr. Henckels was President and Founder of HHB
Systems, an EDA company. Before that he was President and founder of HHB
Softron, an engineering consulting firm.
 
  Mr. Oyler has served as a member of the Board since October 1991. He is
presently President, Chief Executive Officer and Director of Evans &
Sutherland Computer Corporation. Evans & Sutherland develops, manufactures and
markets high performance systems for various applications with demanding
graphics requirements. Prior to his position with Evans and Sutherland, Mr.
Oyler was president of AMG, Inc., a process machine design company. From 1976
to 1990, Mr. Oyler worked at Harris Corporation, most recently as Senior Vice
President and Sector Executive, where he was responsible for nine operating
divisions. Prior to that he held positions as consultant and associate with
Booz, Allen & Hamilton in New York, a consulting company.
 
  Mr. Penisten has been a member of the Board of Directors since September
1985. Since September 1985, he has been a general partner of Alpha Partners, a
venture capital firm and former investor in the Company. From January 1985 to
August 1985, he was a general partner of P & C Venture Partners, a venture
capital firm. From 1982 to 1985, he was a Senior Vice President at Gould/AMI.
From 1976 to 1982, Mr. Penisten served as Chief Executive Officer of AMI, a
semiconductor manufacturer. Mr. Penisten is also a director of Bell Micro-
Products, Inc., Pinnacle Systems, Inc. and Superconductor Technologies and is
Chairman of the Board for Network Peripherals, Inc.
 
  All directors hold office until the next annual meeting of stock holders or
the election and qualification of their successors. The Board of Directors
elects officers annually and such officers serve at the discretion of the
Board.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  The information required by this Item is incorporated by reference to the
section captioned "EXECUTIVE COMPENSATION AND OTHER MATTERS" contained in the
Company's Definitive Proxy Statement related to the Annual Meeting of
Stockholders to be held January 27, 1998, to be filed by the Company with the
Securities and Exchange Commission (the "Proxy Statement").
 
                                      17
<PAGE>
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information required by this Item is incorporated by reference to the
section captioned "GENERAL INFORMATION--Security Ownership of Certain
Beneficial Owners and Management" contained in the Proxy Statement.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  Not applicable.
 
                                       18
<PAGE>
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
  (a)(1) Financial Statements
 
    The following financial statements of the Registrant are filed as part of
  this report:
 
<TABLE>
<CAPTION>
                                                                          PAGE
                                                                          ----
<S>                                                                       <C>
Report of Ernst & Young LLP, Independent Auditors........................ F-1

Consolidated Balance Sheets, September 27, 1997 and September 28, 1996... F-2

Consolidated Statements of Income for the fiscal years ended September
 27, 1997, September 28, 1996 and September 30, 1995..................... F-3

Consolidated Statements of Stockholders' Equity for the fiscal years
 ended September 27, 1997, September 28, 1996 and September 30, 1995..... F-4

Consolidated Statements of Cash Flows for the fiscal years ended
 September 27, 1997, September 28, 1996 and September 30, 1995........... F-5

Notes to Consolidated Financial Statements............................... F-6
 
  (a)(2) Financial Statement Schedule
 
    The following financial statement schedule of the Registrant are filed as
  part of this report:
 

                                                                          PAGE
                                                                          ----
Schedule II--Valuation and Qualifying Accounts........................... S-1
</TABLE> 
 
  All other schedules are omitted because they are not applicable or the
required information is shown in the Financial Statements or notes thereto.
 
  (a)(3) Exhibits
 
    See Index to Exhibits beginning on Page 22 of this report.
 
  (b) The Company filed no reports on Form 8-K during the fourth quarter ended
September 27, 1997.
 
                                      19
<PAGE>
 
                                  SIGNATURES
 
  PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED
ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
 
                                          IKOS Systems, Inc.
 
                                                     /s/ Ramon Nunez
                                          _____________________________________
                                                      Ramon Nunez,
                                           Chief Executive Officer, President
                                                      and Director
 
                               POWER OF ATTORNEY
 
  Each of the officers and directors of IKOS Systems, Inc. whose signature
appears below hereby constitutes and appoints Ramon A. Nunez and Joseph W.
Rockom and each of them, their true and lawful attorneys and agents, with full
power of substitution, each with power to act alone, to sign and execute on
behalf of the undersigned any amendment or amendments to this Report on Form
10-K and to perform any acts necessary in order to file such amendment or
amendments and each of the undersigned does hereby ratify and confirm all that
said attorneys and agents or their or his substitutes, shall do or cause to be
done by virtue hereof.
 
  PURSUANT TO REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT
HAS BEEN SIGNED ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE
DATE INDICATED.
 
<TABLE>
<CAPTION>
             SIGNATURE                           TITLE                    DATE
             ---------                           -----                    ----
 
<S>                                  <C>                           <C>
   /s/ Ramon Nunez                   Chief Executive Officer,      December 15, 1997
____________________________________  President and Director
   (Ramon Nunez)
 
   /s/ Gerald S. Casilli             Chairman of the Board         December 15, 1997
____________________________________
   (Gerald S. Casilli)
 
   /s/ Joseph W. Rockom              Vice President of Finance     December 15, 1997
____________________________________  and Administration and
   (Joseph W. Rockom)                 Chief Finance Officer
                                      (Principal Accounting and
                                      Financial Officer) and
                                      Secretary
 
   /s/ Lutz Henckels                 Director                      December 15, 1997
____________________________________
   (Lutz Henckels)
 
   /s/ James R. Oyler                Director                      December 15, 1997
____________________________________
   (James R. Oyler)
 
   /s/ Glenn E. Penisten             Director                      December 15, 1997
____________________________________
   (Glenn E. Penisten)
</TABLE>
 
                                      20
<PAGE>
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
 EXH. NO.                   DOCUMENTATION DESCRIPTION                     PAGE
 --------                   -------------------------                     ----
 <C>      <S>                                                             <C>
    2.1   Agreement and Plan of Reorganization among the Company, VMW
          Acquisition Corporation and VMW dated May 14, 1996
          (Incorporated by reference to Exhibit 2.1 of the Company's
          registration statement on Form S-3 effective June 26, 1996).
    3.1   Certificate of Incorporation (Incorporation by reference to
          Exhibit 3.1 of the Company's registration statement on Form
          S-1 effective July 25, 1990).
    3.2   Certificate of Amendment of Certificate of Incorporation
          filed May 5, 1994 (Incorporated by reference to Exhibit 4.1
          of the Company's registration statement on Form S-2 effective
          October 12, 1995).
    3.3   Certificate of Amendment of Certificate of Incorporation
          filed April 24, 1995 (Incorporated by reference to Exhibit
          4.2 of the Company's registration statement on Form S-2
          effective October 12, 1995).
    3.4   Certificate of Amendment of Certificate of Incorporation
          filed February 3. 1997 (Incorporated by reference to Exhibit
          3.4 of the Company's quarterly report on Form 10-Q for the
          quarter ending March 29, 1997).
    3.5   By laws (Incorporated by reference to Exhibit 3.2 of the
          Company's registration statement on Form S-1 effective July
          25, 1990).
    4.1   Rights agreement dated as of January 27, 1992 between the
          Company and Manufacturers Hanover Trust Company of
          California, Rights Agent. (Incorporated by reference to
          Exhibit (C)1, in the Company's report on Form 8-K filed
          February 10, 1992).
   10.1   Lease Agreement for the Company's principal facility dated
          March 20, 1992, between Ames Avenue Associates and the
          Company, as amended. (Incorporated by reference to Exhibit
          10.1 of the Company's annual report on 10-K for the year
          ending September 26, 1992).
   10.2   Form of Director and Officer Indemnity Agreement.
          (Incorporated by reference to Exhibit 10.6 of the Company's
          registration statement on Form S-1 effective July 25, 1990).
   10.3   1988 Stock Option Plan. (Incorporated by reference to Exhibit
          10.14 of the Company's registration statement on Form S-1
          effective July 25, 1990).
   10.2   Form of Director and Officer Indemnity Agreement.
          (Incorporated by reference to Exhibit 10.6 of the Company's
          registration statement on Form S-1 effective July 25, 1990).
   10.3   1988 Stock Option Plan. (Incorporated by reference to Exhibit
          10.14 of the Company's registration statement on Form S-1
          effective July 25, 1990).
   10.4   Patent Cross License Agreement dated May 17, 1989 with Zycad
          Corporation (Incorporated by reference to Exhibit 10.20 of
          the Company's registration statement on Form S-1 effective
          July 25, 1990).
   10.5   International Distributorship Agreement dated April 11, 1988,
          with C. Itoh & Co., Ltd. (Incorporated by reference to
          Exhibit 10.24 of the Company's registration statement on Form
          S-1 effective July 25, 1990). Confidential Treatment has been
          granted as to certain portions of this Exhibit.
   10.6   OEM Software License Agreement between CAD Language Systems,
          Inc. and IKOS Systems, Inc. dated June 22, 1989 and amendment
          dated September 1991 (Incorporated by reference to Exhibit
          10.18 of the Company's Annual Report for the year ended
          September 28, 1991).
</TABLE>
 
                                       21
<PAGE>
 
<TABLE>
<CAPTION>
 EXH. NO.                   DOCUMENTATION DESCRIPTION                     PAGE
 --------                   -------------------------                     ----
 <C>      <S>                                                             <C>
  10.7    Technology Transfer and Joint Development Agreement with
          Racal-Redac, Inc. dated July 1, 1993 (Incorporated by
          reference to Exhibit 10.19 of the Company's quarterly report
          on Form 10-Q for the quarter ended July 3, 1993).
          Confidential Treatment has been granted as to certain
          portions of this Exhibit.
  10.8    Settlement Agreement and Release dated March 31, 1994 between
          Racal Redac, Inc. and the Company (Incorporated by reference
          to Exhibit 10.13 of the Company's registration statement on
          Form S-2 effective October 12, 1995).
  10.9    Software License Agreement with Compass Design Automation
          dated December 31, 1993 (Incorporated by reference to Exhibit
          10.17 of the Company's quarterly report on Form 10-Q for the
          quarter ended January 1, 1994).
  10.10   Agreement dated June 2, 1994, by and between the Company and
          Gerald S. Casilli (Incorporated by reference to Exhibit 10.18
          of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
  10.11   Agreement dated June 2, 1994, by and between the Company and
          Daniel R. Hafeman (Incorporated by reference to Exhibit 10.18
          of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
  10.12   Agreement dated June 2, 1994, by and between the Company and
          Stephen McLaughlin. (Incorporated by reference to Exhibit
          10.18 of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
  10.13   Agreement dated June 2, 1994, by and between the Company and
          Larry A. Melling (Incorporated by reference to Exhibit 10.18
          of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
  10.14   Agreement dated June 2, 1994, by and between the Company and
          Ramon A. Nunez (Incorporated by reference to Exhibit 10.18 of
          the Company's quarterly report on Form 10-Q for the quarter
          ended July 2, 1994).
  10.15   Agreement dated June 2, 1994, by and between the Company and
          Joseph W. Rockom (Incorporated by reference to Exhibit 10.18
          of the Company's quarterly report on Form 10-Q for the
          quarter ended July 2, 1994).
  10.16   The Company's 1995 Outside Directors Stock Option Plan
          (Incorporated by reference to Exhibit 10.22 of the Company's
          registration statement on Form S-2 effective October 12,
          1995).
  10.17   Development and OEM Agreement for Verilog/IKOS Co-simulation
          Interface dated August 26, 1994 by and between the Company
          and Precedence Incorporated (Incorporated by reference to
          Exhibit 10.24 of the Company's registration statement on Form
          S-2 effective October 12, 1995).
  10.18   Amendment to OEM Agreement for the acquisition of certain
          software technology, by and between Compass Design
          Automation, Inc. and the Company dated December 27, 1995
          (Incorporated by reference to Exhibit 10.20 of the Company's
          quarterly report on Form 10-Q for the quarter ended December
          30, 1995).
  10.19   Amended and Restated Employment Agreement dated August 1,
          1995 by and between the Company and Ramon Nunez (Incorporated
          by reference to Exhibit 10.21 of the Company's quarterly
          report on Form 10-Q for the quarter ended December 30, 1995).
</TABLE>
 
                                       22
<PAGE>
 
<TABLE>
<CAPTION>
 EXH. NO.                   DOCUMENTATION DESCRIPTION                    PAGE
 --------                   -------------------------                    ----
 <C>      <S>                                                            <C>
  10.20   Patent License Agreement dated December 22, 1993 between
          Massachusetts Institute of Technology and the Company
          (Incorporated by reference to Exhibit 10.20 of the Company's
          quarterly report on Form 10-Q for the quarter ended June 29,
          1996). Confidential treatment has be granted as to certain
          portions of this Exhibit.
  10.21   The Company's 1995 Stock Option Plan. (Incorporated by
          reference to Exhibit 10.21 of the Company's Annual Report on
          Form 10-K for the year ended September 28, 1996).
  10.22   The Company's 1996 Employee Stock Purchase Plan.
          (Incorporated by reference to Exhibit 10.21 of the Company's
          Annual Report on Form 10-K for the year ended September 28,
          1996).
  11.1    Statement of Computation of Earnings per Share.
  21.1    List of Subsidiaries.
  23.1    Consent of Ernst & Young LLP, Independent Auditors.
  24.1    Power of Attorney (Included on page 20 of this report).
  27.1    Financial Data Schedule
</TABLE>
 
                                       23
<PAGE>
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
 
Board of Directors and Stockholders
IKOS Systems, Inc.
 
  We have audited the accompanying consolidated balance sheets of IKOS
Systems, Inc. as of September 27, 1997 and September 28, 1996 and the related
consolidated statements of income, stockholders' equity, and cash flows for
each of the three fiscal years in the period ended September 27, 1997. Our
audit also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of IKOS Systems, Inc. at September 27, 1997 and September 28, 1996, and the
consolidated results of its operations and its cash flows for each of the
three fiscal years in the period ended September 27, 1997, in conformity with
generally accepted accounting principles. Also in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material
respects the information set forth therein.
 
                                          Ernst & Young LLP
 
San Jose, California
October 15, 1997
 
                                      F-1
<PAGE>
 
                               IKOS SYSTEMS, INC.
 
                          CONSOLIDATED BALANCE SHEETS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                    SEPTEMBER 27, SEPTEMBER 28,
                                                        1997          1996
                                                    ------------- -------------
<S>                                                 <C>           <C>
                      ASSETS
Current assets:
  Cash and cash equivalents........................   $  9,486      $ 10,590
  Short-term investments...........................     15,329        14,638
  Accounts receivable (net of allowances for
   doubtful accounts of $501 and $271,
   respectively)...................................     12,228         9,193
  Inventories......................................      4,804         3,514
  Deferred income taxes............................      3,450         4,187
  Prepaid expenses and other assets................        659           537
                                                      --------      --------
    Total current assets...........................     45,956        42,659
Equipment and leasehold improvements
  Office and evaluation equipment..................      3,684         3,088
  Machinery and equipment..........................      7,328         5,738
  Leasehold improvements...........................        337           331
                                                      --------      --------
                                                        11,349         9,157
    Less allowances for depreciation and
     amortization..................................     (7,080)       (5,565)
                                                      --------      --------
                                                         4,269         3,592
Intangible assets (net of amortization of $1,681
 and $421, respectively)...........................      4,626         5,890
Deferred income taxes..............................      1,127         1,125
Other assets.......................................        572           205
                                                      --------      --------
                                                      $ 56,550      $ 53,471
                                                      ========      ========
       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable.................................   $  3,073      $  4,775
  Accrued payroll and related expenses.............      2,437         2,406
  Accrued commissions..............................        742           725
  Income taxes payable.............................      1,072         1,745
  Other accrued liabilities........................      1,551           496
  Deferred revenues................................      5,123         3,843
  Current portion of long-term debt................        350           750
                                                      --------      --------
    Total current liabilities......................     14,348        14,740
Long-term debt, less current portion...............        --            350
Accrued rent.......................................        212           237
Commitments
Stockholders' equity:
  Preferred stock, $.01 par value; 10,000 shares
   authorized, none issued and outstanding.........        --            --
  Common stock, $.01 par value; 50,000 shares
   authorized, 8,579 and 8,179 shares issued and
   outstanding, respectively.......................         85            82
  Additional paid-in capital.......................     57,442        54,994
  Accumulated deficit..............................    (15,537)      (16,932)
                                                      --------      --------
    Total stockholders' equity.....................     41,990        38,144
                                                      --------      --------
                                                      $ 56,550      $ 53,471
                                                      ========      ========
</TABLE>
 
                 See notes to consolidated financial statements
 
                                      F-2
<PAGE>
 
                               IKOS SYSTEMS, INC.
 
                       CONSOLIDATED STATEMENTS OF INCOME
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                  FISCAL YEARS ENDED
                                       -----------------------------------------
                                       SEPTEMBER 27, SEPTEMBER 28, SEPTEMBER 30,
                                           1997          1996          1995
                                       ------------- ------------- -------------
<S>                                    <C>           <C>           <C>
Net revenues
  Product............................     $46,350       $37,619       $23,713
  Maintenance........................       9,746         7,722         4,887
                                          -------       -------       -------
    Total net revenues...............      56,096        45,341        28,600
Cost of revenues
  Product............................      10,745         8,422         5,982
  Maintenance........................       1,707         1,430         1,157
                                          -------       -------       -------
    Total cost of revenues...........      12,452         9,852         7,139
                                          -------       -------       -------
    Gross profit.....................      43,644        35,489        21,461
Operating expenses:
  Research and development...........      10,740         8,146         3,999
  Sales and marketing................      17,516        14,483        11,763
  General and administration.........       3,777         3,420         2,301
  Write-off of acquired in-process
   research and development and
   special charges...................       9,202         9,600           --
  Amortization of intangibles........       1,260           421           --
                                          -------       -------       -------
    Total operating expenses.........      42,495        36,070        18,063
                                          -------       -------       -------
Income (loss) from operations........       1,149          (581)        3,398
Other income (expense):
  Interest income....................       1,198         1,058           159
  Interest expense...................         --            (42)         (107)
  Other..............................          71           124           117
                                          -------       -------       -------
    Total other income...............       1,269         1,140           169
                                          -------       -------       -------
Income before provision for income
 taxes...............................       2,418           559         3,567
Provision (benefit) for income taxes.       1,023        (1,892)          411
                                          -------       -------       -------
  Net income.........................     $ 1,395       $ 2,451       $ 3,156
                                          =======       =======       =======
Earnings per share:
  Net income.........................     $  0.16       $  0.30       $  0.51
                                          =======       =======       =======
  Common and common equivalent shares
   used in computing per share
   amounts...........................       8,927         8,114         6,151
                                          =======       =======       =======
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-3
<PAGE>
 
                               IKOS SYSTEMS, INC.
 
                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                              COMMON STOCK  ADDITIONAL                 TOTAL
                              -------------  PAID-IN   ACCUMULATED STOCKHOLDERS'
                              SHARES AMOUNT  CAPITAL     DEFICIT      EQUITY
                              ------ ------ ---------- ----------- -------------
<S>                           <C>    <C>    <C>        <C>         <C>
Balance at October 1, 1994..  5,504   $ 55   $25,960    $(22,539)     $ 3,476
Issuance of stock under
 employee benefit plans.....    382      4     1,074         --         1,078
Net income..................    --     --        --        3,156        3,156
                              -----   ----   -------    --------      -------
Balance at September 30,
 1995.......................  5,886     59    27,034     (19,383)       7,710
Issuance of stock under
 employee benefit plans.....    437      4     1,589         --         1,593
Issuance of stock in
 connection with stock
 offerings..................  1,743     18    20,159         --        20,177
Issuance of stock and
 warrants in connection with
 the acquisition of VMW.....    113      1     5,198         --         5,199
Income tax benefit from
 stock options exercised....                   1,014         --         1,014
Net income..................    --     --        --        2,451        2,451
                              -----   ----   -------    --------      -------
Balance at September 28,
 1996.......................  8,179     82    54,994     (16,932)      38,144
Issuance of stock under
 employee benefit plans.....    400      3     2,448         --         2,451
Net income..................    --     --        --        1,395        1,395
                              -----   ----   -------    --------      -------
Balance at September 27,
 1997.......................  8,579   $ 85   $57,442    $(15,537)     $41,990
                              =====   ====   =======    ========      =======
</TABLE>
 
 
                See notes to consolidated financial statements.
 
                                      F-4
<PAGE>
 
                               IKOS SYSTEMS, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
         INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS IN THOUSANDS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                  FISCAL YEARS ENDED
                                       -----------------------------------------
                                       SEPTEMBER 27, SEPTEMBER 28, SEPTEMBER 30,
                                           1997          1996          1995
                                       ------------- ------------- -------------
<S>                                    <C>           <C>           <C>
Operating activities:
  Net income.........................    $  1,395      $  2,451       $ 3,156
  Adjustments to reconcile net income
   to net cash provided by operating
   activities:
    Depreciation and amortization....       2,775         1,583         1,259
    Special charges..................       9,202         9,600           --
    Loss on retirement of equipment..           4            27            16
    Deferred income taxes............         735        (5,312)          --
    Deferred rent....................         (25)          (14)           37
Changes in operating assets and
 liabilities:
  Accounts receivable................      (3,035)       (3,147)       (1,162)
  Inventories........................      (1,290)       (2,186)         (234)
  Prepaid expenses and other current
   assets............................        (122)         (266)          (49)
  Other assets.......................        (367)          (92)          (27)
  Accounts payable...................      (1,702)        3,162          (296)
  Accrued payroll and related
   expenses..........................          31         1,211           409
  Accrued commissions................          17            28            47
  Income taxes payable                       (673)        2,571           175
  Other accrued liabilities..........         254            16           120
  Deferred revenues..................         168           813         1,051
                                         --------      --------       -------
    Net cash provided by operating
     activities......................       7,367        10,445         4,502
Investing activities:
  Purchases of equipment and
   leasehold improvements............      (2,192)       (3,142)       (1,053)
  Investment in Virtual Machine
   Works, Inc........................         --        (10,712)          --
  Purchase of Zycad technology.......      (7,289)          --            --
  Purchases of short-term
   investments.......................     (30,347)      (25,393)          --
  Maturities of short-term
   investments.......................      29,656        11,205           110
                                         --------      --------       -------
    Net cash used in investment
     activities......................     (10,172)      (28,042)         (943)
Financing activities:
  Principal payments on long-term
   borrowings........................        (750)        (888)          (754)
  Sale of common stock...............       2,451        21,770         1,078
                                         --------      --------       -------
    Net cash provided by financing
     activities......................       1,701        20,882           324
                                         --------      --------       -------
Increase (decrease) in cash and cash
 equivalents.........................      (1,104)        3,285         3,883
Cash and cash equivalents at
 beginning of period.................      10,590         7,305         3,422
                                         --------      --------       -------
Cash and cash equivalents at end of
 period..............................    $  9,486      $ 10,590       $ 7,305
                                         ========      ========       =======
Supplemental disclosures of cash flow
 information:
  Cash paid for income taxes.........    $    311      $    704       $   230
  Cash paid for interest.............         --       $     42       $   107
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-5
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                              SEPTEMBER 27, 1997
 
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  Nature of operations: The Company develops, manufactures, markets and
supports hardware and software systems for the verification of integrated
circuit designs. The Company's strategy is to serve the needs of a growing
universe of IC designers for fast, accurate verification of complex IC designs
through its family of hardware and software simulation and emulation systems.
The Company performs final assembly and test of all of its products in its
Cupertino, California facility and utilizes third parties for all major
subassembly manufacturing. Certain key components used in the Company's
products are presently available from sole or limited sources. The Company is
dependent upon these suppliers to provide these components on a timely basis.
The Company sells its products to a broad range of customers in the
communications, multimedia/graphics, semiconductor, computer, aerospace and
consumer electronics industries.
 
  Basis of presentation: The accompanying consolidated financial statements
include the Company and its wholly owned subsidiaries after elimination of all
significant inter-company accounts and transactions.
 
  Fiscal year: The Company is on a 52-53 week fiscal year. Accordingly,
September 27, 1997, September 28, 1996 and September 30, 1995 are the fiscal
year-ends for 1997, 1996 and 1995, respectively. Fiscal year 1998 will be a 53
week fiscal year.
 
  Cash equivalents and short-term investments: All liquid investments with
original maturities of three months or less when purchased are considered to
be cash equivalents and are stated at cost, which approximates their fair
value. At September 27, 1997, cash equivalents consisted of money market
funds, certificates of deposits and U.S. corporate overnight securities.
Short-term investments are stated at cost, which approximates market, and
consist primarily of U.S. Treasury securities, commercial paper and other
corporate obligations all due within one year. The Company is exposed to
credit risks in the event of default by the financial institutions or issuers
of investments to the extent of amounts recorded on the balance sheet.
 
  Under Statements of Financial Accounting Standards No. 115 (FAS 115),
"Accounting for Certain Investments in Debt and Equity Securities," debt
securities that the Company has both positive intent and ability to hold to
maturity are carried at amortized cost. Debt securities that the Company does
not have the positive intent and ability to hold to maturity and all
marketable equity securities are classified as available-for-sale or trading
and carried at fair value. Unrealized holding gains and losses on securities
classified as available-for-sale are reported as part of equity while
unrealized holding gains and losses on securities classified as trading are
reported in earnings.
 
  The fair values for marketable debt securities are based on quoted market
prices. The fair value of marketable securities is substantially equal to
their carrying values as of September 27, 1997 and September 28, 1996.
 
  The following is a summary of held-to-maturity securities at September 27,
1997 and September 26, 1996 (in thousands):
 
<TABLE>
<CAPTION>
                               SEPTEMBER 27, SEPTEMBER 28,
                                   1997          1996
                               ------------- -------------
     <S>                       <C>           <C>
     U.S. Treasury
      Securities.............     $   167       $   125
     U.S. Corporate
      Securities.............      14,481        17,399
     Mortgage-Backed
      Securities.............       2,417         2,216
                                  -------       -------
                                  $17,065       $19,740
                                  =======       =======
     Amounts included in
      short-term investments.     $15,329       $14,638
                                  =======       =======
     Amounts included in cash
      and cash equivalents...     $ 1,736       $ 5,102
                                  =======       =======
</TABLE>
 
                                      F-6
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED):
 
  Inventories: Inventories are stated at the lower of cost (first-in, first-
out method) or market (estimated net realizable value). Inventories consist of
the following (in thousands):
 
<TABLE>
<CAPTION>
                                                     SEPTEMBER 27, SEPTEMBER 28,
                                                         1997          1996
                                                     ------------- -------------
     <S>                                             <C>           <C>
     Raw materials..................................    $1,979        $  631
     Work-in-process................................     1,385         2,245
     Finished goods.................................     1,440           638
                                                        ------        ------
                                                        $4,804        $3,514
                                                        ======        ======
</TABLE>
 
  Equipment and leasehold improvements: Equipment and leasehold improvements
are stated at cost and are depreciated or amortized using the straight-line
method over the estimated useful life (generally two to five years) of the
related asset, or in the case of leasehold improvements, the term of the
lease, if shorter.
 
  Goodwill and software development costs and other long-lived assets: The
goodwill presented in the accompanying financial statements relate to the
acquisition of VMW and is being amortized over five years. The carrying value
of the goodwill is reviewed if the facts and circumstances suggest that it may
be impaired. If this review indicates that the asset will not be recoverable,
as determined based on the undiscounted cash flows of the acquired business
over the remaining amortization period, the Company's carrying value is
reduced to net realizable value. There were no writedowns of goodwill in
fiscal 1997 or fiscal 1996.
 
  The Company capitalizes software development costs upon achievement of
technological feasibility, subject to net realizable value considerations in
accordance with Statement of Financial Accounting Standards No. 86. The
Company has defined technological feasibility as completion of a working
model. Such capitalized costs are amortized upon product release on a
straight-line basis over the estimated useful life of two years or the ratio
of current revenue to the total of current and anticipated future revenues,
whichever is greater. For the three fiscal years ended September 27, 1997
capitalizable costs were insignificant and thus charged to research and
development expenses for the respective periods in the accompanying financial
statements. During the fiscal 1995, the Company amortized $257,000 of
previously capitalized software development costs. For fiscal 1997 and 1996,
all capitalized costs had previously been amortized.
 
  Revenue recognition: Product revenues, which include licensing and software
revenues, are generally recognized on shipment provided that no significant
vendor or post-contract support obligations remain outstanding and collection
of the resulting receivable is deemed probable. Insignificant vendor and post-
support obligations are accrued upon shipment. Revenue under maintenance
contracts is recognized ratably over the term of the related contract,
generally twelve months. Revenue recognized under consulting arrangements are
generally recognized upon the achievement of agreed upon milestones.
 
  Warranty: The Company warrants products sold to customers for ninety days
from shipment. A provision for the estimated future cost of warranty is
recorded upon shipment.
 
  Employee stock plans: The Company accounts for its stock option and employee
stock purchase plans in accordance with provisions of the Accounting
Principles Board's Opinion No. 25 (APB 25), "Accounting for Stock Issued to
Employees."
 
  Use of estimates: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts
 
                                      F-7
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED):
 
of liabilities and disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenues and expenses
during the reporting period. Such estimates related to the useful lives of
fixed assets, allowances for doubtful accounts and customer returns, inventory
reserves, other reserves and income tax valuation allowances. Actual results
inevitably will differ from those estimates, and such differences may be
material to the financial statements.
 
  Net income per share: Net income per share is computed using the weighted
average number of shares of common stock and common equivalent shares, when
dilutive, from stock options (using the treasury stock method). Fully diluted
earnings per share is computed using the weighted average common and dilutive
common equivalent shares outstanding, plus other dilutive shares which are not
common equivalent shares.
 
  In February 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share." The
overall objective of the Statement No. 128 is to simplify the calculation of
earnings per share by excluding the dilutive effect of stock options and
warrants from the "basic" earnings per share calculation. The statement is
effective for interim and annual financial statements for periods ending after
December 15, 1997 and earlier application is not permitted. The Company will
not be required to adopt such statement until its first quarter of fiscal 1998
and such adoption, when effective, will not result in a materially different
disclosure of "dilutive" earnings per share than currently disclosed. Pro
forma "basic" earnings per share for fiscal 1997, 1996 and 1995 would be
$0.17, $0.33 and $0.56, respectively.
 
2. ACQUISITIONS
 
  Virtual Machine Works, Inc.: In May 1996, the Company completed the
acquisition of Virtual Machine Works, Inc. (VMW), a development stage company
and a developer of logic emulation systems. Under the terms of the
acquisition, the Company paid approximately $10,712,000 in cash and issued
approximately 113,000 shares of common stock to the former stockholders of
VMW. In addition, the options to purchase VMW stock were converted into
options to purchase approximately 84,000 shares of IKOS common stock. The
transaction was treated as a purchase; accordingly the purchase price has been
allocated to the tangible assets acquired, goodwill and liabilities assumed at
their fair market values using a risk adjusted discounted cash flows approach.
In connection, with the acquisition, the Company recorded a charge of
approximately $9,600,000 for the acquisition of in-process research and
development during the third quarter of fiscal 1996. For fiscal 1997 and 1996,
the Company recorded amortization of $1,260,000 and $421,000 relating to the
capitalized intangible assets, respectively.
 
  The evaluation of the underlying technology and patent rights acquired
considered the inherent difficulties and uncertainties in completing the
development, and thereby achieving technological feasibility, and the risks
related to the viability of and potential changes in future target markets.
The underlying technology and patent rights had no alternative use (in other
research and development projects or otherwise) since the technology was
acquired for the sole purpose of developing emulation products.
 
  Zycad Corporation: In April and August 1997, the Company completed the
purchase of certain software and hardware simulation technology from Zycad
Corporation for approximately $7,600,000 in cash. Under the terms of the
agreements, the companies have jointly implemented a product transition
program for all of Zycad's current logic simulation customers. Through
September 27, 1997, IKOS has paid approximately $7,300,000 with the remaining
$300,000 is to be paid in two installments through June 1998. The technology
acquisition was charged to operations and in addition, in connection with the
customer transition program, the anticipated cost of approximately $1,600,000
of such program was charged to operations in the current fiscal year.
 
                                      F-8
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
3. LONG-TERM DEBT
 
<TABLE>
<CAPTION>
                                                   SEPTEMBER 27, SEPTEMBER 28,
                                                       1997          1996
                                                   ------------- -------------
                                                         (IN THOUSANDS)
     <S>                                           <C>           <C>
     Debt obligation to Racal-Redac, Inc. payable
      in sixteen quarterly payments through 1998..     $ 350        $1,100
     Less current portion.........................      (350)         (750)
                                                       -----        ------
     Long-term debt...............................     $ --         $  350
                                                       =====        ======
</TABLE>
 
  Racal-Redac Agreement--In July 1993, the Company and Racal-Redac, Inc.
("Racal") amended the May 1991 Technology Transfer and Joint Development
Agreement which provided for the exchange of certain VHDL technologies and for
the joint ownership in certain Racal technology for cash, common stock and
future payments based on future sales. Under the terms of the July agreement
the original agreement was amended to require payments of $3,600,000 (payable
over four years) in lieu of the future payments based on product sales.
Through September 27, 1997, the Company has paid an aggregate amount under the
agreement of $3,250,000. The remaining $350,000 is due to be paid in fiscal
1998. In the event that the Company defaults in the payment of the promissory
note, Racal may obtain all rights to the software, including access to the
source code of the software.
 
4. COMMITMENTS
 
  Non cancelable operating leases include building leases which expire in
September 2000. The Company has the option to renew its building lease at its
principal offices for up to an additional nine years, commencing in September
2000, at the fair market value at the time of renewal. The Company subleased
certain facilities through April of fiscal 1997. Sublease rental income was
approximately $67,000, $122,000 and $117,000, in fiscal 1997, 1996 and 1995,
respectively.
 
  Rent expense approximated $1,153,000, $975,000 and $901,000 in fiscal 1997,
1996 and 1995, respectively.
 
  Future minimum payments under non cancelable operating leases at September
27, 1997 are as follows (in thousands):
 
<TABLE>
<CAPTION>
       FISCAL YEAR                                                        AMOUNT
       -----------                                                        ------
       <S>                                                                <C>
       1998.............................................................. $  835
       1999..............................................................    777
       2000..............................................................    731
                                                                          ------
         Total........................................................... $2,343
                                                                          ======
</TABLE>
 
5. STOCKHOLDERS' EQUITY
 
  Common stock: In October 1995, the Company sold 1,150,000 shares of common
stock in a public offering resulting in net proceeds to the Company of
approximately $10,450,000. In July 1996, the Company completed a second
offering of common stock whereby approximately 593,000 shares of common stock
were sold resulting in net proceeds to the Company of approximately
$9,727,000.
 
  Preferred Stock Purchase Rights Plan: The Company has a Preferred Stock
Purchase Rights Plan (the "Rights Plan") which provides existing shareholders
with the right to purchase 1/100 preferred share for each
 
                                      F-9
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
5. STOCKHOLDERS' EQUITY (CONTINUED):
 
common share held in the event of certain changes in the Company's ownership.
The Rights Plan may serve as a deterrent to takeover tactics, which are not in
the best interests of shareholders. The Board of Directors of the Company has
designated 500,000 shares of Series G Preferred Stock, $0.01 par value per
share, and has reserved such shares for issuance pursuant to the Company's
Rights Plan.
 
  Stock Repurchase: Subsequent to September 27, 1997, the Company announced
its intention to repurchase up to 1,000,000 shares of its outstanding common
stock on the open market. Through December 15, 1997, the Company had
repurchased 199,000 shares at a weighted-average per share price of $8.14.
 
  VMW Acquisition: In connection with the acquisition of VMW (see Note 1), the
Company issued approximately 113,000 shares of common stock in exchange for
VMW shares. In addition, the Company granted options to purchase approximately
84,000 shares of common stock in exchange for VMW options. The option prices
range from $0.85--$2.54 and are included in the grants in the table below. In
connection with the acquisition, the Company also issued warrants to purchase
25,000 shares of common stock at $23.50 per share in return for professional
services rendered. These warrants, which were valued at approximately
$200,000, are included as consideration in connection with the acquisition.
These warrants expire on April 19, 2001. At September 27, 1997, options to
purchase approximately 21,000 shares of common stock and warrants to purchase
25,000 shares of common stock remain outstanding. The Company has reserved
approximately 46,000 shares of common stock for issuance in connection with
these options and warrants.
 
  Stock option plans: In 1988, the Company established a Stock Option Plan
(the Plan) which provides for the granting of options to employees or
directors to purchase shares of the Company's common stock. During fiscal
1996, the Company replaced the 1988 Stock Option Plan by establishing the 1995
Stock Option Plan (the "1995 Plan"). The terms of the 1995 Plan are similar to
the 1988 Plan. Any shares remaining available for grant under the 1988 Plan
were converted to the 1995 Plan and an additional 750,000 shares were reserved
for future grants under the 1995 Plan. During 1997, an additional 450,000
shares were reserved for future grants under the 1995 Plan.
 
  In August 1997, the Board of Directors authorized the Company to offer all
employees, except for officers of the Company, the opportunity to cancel
certain previously granted options in exchange for new options with new
vesting and expiration terms at the then fair market value price of $15.25 per
share. At September 27, 1997, options to purchase 263,987 shares of common
stock with a weighted-average price of $23.51 were exchanged for new options.
The exchange is included in the table below.
 
                                     F-10
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
5. STOCKHOLDERS' EQUITY (CONTINUED):
 
  The following table summarizes the activity for the stock option plans (in
thousands, except per share data):
 
<TABLE>
<CAPTION>
                                            OPTIONS AND RIGHTS OUTSTANDING
                                        (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                       ----------------------------------------
                                        NUMBER     AGGREGATE         PRICE
                                       OF SHARES EXERCISE PRICE    PER SHARE
                                       --------- -------------- ---------------
<S>                                    <C>       <C>            <C>
Balance at October 1, 1994               1,273      $ 4,451     $ 0.350-$ 5.250
  Granted.............................     391        2,526       3.500- 13.250
  Exercised...........................    (410)      (1,356)      0.350-  6.000
  Forfeitures.........................     (48)        (235)      3.000-  9.250
                                         -----      -------
Balance at September 30, 1995.........   1,206        5,386       0.350- 13.250
  Granted.............................     863       11,115       0.850- 28.375
  Exercised...........................    (419)      (1,424)      0.350- 11.125
  Forfeitures.........................     (85)        (580)      0.850- 18.500
                                         -----      -------
Balance at September 28, 1996.........   1,565       14,497       0.850- 28.375
  Granted.............................     658       12,912      12.500- 25.125
  Exercised...........................    (339)      (1,756)      0.850- 19.125
  Forfeitures.........................    (400)      (8,018)      0.850- 28.375
                                         -----      -------
Balance at September 27, 1997.........   1,484      $17,635     $ 0.850-$28.375
                                         =====      =======
</TABLE>
 
  The following table summarizes information about options outstanding at
September 27, 1997:
 
<TABLE>
<CAPTION>
                                     OPTIONS OUTSTANDING              OPTIONS EXERCISABLE      
                           --------------------------------------- --------------------------  
                                        WEIGHTED-                                              
                                         AVERAGE                                               
       RANGE OF              NUMBER     REMAINING     WEIGHTED-      NUMBER      WEIGHTED-     
       EXERCISE            OUTSTANDING CONTRACTUAL     AVERAGE     EXERCISABLE    AVERAGE      
        PRICES             AT 9/27/97  LIFE (YEARS) EXERCISE PRICE AT 9/27/97  EXERCISE PRICE  
   ---------------         ----------- ------------ -------------- ----------- --------------  
   <S>                     <C>         <C>          <C>            <C>         <C>             
                                                                                               
   $ 0.850-$ 4.000            266,114      6.06         $ 3.44       190,723       $ 3.53      
                                                                                               
     4.125-  9.125            383,122      7.16           7.48       197,181         6.70      
                                                                                               
     9.250- 13.000             83,275      8.02          10.39        37,344        10.07      
                                                                                               
    13.250- 16.750            416,471      9.56          15.50        32,318        16.02           
                                                                                                    
    17.125- 28.375            334,638      8.84          19.53       135,840        19.43           
                            ---------                                -------                        
                                                                                                    
   $ 0.850-$28.375          1,483,620      8.06         $11.89       593,406       $ 9.31           
                            =========                                =======                         
</TABLE>
 
  Exercisable options were approximately 593,000, 544,000 and 785,000 at
fiscal year end for 1997, 1996 and 1995, respectively. At September 27, 1997,
there were no shares that were exercised and subject to repurchase.
 
  Vesting provisions with respect to the Stock Option Plans are determined by
the Board of Directors at the date of grant. Generally, shares issued pursuant
to the Plan vest at 12 1/2% upon an employee's six-month employment date and
ratably thereafter in monthly installments over three and one-half years. At
September 27, 1997, options to purchase approximately 593,000 shares of common
stock were vested.
 
  Included in the table above are options to purchase approximately 73,000
shares of common stock which were granted outside of the Plans during fiscal
1995. These options were granted to various employees and have
 
                                     F-11
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
5. STOCKHOLDERS' EQUITY (CONTINUED):
 
rights and vesting provisions which are the same as those granted pursuant to
the plan. At September 27, 1997, options to purchase approximately 22,000
shares of common stock remain outstanding.
 
  Total shares reserved for grant under option plans total 3,343,000
(excluding options subject to grant under the Outside Directors Stock Option
Plan), of which approximately 3,020,000 shares were granted, leaving
approximately 323,000 shares available for grant at September 27, 1997.
 
  The Company has reserved 1,840,000 shares of common stock for future
issuance under the stock option plans for outstanding options and options
available for grant at September 27, 1997 and 22,000 shares of common stock
for future issuance of shares granted outside of the option plan.
 
  1995 Outside Directors Stock Plan: The Company's 1995 Directors Stock Option
Plan (the "Directors Plan") was adopted by the Company's Board of Directors in
June 1995 and approved in February 1996. A total of 100,000 shares of Common
Stock has been reserved for issuance under the Directors Plan. As of September
27, 1997, 45,000 shares had been granted to Directors under the plan and are
included in the table presented above.
 
  1996 Stock Purchase Plan: In fiscal 1996, the 1996 Employee Stock Purchase
Plan (ESPP) was approved and 100,000 shares of common stock was reserved for
issuance under this plan. The ESPP provides that substantially all employees
may purchase stock at 85% of its fair value on certain specified dates via a
payroll deduction plan. Through September 27, 1997, approximately 82,000
shares have been issued under this plan. A summary of stock purchased under
the plan is shown below (in thousands, except employee participants).
 
<TABLE>
<CAPTION>
                                                                1997     1996
                                                              -------- --------
     <S>                                                      <C>      <C>
     Aggregate purchase price................................ $961,294 $197,479
     Shares purchased........................................   64,138   18,774
     Employee participants...................................      146       59
</TABLE>
 
  Pro forma information regarding net income (loss) and net income (loss) per
share is required by SFAS 123 for awards granted after October 1, 1995 as if
the Company had accounted for its stock-based awards to employees under the
fair value method of SFAS 123. The fair value of the Company's stock-based
awards to employees was estimated using a Black-Scholes option pricing model.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, the Black-Scholes model requires the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's stock-based awards to employees have characteristics
significantly different from those of traded options, and because changes in
the subjective input assumptions can materially affect the fair value
estimate, in management's opinion, the existing models do not necessarily
provide a reliable single measure of the fair value of its stock-based awards
to employees. The fair value of the Company's stock-based awards to employees
was estimated assuming no expected dividends and the following weighted-
average assumptions:
 
<TABLE>
<CAPTION>
                                                       OPTIONS        ESPP
                                                     ------------  ------------
                                                     1997   1996   1997   1996
                                                     -----  -----  -----  -----
     <S>                                             <C>    <C>    <C>    <C>
     Expected life (years)..........................  2.65   2.67    0.5    0.5
     Expected stock price volatility................ 66.23% 67.04% 68.19% 68.09%
     Risk-free interest rate........................  6.03%  5.92%  5.82%  5.71%
</TABLE>
 
                                     F-12
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
5. STOCKHOLDERS' EQUITY (CONTINUED):
 
  For pro forma purposes, the estimated fair value of the Company's stock
based awards to employees is amortized over the options' vesting period (for
options) and the six month purchase period (for stock purchased under the
ESPP). The weighted-average fair value of stock options and employee stock
purchase rights granted during 1997 was $8.62 and $7.53 per share,
respectively. The weighted-average fair value of stock options and employee
stock purchase rights granted during 1996 was $6.29 and $5.85
 
  The Company's pro forma information follows (in thousands, except per share
amounts):
 
<TABLE>
<CAPTION>
                                                                  1997    1996
                                                                 ------  ------
     <S>                                                         <C>     <C>
     Net income--as reported.................................... $1,395  $2,451
     Net income (loss)--pro forma............................... (1,113)  1,480
     Net income per share--as reported..........................   0.16    0.30
     Net income (loss) per share--pro forma.....................  (0.13)   0.18
</TABLE>
 
  Because SFAS 123 is applicable only to awards granted subsequent to October
1, 1995, its pro forma effect will not be fully reflected until approximately
2000.
 
6. EMPLOYEE SAVINGS AND INVESTMENT PLAN
 
  During fiscal 1996, the Company amended its 401(k) savings and investment
plan in which all employees, at least 21 years of age, are eligible to
participate. The amended plan allows for the Company to make matching
contributions based on an employee's elective deferrals. For fiscal 1997, the
matching contributions may not exceed $1,800 per employee, and through
September 27, 1997, the matching contributions were approximately $304,000
($62,000 in fiscal 1996).
 
7. INCOME TAXES
 
  The provision (benefit) for income taxes consists of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                   FISCAL YEAR ENDED
                                       -----------------------------------------
                                       SEPTEMBER 27, SEPTEMBER 28, SEPTEMBER 30,
                                           1997          1996          1995
                                       ------------- ------------- -------------
<S>                                    <C>           <C>           <C>
Federal:
  Current.............................    $ (283)       $ 2,591        $ 90
  Deferred............................       740         (4,326)        --
                                          ------        -------        ----
                                             457         (1,735)         90
State:
  Current.............................        35            273         112
  Deferred............................        (5)          (987)        --
                                          ------        -------        ----
                                              30           (714)        112
Foreign:
  Current.............................       536            557         209
                                          ------        -------        ----
                                          $1,023        $(1,892)       $411
                                          ======        =======        ====
</TABLE>
 
  Pretax income from foreign operations was $1,330,000 in 1997, $680,000 in
1996 and $30,000 in 1995.
 
                                     F-13
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
7. INCOME TAXES (CONTINUED):
 
  A reconciliation between the Company's effective tax rate and the U.S.
statutory rate of 35% follows (in thousands):
 
<TABLE>
<CAPTION>
                                                   FISCAL YEAR ENDED
                                       -----------------------------------------
                                       SEPTEMBER 27, SEPTEMBER 28, SEPTEMBER 30,
                                           1997          1996          1995
                                       ------------- ------------- -------------
   <S>                                 <C>           <C>           <C>
   Tax provision at U.S. statutory
    rate.............................     $  846        $   196       $ 1,249
   Benefit of operating loss
    carryforwards....................        --          (4,756)       (1,080)
   Research and development credit...       (229)        (1,263)          --
   In process research and
    development......................        --           3,264           --
   Goodwill amortization.............        442            143           --
   Foreign taxes in excess of U.S.
    rate.............................        139            261           130
   Foreign sales corporation benefit.       (181)            --           --
   Other individually immaterial
    items............................        (13)            83           --
   State taxes.......................         19            180           112
                                          ------        -------       -------
                                          $1,023        $(1,892)      $   411
                                          ======        =======       =======
</TABLE>
 
  As of September 27, 1997, the Company had federal and state net operating
loss carryforwards of approximately $5,600,000 and $2,500,000, respectively.
The Company also had federal and California research and development tax
credit carryforwards of approximately $1,270,000 and $430,000, respectively.
The Company also has federal alternative minimum tax credit carryforwards of
approximately $270,000. The net operating loss and federal research credit
carryforwards will expire at various dates beginning in 2001 through 2012, if
not utilized. The California research credit carryforwards and alternative
minimum tax credit carryforwards have no expiration date.
 
  Utilization of the net operating losses and credits may be subject to an
annual limitation due to the ownership change limitations provided by the
Internal Revenue Code of 1986, as amended, and similar state provisions. The
annual limitation could result in the expiration of net operating losses and
credits before utilization.
 
  Significant components of the Company's deferred tax assets and liabilities
are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                     SEPTEMBER 27, SEPTEMBER 28,
                                                         1997          1996
                                                     ------------- -------------
   <S>                                               <C>           <C>
   Deferred tax assets:
     Net operating loss carryforwards..............     $ 2,079       $4,059
     Research credits and alternative minimum tax
      credit.......................................         965          892
     Capitalized software..........................         500        1,028
     Deferred revenue..............................       1,655        1,770
     Purchased technology..........................       3,073          --
     Accrued expenses and reserves.................       1,931        1,093
                                                        -------       ------
       Total deferred tax assets...................      10,203        8,842
 
       Valuation allowance for deferred tax assets.      (5,626)      (3,530)
                                                        -------       ------
   Net deferred tax assets.........................     $ 4,577       $5,312
                                                        =======       ======
</TABLE>
 
                                     F-14
<PAGE>
 
                              IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                              SEPTEMBER 27, 1997
 
 
7. INCOME TAXES (CONTINUED):
 
  At September 27, 1997, the Company had deferred tax assets arising from
deductible temporary differences, tax losses, and tax credits of $4,577,000
(net of the valuation allowance). Realization of the net deferred tax asset is
dependent on the Company's ability to generate future U.S. taxable income.
Management believes that it is more likely than not that the asset will be
realized base don forecasted U.S. income. However, there can be no assurance
that the company will meet its expectations of future U.S. income. As a
result, the amount of the deferred tax assets considered realizable could be
reduced in the near and long term if estimates of future U.S. income are
reduced. Such an occurrence could materially adversely affect the Company's
financial results and condition. The Company will continue to evaluate the
realizability of the deferred tax assets quarterly by assessing the need for a
valuation allowance.
 
  Management has established a valuation allowance covering a portion of the
gross deferred tax assets based on management's expectations of future taxable
income and the actual taxable income during the three years ended September
27, 1997. The valuation allowance increased by $2,096,000 during the current
fiscal year after decreasing by $4,670,000 during the fiscal year ended
September 28, 1996. Approximately $4,446,000 of the valuation allowance is
attributable to stock options which will be credited to equity when realized.
Approximately, $1,180,000 of the valuation allowance is attributable to VMW
pre-acquisition deferred tax assets which will be credited to goodwill when
recognized.
 
8. GEOGRAPHIC, MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISKS
 
  The Company and its subsidiaries operate in one segment, principally the
development, manufacture, sale and service of high performance hardware-
assisted systems for simulation and emulation of integrated circuits (ICs) and
IC-based electronic systems. The Company sells its products to a broad range
of customers in the communications, multimedia/graphics, semiconductor,
computer, aerospace and consumer electronics industries. The Company performs
ongoing credit evaluations of its customers and generally does not require
collateral. The Company maintains reserves for potential credit losses and
such losses have been within management's expectations.
 
  Total international sales by geographic region, including export sales and
foreign operation net revenues, are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                   FISCAL YEAR ENDED
                                       -----------------------------------------
                                       SEPTEMBER 27, SEPTEMBER 28, SEPTEMBER 30,
                                           1997          1996          1995
                                       ------------- ------------- -------------
     <S>                               <C>           <C>           <C>
     Far East.........................    $ 6,228       $ 7,012       $ 4,841
     Europe...........................     12,966         7,878         5,613
     Other............................        --            --            106
                                          -------       -------       -------
                                          $19,194       $14,890       $10,560
                                          =======       =======       =======
</TABLE>
 
  In fiscal 1997, one customer, Lucent Technologies, Inc., accounted for
approximately 11% of net revenues. In fiscal 1996, one customer, S3, Inc., and
one distributor, Itochu & Co. Ltd. ("Itochu"), accounted for 14% and 12% of
net revenues, respectively. For the fiscal year ended September 30, 1995, one
distributor, Itochu, accounted for approximately 15% of net revenues.
 
                                     F-15
<PAGE>
 
                               IKOS SYSTEMS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               SEPTEMBER 27, 1997
 
 
9. UNAUDITED QUARTERLY CONSOLIDATED FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                                   FISCAL QUARTERS ENDED
                                           --------------------------------------
                                           DEC. 28, MARCH 29, JUNE 28,  SEPT. 27,
                                             1996     1997      1997      1997
                                           -------- --------- --------  ---------
<S>                                        <C>      <C>       <C>       <C>
Net revenues.............................. $14,189   $14,475  $14,429    $13,003
Gross profit..............................  11,076    11,331   11,166     10,071
Total operating expenses..................   7,894     7,657   15,267     11,677
Income (loss) from operations.............   3,182     3,674   (4,101)    (1,606)
Net income (loss).........................   2,175     2,515   (2,344)      (951)
Net income (loss) per share............... $  0.25   $  0.28  $ (0.28)   $ (0.11)
                                           =======   =======  =======    =======
Common and common equivalent shares
 used in computing per share amounts......   8,856     8,984    8,457      8,553
                                           =======   =======  =======    =======
<CAPTION>
                                                   FISCAL QUARTERS ENDED
                                           --------------------------------------
                                           DEC. 30, MARCH 30, JUNE 29,  SEPT. 28,
                                             1995     1996      1996      1996
                                           -------- --------- --------  ---------
<S>                                        <C>      <C>       <C>       <C>
Net revenues.............................. $ 9,277   $11,154  $11,850    $13,060
Gross profit..............................   7,141     8,757    9,340     10,251
Total operating expenses..................   5,724     6,178   16,636      7,532
Income (loss) from operations.............   1,417     2,579   (7,296)     2,719
Net income................................   1,375     2,410   (7,416)     6,082
Net income per share...................... $  0.18   $  0.31  $ (1.00)   $  0.69
                                           =======   =======  =======    =======
Common and common equivalent shares
 used in computing per share amounts......   7,519     7,843    7,407      8,817
                                           =======   =======  =======    =======
</TABLE>
 
                                      F-16
<PAGE>
 
                                                                     SCHEDULE II
 
                               IKOS SYSTEMS, INC.
 
                       VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                     BALANCE AT CHARGED TO            BALANCE AT
                                     BEGINNING  COSTS AND  DEDUCTIONS    END
                                     OF PERIOD   EXPENSES  WRITE-OFFS OF PERIOD
                                     ---------- ---------- ---------- ----------
<S>                                  <C>        <C>        <C>        <C>
Allowance for doubtful accounts:
  Year ended September 30, 1995.....    $122       $ 49      $ --        $171
                                        ====       ====      =====       ====
  Year ended September 28, 1996.....    $171       $100      $ --        $271
                                        ====       ====      =====       ====
  Year ended September 27, 1997.....    $271       $230      $ --        $501
                                        ====       ====      =====       ====
</TABLE>
 
                                      S-1