<PAGE>
 
                                 EXHIBIT 13.1
                                        
                      SUMMARY CONSOLIDATED FINANCIAL DATA
                     (in thousands except per share data)

<TABLE> 
<CAPTION> 
                                                                       DECEMBER 31,                                 
                                          ------------------------------------------------------------------------    
                                              1994          1995          1996          1997            1998        
                                          ------------  ------------  ------------  ------------    -------------   
<S>                                       <C>           <C>           <C>           <C>             <C>             
Total revenues                              $   8,385    $   14,430    $   15,558    $    9,471      $       753    
Operating loss                                 (1,218)         (612)       (1,701)       (6,551)         (10,689)   
Net loss                                       (1,190)         (509)       (1,606)       (6,329)         (10,025)   
Basic and diluted net loss per share            (0.11)        (0.05)        (0.15)        (0.56)           (0.77)        
Weighted average shares  outstanding           10,421        10,501        10,564        11,320           13,084          
Cash and short-term investments                 3,034         6,281         4,151        17,633            7,977          
Total assets                                    4,468        10,032         7,487        19,775            9,084          
Non-current liabilities                            66         1,429           208            54               14          
Stockholders' equity                        $   2,689    $    2,514    $    3,211    $   18,716      $     8,518          
</TABLE>


                     SELECTED QUARTERLY OPERATING RESULTS
                     (in thousands except per share data)
 
<TABLE> 
<CAPTION> 
                                                                            QUARTER ENDED
                                     ----------------------------------------------------------------------------------------
                                                          1997                                          1998
                                     ----------------------------------------------------------------------------------------
                                           MARCH 31  JUNE 30   SEPT. 30   DEC. 31     MARCH 31   JUNE 30   SEPT. 30   DEC. 31
                                           --------  --------  ---------  --------    ---------  --------  ---------  --------
<S>                                    <C>           <C>       <C>        <C>         <C>        <C>       <C>        <C>
Total revenues                             $ 3,028   $ 3,018    $ 2,571   $   854      $   281   $   153    $   149   $   170
Operating loss                              (1,429)   (1,264)      (943)   (2,915)      (3,037)   (2,861)    (2,653)   (2,137)
Net loss                                    (1,409)   (1,264)      (979)   (2,678)      (2,811)   (2,670)    (2,472)   (2,042)
Basic and diluted net loss per share         (0.13)    (0.12)     (0.09)    (0.21)       (0.21)    (0.20)     (0.19)    (0.16)
Weighted average shares outstanding         10,715    10,717     10,836    12,991       13,106    13,084     13,073    13,073
</TABLE>
<PAGE>
 
          MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                           AND RESULTS OF OPERATIONS

OVERVIEW

     Historically, the Company has derived its revenues from development fees,
software license fees, and packaged software products. The Company expects that
revenues from development fees and packaged software products will continue its
recent decline as business efforts are focused on developing and licensing
software based on its digital image science technology to users of high quality
digital image systems. During 1997 the Company reduced its workforce to focus on
a more effective implementation of this market strategy. If this plan is
successful, the Company believes that a majority of its future revenues will be
derived from license fees for its software.

     In September 1994 the Company entered into an agreement (1994 Agreement)
with MCI Telecommunications Corporation (MCI) to provide for development of
certain advanced compression technology for use in telecommunications
applications. MCI paid the Company approximately $36,000,000 over the next three
years for development of specific technology and the exclusive rights to use and
sublicense specified technology in telecommunications markets until September
1997. The 1994 Agreement expired in September 1997. Effective August 7, 1998,
the Company and MCI entered into a new agreement that provides MCI with a non-
exclusive, royalty-free license to use certain deliverables developed by the
Company under the 1994 Agreement. In addition the Company granted MCI warrants
to purchase up to 1,452,570 shares of common stock at $5 per share. The term of
the warrant is four years.

FINANCIAL CONDITION

     In an initial public offering on September 29, 1997, on the Oslo Stock
Exchange, the Company sold 2,040,000 shares and certain shareholders sold
710,300 shares of common stock at $10 per share resulting in net proceeds to the
Company of $18,579,000.

     The Company has not registered any securities with the U.S. Securities and
Exchange Commission under the Securities Act of 1933, as amended, other than
pursuant to its Form S-8 Registration Statement filed on December 9, 1998.
Securities of the Company may not be offered for sale or sold in the U.S., or to
or for the account or benefit of any "U.S. person" (as defined in the Securities
Act), unless the securities are registered under the Securities Act or an
exemption from such registration requirements is available.

     As shown in the financial statements, the Company incurred a net loss of
$10,025,000 in 1998, and an accumulated deficit of $21,462,000. The Company
experienced negative cash flows from operations of $9,043,700, and revenues
decreased approximately 92% from the prior year. The Company maintains a
combined cash and short-term investment balance of $7,977,000 as of December 31,
1998. The funds were generated by the proceeds of the September 1997 initial
public stock offering and have enabled the Company to meet its obligations
during 1998 despite negative cash flows. However, the Company may not be able to
depend solely on such funds to meet its planned obligations during 1999. The
Company is finalizing the development of its new software products and expects
initial revenues in the first quarter of 1999. The Company may also seek to
raise additional investment capital and cash in order to fund operations. The
Company may also undertake certain cost cutting measures that would slow down
its research and development efforts. It is not possible to predict the outcome
of the Company's efforts and there is no assurance that the Company will be
successful in increasing revenues or obtaining financing.

     In 1997 and 1998, operating activities used cash of $7,511,000 and
$9,044,000, respectively.

     In 1997 and 1998 investing activities (used) provided cash of $(10,445,000)
and $5,475,000, respectively. In 1997 cash was primarily used for the purchase
of short-term investments with the proceeds from the Company's initial public
offering. During 1998 short-term investments provided funds for purchase of
property and equipment and to fund operating activities.

     In 1997 and 1998 financing activities provided (used) funds of $21,439,000
and ($358,000), respectively. In 1997 cash provided by financing activities was
primarily attributable to borrowings of $3,000,000 under the shareholder credit
facility described below and $18,579,000 net proceeds from the Company's initial
public offering. In 1998 cash used in financing activities was primarily for the
repurchase of the Company's common stock on the open market.

     On June 30, 1997, the Company amended its Bridge Financing Credit Facility
with Mosvold Farsund AS, one of its shareholders. The amended Credit Facility
allowed the Company to borrow up to $6,000,000 from Mosvold until June 30, 1998,
at which time the Company could convert any outstanding balance into a four year
term loan. During the second quarter of 1997, the Company borrowed $3,000,000
from Mosvold under this financing agreement and during the fourth quarter of
1997, Mosvold exercised its option to convert the $3,000,000 borrowings into
300,000 shares of the Company's Common Stock at $10 per share. No further
borrowings occurred under the Credit Facility which expired on June 30, 1998.
<PAGE>
 
RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 1998, COMPARED TO YEAR ENDED DECEMBER 31, 1997

     Revenues. Total revenues decreased 92% to $753,000 during 1998 from
$9,471,000 in 1997. The decrease in revenues is mainly due to MCI making its
final development fee payment in 1997 under the 1994 Agreement and to the
Company's shift in market strategy to increased emphasis on the development of
its software to be licensed to users of high quality digital image systems.

     Cost of Product Revenues. Cost of product revenues decreased 100% to $0
during 1998 from $128,000 in 1997 as the Company pursued its strategy of exiting
its package software product business.

     Sales and Marketing. Sales and marketing expenses decreased 16% to
$4,172,000 during 1998 from $4,993,000 in 1997. The Company initiated sales and
marketing workforce reductions in 1997 as part of the implementation of its
revised market strategy.

     Research, Development, and Engineering. Research, development, and
engineering expenses decreased 37% to $5,237,000 during 1998 from $8,261,000 in
1997. The decrease is primarily the result of the workforce reductions resulting
from ending the 1994 Agreement and the implementation of the Company's revised
market strategy.

     General and Administrative. General and administrative expenses decreased
23% to $2,024,000 during 1998 from $2,640,000 in 1997. The decrease is primarily
due to $519,000 of one-time charges the Company recorded in the fourth quarter
of 1997, the largest component of which was a $399,000 write-off of an
uncollectible receivable from a single customer.

     During 1998 the Company wrote off the remaining balance of its inventory
relating to the Company's older compression accelerator hardware boards.

     Interest Income. Interest income increased 80% to $715,000 during 1998 from
$396,000 in 1997. The increase is due to the higher levels of interest on cash
equivalents and short-term investments the Company experienced during 1998 from
the proceeds of its initial public offering of Common Stock.

     Interest Expense. Interest expense decreased by 91% to $16,000 during 1998
from $176,000 in 1997. The decrease is primarily due to the decrease in interest
expense on the $3,000,000 in outstanding borrowings under the Mosvold Credit
Facility. Prior to its conversion to equity in October 1997, interest expense on
these borrowings amounted to $112,000.

YEAR ENDED DECEMBER 31, 1997, COMPARED TO YEAR ENDED DECEMBER 31, 1996

     Revenues. Total revenues decreased 39% to $9,471,000 during 1997 compared
to $15,558,000 in 1996. The decrease in revenues is mainly due to the expiration
of the 1994 Agreement, and by the execution of a one-time sale of custom built
decompression hardware boards resulting in revenue of $1,484,000 in 1996.

     Cost of Product Revenues and Inventory Writedowns. Cost of product revenues
decreased 86% to $128,000 during 1997 from $923,000 in 1996. The decrease is the
result of the one-time sale of custom-built decompression hardware boards
discussed above which produced cost of product revenues of $685,000 in 1996.

     During 1996, there was an inventory writedown of $238,000 relating to the
Company's older compression accelerator hardware boards.

     Sales and Marketing. Sales and marketing expenses decreased 3% to
$4,993,000 during 1997 from $5,146,000 in 1996. Sales and marketing workforce
reductions in the third quarter of 1997 offset the higher levels of staffing
during the first six months of 1997, and resulted in slightly lower expenses for
the year ended December 31, 1997.

     Research, Development, and Engineering. Research, development, and
engineering expenses decreased 8% to $8,261,000 during 1997 from $8,966,000 in
1996. The decrease is primarily the result of the workforce reductions discussed
previously.

     General and Administrative. General and administrative expenses increased
33% to $2,640,000 during 1997 from $1,986,000 in 1996. This increase is
attributable to the charges discussed previously that the Company took during
the fourth quarter of 1997.

     Interest Income. Interest income increased 107% to $396,000 during 1997
from $191,000 in 1996. The increase is due to the higher levels of interest
earnings on cash equivalents and short-term investments the Company experienced
during the fourth quarter of 1997 as a result of the initial public offering of
common stock in the third quarter.

     Interest Expense. Interest expense increased 105% to $176,000 during 1997
from $86,000 in 1996. The increase is due to interest expense on the $3,000,000
in outstanding borrowings under the Mosvold Credit Facility. Prior to its
conversion to equity in October 1997, interest expense on these borrowings
amounted to $112,000 while it was outstanding during 1997.
<PAGE>
 
IMPACT OF YEAR 2000

     The Company is in the process of evaluating the potential impact of what is
commonly referred to as the year 2000 issue, concerning the inability of certain
computer systems to properly recognize and process dates starting with the year
2000 and beyond. The Company is taking steps to ensure that its business systems
software and equipment will continue to function properly after December 31,
1999. In doing so, the Company has established a team, which will work directly
with management to (1) assess and test all internal information systems and
other systems that may be affected by the year 2000 date change; (2) assess and
test its products that may be affected by the year 2000 date change; (3)
communicate with third parties that supply its products to ensure they are
addressing the year 2000 issue; and (4) compose a contingency and disaster
recovery plan to ensure resolution of problems that may arise as a result of the
year 2000 date change. Until this assessment is completed, the Company will not
be able to determine the costs of becoming year 2000 compliant, the risks of
non-compliance, and its ability to conduct its business under a contingency
plan.

     The Company's products do not contain any real-time clocks and therefore
the products themselves do not present any year 2000 issues.

     With respect to its information technology accounting systems, the
assessment of equipment and software was started in June 1998. The Company will
have completed the upgrade of these systems to versions that are stated to be
2000 compliant by June 30, 1999.

     The Company has commenced testing to determine that its internal systems
are year 2000 compliant.  The Company expects to complete testing and establish
compliance with respect to all of its systems and products by June 30, 1999,
subject to possible equipment upgrades during 1999 and ongoing communications
with third parties.  The Company believes that this time frame will allow
internal auditing and testing of its systems, as well as further remediation, if
necessary.

     The Company plans to devote the necessary resources to resolve all
significant year 2000 issues in a timely manner. Based upon current estimates,
the Company believes that its direct costs for year 2000 compliance will consist
primarily of costs related to the staff time devoted to year 2000 compliance.
The Company does not expect material capital expenditures will be necessary for
year 2000 related compliance costs and capital expenditures in these areas have
not been material for historical periods.

     Regardless of the year 2000 compliance of its systems and products, the
Company may be adversely affected by disruptions in the operations of the
enterprises with which it interacts. These business enterprises include
suppliers, corporate partners, both domestic and international, government
agencies, and other third parties.  The Company cannot reasonably predict the
impact on its operations and financial condition if any such businesses are
adversely affected by the year 2000 issue.

     Statements made herein about the implementation of various phases of the
Company's year 2000 program, the costs expected to be associated with that
program, and the results it expects to achieve constitute forward-looking
information. There are many uncertainties involved in the year 2000 issue and
the following important factors, among others, could affect the impact of the
year 2000 issue: (1) the inherent uncertainty of the costs and timing of
achieving compliance on the wide variety of systems used by the Company; (2) the
reliance on the efforts of vendors, customers, government agencies, and other
third parties beyond its control to achieve adequate compliance and avoid
disruption of its business in early 2000; and (3) the uncertainty of the
ultimate costs and consequences of any unanticipated disruption of its business
resulting from the failure of one of its applications or of a third party's
systems.

SOFTWARE REVENUE RECOGNITION

     The American Institute of Certified Public Accountants issued Statement of
Position 97-2 ("SOP 97-2"), SOP 98-4, and SOP 98-9, to clarify guidance on
applying generally accepted accounting principles to software transactions and
to provide guidance on when revenue should be recognized and in what amounts for
licensing, selling, leasing, or otherwise marketing computer software. The
adoption of this guidance had no impact on the Company's methods of recognizing
revenue.

EARNINGS PER SHARE OF COMMON STOCK

     In February 1997 the Financial Accounting Standards Board ("FASB") issued
Statement No. 128, Earnings Per Share ("Statement 128"), which establishes
standards for computing and presenting earnings per share ("EPS") for entities
with publicly held common stock or potential common stock. Statement 128
requires the presentation of basic and diluted EPS on the face of the income
statement for all entities with complex capital structures. The Company adopted
Statement 128 in 1997 and, in accordance with the requirements thereof, restated
its net loss per share for all prior periods. The effect of adoption was not
material to the accompanying consolidated financial statements. Net loss per
share of common stock is computed based on the weighted average number of shares
outstanding during each period.

COMPREHENSIVE INCOME

     On January 1, 1998, the Company adopted Statement No. 130, Reporting
Comprehensive Income, Statement ("130"). The Company reported comprehensive loss
in its statement of changes in stockholders' equity. The adoption of Statement
130 resulted in revised and additional disclosures but had no effect on the
financial position, results of operations, or liquidity of the Company.
<PAGE>
 
BUSINESS SEGMENTS

     In June 1997, the FASB also issued Statement No. 131, Disclosures about
Segments of an Enterprise and Related Information ("Statement 131"), which
establishes standards for the way public business enterprises report information
about operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports issued to shareholders. Operating segments are components of
an enterprise about which separate financial information is available that is
evaluated regularly by the chief operating decision maker in deciding how to
allocate resources and in assessing performance. Statement 131 also establishes
standards for related disclosures about products and services, geographic areas,
and major customers. Statement 131 is effective for financial statements for
periods beginning after December 15, 1997. The Company has disclosed its
business segments in the footnotes to its financial statements. The adoption of
Statement 131 resulted in additional disclosures but had no effect on the
financial position, results of operations, or liquidity of the Company.

INFLATION

     The effects of inflation on the Company's operations were not significant
during the periods presented in the consolidated financial statements, and the
effects thereof are not considered to be of significance in the future.
Generally, throughout the periods discussed above, the changes in revenue have
resulted primarily from fluctuations in sales levels, rather than price changes.

MARKET RISK

     Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of short-term investments,
trade accounts receivable, and accounts payable.

     The Company maintains cash and cash equivalents and certain other financial
instruments with various financial institutions. Company policy is designed to
limit exposure at any one institution. Certain investments are in excess of
Federal Deposit Insurance Corporation ("FDIC") guaranteed amounts. The Company
performs periodic evaluations of the relative credit standing of those financial
institutions that are considered in the Company's investment strategy.

     The carrying amounts reported in the balance sheet for cash and cash
equivalents, short-term investments, accounts receivable, accounts payable, and
notes payable approximate their estimated fair values.
 
<PAGE>
 
CONSOLIDATED FINANCIAL STATEMENTS

                            ITERATED SYSTEMS, INC.
                                        
                 Years ended December 31, 1996, 1997, and 1998
                      with Report of Independent Auditors
<PAGE>
 
CONSOLIDATED FINANCIAL STATEMENTS

                            ITERATED SYSTEMS, INC.
                                        
                 Years ended December 31, 1996, 1997, and 1998

<TABLE> 
<CAPTION> 
CONTENTS
     <S>                                                                        <C>
     Report of Independent Auditors..........................................   16

     Audited Consolidated Financial Statements
 
     Consolidated Balance Sheets.............................................   17
     Consolidated Statements of Operations...................................   18
     Consolidated Statements of Shareholders' Equity and Comprehensive Loss..   19
     Consolidated Statements of Cash Flows...................................   20
     Notes to Consolidated Financial Statements..............................   21
</TABLE>
<PAGE>
 
REPORT OF INDEPENDENT AUDITORS


Board of Directors
Iterated Systems, Inc.

     We have audited the accompanying consolidated balance sheets of Iterated
Systems, Inc. as of December 31, 1997 and 1998, and the related consolidated
statements of operations, shareholders' equity and comprehensive loss and cash
flows for each of the three years in the period ended December 31, 1998. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Iterated Systems, Inc. at December 31, 1997 and 1998, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted accounting
principles.



/s/ Ernst & Young LLP

Atlanta, Georgia
January 15, 1999
<PAGE>
 
                            ITERATED SYSTEMS, INC.
                          CONSOLIDATED BALANCE SHEETS
                                        
<TABLE>
<CAPTION>
                                                                                        DECEMBER 31
                                                                              1997                      1998
                                                                        ------------------------------------------ 
<S>                                                                     <C>                         <C>
ASSETS
Current assets:
 Cash and cash equivalents                                                $  7,633,283              $  3,706,070
 Short-term investments                                                      9,999,420                 4,270,444
 Accounts receivable, net of reserves for doubtful accounts
  of $9,000 and $5,668, respectively                                           495,667                   214,088
 Inventory                                                                       8,275                         -
 Prepaid expenses and other assets                                             360,752                   212,132
                                                                        ------------------------------------------ 
Total current assets                                                        18,497,397                 8,402,734
                                                                        ------------------------------------------ 
 
Property and equipment:
 Computer equipment and purchased software                                   3,836,507                 2,872,013
 Furniture and equipment                                                       366,084                   390,158
 Leasehold improvements                                                        134,398                   135,566
                                                                        ------------------------------------------ 
                                                                             4,336,989                 3,397,737
 Accumulated depreciation and amortization                                  (3,103,756)               (2,761,119)
                                                                        ------------------------------------------ 
                                                                             1,233,233                   636,618
 
Other assets                                                                    44,464                    44,699
                                                                        ------------------------------------------ 
Total assets                                                              $ 19,775,094              $  9,084,051
                                                                        ========================================== 
 
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
 Accounts payable                                                         $    206,321              $    153,670
 Accrued expenses                                                              639,461                   353,086
 Deferred revenue                                                                5,126                     5,126
 Current maturities of long-term debt                                           80,784                         -
 Current portion of capitalized lease obligations                               38,829                     4,874
 Other liabilities                                                              34,572                    34,572
                                                                        ------------------------------------------ 
Total current liabilities                                                    1,005,093                   551,328
 
Non-current liabilities:
 Capitalized lease obligations                                                   4,874                         -     
 Other liabilities                                                              48,977                    14,405
 
Shareholders' equity:
 Common stock, $.01 par value:
  Authorized shares - 20,000,000
  Issued and outstanding shares - 13,102,025
     and 13,073,025, respectively                                              131,020                   130,730
 Additional paid-in capital                                                 30,012,720                29,806,036
 Accumulated deficit                                                       (11,436,434)              (21,461,546)
 Currency translation adjustments                                                8,844                    43,098
                                                                        ------------------------------------------ 
Total shareholders' equity                                                  18,716,150                 8,518,318
                                                                        ------------------------------------------ 
Total liabilities and shareholders' equity                                $ 19,775,094              $  9,084,051
                                                                        ==========================================
</TABLE>
                                                                                
See accompanying notes.
<PAGE>
 
                            ITERATED SYSTEMS, INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                               YEAR ENDED DECEMBER 31
                                                                 1996                   1997                 1998
                                                             --------------------------------------------------------- 
<S>                                                          <C>                    <C>                   <C>
Revenues:
 Development and exclusive license fees                      $13,595,272            $ 9,088,972           $    671,161
 Software products                                             1,951,337                284,691                  1,943
 Other                                                            11,650                 97,500                 80,000
                                                             --------------------------------------------------------- 
                                                              15,558,259              9,471,163                753,104
Costs and expenses:
 Costs of product revenues                                       923,253                128,392                      -
 Sales and marketing                                           5,145,754              4,993,471              4,172,443
 Research, development, and engineering                        8,965,758              8,260,615              5,237,166
 General and administrative                                    1,986,449              2,640,183              2,024,008
 Inventory writedowns                                            238,000                      -                  8,275
                                                             --------------------------------------------------------- 
                                                              17,259,214             16,022,661             11,441,892
                                                             --------------------------------------------------------- 
 
Operating loss                                                (1,700,955)            (6,551,498)           (10,688,788)
 
Other income (expense):
 Interest income                                                 191,266                395,927                714,555
 Interest expense                                                (86,129)              (176,464)               (16,287)
 Foreign currency exchange gain (loss)                           (10,652)                 2,986                (34,592)
                                                             --------------------------------------------------------- 
Net loss                                                     $(1,606,470)           $(6,329,049)          $(10,025,112)
                                                             ========================================================= 
 
Basic and diluted net loss per share of common
 stock                                                             $(.15)                 $(.56)                 $(.77)
                                                             ========================================================= 
Weighted average number of shares of common stock
 outstanding                                                  10,563,500             11,319,600             13,083,954
                                                             ========================================================= 
</TABLE>
                                        

See accompanying notes.
<PAGE>
 
                            ITERATED SYSTEMS, INC.
    CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE LOSS
                                        
<TABLE>
<CAPTION>
                                                                                               ACCUMULATED
                                                                ADDITIONAL                        OTHER 
                                           COMMON STOCK           PAID-IN      ACCUMULATED    COMPREHENSIVE
                                    ------------------------
                                        SHARES       AMOUNT       CAPITAL        DEFICIT          LOSS        TOTAL
                                    ------------------------------------------------------------------------------------
<S>                                 <C>             <C>         <C>           <C>             <C>         <C>           
Balance at December 31, 1995          10,509,400    $105,094    $ 5,914,429   $ (3,500,915)     $(4,625)  $  2,513,983  
 Comprehensive loss:                                                                                                    
        Net loss                               -           -              -     (1,606,470)           -     (1,606,470) 
        Currency translation                                                                                            
         adjustment                            -           -              -              -       22,109         22,109  
                                                                                                          --------------
 Comprehensive loss                                                                                         (1,584,361) 
                                                                                                          --------------
 Issuance of common stock                200,000       2,000      1,996,634              -            -      1,998,634  
 Exercise of stock options                 5,200          52          4,605              -            -          4,657  
 Compensation related to options                                                                                        
  for 714,200 shares of common stock           -           -        278,316              -            -        278,316   
                                    ------------------------------------------------------------------------------------
Balance at December 31, 1996          10,714,600     107,146      8,193,984     (5,107,385)      17,484      3,211,229  
 Comprehensive loss:                                                                                                    
        Net loss                               -           -              -     (6,329,049)           -     (6,329,049) 
        Currency translation                                                                                            
         adjustment                            -           -              -              -       (8,640)        (8,640) 
                                                                                                          --------------
 Comprehensive loss                                                                                         (6,337,689) 
                                                                                                          --------------
 Initial public offering of stock,                                                                                      
  net of $1,821,000 of offering                                                                                         
  costs                                2,040,000      20,400     18,558,746              -            -     18,579,146  
 Conversion of note payable to                                                                                          
  stockholder to common stock            300,000       3,000      2,997,000              -            -      3,000,000  
 Issuance of common stock                  2,600          26         25,974              -            -         26,000  
 Exercise of stock options                44,825         448        132,211              -            -        132,659         
 Compensation related to options                                                                                        
  for 570,200 shares of common stock           -           -        104,805              -            -        104,805    
                                    ------------------------------------------------------------------------------------
Balance at December 31, 1997          13,102,025     131,020     30,012,720    (11,436,434)       8,844     18,716,150  
 Comprehensive loss:                                                                                                    
        Net loss                               -           -              -    (10,025,112)           -    (10,025,112) 
        Currency translation                                                                                            
         adjustments                           -           -              -              -       34,254         34,254  
                                                                                                          --------------
 Comprehensive loss                                                                                         (9,990,858) 
                                                                                                          --------------
 Issuance of warrants                          -           -         31,597              -            -         31,597  
 Exercise of stock options                 7,200          72          2,221              -            -          2,293  
 Purchase and retirement of common                                                                                      
  stock                                  (36,200)       (362)      (240,502)             -            -       (240,864) 
                                    ------------------------------------------------------------------------------------
Balance at December 31, 1998          13,073,025    $130,730    $29,806,036   $(21,461,546)     $43,098   $  8,518,318  
                                    ====================================================================================
</TABLE>
                                        
See accompanying notes.
<PAGE>
 
                            ITERATED SYSTEMS, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                        
<TABLE>
<CAPTION>
                                                                                YEAR ENDED DECEMBER 31
                                                                  1996                   1997                  1998
                                                              --------------------------------------------------------- 
<S>                                                           <C>                   <C>                    <C>
OPERATING ACTIVITIES
Net loss                                                      $(1,606,470)          $ (6,329,049)          $(10,025,112)
Adjustments to reconcile net loss to net cash used
 in operating activities:
  Depreciation and amortization                                 1,285,317              1,468,109                863,782
  Loss (gain) on sales of property and equipment                      832                   (180)               (13,181)
  Compensatory stock options                                      278,316                104,805                      -
  Issuance of warrants                                                  -                      -                 31,597
  Foreign currency transaction gain (loss)                         10,652                 (2,986)                34,592
  Changes in operating assets and liabilities:
   Accounts receivable                                            168,495                (84,561)               281,579
   Inventory                                                      249,480                 15,789                  8,275
   Prepaid expenses and other assets                             (125,879)               240,418                148,385
   Accounts payable                                               (57,162)              (102,219)               (52,651)
   Accrued expenses                                              (338,959)              (234,842)              (286,375)
   Deferred revenue                                            (2,557,433)            (2,552,000)                     -
   Other liabilities                                              (34,572)               (34,572)               (34,572)
                                                              --------------------------------------------------------- 
Net cash used in operating activities                          (2,727,383)            (7,511,288)            (9,043,681)
 
INVESTING ACTIVITIES
Purchases of property and equipment                            (1,158,042)              (445,971)              (294,037)
Proceeds from sale of property and equipment                       15,797                    400                 39,574
(Purchases) sales of short-term investments                             -             (9,999,420)             5,728,976
                                                              --------------------------------------------------------- 
Net cash (used in) provided by investing activities            (1,142,245)           (10,444,991)             5,474,513
 
FINANCING ACTIVITIES
Proceeds from note payable to stockholder                               -              3,000,000                      -
Payments on note payable to bank                                 (138,487)              (138,487)               (80,784)
Proceeds from capital leases                                       12,500                      -                      -
Principal payments on capital lease obligations                  (138,191)              (160,710)               (38,829)
Net proceeds from initial public offering
   of common stock                                                      -             18,579,146                      -
Issuance of common stock                                        2,003,291                158,659                  2,293
Repurchase of common stock                                              -                      -               (240,864)
                                                              --------------------------------------------------------- 
Net cash provided by (used in) financing activities             1,739,113             21,438,608               (358,184)
 
Effect of exchange rate fluctuation on cash                           416                    120                    139
                                                              --------------------------------------------------------- 
Change in cash and cash equivalents                            (2,130,099)             3,482,449             (3,927,213)
Cash and cash equivalents at beginning of year                  6,280,933              4,150,834              7,633,283
                                                              --------------------------------------------------------- 
Cash and cash equivalents at end of year                      $ 4,150,834           $  7,633,283           $  3,706,070
                                                              =========================================================
NON-CASH ITEMS
Conversion of proceeds on note payable to
 stockholder to common stock                                  $         -           $  3,000,000           $          -
                                                              =========================================================
</TABLE>

See accompanying notes.
<PAGE>
 
                            ITERATED SYSTEMS, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                               December 31, 1998

1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

DESCRIPTION OF BUSINESS

     Iterated Systems, Inc. (the "Company") develops and markets patented
digital image science technology based upon its Imaging Systems Architecture(TM)
to users of high quality digital image systems needing innovative, high
performance solutions that make workflows faster and more efficient. The
Company's patented technologies are based upon its research and development
expertise in digital image science and fractal-based mathematics that have
evolved over more than ten years experience.

     During 1998 the Company has focused its efforts on products, including its
award-winning STiNG(TM) technology, which generate reusable, repurposable image
assets that can be converted to industry-standard formats for print and on-line
media at any resolution. The digital image systems industry in which the Company
operates is subject to rapid technological change.

     As shown in the financial statements, the Company incurred a net loss of
$10,025,112 in 1998, and has an accumulated a deficit of $21,461,546 at December
31, 1998. The Company experienced negative cash flows from operations of
$9,043,681, and revenues decreased approximately 92% from the prior year. The
Company has a combined cash and short-term investment balance of $7,976,514 as
of December 31, 1998. These funds were generated by the proceeds of the
Company's September 1997 initial public stock offering and have enabled the
Company to meet obligations during 1998 despite negative cash flows. However,
the Company may not be able to depend solely on such funds to meet its planned
obligations during 1999. The Company is finalizing the development of its new
software products and expects initial revenues related thereto in the first
quarter of 1999. The Company may also seek to raise additional investment
capital in order to fund operations. The Company may also undertake certain cost
cutting measures that would slow down its research and development efforts. It
is not possible to predict the outcome of the Company's efforts and there is no
assurance that the Company will be successful in increasing revenues or
obtaining financing.

PRINCIPLES OF CONSOLIDATION

     The consolidated financial statements include the accounts of the Company
and its wholly-owned United Kingdom subsidiary, Iterated Systems Limited
("ISL"). Significant intercompany accounts and transactions have been eliminated
in consolidation.

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 amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

CASH EQUIVALENTS

     The Company considers all highly-liquid investments with a maturity of
three months or less when purchased to be cash equivalents.

SHORT-TERM INVESTMENTS

     The Company's short-term investments are classified as held-to-maturity and
are stated at cost. These investments mature within one year and the carrying
amounts reported in the balance sheets for these investments approximates their
fair values.

PROPERTY AND EQUIPMENT

     Property and equipment are stated at cost. Depreciation and amortization
expense is calculated over the estimated useful lives of the related assets
(three to seven years) using the straight-line method for financial reporting
purposes. Amortization of assets recorded under capital leases is included with
depreciation and amortization expense.

ADVERTISING COSTS

     Advertising costs are expensed in the period incurred. Such costs amounted
to $299,000, $132,000, and $23,000 during 1996, 1997, and 1998, respectively.

RESEARCH AND DEVELOPMENT

     Research and development expenditures are expensed when incurred.

SOFTWARE REVENUE RECOGNITION

     The American Institute of Certified Public Accountants issued Statement of
Position ("SOP") 97-2, SOP 98-4 and SOP 98-9 to clarify guidance on applying
generally accepted accounting principles to software transactions and to provide
guidance on when 
<PAGE>
 
revenue should be recognized and in what amounts for licensing, selling,
leasing, or otherwise marketing computer software. The Company adopted this
guidance during 1997. The adoption of this guidance had no effect on the
Company's methods of recognizing revenue.

     Development fees are recognized based on the Company's estimate of the
percentage of completion using actual costs incurred as a percentage of expected
total costs of individual development agreements or contracts. Exclusive license
fees are recognized over the exclusivity period, if applicable.

     Revenues from the sale of hardware and packaged software products are
recognized upon the shipment of the products to the customers.

INCOME TAXES

     Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for tax purposes. Such amounts are measured using
enacted tax rates and laws that are expected to be in effect when the
differences reverse.

FOREIGN CURRENCY TRANSLATION

     ISL considers the British pound to be its functional currency. The Company
considers its functional currency to be the US dollar. ISL's assets and
liabilities are translated at year-end rates of exchange and its revenues and
expenses are translated at the average rates of exchange during the year.

     Gains and losses resulting from currency translation are accumulated as
separate components of shareholders' equity and comprehensive loss. Gains and
losses resulting from foreign currency transactions are included in the
determination of net loss.

EMPLOYEE STOCK OPTIONS

     In October 1995, the Financial Accounting Standards Board ("FASB") issued
Statement No. 123, Accounting for Stock-Based Compensation ("Statement 123").
Under Statement 123, the Company may continue following previously existing
accounting rules or adopt a new fair value method of valuing stock-based awards
to employees. The Company elected to continue following the existing accounting
rules under Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees ("APB 25"), and related Interpretations in accounting for
its employee stock options. The pro forma effect on the accompanying
consolidated statements of operations of adopting Statement 123 is presented in
Note 9.

NET LOSS PER SHARE OF COMMON STOCK

     In February 1997, the FASB issued Statement No. 128, Earnings Per Share
("Statement 128"), which establishes standards for computing and presenting
earnings per share ("EPS") for entities with publicly held common stock.
Statement 128 requires the presentation of basic and diluted EPS on the face of
the income statement for all entities with complex capital structures. The
Company adopted Statement 128 in 1997 and, in accordance with the requirements
thereof, restated its net loss per share for all prior periods. The effect of
adoption was not material to the accompanying consolidated financial statements.
Net loss per share of common stock is computed based on the weighted average
number of shares outstanding during the year. Stock options and warrants were
not included in the EPS calculation as they were antidilutive.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

     On January 1, 1998, the Company adopted Statement No. 130, Reporting
Comprehensive Income ("Statement 130"). The Company reported comprehensive
income in its statement of changes in stockholders' equity. The adoption of
Statement 130 resulted in revised and additional disclosures but had no effect
on the financial position, results of operations, or liquidity of the Company.

     In June 1997, the FASB also issued Statement No. 131, Disclosures about
Segments of an Enterprise and Related Information ("Statement 131"), which
establishes standards for the way public business enterprises report information
about operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports issued to shareholders. Operating segments are components of
an enterprise about which separate financial information is available which is
evaluated regularly by the chief operating decision maker in deciding how to
allocate resources and in assessing performance. Statement 131 also establishes
standards for related disclosures about products and services, geographic areas,
and major customers. The Company adopted Statement 131 in 1998, and the effect
of the adoption was not material to the consolidated financial statements (see
Note 10).

RECLASSIFICATIONS

     Certain reclassifications were made to the 1996 and 1997 financial
statements to conform with the 1998 presentation.

2. FINANCIAL INSTRUMENTS

     Financial instruments which potentially subject the Company to significant
concentrations of credit risk consist principally of short-term investments and
trade accounts receivable.
<PAGE>
 
     The Company maintains cash and cash equivalents and certain other financial
instruments with various financial institutions. Company policy is designed to
limit exposure at any one institution. Certain investments are in excess of
Federal Deposit Insurance Corporation guaranteed amounts. The Company performs
periodic evaluations of the relative credit standing of those financial
institutions which are considered in the Company's investment strategy.

     The carrying amounts reported in the balance sheet for cash and cash
equivalents, short-term investments, accounts receivable, accounts payable, and
notes payable approximate their estimated fair values.

3. INVENTORY

     During 1995, the Company upgraded certain of its software products. The
upgraded software operates in such a way that, when used in conjunction with
recently available personal computer central processors and operating systems,
the Company's older hardware products became unnecessary for fully functional
operation. Accordingly, during 1996, the Company recorded reserves totaling
$238,000 to reduce the carrying value of certain inventory items and to reflect
inventory purchase commitments in excess of net realizable value. There is no
inventory balance as of December 31, 1998.

4. LONG-TERM DEBT AND CREDIT FACILITY

     As of December 31, 1997, long-term debt consisted of a note payable to a
bank through July 1998 at approximately $12,000 per month, plus interest at
prime (8.5% at December 31, 1997), secured by certain computer equipment. The
note was repaid during 1998.

     On May 31, 1996, (amended June 30, 1997), the Company entered into a Bridge
Financing Credit Facility (the "Credit Facility") with one of its shareholders
(the "Lender"). The Agreement allowed the Company to borrow up to $6,000,000
($3,000,000 at December 31, 1997) at prime plus 1% (9.5% at December 31, 1997)
from the Lender until June 30, 1998, without collateral. In addition, the Lender
received a warrant to purchase 100,000 shares of the Company's common stock at
$10 per share. The warrant expires on May 31, 1999.

     On June 9, 1997, the Company borrowed $3,000,000 under the Credit Facility.
On October 31, 1997, the Lender exercised the option to convert those borrowings
into 300,000 shares of the Company's common stock at $10 per share. The Company
paid the Lender $112,000 in interest on the outstanding borrowings during 1997,
and commitment fees on amounts not borrowed of $26,000 and $9,400 for 1997 and
1998, respectively. No further borrowings occurred and the Credit Facility
expired on June 30, 1998.

5. CAPITALIZED LEASE OBLIGATIONS
Property and equipment includes the following amounts for leases that have been
capitalized:

<TABLE>
<CAPTION>
                                                                    DECEMBER 31
                                                             1997                1998
                                                         ---------------------------------- 
               <S>                                       <C>                   <C>
               Telephone equipment                         $ 108,000           $
               Computer equipment                            340,000               13,000
                                                         ---------------------------------- 
                                                             448,000               13,000
               Less accumulated amortization                (426,000)             (10,000)
                                                         ----------------------------------
                                                           $  22,000             $  3,000
                                                         ================================== 
</TABLE>
                                        
     Amortization of leased assets is included in depreciation and amortization
expense. The computer equipment lease provides for a bargain purchase option at
the end of the lease. Amortization of leased assets is included in depreciation
and amortization expense.

     Future minimum lease payments under capital leases consist of $5,300 for
1999, of which $500 relates to interest.

6. OPERATING LEASES

     The Company leases certain office equipment and office space under
noncancellable agreements. The office equipment lease provides for an extension
of the lease term at fair rental value or a purchase option at fair market
value. One of the office space leases provides for a five year extension with
rent escalation clauses linked to the Consumer Price Index. Rent expense under
all operating leases approximated $727,000, $695,000, and $643,000 during 1996,
1997, and 1998, respectively.
<PAGE>
 
     Future minimum lease payments under noncancellable operating leases, with
initial lease terms of at least one year at the time of inception, are as
follows at December 31, 1998:

<TABLE>
     <S>                                               <C>
     1999...........................................           $  706,000
     2000...........................................              439,000
     2001...........................................               89,000
     2002...........................................               89,000
     2003 and after.................................              849,000
                                                              ----------- 
                                                                2,172,000
                                                              ----------- 
 less: rental income from subleases.............                 (288,000)
                                                              ----------- 
                                                               $1,884,000
                                                              ===========
</TABLE>

7. SIGNIFICANT CONTRACTS

     In 1994, the Company entered into a Development and License Agreement (the
"1994 Agreement") with a major international telecommunications company (the
"Licensee") to provide for further development of certain advanced compression
technology for use in telecommunications applications. The Licensee supplied
significant funding for development and had certain exclusive rights until
September 1997 for specified modules in telecommunications markets. During 1996
and 1997, the Company recognized $10,873,000 and $5,752,000, respectively, in
development fee revenues and $1,800,000 and $1,350,000, respectively, in
exclusive license fee revenues under the contract. Except for certain
provisions, notably with respect to the continuing licensing of specific
technology components referred to above, the Agreement expired in September
1997.

     The Company and Licensee entered into a new agreement on August 7, 1998,
that cancelled the 1994 Agreement and provides the Licensee with rights to
certain deliverables as defined in the agreement. Additionally, the Company
granted the Licensee warrants to purchase up to 1,452,570 shares of common
stock. The warrants expire four years from the issue date, are exercisable at $5
per share, and had an appraised value of $31,597 as of August 7, 1998. The
warrants have not been exercised as of December 31, 1998. In connection with
this issuance, the Company recorded a charge to earnings of $31,597 representing
the fair value of the warrant.

8. COMMON STOCK

INITIAL PUBLIC OFFERING

     In September 1997, the Company sold 2,040,000 shares of common stock in an
initial public offering at $10.00 per share on the Oslo Stock Exchange.

STOCK SPLIT

     On September 2, 1997, (a) the Company's Board of Directors agreed to effect
a 100 for 1 stock split in the form of a stock dividend and to increase the
number of authorized shares of common stock from 10,000,000 shares to 20,000,000
shares, effective September 3, 1997; and (b) the Company's shareholders approved
such Board actions. All share and per share amounts have been adjusted in the
accompanying consolidated financial statements to reflect such stock split.

OTHER

     The Company has not registered any securities with the U.S. Securities and
Exchange Commission under the Securities Act of 1933, as amended, other than
pursuant to its registration statement on Form S-8 filed on December 9, 1998.
Securities of the Company may not be offered for sale or sold in the U.S., or to
or for the account or benefit of any "U.S. person" (as defined in the Securities
Act), unless the securities are registered under the Securities Act or an
exemption from such registration requirements is available.

9. STOCK OPTION PLANS

     In 1992, the Company approved a stock option plan, which was amended by the
1994 Amended and Restated Stock Option Plan (the "Plan"). Options may be granted
to employees of the Company or key persons as defined by the Plan. The options
may be issued as incentive or nonqualified stock options. The terms and
conditions of options granted under the Plan, including the number of shares,
the exercise price and the time at which such options become exercisable are
determined by the Board of Directors. The terms of options granted under the
Plan may not exceed 10 years.

     The Company granted options as to 311,000, 553,100, and 3,143,700 shares
under the Plan during 1996, 1997, and 1998, respectively, at exercise prices
ranging from $2 to $10. Options as to 707,700 shares granted in 1994 resulted in
$248,000 and $80,000 of compensation expense during 1996 and 1997, respectively.
This expense relates to the aggregate difference between the estimated fair
market values of the shares at the date of the grant and the exercise prices,
which was expensed over the vesting period.
<PAGE>
 
     At December 31, 1998, options as to 189,675 shares are available for future
grants under the Plan and the Company has reserved 3,293,575 shares for further
issuance.

     During 1994, the Company adopted a Directors Stock Option Plan for up to
180,000 shares of common stock for awards to non-employee directors. Options
granted under this plan vest over a three-year period. The Company granted
options as to 25,000 and 15,000 shares at exercise prices of $6 and $10 in 1996
and 1997, respectively. Grants issued under the plan resulted in $30,000 and
$25,000 of compensation expense during 1996 and 1997, respectively, which
relates to the aggregate difference between the estimated fair market values of
the shares at the dates of grant and the exercise prices, which is being
expensed over the vesting period. The Company has reserved 180,000 shares for
future issuance under this plan at December 31, 1998.

     During 1998, options to purchase 1,758,200 shares of common stock were
canceled and reissued and options to purchase 40,000 shares of common stock were
repriced at lower prices.

     A summary of stock option activity under both of the above-described plans
follows:

<TABLE>
<CAPTION>
                                                                                                                  
                                                                                  PRICE              WEIGHTED -   
                                                      NUMBER OF SHARES          PER SHARE           AVERAGE PRICE 
                                                   ----------------------------------------------------------------
<S>                                                <C>                         <C>                  <C>
Outstanding options at December 31, 1995                  1,847,900
 Options granted                                            326,000            $      10.00             $10.00
 Options exercised                                           (5,200)           0.32 -  6.00               0.82
 Options forfeited                                          (39,500)           6.00 - 10.00               8.00
                                                   ------------------- 
Outstanding options at December 31, 1996                  2,129,200            0.32 - 10.00               6.29
                                                                               
    Options granted                                         553,100            7.40 - 10.00               9.42
    Options exercised                                       (44,825)           0.32 -  8.00               2.96
    Options forfeited                                      (634,725)           0.32 - 10.00               7.79
                                                   -------------------     
Outstanding options at December 31, 1997                  2,002,750            0.32 - 10.00               6.76
                                                                               
 Options granted                                          3,143,700            2.00 -  7.48               5.12
 Options exercised                                           (7,200)                   0.32               0.32
 Options forfeited                                         (177,150)           4.50 - 10.00               6.85
 Options canceled                                        (1,758,200)           4.50 - 10.00               7.77
                                                   -------------------
Outstanding options at December 31, 1998                  3,203,900            0.32 -  8.00               4.40
                                                   ===================
</TABLE>


     The following table summarizes information concerning outstanding and
exercisable options at December 31, 1998:

<TABLE>
<CAPTION>
                                      OPTIONS OUTSTANDING                             OPTIONS EXERCISABLE
                         -------------------------------------------     -------------------------------------------
 
                                                                   
                                                   WEIGHTED AVERAGE                                                 
   RANGE OF                     NUMBER                 REMAINING                NUMBER             WEIGHTED AVERAGE 
EXERCISE PRICES               OUTSTANDING          CONTRACTUAL LIFE           EXERCISABLE           EXERCISE PRICE  
---------------          -------------------     -------------------     -------------------     -------------------
<S>                      <C>                     <C>                     <C>                     <C>
   $     0.32                        4,700                 4                      4,700               $     0.32
         2.00                      675,700                10                     35,000                     2.00
    4.00-5.00                    2,059,400                10                    749,400                4.00-5.00
    6.00-8.00                      464,100                 6                    463,725                6.00-8.00
</TABLE>

     The Company has elected to follow APB 25 and related Interpretations in
accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under Statement 123 requires use
of option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, when the exercise price of the Company's stock
options equals or exceeds the market price of the underlying stock on the date
of grant, no compensation expense is recognized.

     Pro forma information regarding net income is required by Statement 123,
which also requires that the information be determined as if the Company has
accounted for its employee stock options granted subsequent to December 31,
1994, under the fair value method. The fair values for these options were
estimated at the dates of grant using the minimum value method prior to the
Company's Initial Public Offering in September 1997 and the Black-Scholes method
thereafter, with the following weighted-average assumptions for 1996, 1997, and
1998; risk-free interest rates of 6.36%, 6.20%, and 5.07%, respectively; no
dividend yield; volatility 
<PAGE>
 
of .01 prior to the effective date of the Company's Initial Public Offering in
September 1997, .421 for the remainder of 1997, and .740 in 1998; and a 
weighted-average expected life of 6 years.

     For purposes of pro forma disclosures, the estimated fair values of the
options are amortized to expense over the options' vesting periods. The
Company's pro forma net loss, assuming Statement 123 had been adopted, would
have been approximately $1,866,000, $6,755,000, and $11,232,000 during 1996,
1997, 1998, respectively. The Company's pro forma net loss per share, assuming
Statement 123 had been adopted, would have been, $0.18, $0.60, and $0.86 during
1996, 1997, 1998, respectively.

     The weighted-average fair values of options granted for the years ended
December 31, 1996, 1997, and 1998 were $2.52, $2.90, and $2.01, respectively.
Because Statement 123 is applicable only to options granted subsequent to
December 31, 1994, its pro forma effect will not be fully reflected until 1999.

10.  SEGMENT INFORMATION

     In accordance with the requirements of Statement 131, the following
disclosure represents the information used by management when evaluating the
operating performance of its business units. The information reviewed by
management includes the operating revenue from external customers, net loss, and
identifiable assets for the Company's two geographic areas, the United States
and the United Kingdom. Both operating segments are involved in developing and
marketing patented digital image science technology.

The net assets of the foreign operations exclude intercompany accounts payable
to the Company (for which settlement is not planned or anticipated in the
foreseeable future).

<TABLE>
<CAPTION>
                                                                      YEAR ENDED DECEMBER 31                          
                                                         1996                  1997                   1998           
                                                     ---------------------------------------------------------   
      <S>                                            <C>                    <C>                    <C>                      
      OPERATING REVENUE                                                                                          
      United States                                  $15,462,000            $ 9,425,000            $   750,000   
      United Kingdom                                      96,000                 46,000                  3,000   
                                                     ---------------------------------------------------------   
     Total                                           $15,558,000            $ 9,471,000            $   753,000   
                                                     =========================================================   
                                                                                                                 
     NET LOSS                                                                                                    
      United States                                  $   973,000            $ 5,511,000            $ 9,371,000   
      United Kingdom                                     633,000                818,000                654,000   
                                                     ---------------------------------------------------------
     Total                                           $ 1,606,000            $ 6,329,000            $10,025,000   
                                                     =========================================================   
                                                                                                                 
     IDENTIFIABLE ASSETS, NET                                                                                    
      United States                                  $ 3,144,000            $18,550,000            $ 8,621,000   
      United Kingdom                                      67,000                166,000               (103,000)  
                                                     ---------------------------------------------------------
     Total                                           $ 3,211,000            $18,716,000            $ 8,518,000   
                                                     =========================================================    
</TABLE>

MAJOR CUSTOMERS

     Several customers of the domestic operating segment comprised a significant
portion of consolidated revenues in each period. During 1996, revenues of
$12,673,000 were recognized from a major international telecommunications
company (as discussed in Note 7), and $1,484,000 from product sales to a foreign
government. During 1997, $7,102,000 in revenues were recognized from a major
international telecommunications company, and $1,043,000 was recognized from a
foreign satellite transmission company. During 1998, revenues were derived from
sales to a government agency and from two different software development
companies, in the amount of $478,000, $105,000, and $72,000, respectively.

11. SIGNIFICANT EMPLOYMENT AGREEMENTS

     In 1994, the Company entered into employment agreements of an indefinite
term with its two co-founders, who each serve as Executive Vice Presidents. The
agreements provide for: (a) a grant of stock options; (b) ongoing annual base
salaries; (c) salary continuation rights in the event of employment termination
under certain circumstances; and (d) possible performance-based cash bonuses
each year through 1996. There were no charges to expense for cash bonuses under
these agreements in 1996, 1997, and 1998.

     In December 1997, the Company restated the employment agreement with the
President/Chief Executive Officer. The restated agreement acknowledges his
request to relinquish the President/Chief Executive Officer titles and to become
the Vice-Chairman of the Company's Board of Directors together with (a) a
reduction of base salary to reflect his advisory role; (b) an additional grant
of 124,100 stock options; and (c) a performance-based cash bonus in the amount
of $150,000, which was paid in 1997. The restated agreement also provides for
the immediate vesting of options as to 706,000 shares of common stock previously
granted and the forfeiture of options as to 218,300 shares of common stock
previously granted.
<PAGE>
 
     In February 1998, the Company entered into an employment agreement with its
new President and Chief Executive Officer. The agreement provides for (a)
granting of immediate stock options; (b) granting of additional stock options
under certain circumstances; (c) granting of cash bonuses under certain
circumstances; and (d) salary continuation rights for 18 months in the event of
termination of employment under certain circumstances. There were no charges to
expense for bonuses or additional grants of stock options under this agreement
in 1998.

12. INCOME TAXES

     The Company and ISL file income tax returns in the United States and the
United Kingdom, respectively.

     At December 31, 1997, and December 31, 1998, the Company has net operating
loss carryforwards in the United States of $11,941,000 and $20,992,000,
respectively, which begin expiring in 2007. In addition, at December 31, 1997,
and December 31, 1998, the Company has $920,000 and $1,087,000, respectively, of
research and development credits available for offset against future United
States income taxes which also begin expiring in 2007. The utilization of net
operating loss carryforwards to offset future taxable income may be limited due
to any future changes in ownership of the Company.

     At December 31, 1997, and December 31, 1998, ISL has net operating loss
carryforwards in the United Kingdom of (Pounds)1,600,000 ($2,633,000) and
(Pounds)2,052,000 ($3,405,000), respectively, which are available for offset
against future United Kingdom taxable income.

     For financial reporting purposes, a valuation allowance has been recognized
to reduce the net deferred tax assets to zero due to uncertainties with respect
to the Company's ability to generate taxable income in the future sufficient to
realize the benefit of such deferred income tax assets.

     The Company's deferred income tax liabilities and assets are as follows:

<TABLE>
<CAPTION>
                                                                                  DECEMBER 31
                                                                          1997                 1998
                                                                  -----------------------------------------
<S>                                                               <C>                     <C> 
Deferred income tax liabilities:
 Prepaid insurance                                                    $    19,000         $     14,000
                                                                  -----------------------------------------
Total deferred income tax liabilities                                      19,000               14,000
Deferred income tax assets:
 Book over tax depreciation                                               158,000              255,000
 Research and development credits                                         920,000            1,087,000
 Allowance for bad debts                                                    3,000                2,000
 Net operating loss carryforwards-U.S.                                  4,538,000            7,965,000
 Net operating loss carryforwards-U.K.                                    869,000            1,294,000
 Contribution carryover                                                         -                5,000
 Compensatory stock options                                               266,000              250,000
 Deferred revenue                                                           2,000                2,000
 Alternative minimum tax credit                                           115,000              115,000
 Bonuses                                                                   10,000               24,000
                                                                  ----------------------------------------- 
Total deferred income tax assets                                        6,881,000           10,999,000
Valuation allowance for deferred income tax assets                     (6,862,000)         (10,985,000)
                                                                  ----------------------------------------- 
Net deferred income tax assets                                             19,000               14,000
                                                                  -----------------------------------------
Net deferred income taxes                                             $         -         $          -
                                                                  =========================================
</TABLE>
<PAGE>
 
A reconciliation of the provision for income taxes to the federal statutory rate
is as follows:

<TABLE>
<CAPTION>
                                                  1996            1997             1998         
                                              ---------------------------------------------
     <S>                                      <S>             <C>              <C>                  
          Tax at statutory rate               $ (546,000)     $(2,152,000)     $(3,409,000) 
     State taxes, net of federal benefit         (64,000)        (253,000)        (401,000) 
     Permanent differences and other             (34,000)         (79,000)        (313,000) 
          Valuation allowance                    644,000        2,484,000        4,123,000  
                                              ---------------------------------------------  
                                              $        -      $         -      $         -                 
                                              =============================================   
</TABLE>

13. RETIREMENT PLAN

     The Company maintains a defined contribution plan (the "401(k) Plan")
covering all employees. The Company makes matching contributions equal to 50% of
eligible employees' contributions, up to 4% of the employee's compensation,
increased to 6% effective June 1, 1998. The Company expensed $102,000, $102,000,
and $100,000 during 1996, 1997, and 1998, respectively, related to this plan.