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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------

                                   FORM 10-K
                            ------------------------
(MARK ONE)

      [X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
        SECURITIES EXCHANGE ACT OF 1934

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999

                                       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 0-21126

                                S3 INCORPORATED
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S>                                            <C>
                   DELAWARE                                      77-0204341
(STATE OR OTHER JURISDICTION OF INCORPORATION       (I.R.S. EMPLOYER IDENTIFICATION NO.)
               OR ORGANIZATION)

        2841 MISSION COLLEGE BOULEVARD
           SANTA CLARA, CALIFORNIA                                 95054
   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                      (ZIP CODE)
</TABLE>

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 588-8000

        SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE

          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

                         COMMON STOCK, $.0001 PAR VALUE

             SERIES A PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS

     Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [ ]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference to Part III of this Form 10-K or any
amendment to this Form 10-K.  [ ]

     The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $1,350,205,400 as of March 1, 2000, based upon the
closing price on the Nasdaq National Market reported for such date. This
calculation does not reflect a determination that certain persons are affiliates
of the Registrant for any other purpose.

     89,905,506 shares of the Registrant's Common stock, $.0001 par value, were
outstanding at March 1, 2000.

                      DOCUMENTS INCORPORATED BY REFERENCE

     Items 10 (as to directors), 11 and 12 of Part III incorporate by reference
information from the Registrant's Proxy Statement to be filed with the
Securities and Exchange Commission in connection with the solicitation of
proxies for the Registrant's 2000 Annual Meeting of Stockholders.
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<PAGE>   2

                                S3 INCORPORATED

                                   FORM 10-K

                                     INDEX

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                                   PART I

Item 1.   Business....................................................    3
Item 2.   Properties..................................................   14
Item 3.   Legal Proceedings...........................................   15
Item 4.   Submission of Matters to a Vote of Security Holders.........   17

                                  PART II

Item 5.   Market For Registrant's Common Equity and Related
          Stockholder Matters.........................................   18
Item 6.   Selected Consolidated Financial Data........................   18
Item 7.   Management's Discussion and Analysis of Financial Condition
          and Results of Operations...................................   20
Item 7A.  Quantitative and Qualitative Disclosures About Market
          Risk........................................................   40
Item 8.   Financial Statements and Supplementary Data.................   42
Item 9.   Changes in and Disagreements With Accountants on Accounting
          and Financial Disclosure....................................   71

                                  PART III

Item 10.  Directors and Executive Officers of the Registrant..........   71
Item 11.  Executive Compensation......................................   72
Item 12.  Security Ownership of Certain Beneficial Owners and
          Management..................................................   72
Item 13.  Certain Relationships and Related Transactions..............   72

                                  PART IV

Item 14.  Exhibits, Financial Statement Schedules and Reports on Form
          8-K.........................................................   72
SIGNATURES............................................................   77
</TABLE>

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                                     PART I

ITEM 1. BUSINESS.

     When used in this report, the words "expects", "anticipates", "plans",
"believes", and "could" and similar expressions are intended to identify
forward-looking statements. Such statements, which include statements concerning
the timing of availability and functionality of products under development,
trends in the personal computer ("PC") market, the percentage of export sales
and sales to strategic customers, and the adoption or retention of industry
standards, and the availability and cost of products from the Company's
suppliers, are subject to risks and uncertainties, including those set forth
under "Management's Discussion and Analysis of Financial Condition and Results
of Operations -- Factors That May Affect Our Results" and elsewhere in this
report, that could cause actual results to differ materially from those
projected. These forward-looking statements speak only as of the date of this
report. The Company expressly disclaims any obligation or undertaking to release
publicly any updates or revisions to any forward-looking statements contained
herein to reflect any change in the Company's expectations with regard thereto
or any change in events, conditions or circumstances on which any such statement
is based.

GENERAL

     S3 Incorporated ("S3" or the "Company") designs, develops, manufactures and
distributes multimedia, connectivity and Internet appliance products for the PC
and consumer appliance markets. The Company has been a leading supplier of
graphics and multimedia accelerator subsystems for PCs for over ten years. In
September 1999, S3 made a significant strategic shift by merging with Diamond
Multimedia Systems, Inc. ("Diamond"), an established original PC equipment
manufacturer ("OEM") and retail provider of communications and home networking
solutions, PC graphics and audio add-in boards, digital audio players and
Internet appliances. After the merger, S3 restructured its businesses into three
divisions along three distinct product lines: Communications, Multimedia and
Professional Graphics.

     Communications. S3 is a leading supplier of PC communications equipment.
S3's Communications Division sells home networking cards, digital audio players
and modems under the Diamond Multimedia brand. Product brands within the
Communications Division include the HomeFree line of home networking and DSL
gateway products, the Rio family of digital audio players and the Supra line of
modems. The Communications Division, which is based in Vancouver, Washington, is
also developing Internet appliances.

     Multimedia. The Multimedia Division is a leading provider of notebook
graphics chips, PC graphics add-in boards using its own graphics chips and PC
audio add-in boards for the OEM, channel and retail markets. S3 has been a
pioneer in the PC graphics acceleration hardware and associated software since
1991, when it was the first company to ship in volume a single chip graphics
accelerator with a local bus interface. The Company's accelerators are designed
to work cooperatively with a PC's central processing unit ("CPU"), implementing
functions best suited for a dedicated accelerator while allowing the CPU to
perform the more general purpose computing functions. As the demand for greater
multimedia capabilities in PCs increases, S3 is focused on delivering
accelerator solutions for use in business desktop, home and mobile computing
systems. S3's families of accelerator products and software are currently used
by many of the world's leading OEMs and motherboard manufacturers.

     The Multimedia Division combines the graphics accelerator chip expertise
that has traditionally been the core of S3's business with Diamond's OEM and
retail add-in board business. Product brands within the Multimedia Division
include the Savage family of desktop and notebook graphics chips, the Stealth,
Viper and Speedstar series of graphics boards and the Monster Sound and Sonic
Impact series of audio boards. In addition, S3's Multimedia Division has entered
into a joint venture with VIA Technologies, Inc. ("VIA") to produce a family of
highly integrated graphics and core logic chips targeted for the low-cost
segment of the desktop and notebook OEM PC markets. The Multimedia Division is
based in Santa Clara, California.

     Professional Graphics. S3's Professional Graphics Division designs,
develops and markets graphics solutions for Windows NT workstations. Using IBM's
high-end graphics technology, the Fire GL line of

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add-in boards adds high end products to S3's line of graphics accelerators. The
Professional Graphics division is based in Starnberg, Germany.

     In addition to its communications, multimedia and professional graphics
business, S3 sells its products through e-commerce websites, including its own
on-line store at www.diamondmm.com, mail order catalog organizations and
national reseller organizations.

     Headquartered in Santa Clara, California, S3 has sales, marketing and
technical facilities in several locations including Austin, Texas; Hong Kong;
Paris; Saarbruecken, Germany; Seoul; Singapore; Starnberg, Germany; Sydney,
Australia; Taiwan; Tokyo, Winnersh, U.K. and Vancouver, Washington.

     S3 was incorporated on January 9, 1989 in the State of Delaware. The
Company operates in one principal industry segment.

S3'S INVESTMENTS

     In October 1999, S3 caused RioPort.com, Inc., which was a wholly owned
subsidiary, to sell shares of its preferred stock to third party investors.
RioPort.com, Inc. is developing an integrated platform for acquiring, managing
and experiencing music and spoken audio programming from the Internet. As a
result, the Company retains a minority investment in RioPort.com, Inc. and
accounts for its investment using the equity method of accounting. In addition,
in November 1999, the Company received $10.9 million for the sale of OneStep,
LLC to RioPort.com, Inc.

     In 1995, S3 entered into a joint foundry venture with United
Microelectronics Corporation ("UMC") to build United Semiconductor Corporation
("USC"), a semiconductor manufacturing facility in Taiwan, R.O.C. In addition to
providing S3 with access to world-class semiconductor manufacturing capacity,
S3's investment has appreciated substantially. As of March 1, 2000, S3's 252
million UMC shares were worth over $1 billion, based on the closing price of UMC
shares on the Taiwan Stock Exchange on that date. The value of the Company's UMC
shares fluctuates based on the trading price of UMC shares on the Taiwan Stock
Exchange. As the shares owned in UMC are publicly traded and the Company
accounts for its investment on the cost basis, the investment will be adjusted
to market value in the first quarter of 2000, in accordance with SFAS 115. No
assurance can be given that the Company would realize over $1 billion if it were
to liquidate its investment.

RECENT DEVELOPMENTS

     In 1999, S3 introduced the Savage4 and Savage 2000 accelerator chips. These
accelerator chips are designed to deliver high-performance multimedia graphics,
utilizing S3 texture compression ("S3TC") and single-pass trilinear filtering
technologies. S3TC(TM) is a compression technology that compresses data in up to
one-sixth the normally required space, which allows for cost effectiveness, and
was selected by Microsoft Corporation ("Microsoft") as the standard compression
technique in DirectX(TM). The compression technique is also able to deliver
photo-realistic 3D quality. S3TC was widely adopted for use in many of 1999's
top 3D software game titles, including Unreal and Unreal Tournament, Quake3
Arena, Half Life, Anachronox, Expendable and TrueSpace4 and is being
incorporated in future software titles.(1) Combined with S3TC, the single-pass
trilinear filtering enhances image quality over traditional bilinear filtering
and enables high 3D graphics performance by removing motion artifacts for
smoother images without performance degradation.

     In 1999, S3 also introduced its third generation of mobile accelerators,
Savage/MX and Savage/IX. The Company's mobile strategy is to combine the same
level of 2D, 3D and video capabilities found in its desktop accelerators with
advanced power management and flat panel display support. S3's Savage/MX and
Savage/IX accelerators bring enhanced capabilities to notebook PC users, such as
fully-integrated TV-out, DuoView+ dual display capability and AGP support using
S3's S3TC. See "Current Products and Future Product Plans -- Graphics and Video
Accelerator Chips."

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

(1) The software titles set forth above may be trademarks or registered
    trademarks of their respective owners.
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     On September 24, 1999, S3 completed its merger with Diamond, marking a
significant strategic shift. Diamond is a supplier of graphics and multimedia
accelerator subsystems for PCs and multimedia and connectivity products for the
home, enabling users to create, access and experience new media content from
their desktops and through the Internet. Diamond products include the Rio line
of Internet music players, the Stealth and Viper series of video accelerators,
the Monster series of gaming accelerators, the Fire series of NT workstation 3D
graphics accelerators, the Supra series of modems and the HomeFree line of home
networking products. The merger with Diamond establishes S3 as a single graphics
solutions provider (silicon, board and software) in the retail, commercial and
OEM PC graphics markets.

     In November 1999, the Company and VIA established a joint venture to
design, produce and market high-performance integrated graphics and core logic
chip sets to the volume OEM desktop and notebook PC markets. The joint venture,
S3-VIA Inc., is jointly funded and enjoys access to both S3's and VIA's
technology as well as distribution rights for developed products between S3 and
VIA. S3 owns 50.1% of the voting common stock of S3-VIA and, accordingly, will
consolidate the accounts of S3-VIA Inc. in its consolidated financial
statements.

     In January 2000, the Company publicly announced that it is exploring
business transactions intended to increase stockholder value by separating the
Graphics Division from its other business.

     In February 2000, the Company purchased substantially all of the assets of
Number Nine Visual Technology Corporation ("Number Nine"). Number Nine was a
supplier of graphics accelerator subsystems for PCs using S3 graphics chips. The
acquisition of the assets of Number Nine, a supplier to IBM, allows S3 to
consolidate its graphics business with IBM into a single source distribution
model and furthers S3's strategy of becoming a single graphics solution provider
to the PC graphics market. The acquisition also adds skilled hardware and
software engineering resources to S3's existing teams.

     In February 2000, VIA purchased from the Company 10,775,000 shares of the
Company's Common Stock for an aggregate purchase price of $145,462,500.

CURRENT PRODUCTS AND FUTURE PRODUCT PLANS

     Rio Digital Audio Players. The Rio 300 and Rio 500 are the Company's first
Internet appliances. The Rio is a portable digital audio playback device that
allows users to enjoy near-CD quality audio that has been uploaded to the device
from a PC's hard drive in the MP3 compression format. Users may compress and
transfer music from personal CDs and other digital formats for upload to, and
playback using, a Rio player. The Rio player uses flash memory and is battery
powered, allowing the portable playback of computer based music in the MP3
format.

     Diamond shipped the industry's first hand-held digital audio player in
November 1998. In 1999, as competitors entered the market with similar first
generation devices, Diamond introduced the second-generation Rio 500 handheld
player. The PC and Macintosh-compatible Rio 500 stores and plays up to two hours
of music with improved fidelity and gives users more freedom to manage their
audio content, compared to the Rio 300, and uses a USB connection for faster
upload speeds. S3 is developing its third generation handheld Rio players, which
it plans to introduce in 2000. In addition to its handheld Rio devices, S3 is
also developing other digital audio products for use in consumers' homes,
offices and automobiles.

     HomeFree Home Networking and DSL Residential Gateway Products. S3's Diamond
Multimedia-branded HomeFree communications products allow users to network
multiple PCs throughout their home via phone lines to share Internet access,
content and peripheral devices and to engage in multiple platform applications
such as head-to-head gaming.

     S3's HomeFree Phoneline USB uses a USB connection and is the only
cross-platform (Windows and Mac-compatible) home networking product on the
market. The Company's HomeFree Phoneline 10mb networking product allows users to
share Internet access, content and peripheral devices, transferring information
at speeds of up to 10Mbps. In addition, the recently announced HomeFree ADSL
Residential Gateway allows users to network their DSL Internet connection
throughout their entire household.

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     In December 1999, S3 and Covad Communications, Inc. ("Covad") a nationwide
DSL service provider, agreed to jointly market and sell S3's HomeFree Phoneline
and Residential Gateway products with Covad's services, providing consumers with
a one-stop shopping DSL solution.

     Supra Modems. Under the Diamond Multimedia brand, S3 markets a family of
dial-up fax/data modems that include the SupraExpress and SupraMax family of
modems. The SupraExpress family of modems are external fax/data modems that
connect via a serial cable or USB interface, support the 56K ITU standard (V.90)
and are PC and/or Macintosh compatible. The SupraMax family of modems are
internal fax/data modem solutions that connect via the PCI or ISA interface for
legacy configurations, while providing an upgraded 56K connection.

     Internet Appliances. S3 is exploring and developing a diverse range of
Internet devices that are intended to combine its existing expertise in home
networking, consumer design and ease of use with core technology from
industry-leaders such as Transmeta, Cirrus Logic, Ravisent Technology and
others. One product in development is a web pad based on Transmeta's recently
released Crusoe processor. The web pad is a portable device designed for web
surfing, portable multimedia, electronic books, streaming audio and video and
basic productivity applications. The web pad is currently expected to be
introduced in mid-2000 with initial versions geared toward commercial customers,
such as hotels, and later versions designed for retail customers.

     Graphics Products. The Company's graphics and video accelerator product
line includes a broad array of products, including add-in cards sold under the
Diamond Multimedia brand, and graphics chips to support motherboard and computer
system OEM designs in both desktop and mobile markets. S3's family of products
range from accelerators designed for the desktop market that target
cost-conscious consumers to fully-featured multimedia systems designed for the
high-end mobile PC market, to professional graphics solutions for the Windows NT
workstation market.

  Graphics and Video Accelerator Chips

     Savage2000. Savage2000 is the third generation of S3's Savage family of
accelerators. Designed for the consumer and commercial PC markets, the
Savage2000 supports 3D rendering, digital video playback and TV-out support for
home users, and high-resolution 2D image quality and digital flat panel support
for professional users. Suitable for use in retail add-in cards, as well as
high-performance OEM systems, the Savage2000 offers 128-bit memory support (up
to 166MHz) and up to a 150MHz engine clock. The Savage2000+, which the Company
expects to ship in 2000, will offer 128-bit memory support (up to 200MHz) and up
to a 200MHz engine clock. Both configurations provide up to 64MB of memory, a
350MHz RAMDAC, DVI-compliant digital panel technology, advanced TV-out support
and complete AGP 4X technology.

     Savage4. Savage4 is the second generation of the Savage family of
accelerators. Designed for the consumer and commercial PC markets, S3's Savage4
delivers 2D graphics and video acceleration, as well as 3D rendering
capabilities equivalent to high-end, niche gaming solutions. Savage4 features a
128-bit 3D engine, AGP 4X technology, true 32-bit 3D rendering, S3TC, trilinear
filtered single-pass multi-texturing, hardware accelerated DVD, 32MB memory
support and complete digital flat panel support. Currently, Savage4 comes in two
configurations: the Savage4 PRO and the Savage4 GT. The Savage4 PRO incorporates
AGP 4X technology, 143MHz memory support and up to a 32MB local frame buffer,
while the Savage4 GT incorporates AGP 2X technology, 125MHz memory support and
up to a 16MB local frame buffer for low-end PC markets.

     Trio3D. Trio3D is the third generation of the Trio family of accelerators.
Trio3D features a 128-bit pipeline architecture, support for 125 MHz SGRAM
memory and S3's Burst Command Interface(TM) -- a proprietary protocol technology
that works in conjunction with either the PCI or AGP bus to increase the command
and data efficiency of the Trio3D architecture. Trio3D also supports 3D
rendering and is the first accelerator to fully implement the industry standard
Video Interface Port bus which provides a dedicated interface from the graphics
accelerator to digital video devices and streamlines the movement of this data
versus current PCI bus solutions. The Trio3D provides a low-cost,
easy-to-implement interface to third party multimedia peripherals such as video
cameras, TV-tuners and DVD/MPEG-2 decoders. It also provides
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support for AGP standard and is designed to be pin-compatible with existing Trio
and ViRGE-based designs. In addition, Trio3D's software compatibility with
previous generations of S3 products is intended to enable faster time-to-market
for manufacturers.

     Mobile Savage. Based on S3's Savage desktop architecture, the Mobile
Savage/MX and Mobile Savage/IX bring state-of-the-art 3D graphics acceleration
and digital video playback to the notebook PC market, allowing PC users to run
the same applications on their notebook as they would on their desktop. The
Savage/MX uses discrete memory to provide a high-performance, cost effective
solution for desktop replacement notebooks, while the Savage/IX features a
unique integrated memory design supporting up to 16MB, the most available on the
market today, making it a competitive high-performance solution for thin and
light notebook computers. S3's Mobile Savage chips have been designed into
multiple notebook models by Toshiba, NEC and MicronPC.com.

  S3-VIA Integrated Graphics/Core Logic Chips

     In 1999, S3 and VIA formed a joint venture to bring a family of
high-performance integrated graphics and core logic chip sets to the volume OEM
desktop and notebook PC markets in 2000 by combining S3's graphics and VIA's
processor technologies. Although competing products are having limited success
in the extreme value segments of the PC markets, S3 believes that there is a
demand in the volume OEM PC market for integrated products that offer
cost-savings without sacrificing performance. Combining S3's cutting-edge
graphics and video technology with VIA's comprehensive chip set technology, the
joint venture plans to introduce products designed to address this potential
market. With the joint venture's first product scheduled to be in mass
production by mid-2000, the joint venture is currently working on the next
generation of designs. These next-generation designs include an integrated
mobile chip set and a higher performance integrated desktop chip set.

  Graphics Boards

     Delivering a range of performance and functionality suitable for use in
professional workstations to value PCs, S3's Fire GL, Viper, Stealth and
SpeedStar product lines form a comprehensive family of graphics add-in board
solutions.

     Fire GL. Based on IBM's high-end graphics technology, S3's Fire GL1
graphics board provides advanced performance in 2D and 3D NT workstation
graphics. Targeted at users of CAD/CAM and digital content creation
applications, Fire GL1 is available in both PCI and AGP versions. The Fire GL1
comes with 32MB of memory and includes a full suite of software drivers for the
leading workstation graphics applications.

     Viper. S3's Viper II graphics solution delivers a low-cost solution that is
compatible with some of today's most popular 3D games including Quake III: Arena
and Unreal Tournament. In addition to improved 3D graphics performance, Viper II
offers digital video (DVD/DTV) and TV functionality for consumers and
high-resolution 2D imagery and flat panel support for home office users.
Extending the functionality of the Viper II, S3 recently announced a newly
designed low-profile Viper II DVI board with AGP 4X support. The new Viper II
delivers levels of 3D and DVD performance in a smaller design footprint, as well
as comprehensive DVI support for digital display technologies, and is intended
to provide OEMs with a graphics solution meeting the size constraints of
increasingly slimmer PC form factors.

     Stealth and SpeedStar. S3 supplies its Stealth III S540 and Stealth III
S540 Xtreme boards to the volume retail and OEM PC markets. SpeedStar A-55,
SpeedStar A-90 and SpeedStar A-200 boards are lower cost, entry level add-in
cards based on multiple versions of S3's Savage4 and Trio3D graphics chips. S3
derives a substantial portion of its graphics revenue from these boards.

  Graphics Software

     The Company believes that a complete solution for users of its graphics
solutions must include not only high performance acceleration features
implemented in silicon, but also a broad line of software, including BIOS,
drivers and utilities, that are designed to optimize the performance of its
accelerators. The software is

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shipped as an integral part of the Company's accelerator products. The Company
maintains a flexible driver architecture, allowing its drivers to be easily
upgraded for the enhanced features supported in next generation accelerator
products. S3 uses a combination of in-house software developers and independent
contractors to develop its software drivers. The Company's in-house software
development team develops strategic software, including BIOS and drivers for the
Windows family of operating systems. The Company believes that software
expertise is vital to determining the optimal trade-off between silicon and
software for next generation accelerator performance and functionality
enhancements. The Company has also developed extensive capabilities for testing
its accelerators, software drivers and BIOS across a range of applications and
OEM system configurations.

     S3 is also actively developing software drivers for what have emerged as
the standard APIs for 3D acceleration. Microsoft's Direct3D has emerged as the
standard API for the mainstream PC platform and Silicon Graphics, Inc.'s
("Silicon Graphics") OpenGL has emerged as the standard API for high-
performance 3D graphics. S3 develops drives for both of these APIs.

  Future Graphics Accelerators and Software

     S3 is developing several graphics and video accelerators and related
software products currently scheduled for introduction throughout 2000. S3
believes that its extensive software, systems and silicon expertise, use of
advanced design tools, centralized engineering group with strong design
expertise and close working relationships with strategic customers and software
developers should position the Company to continue to rapidly and
cost-effectively define, develop and market advanced accelerators and related
software for the PC market.

  Sound Cards. S3's Monster Sound and Sonic Impact boards deliver audio
solutions for the retail and OEM markets. Featuring advanced 3D positional audio
based on ESS Technology hardware and Quadraphonic HRTF-based "true" 4 speaker
playback, the Monster Sound MX400 provides a high-quality audio for PC gaming
and music playback, while the Sonic Impact 100 offers a lower cost audio sound
solution for PC consumers.

     S3's successful development, manufacture and marketing of its current and
planned products are subject to a number of factors. See "Factors That May
Affect Our Results"

MARKETS AND STRATEGY

     S3's business strategy is to identify emerging markets and customers'
needs, to use its technological expertise to quickly provide integrated, easy to
install and use, high-performance multimedia and connectivity solutions for the
PC platform, and to use its worldwide channels to achieve broad distribution and
support of its products. The Company aims to expand its position as a leader in
multimedia and connectivity products for the home, enabling consumers to create,
access and experience compelling new media content from their desktops and
through the Internet. The Company's objectives for the coming year include:
capitalizing on new technologies such as digital audio over the Internet,
digital video over the Internet, 3D graphics for NT workstations, broadband
modems and home networking; expanding business with large OEMs, international
retailers and value added resellers ("VARs") and expanding international sales;
and increasing penetration of the market for its digital audio players and its
mobile and other graphics accelerators.

     S3's graphics products strategy is to offer an integrated 2D/3D multimedia
solution comprised of hardware and software designed around a common
architecture that will become the standard graphics engine and a cost-effective
package for the desktop and mobile markets. The Company works closely with its
key customers in each of those areas to design the products that meet the needs
of the individual markets. Through several recent acquisitions, S3 has become a
single graphics solutions provider (silicon, board and software) in the retail,
commercial and OEM PC graphics markets. See "Recent Developments."

     Recognizing the rapid conversion of consumer electronic products from
analog to digital technology, the convergence of consumer and computing systems
into new and evolving information access devices and the personal computer's
inherent position as the most advanced and well-positioned digital platform, the
Company
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intends to leverage its PC system architecture and multimedia acceleration
expertise to develop new products for both computer and consumer applications
that exploit these trends. Through several recent acquisitions, S3 has been able
to add to its technical expertise and expand product offerings while further
improving its distribution channels and market presence both domestically and
internationally. See "Recent Developments."

SALES, MARKETING, DISTRIBUTION AND CUSTOMER SUPPORT

     The Company sells its products through independent domestic and
international distributors and directly to larger computer retailers, mass
merchants, system integrators, VARs and OEMs.

     Retail Products. The Company sells its retail products, such as its
communications products and graphics and sound add-in cards, in the United
States through e-commerce websites, including its own on-line store at
www.diamondmm.com, mail-order catalog organizations and national reseller
organizations. The Company is currently seeking to expand its penetration of
e-commerce, consumer electronics retail/mass merchant channels, and VAR
channels, including programs to address the large and growing channel assembly
business, and to increase its sales to large PC systems manufacturers. See
"Factors That May Affect Our Results -- We Are Subject To Risks Relating To
Product Returns and Price Protection" and "-- We Depend On Sales Through
Distributors."

     The Company undertakes significant efforts to expand its retail sales
channels through international penetration in Europe, Latin America, and
Asia-Pacific, including Japan. The requirements of these regions are, however,
substantially different from one another and from the North American market. Any
inability of the Company to successfully penetrate these channels or to manage
them on a profitable basis could have a material adverse effect on operating
results. See "Factors That May Affect Our Results -- We Have Significant
Exposure To International Markets."

     OEM Products. S3 markets and distributes its graphics solutions through a
direct sales organization supported by field applications engineers, as well as
through a network of independent manufacturers' representatives and regional
distributors. In North America, the Company uses a combination of independent
manufacturers' representatives and a direct sales force operating from the
Company's sales offices in California, Georgia, North Carolina and Texas. In
Asia, the Company operates from sales and distribution offices in Hong Kong,
Japan, Singapore and Taiwan, and through manufacturers' representatives and
local distributors located in Hong Kong, Japan, Korea and Taiwan. In Europe, the
Company uses organizations that are both manufacturers' representatives and
distributors in France, Germany and the United Kingdom. The loss of one or more
representatives could have an adverse effect on the Company's operating results.
The Company has a global shipment program that allows certain finished products
(primarily graphics chips and add-in cards) to ship directly to customers from
the Company's independent assembly and testing houses. This program is intended
to provide more timely delivery of such products to those customers by
eliminating the intermediate step of shipping finished products to the Company's
California facilities for repackaging and reshipment.

     The Company sells multimedia accelerator chips to OEMs, motherboard
manufacturers and distributors. Sales to these customers are typically made
pursuant to specific purchase orders, which are cancelable without significant
penalties. In 1999, three customers, IBM Corporation, Dell Computer Corporation
and Synnex Technology, Inc. ("Synnex") accounted for 19%, 10% and 9%
respectively, of net sales. In 1998, three customers, Synnex, IBM Corporation
and Promate Electronics Co., accounted for 39%, 14% and 13%, respectively, of
net sales. In 1997, three customers, Synnex, CNW International Limited, and
Compaq Computer Corporation, accounted for 20%, 13% and 12%, respectively, of
net sales. Synnex, CNW International Limited and Promate Electronics Co. are
distributors. The Company expects a significant portion of its future sales of
graphics products to remain concentrated within a limited number of strategic
customers. There can be no assurance that the Company will be able to retain its
strategic customers or that such customers will not otherwise cancel or
reschedule orders, or in the event of canceled orders, that such orders will be
replaced by other sales. In addition, sales to any particular customer may
fluctuate significantly from quarter to quarter. The occurrence of any such
event could have a material adverse effect on the

                                        9
<PAGE>   10

Company's operating results. See "Factors That May Affect Our Results -- A
Significant Portion of Our Sales Are Concentrated Within A Limited Number of
Customers" and "-- We Depend On Sales Through Distributors."

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

     Export sales accounted for 70%, 89% and 70% of net graphics chip sales in
1999, 1998 and 1997, respectively. Approximately 35% of graphics chip export
sales in 1999 were to affiliates of United States customers. Due to its graphics
export sales, the Company is subject to the risks of conducting business
internationally, including those set forth under "Factors That May Affect Our
Results -- We Have Significant Exposure to International Markets."

  Customer Support and Service

     Support for Retail Products. The Company maintains a customer service and
technical support organization focused on providing value to the Company's
customers beyond the purchase of the Company's products. In this regard, the
Company provides on-line customer service and technical support to retail
customers via email and telephone and an artificial intelligence "wizard"
accessible through the Company's website, as well as through facsimile and
direct telephonic communication. The Company supports the online community
through its presence on the Internet, where technical support, frequently asked
questions and a searchable knowledge base can be found. More than 80% of the
Company's customer support contacts are currently handled by automated systems.

     Support for OEM Customers. The Company believes that customer service and
technical support are important competitive factors in the graphics accelerator
market. The Company provides technical support for its OEM customers in major
markets in North America, Europe and Asia. Distributors and manufacturers'
representatives supplement the Company's efforts by providing additional
customer service and technical support to OEM customers for the Company's
graphics products. The Company also provides several other types of technical
support to its OEM customers, including software distribution, through the
Internet, product demonstration software, evaluation boards and application
notes.

     The Company works closely with its OEM customers in tracking the progress
of its product designs, providing applications design support and upgrading the
customers' software to provide the latest enhancements. The Company believes
that close contact with its OEM customers not only improves their level of
satisfaction, but also provides important insights into defining the system
requirements for next generation accelerators and related software products.

RESEARCH AND DEVELOPMENT

     The Company believes that continued investment in research and development
are critical to its ability to introduce, on a timely basis and at competitive
prices, new and enhanced products incorporating the latest technology and
addressing emerging market needs. The Company's research and development staff
consisted of 356 employees at December 31, 1999. The Company's software
engineers are engaged in ongoing development of software and firmware drivers to
enhance the performance of graphics, video and audio accelerators, analog and
digital modems, and various PC/Internet appliances, as well as upgrades to the
Company's proprietary software utility applications. The Company's engineers are
also engaged in the development of new products such as a web pad, new
generations of the Rio player, home networking devices, multimedia system boards
that will offer various combinations of 3D graphics, digital video, 3D sound,
and

                                       10
<PAGE>   11

other emerging PC and Internet multimedia functions. Research and development
expenses were $73.9 million, $78.6 million and $78.6 million in the years ended
December 31, 1999, 1998 and 1997, respectively.

     The Company also endeavors to work closely with third parties that are
strategic to the Company's business. The Company works with suppliers of audio,
modem and other multimedia chipsets in an effort to select the appropriate
advanced components for the Company's new PC multimedia products. The Company
seeks to develop in a timely manner the software required to incorporate the
chipsets into the Company's products, and the Company's products into the
evolving architecture and capabilities of the PC and the Internet. The Company
also works with leading personal computer hardware, operating system and
software applications suppliers in order to stay abreast of emerging
opportunities and new standards in the market. There can be no assurance that
the Company's development efforts will be successful, or that the Company will
be able to introduce competitive new products into the marketplace in a timely
manner.

MANUFACTURING METHODOLOGY

     Hardware. The Company uses an international network of independent
electronics assembly subcontractors, principally located in Asia, to assemble
and test its products. The Company generally procures its hardware products on a
turnkey basis from its subcontract manufacturing suppliers, but may procure
architectural components and consign these to its subcontractors for assembly
and board-level testing. The Company performs quality assurance on its products,
but subcontracts production level product testing. In 1997, Diamond started the
use of full turnkey offshore subcontractors. In 1998 and 1999, the proportion of
products manufactured by full turnkey subcontractors increased. The Company
anticipates that in the future, the only products not being procured primarily
on a turnkey basis will be new products in their launch phase.

     The Company packages the assembled products its receives from its
subcontractors with software, manuals and additional hardware components,
placing such materials in retail packaging for the retail/mass merchant channel
and in bulk packaging for the OEM and system integrator channels. While the
Company uses several electronics assembly subcontractors to minimize the risk of
business interruption, there can be no assurance that a problem will not arise
with one or more of these suppliers that could adversely affect operating
results. See "Factors That May Affect Our Results -- We Depend On Third Parties
For the Manufacture Of Our Products," and "Our Semiconductor,
Semiconductor-based or Software Products Could Have Design Defects."

     Graphics Chips. The Company currently relies on two foundries to
manufacture all of its graphics accelerator chips. The Company's strategy is to
utilize qualified foundries that it believes provide cost, technology or
capacity advantages for specific products. This "fabless" strategy allows the
Company to avoid the significant capital investment needed to construct an
in-house wafer fabrication facility and is a well-established business model
within the semiconductor industry. As a result, the Company is able to focus its
resources on product design and development, quality assurance, marketing and
customer support. The Company's accelerators are currently manufactured using a
five level metal complementary metal oxide semiconductor process with line
geometries as small as 0.18 micron. In order to provide increased functionality
to meet the needs of the multimedia market without substantially increasing die
size, the Company's products will have to be manufactured using increasingly
smaller line geometries. The Company designs its products using proprietary
circuit modules that are scalable in size to enable more rapid adoption of
smaller line geometry manufacturing processes and a common design rule approach
to operate within the process parameters of multiple foundries. Multiple sources
for certain products increase the Company's ability to supply its customers with
those products and reduce the Company's dependence on any single foundry.
However, the Company has not developed alternate sources of supply for certain
products, and its newly introduced products are typically produced initially by
a single foundry until alternate sources can be qualified. The Company currently
has long-term manufacturing capacity arrangements with two suppliers as
described below. To the extent a foundry terminates its relationship with the
Company or should the Company's supply from a foundry be interrupted or
terminated for any other reason, such as a natural disaster, the Company may not
have a sufficient amount of time to replace the supply of products manufactured
by that foundry.

                                       11
<PAGE>   12

     Historically, certain subcontract suppliers have also provided packaging
and testing for the Company's products and other activities necessary to deliver
finished products. The Company pays those suppliers for assembled or fully
tested products meeting predetermined specifications. In the assembly process,
the silicon wafers are separated into individual die after wafer level testing
that are then assembled into packages and tested in accordance with the
Company's test procedures. Following assembly, the packaged devices are further
tested and inspected pursuant to the Company's quality assurance program before
shipment to customers. Due to increasing complexity and high pin counts required
by the Company's products, the Company is increasing its use of Ball Grid Array
packaging. This package technology is now widely sourced in the industry, and
the Company presently has three sources of supply qualified and in production.
To ensure the integrity of its foundries' quality assurance procedures, the
Company develops detailed test procedures and specifications for each product
and requires the foundry to use those procedures and specifications before
shipping finished products or wafers. Product returns to date have not been
significant.

     In 1995, the Company entered into two long-term manufacturing capacity
arrangements. The Company entered into an agreement with UMC and Alliance
Semiconductor Corporation to form USC, a separate Taiwanese company, for the
purpose of building and managing a semiconductor manufacturing facility in the
Science-Based Industrial Park in Hsin Chu City, Taiwan. The facility began
production utilizing advanced submicron semiconductor manufacturing processes in
1996. The Company has the right to purchase 31.25% of the output from the
foundry. See Note 4 of Notes to Consolidated Financial Statements for a
description of the sale of a portion of the Company's investment in USC. In
addition, the Company expanded and formalized its relationship with Taiwan
Semiconductor Manufacturing Company ("TSMC") to provide additional capacity over
the 1996 to 2000 timeframe. The agreement with TSMC requires the Company to make
certain annual advance payments to be applied against the following year's
capacity. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources."

     There can be no assurance that the Company will obtain sufficient sources
of supply of product to meet customer demand in the future. Obtaining sufficient
foundry capacity is particularly difficult during periods of high growth, and
may become substantially more difficult if the Company's product requirements
increase significantly. In addition, because the Company must order products and
build inventory substantially in advance of product shipments, there is a risk
that the Company will forecast incorrectly and produce excess or insufficient
inventories of particular products. This inventory risk is heightened because
certain of the Company's key customers place orders with short lead times. See
"Factors That May Affect Our Results -- We Depend On Third Parties For the
Manufacture Of Our Products," "-- The Manufacturers On Which We Depend May
Experience Manufacturing Yield Problems That Could Increase Our Per Unit costs
and Otherwise Jeopardize the Success of Our Products," and "-- Our
Semiconductor, Semiconductor-based or Software Products Could Have Design
Defects".

     PC graphics and multimedia subsystems include, in addition to the Company's
products, a number of other components, which are supplied by third party
manufacturers. Any shortage of such components in the future could adversely
affect the Company's business and operating results. See "Factors That May
Affect Our Results -- We Depend On a Limited Numbers Of Suppliers From Whom We
Do Not Have A Guarantee of Adequate Supplies."

     The Company uses an automated design environment based on advanced
workstations, dedicated product simulators, system simulation with hardware and
software modeling, and the use of a high level design description language in
order to more rapidly define, develop and deliver new and enhanced products. The
Company considers its computer-aided engineering ("CAE") and computer-aided
design ("CAD") capabilities to be important to its future success in all areas
of new product development and intends to continue to enhance its CAE/CAD
systems. Although the Company extensively tests its software and hardware
products prior to their introduction, it is possible that design errors may be
discovered after initial product sampling, resulting in delays in volume
production or recall of products sold. The occurrence of any such errors could
have a material adverse effect on the Company's product introduction schedule
and operating results. See "Factors That May Affect Our Results -- Our
Semiconductor, Semiconductor-based or Software Products Could Have Design
Defects."
                                       12
<PAGE>   13

COMPETITION

     The markets in which the Company competes are extremely competitive and the
Company expects that competition will increase. The Company competes directly
against a large number of suppliers of graphics chips, PC add-in visual and
audio subsystems, Internet appliances, home networking products, and PC
communications products, as well as indirectly against OEMs and semiconductor
suppliers to the extent they manufacture their own add-in subsystems or
incorporate on their personal computer motherboards the functionality provided
by the Company's add-in or add-on products. The Company's markets are expected
to become increasingly competitive as multimedia and connectivity functions
continue to converge, the price of the average PC drops and companies that
previously supplied products providing distinct functions (for example,
companies in the graphics, video, sound, modem and networking markets) emerge as
competitors across broader product categories and in the emerging category of PC
and Internet appliances. See "Factors That May Affect Our Results -- We Operate
In Markets That Are Intensely and Increasingly Competitive."

     The market for the Company's graphics accelerator products, in particular,
is extremely competitive and is characterized by declining selling prices over
the life of a particular product and rapid technological changes. The Company's
principal competitors for graphics accelerators include 3Dfx Interactive Inc.,
ATI Technologies, Inc., Intel Corporation, Matrox Graphics Inc., NVIDIA
Corporation, NeoMagic Corporation and Trident Microsystems, Inc. The Company's
principal competitors in the multimedia market include these same companies as
well as a number of smaller companies which may have greater flexibility to
address specific market needs. Potential competitors in these markets include
both large and emerging domestic and foreign semiconductor companies. In
particular, there are a significant number of established and emerging companies
that have developed, are developing or have announced plans to develop 3D
graphics chips. There can be no assurance that the Company's product offerings
to address the demand for the next generation of 2D/3D accelerators will be
competitive, and if such product offerings are not competitive, the Company's
results of operations in 2000 and future periods could be materially and
adversely affected. The market segment in which S3 participates is highly
competitive. To the extent the Company expands its product line to add products
with additional functionality, it will encounter substantial competition from
established semiconductor companies and may experience competition from
companies designing chips based on different technologies. In addition, certain
of the Company's potential competitors that supply add-in cards and/or
motherboards, such as Intel, may seek to use their card/board business to
leverage the startup of their graphics accelerator business. Certain of the
Company's current and potential competitors have greater technical,
manufacturing, financial and marketing and distribution resources than the
Company.

     The Company believes that its ability to compete successfully depends upon
a number of factors both within and outside of its control, including product
performance, product features, product availability, price, brand strength,
quality, timing of new product introductions by the Company and its competitors,
the emergence of new graphics and PC standards, customer support and industry
and general economic trends. There can be no assurance that the Company will
have the financial resources, technical expertise or marketing, distribution and
support capabilities to compete successfully. The Company's future success will
be highly dependent upon the successful development and introduction of new
products that are responsive to market needs. There can be no assurance that the
Company will be able to successfully develop or market any such products.

LICENSES, PATENTS AND TRADEMARKS

     The Company regularly files United States patent applications for its
technology. To date, the Company has been issued or has acquired a total of 128
United States patents. The Company has also built its patent portfolio
substantially through acquisitions. In 1997, the Company acquired certain
microprocessor patents from Exponential Technology Inc. In January 1998, the
Company entered into a patent purchase and cross-licensing agreement with Cirrus
Logic, Inc. pursuant to which the Company purchased 10 graphics patents and 25
graphics patent applications and cross-licensed other graphics-related
technology. Since the purchase date, 12 of these patent applications have become
issued patents. In September, 1999, the Company acquired an additional 23
unexpired patents and 35 patent applications and a number of additional
cross-licenses through its acquisition of Diamond. The Company attempts to
protect its trade secrets and other proprietary
                                       13
<PAGE>   14

information through agreements with its customers, suppliers, employees and
consultants, and through other security measures. Although the Company intends
to protect its rights vigorously, there can be no assurance that these measures
will be successful or that any issued patents will provide the Company with
adequate protection with respect to the covered products, technology or
processes.

     The Company has applied to the United States Patent and Trademark Office
for registration of a number of trademarks and also holds common law rights in a
number of trademarks. The Company has also applied for trademark registration of
some of its trademarks in certain foreign jurisdictions. There can be no
assurance that the Company will obtain the registrations for which it has
applied. Trademarks referenced in this document are owned by their respective
companies.

     If the Company's use of a registered or unregistered trademark were found
to violate a third party's common law or statutory trademark rights, the
Company's business could be adversely affected. In addition, the laws of certain
countries in which the Company's products are or may be developed, manufactured
or sold, including Hong Kong, Japan and Taiwan, may not protect the Company's
products and intellectual property rights to the same extent as the laws of the
United States.

BACKLOG

     Sales of the Company's products are made pursuant to standard purchase
orders that are cancelable without significant penalties. In addition, purchase
orders are subject to price renegotiations and to changes in quantities of
products and delivery schedules in order to reflect changes in customers'
requirements and manufacturing availability. The Company's business, and to a
large and growing extent that of the entire semiconductor and personal computer
connectivity industries, are characterized by short lead time orders and quick
delivery schedules. In addition, the Company's actual shipments depend on the
manufacturing capacity of the Company's suppliers and the availability of
products from such suppliers. As a result of these factors, the Company does not
believe that backlog at any given time is a meaningful indicator of future
sales.

EMPLOYEES

     At December 31, 1999, the Company employed 1029 individuals, of whom 182
were employed in operations, 356 in research and development, 299 in sales,
marketing and technical support and 192 in administration and other support
functions. Competition for personnel in the semiconductor, software and the PC
industry in general is intense, as is competition for all categories of
personnel in the Silicon Valley where many of the Company's employees are
located. The Company believes that its future success will depend, in part, on
its ability to continue to attract, train, motivate, retain and manage highly
skilled technical, marketing and management personnel.

     None of the Company's employees is represented by a labor union or is
subject to a collective bargaining agreement. The Company believes that its
relations with its employees are good.

ITEM 2. PROPERTIES.

     The Company's principal administrative, sales, marketing, research and
development facilities in Santa Clara, California consists of one building of
approximately 150,000 square feet of space which is leased by the Company
through January 2008. The Company relocated to its Santa Clara facilities in
1997, at which time it leased and occupied both its current space and an
adjacent building also consisting of approximately 150,000 square feet. The
Company developed both buildings in partnership with a real estate developer
during 1995 and 1996. In October 1998, the Company sublet one of the buildings
for the remaining term of the lease. In June 1999, the Company assigned its
entire interest in the partnership to the developer for $7.8 million.

     As of December 31, 1999, the Company leased two of Diamond's former
administrative, sales, marketing, research and development facilities in San
Jose, California consisting of one building of approximately 80,000 square feet
which is leased by the Company through January 2002, and a second building of
approximately 30,000 square feet which is leased by the Company through January
2003. In February 2000, the Company terminated the lease for the 30,000 square
foot building. Additionally, the Company leases an

                                       14
<PAGE>   15

83,000 square foot facility in Milpitas, California, primarily for manufacturing
and logistics, which is leased through January 2001. The Company also leases
research and development and administrative facilities in Vancouver, Washington,
expiring in November 2000; in Starnberg, Germany through 2001 and Winnersh, U.K.
through May 2011 with three, five and 10-year cancellation options. The Company
also leases a 35,800 square foot facility in Albany, Oregon.

     The Company also leases sales or software development offices in Atlanta,
Georgia; Dallas, Houston and Austin, Texas; Chicago, Illinois; Huntsville,
Alabama; Miami and Coral Springs, Florida; Boston, Massachusetts; Red Bank, New
Jersey and Raleigh, North Carolina. The Company leases international sales,
distribution or technical support offices in the metropolitan areas of Ontario,
Canada; Tokyo, Japan; Paris, France; Seoul, South Korea; Sydney, Australia and
Taiwan as well as a warehouse in Singapore in order to provide sales,
distribution and technical support to customers in the United States and Asia.
The Company recently opened a logistics center in Kowloon Bay, Hong Kong to
support offshore turnkey operations and sales in Asia. The facility is owned and
run by a third party service provider on a service contract that expires in
September 2000.

     The Company believes that its existing facilities are adequate to meet its
facilities requirements for the near term.

ITEM 3. LEGAL PROCEEDINGS.

     Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of the Company's common stock at various
times between April 18, 1996 and November 3, 1997. The complaints name as
defendants the Company, certain of its officers and former officers, and certain
directors of the Company, asserting that they violated federal and state
securities laws by misrepresenting and failing to disclose certain information
about the Company's business. In addition, certain stockholders have filed
derivative actions in the state courts of California and Delaware seeking
recovery on behalf of the Company, alleging, among other things, breach of
fiduciary duties by such individual defendants. The plaintiffs in the derivative
action in Delaware have not taken any steps to pursue their case. The derivative
cases in California state court have been consolidated, and plaintiffs have
filed a consolidated amended complaint. The court has entered a stipulated order
in those derivative cases suspending court proceedings and coordinating
discovery in them with discovery in the class actions in California state
courts. On plaintiffs' motion, the federal court has dismissed the federal class
actions without prejudice. The class actions in California state court have been
consolidated, and plaintiffs have filed a consolidated amended complaint. The
Company has answered that complaint. Discovery is pending. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regards to these lawsuits
would not have a material adverse effect on the Company's financial condition or
results of operations.

     The Company has received from the United States Securities and Exchange
Commission (the "SEC") a request for information relating to the Company's
restatement announcement in November 1997. The Company has responded and intends
to continue to respond to such requests.

     The Company is also defending several putative class action lawsuits naming
Diamond which were filed in June and July 1996 and June 1997 in the California
Superior Court for Santa Clara County and the U.S. District Court for the
Northern District of California. Certain former executive officers and directors
of Diamond are also named as defendants. The plaintiffs purport to represent a
class of all persons who purchased Diamond's Common Stock between October 18,
1995 and June 20, 1996 (the "Class Period"). The complaints allege claims under
the federal securities laws and California law. The plaintiffs allege that
Diamond and the other defendants made various material misrepresentations and
omissions during the Class Period. The complaints do not specify the amount of
damages sought. On March 24, 2000, the District Court for the Northern District
of California dismissed the federal action without prejudice. The Company
believes that it has good defenses to the claims alleged in the California
Superior Court lawsuit and will defend itself vigorously against this action. No
trial date has been set for this action. The ultimate outcome of

                                       15
<PAGE>   16

this action cannot be presently determined. Accordingly, no provision for any
liability or loss that may result from adjudication or settlement thereof has
been made in the accompanying consolidated financial statements.

     In addition, the Company has been named, with Diamond, as a defendant in
litigation relating to the merger. On August 4, 1999, two alleged stockholders
of Diamond filed a lawsuit, captioned Strum v. Schroeder, et al., in the
Superior Court of the State of California for the County of Santa Clara.
Plaintiffs, on behalf of themselves and a class of all former Diamond
stockholders similarly situated whom they purportedly represent, challenge the
terms of the merger. The complaint names Diamond, the former directors of
Diamond and the Company as defendants. The complaint alleges generally that
Diamond's directors breached their fiduciary duties to stockholders of Diamond
and seeks rescission and the recovery of unspecified damages, fees and expenses.
The Company believes, as do the individual defendants, that it has meritorious
defenses to the lawsuit and the Company and the individual defendants intend to
defend the suit vigorously.

     On April 23, 1999, 3Dfx Interactive, Inc. ("3Dfx") filed a lawsuit against
Diamond for breach of contract based upon unpaid invoices in the amount of
$3,895,225. On June 4, 1999 the Company filed an answer and cross-complaint
alleging breach of contract, breach of the implied covenant of good faith and
fair dealing, breach of implied warranty and negligence. On February 10, 2000,
this matter was settled. As part of the settlement, the Company paid $1,950,000
to 3Dfx, which was accrued at December 31, 1999.

     Sega initiated a claim for arbitration in Tokyo, Japan against Diamond in
December 1998. The claim arises out of an agreement entered into between Sega
and Diamond in September 1995, in which Sega agreed to provide Diamond with Sega
game software that Diamond would bundle with its 3-D graphics board "The Edge."
Sega claims that Diamond breached the parties' agreement by failing to pay Sega
a contractual minimum royalty fee for the games as set forth in the agreement.
Sega claims as damages $3,800,000 in unpaid royalties and pre-judgment interest.
On May 28, 1999, Diamond responded to Sega's claims by filing an answer in which
it denied the material allegations of Sega's claims. The parties have filed
additional briefs in support of their claims and defenses. An evidentiary
hearing on this action has not yet been scheduled. The Company contests the
material allegations of Sega's claims. In addition, the Company has pleaded that
Sega's failure to provide it with 3-D optimized game software on a timely basis
adversely affected sales of The Edge. The Company claims that these lost sales
and profits therefrom should provide an offset to Sega's claims in the
arbitration, and intends to defend the suit vigorously.

     C3 Sales, Inc. ("C3") filed suit against S3 on October 6, 1999 in the
Harris County (Houston), Texas District Court. The petition sought a judicial
declaration that a Sales Representative Agreement entered into between C3 and S3
on May 19, 1999 was a valid contract that governed the relationship between the
two parties. On November 8, 1999, S3 answered acknowledging that the May 19,
1999 agreement was a contract between the two parties. C3 failed to respond to
informal requests by S3 to dismiss the declaratory relief action on grounds that
no justiciable controversy existed between the parties. On December 3, 1999, S3
filed a summary judgment motion seeking judgment against C3 on the grounds that
no issues of material fact remain to be determined regarding the declaratory
judgment sought by C3. C3 responded by filing an amended petition raising new
matters. Specifically, C3's new claims allege that the Sales Representative
Agreement applies to Diamond products, and that certain commissions due under
the agreement have not been paid. S3 intends to defend this action vigorously.

     On January 6, 2000, PhoneTel Communications, Inc. ("PhoneTel") filed a
complaint for patent infringement against a group of defendants,including
Diamond, in the United States District Court for the Northern District of Texas.
PhoneTel generally alleges that Diamond and the other defendants are infringing
its two patents by making, using, selling, offering to sell and/or importing
digital synthesizers, personal computers, sound cards, or console game systems.
PhoneTel does not specify which Diamond products allegedly infringe its patents.
S3 filed Diamond's answer to the complaint on March 28, 2000. S3 believes that
the complaint is without merit and will vigorously defend itself against the
allegations made in the complaint.

     The semiconductor and personal computing multimedia and connectivity
industries are characterized by frequent litigation regarding patent and other
intellectual property rights. The Company is party to various claims of this
nature. Although the ultimate outcome of these matters is not presently
determinable,

                                       16
<PAGE>   17

management believes that the resolution of all such pending matters will not
have a material adverse effect on the Company's financial position or results of
operations.

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

     Not applicable.

EXECUTIVE OFFICERS OF THE REGISTRANT

     The executive officers of the Company and their ages as of March 31, 2000
are as follows:

<TABLE>
<CAPTION>
                 NAME                   AGE
                 ----                   ---
<S>                                     <C>    <C>
Kenneth F. Potashner..................  42     President and Chief Executive Officer,
                                               Chairman of the Board
Walter D. Amaral......................  48     Senior Vice President Finance, Chief
                                               Financial Officer
Paul G. Franklin......................  56     President, Multimedia Division
Rick Bergman..........................  36     Vice President & General Manager,
                                               Mobile/Integrated Products
Andy Wolfe............................  37     Chief Technical Officer
</TABLE>

     Mr. Potashner has served as Chairman of the Board, Chief Executive Officer
and President of the Company since November 1998. Mr. Potashner has been a
director of Maxwell Technologies, Inc. since April 1996 and became Chairman of
the Board of Maxwell Technologies in April 1997. From the time he joined Maxwell
Technologies in April 1996 until October 1998, Mr. Potashner served as the
President, Chief Executive Officer and Chief Operating Officer. From 1994 to
April of 1996, he served as Executive Vice President, Operations for Conner
Peripherals, Inc From 1991 through 1994, Mr. Potashner was Vice President,
Product Engineering, for Quantum Corporation. Mr. Potashner is also a member of
the Board of Directors of Newport Corporation.

     Mr. Amaral, Senior Vice President and Chief Financial Officer, joined the
Company in August 1997. From April 1995 to August 1997, Mr. Amaral served as
Senior Vice President, Finance and Chief Financial Officer of NetManage
Incorporated, a supplier of networking software. From April 1992 to April 1995,
Mr. Amaral was Senior Vice President and Chief Financial Officer of Maxtor
Corporation, a disk drive manufacturer. From 1977 to 1992, Mr. Amaral held
numerous positions at Intel Corporation, where he was most recently Corporate
Controller. Mr. Amaral holds a B.S. in Business with a concentration in
Accounting from San Jose State University.

     Mr. Franklin, President of the Multimedia Division, joined the Company in
September 1992. From March 1991 to September 1992 he was a consultant to the
Company. Mr. Franklin was a consultant for a number of semiconductor companies
from January 1990 through March 1991. From March 1986 to December 1989, Mr.
Franklin was Vice President of Operations of Actel Corporation, a supplier of
field programmable gate arrays. Prior to 1986 Mr. Franklin held various
management positions at Monolithic Memories Inc., a supplier of semiconductor
memories and programmable logic.

     Mr. Bergman, Vice President and General Manager, Mobile & Integrated
Products, joined S3 in June 1997. Mr. Bergman was Vice President of Marketing at
Exponential Technology from February 1996 through June 1997. From June 1986 to
February 1996 he served in a variety marketing positions at Texas Instruments
where he was most recently marketing manager.

     Mr. Wolfe joined the Company in June 1997 and became Chief Technical
Officer in May 1999. From September 1991 to 1997 he was an Assistant Professor
at Princeton University where he taught Electrical Engineering. He holds a Ph.D.
in Computer Engineering from Carnegie Mellon University.

                                       17
<PAGE>   18

                                    PART II

ITEM 5.MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

     The Company's common stock is traded on the Nasdaq National Market under
the symbol "SIII". See "Selected Quarterly Consolidated Financial Data
(Unaudited)" in "Item 8. -- Financial Statements and Supplementary Data" for the
range of high and low closing sales prices for the common stock on the Nasdaq
National Market, as reported by Nasdaq.

     On September 20, 1999, the Company issued and sold to VIA 1,350,000 shares
of Common Stock for an aggregate purchase price of $14,065,650. On February 20,
2000, the Company issued and sold an additional 10,775,000 shares of Common
Stock to VIA at an aggregate purchase price of $145,462,500. In each case, the
Company relied upon the exemption provided by Section 4(2) of the Securities Act
of 1933, as amended (the "Act"), because neither transaction involved a public
offering and VIA represented that it was an "accredited investor" as such term
is defined in rules of the SEC promulgated under the Act.

     In December 1998, the Company entered into an agreement pursuant to which
it agreed to issue to Intel Corporation a warrant to purchase 1,000,000 shares
of the Company's Common Stock at an exercise price of $9.00 per share. The
purchase price for the warrant was $990,000. In February 2000, Intel exercised
its warrant and paid the exercise price using some of the shares of the
Company's Common Stock it would have otherwise received upon exercise, acquiring
429,477 shares of Common Stock. The Company relied upon the exemption provided
by Section 4(2) of the Securities Act of 1933, as amended (the "Act"), because
the transaction did not involve a public offering and Intel represented that it
was an "accredited investor" as such term is defined in rules of the SEC
promulgated under the Act.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.

<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,
                                            ------------------------------------------------------
                                             1999(1)      1998        1997       1996       1995
                                            ---------   ---------   --------   --------   --------
                                             (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND RATIOS)
<S>                                         <C>         <C>         <C>        <C>        <C>
STATEMENT OF OPERATIONS DATA
Net sales.................................  $ 352,583   $ 224,639   $436,359   $439,243   $316,309
Gross margin (loss).......................     45,422      (2,072)   135,174    168,876    126,542
Research and development expenses.........     73,896      78,566     78,612     63,382     42,080
Selling, marketing and administrative
  expenses................................     52,832      41,926     55,879     48,800     33,510
Other operating expense(2)................      6,700      41,335     17,180         --         --
Amortization of goodwill and intangibles
  related to the Diamond acquisition......     12,156          --         --         --         --
Income (loss) from operations.............   (100,162)   (163,899)   (16,497)    56,694     50,952
Net income (loss).........................    (30,780)  $(113,204)  $  8,878   $ 41,588   $ 35,374
Per share amounts:
  Basic...................................  $   (0.52)  $   (2.22)  $   0.18   $   0.88   $   0.83
  Diluted(3)..............................  $   (0.52)  $   (2.22)  $   0.17   $   0.81   $   0.75
Shares used in computing per share
  amounts:
  Basic...................................     59,244      51,078     49,519     47,460     42,691
  Diluted(3)..............................     59,244      51,078     51,740     52,451     47,013
Ratio of earnings to fixed charges(4).....         --          --         --      23.68x        --
BALANCE SHEET DATA
Cash and equivalents......................  $  45,825   $  31,022   $ 90,484   $ 94,616   $ 69,289
Short-term investments....................     58,918      88,553     27,186     62,768     24,630
Working capital...........................    100,149     152,244    209,993    225,550    144,620
Total assets..............................    722,647     325,801    492,854    485,172    321,643
Other long-term liabilities...............     12,010      13,837     27,070     20,852     24,761
Convertible subordinated notes............    103,500     103,500    103,500    103,500         --
Stockholders' equity......................  $ 382,633   $ 163,530   $270,840   $260,321   $205,864
</TABLE>

                                       18
<PAGE>   19

---------------
(1) On September 24, 1999, the Company completed the acquisition of all of the
    outstanding common stock of Diamond Multimedia Systems, Inc. ("Diamond").
    Diamond designs, develops, manufactures and markets multimedia and
    connectivity products for personal computers. The transaction was accounted
    for as a purchase and, accordingly, the results of operations of Diamond and
    the estimated fair value of assets acquired and liabilities assumed are
    included in the Company's consolidated financial statements as of September
    24, 1999, the effective date of the purchase, through the end of the fiscal
    year. See Note 2 of Notes to Consolidated Financial Statements.

(2) Other operating expense for 1999 includes a write-off of acquired
    technologies of $6.7 million. Other operating expense for 1998 includes a
    write-off of acquired technologies of $8.0 million, a charge for impairment
    of long-lived assets of $27.2 million and a restructuring charge of $6.1
    million. Other operating expense for 1997 includes a charge for impairment
    of long-lived assets of $17.2 million.

(3) Diluted earnings per share includes the effect of incremental shares
    issuable upon the conversion of the convertible subordinated notes, the
    dilutive effect of outstanding options and an adjustment to net income for
    the interest expense (net of income taxes) related to the notes unless the
    impact of such conversion is anti-dilutive. The effect of the conversion was
    anti-dilutive in 1999 and 1998.

(4) For purposes of calculating the ratio of earnings to fixed charges, (i)
    earnings consist of consolidated income before income taxes, equity in net
    income of joint venture and minority interest plus fixed charges and (ii)
    fixed charges consist of interest expense incurred, amortization of debt
    issuance costs and the portion of rental expense under operating leases
    deemed by the Company to be representative of the interest factor. Earnings
    were insufficient to cover fixed charges in the years ended December 31,
    1999, 1998 and 1997, as evidenced by the less than 1:1 coverage ratio.
    Additional earnings of $78.6 million, $142.6 million and $18.6 million were
    necessary to provide a 1:1 coverage ratio for December 31, 1999, 1998 and
    1997, respectively. The Company had no fixed charges in 1995.

                                       19
<PAGE>   20

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

     When used in this discussion, the words "expects," "anticipates,"
"estimates" and similar expressions are intended to identify forward-looking
statements. Such statements, which include statements concerning the timing of
availability and functionality of products under development, product mix,
trends in average selling prices, trends in the PC market, the percentage of
export sales and sales to strategic customers and the availability and cost of
products from the Company's suppliers, are subject to risks and uncertainties,
including those set forth below under "Factors That May Affect Our Results,"
that could cause actual results to differ materially from those projected. These
forward-looking statements speak only as of the date hereof. The Company
expressly disclaims any obligation or undertaking to release publicly any
updates or revisions to any forward-looking statements contained herein to
reflect any change in the Company's expectations with regard thereto or any
change in events, conditions or circumstances on which any statement is based.

     On September 24, 1999, the Company completed the acquisition of all of the
outstanding common stock of Diamond. Diamond designs, develops, manufactures and
markets multimedia and connectivity products for personal computers. The
transaction was accounted for as a purchase and, accordingly, the results of
operations of Diamond and the estimated fair value of assets acquired and
liabilities assumed are included in the Company's consolidated financial
statements as of September 24, 1999, the effective date of the purchase, through
the end of the fiscal year. See Note 2 of Notes to Consolidated Financial
Statements.

RESULTS OF OPERATIONS

     The following table sets forth for the years indicated certain financial
data as a percentage of net sales:

<TABLE>
<CAPTION>
                                                               YEARS ENDED DECEMBER 31,
                                                              --------------------------
                                                               1999      1998      1997
                                                              ------    ------    ------
<S>                                                           <C>       <C>       <C>
Net sales...................................................  100.0%    100.0%    100.0%
Cost of sales...............................................   87.1     100.9      69.0
                                                              -----     -----     -----
Gross margin (loss).........................................   12.9      (0.9)     31.0
Operating expenses:
  Research and development..................................   21.0      35.0      18.0
  Selling, marketing and administrative.....................   15.0      18.7      12.8
  Other operating expense...................................    1.9      18.4       4.0
  Amortization of goodwill and intangibles related to the
     Diamond acquisition....................................    3.4        --        --
                                                              -----     -----     -----
          Total operating expenses..........................   41.3      72.1      34.8
                                                              -----     -----     -----
Loss from operations........................................  (28.4)    (73.0)     (3.8)
  Gain on sale of joint venture.............................    6.4      11.8        --
  Other income (expense), net...............................   (0.3)     (2.3)     (0.5)
                                                              -----     -----     -----
Loss before income taxes and equity in income of
  manufacturing joint venture and minority interest in
  Rioport...................................................  (22.3)    (63.5)     (4.3)
Benefit for income taxes....................................  (13.6)     (5.3)     (2.0)
                                                              -----     -----     -----
Loss before equity in income of manufacturing joint venture
  and minority interest in Rioport..........................   (8.7)    (58.2)     (2.3)
Equity in income from manufacturing joint venture...........    1.3       7.8       4.3
Minority interest in Rioport................................   (1.3)       --        --
                                                              -----     -----     -----
Net income (loss)...........................................   (8.7)%   (50.4)%     2.0%
                                                              =====     =====     =====
</TABLE>

NET SALES

     The Company's net sales to date have been generated from the sale of its
graphics and multimedia accelerators, connectivity products for the home and
products for acquiring, managing and experiencing music and spoken audio
programming from the Internet. The Company's products are used in, and its
business is dependent on, the personal computer industry and growth of the
Internet with sales primarily in the U.S., Asia and Europe. Net sales were
$352.6 million in 1999, an increase of 57% from $224.6 million in 1998. Net
sales

                                       20
<PAGE>   21

for 1999 consisted primarily of the Company's 2D, 3D Mobile, video accelerators,
graphics accelerators, modem and home networking products.

     Sales increased from 1998 to 1999 because of the acquisition of Diamond
Multimedia and the inclusion of the revenue of its products in the Company's
financial results of operations from September 24, 1999 through December 31,
1999. In addition, the Company introduced products into new markets such as
add-in graphics cards and replaced older generation products with Savage4
products in the desktop and laptop PC markets, resulting in an increased volume
of product shipments and higher average selling prices.

     Sales decreased from 1997 to 1998 because of declining unit average selling
prices due to aggressive pricing from certain of the Company's competitors, the
sale of older generation products at lower prices, a significant decrease in
unit volumes and the lack of products available at the high end of the market.

     The Company expects that the percentage of its net sales represented by any
one product or type of product may change significantly from period to period as
new products are introduced and existing products reach the end of their product
life cycles. Due to competitive price pressures, the Company's products
experience declining unit average selling prices over time, which at times can
be substantial.

     Export sales accounted for 70%, 89% and 70% of net sales in 1999, 1998 and
1997 respectively. Approximately 35% of export sales in 1999 were to affiliates
of United States customers. The Company expects that export sales will continue
to represent a significant portion of net sales, although there can be no
assurances that export sales as a percentage of net sales will remain at current
levels. All sales transactions are denominated in U.S. dollars.

     Three customers accounted for 19%, 10% and 9% of net sales in 1999. Three
customers accounted for 39%, 14% and 13% of net sales in 1998. Three customers
accounted for 20%, 13% and 12% of net sales in 1997. The Company expects a
significant portion of its future sales to remain concentrated within a limited
number of strategic customers. Sales to any particular customer may fluctuate
significantly from quarter to quarter. Sales to original equipment manufacturers
("OEMs") were significant to the Company's net sales in 1999. Sales to the three
largest OEM customers accounted for 36% of net revenue in 1999.

GROSS MARGIN

     The Company had a gross margin percentage of 13% in 1999, a negative gross
margin percentage of 1% in 1998 and a gross margin percentage of 31% in 1997.
The gross margin in 1999 was favorably impacted by an increase in average
selling prices and an increase in sales of products with higher margins,
partially offset by charges for excess and obsolete inventory and lower of cost
or market reserves compared to 1998.

     The negative gross margin in 1998 was a result of decreases in overall
average selling prices of the ViRGE and Trio family of accelerators. Also
affecting the negative gross margin were charges for excess and obsolete
inventory, lower of cost or market reserves established for the Company's 2D and
3D products, a $4.0 million charge for underutilized prepaid production capacity
and yield losses.

     In the future, the Company's gross margin percentages may be affected by
increased competition and related decreases in the unit average selling prices
(particularly with respect to older generation products), timing of volume
shipments of new products, the availability and cost of products from the
Company's suppliers, changes in the mix of products sold, the extent to which
the Company forfeits or utilizes its production capacity rights with TSMC, the
extent to which the Company will incur additional licensing fees and shifts in
sales mix between add-in card and motherboard manufacturers and systems OEMs.

RESEARCH AND DEVELOPMENT EXPENSES

     The Company has made and intends to continue to make significant
investments in research and development to remain competitive by developing new
and enhanced products. Research and development expenses were $73.9 million in
1999, $78.6 million in 1998 and $78.6 million in 1997. Research and development
expenses decreased by 6% from 1998 to 1999 as a result of an increased focus on
core technology and products. Concentration of research and development efforts
resulted in lower headcount and related

                                       21
<PAGE>   22

costs. Write-offs of idle and excess capital equipment in 1998 resulted in lower
depreciation and maintenance charges in 1999.

     Research and development expenses for 1998 reflect approximately $3.0
million in charges for the Company's discontinued audio and communications
product lines and the write-offs of idle, excess and obsolete capital equipment
associated with research and development projects terminated during the year.
Excluding these charges, research and development expenses decreased from 1997
to 1998 as a result of reductions in engineering staff due to discontinuing
certain product lines during the year.

SELLING, MARKETING AND ADMINISTRATIVE EXPENSES

     Selling, marketing and administrative expenses were $52.8 million in 1999,
$41.9 million in 1998 and $55.9 million in 1997. The 26% increase in selling,
marketing and administrative expenses from 1998 to 1999 is due primarily to the
acquisition of Diamond and additional sales, marketing and administrative
expenses required to support the increase in revenue from 1998 to 1999. As a
percentage of revenue, selling, marketing and administrative expenses decreased
from 19% in 1998 to 15% in 1999.

     Selling, marketing and administrative headcount decreased by 33% and
commission expense decreased by approximately $7.0 million from 1997 to 1998,
accounting for the 25% decrease in sales, marketing and administrative expense
from 1997 to 1998.

OTHER OPERATING EXPENSE

     Other operating expense in 1999 includes a write-off of acquired
technologies of $6.7 million related to the purchase of Diamond on September 24,
1999. This was determined through valuation techniques generally used by
appraisers in the high-technology industry and was immediately expensed in the
period of acquisition because technological feasibility had not been established
and no alternative use had been identified. The charge is discussed in more
detail in Note 2 to the Consolidated Financial Statements contained herein.

     Other operating expense in 1998 includes a write-off of acquired
technologies of $8.0 million, a charge for impairment of long-lived assets of
$27.2 million and a restructuring charge of $6.1 million.

     In January 1998, the Company entered into a $40.0 million technology
exchange with Cirrus Logic, Inc. to obtain graphic functionality technologies.
As a result of the exchange, the Company acquired the technology covered by 10
graphic patents and 25 graphic patent applications, as well as cross-licensed
Cirrus Logic's remaining patents. Under the terms of the cross-licensing
provisions, the Company and Cirrus Logic have a perpetual license to each
other's graphic patents and additional licenses with respect to the other
party's patents for agreed upon periods of time. The Company wrote-off $8.0
million of the value of the acquired technologies that were not realizable based
on estimated cash flows from the sale of products currently sold by the Company.
The remaining $32.0 million intangible asset was being amortized to cost of
sales based on the estimated lives of the currently utilized core technologies,
which was generally five years.

     However, during the fourth quarter of 1998, management reevaluated the
carrying value of the intangible assets recorded in connection with the
technology exchange with Cirrus Logic, Inc., and related to the patents obtained
from Brooktree, as well as other long-lived assets, including property and
equipment. This revaluation was necessitated by management's determination based
on recent results of operations that the future expected sales and cash flows
for the Company's operations would be substantially lower than had been
previously expected by management. Expected undiscounted future cash flows were
not sufficient to recover the carrying value of such assets. Accordingly, an
impairment loss of $27.2 million, representing the excess of the carrying value
over the estimated fair value of the assets, was recognized for write-downs of a
substantial portion of the intangible assets. The estimated fair value of the
intangible assets was based on management's best estimate of the patent
portfolio based on a comparison to other graphics technology portfolios in the
marketplace. The Company determined that no write-down of property and equipment
was necessary at December 31, 1998 based on its estimate of the fair value of
such assets. Due to technological changes in the graphics marketplace, the
Company concluded it should accelerate its amortization of its remaining patent

                                       22
<PAGE>   23

portfolio, of approximately $4.0 million, over the current estimated life of the
currently utilized core technologies, which is two years.

     In July 1998, the Company implemented a restructuring plan in order to
align resources with a new business model and to lower the Company's overall
cost structure. In connection with the restructuring, the Company reduced its
headcount and consolidated facilities. Severance and related benefits
represented the reduction of approximately 70 employees. All severance packages
were paid by the end of the second quarter of 1999. The number of temporary
employees and contractors used by the Company was also reduced. The
restructuring expense included the write-off and write-down in carrying value of
equipment, which consists primarily of workstations, personal computers and
furniture, that will no longer be utilized in the Company's operations. These
assets were written down to their estimated fair value less cost to sell.
Facility closure expenses were incurred as a result of the Company vacating one
of two leased buildings at the Company's headquarters facility and include
leasehold improvements, furniture, fixtures and network costs. The Company
completed its move in the second quarter of 1999.

     During the fourth quarter of 1997, the Company wrote-off approximately
$17.2 million of intangible assets including certain licenses, patents and other
technology, as a result of management's decision to focus attention on the core
graphics business. As a result of this decision, no future cash flows were
expected related to these assets.

GAIN ON SALE OF MANUFACTURING JOINT VENTURE

     On December 31, 1997, the Company entered into an agreement with UMC to
sell to UMC 80 million shares of stock of USC for a purchase price of 2.4
billion New Taiwan dollars. The Company received the purchase price
(approximately $68.0 million in cash) in January 1998 upon closing. The gain on
the sale of stock in USC recorded in 1998 was $26.6 million.

     In June 1999, the Company amended its agreements with UMC. Under the terms
of the amended agreements, UMC has agreed to pay the Company, subject to certain
conditions, 1.4 billion New Taiwan dollars (approximately $43.3 million in cash)
and the Company has agreed to release UMC from contingencies associated with the
sale of 80 million shares of stock of USC in January 1998 and to grant a license
to patents covering multimedia products and integrated circuit manufacturing
technology for use in products manufactured by UMC. Payments are being received
over five fiscal quarters beginning in the quarter ended June 30, 1999. In 1999,
the gain on the sale of stock in USC was $22.4 million.

OTHER INCOME (EXPENSE), NET

     Other expense, net decreased in 1999 to $0.9 million from $5.3 million in
1998. The decrease was due primarily to non-recurring write-offs of certain
equity investments and royalty expenses that occurred in 1998 and an increase in
sublease income in 1999, partially offset by an increase in interest expense and
a decrease in interest income. Other expense, net, increased in 1998 to $5.3
million from $2.1 million in 1997. The increase was primarily the result of
write-offs of certain equity investments in technology companies.

INCOME TAXES

     The Company's effective tax rate for 1999 was a benefit of 61%, compared to
the benefit tax rates of 8% and 46% for 1998 and 1997, respectively. The
effective tax rate for 1999 reflects the expected benefits of current year and
prior year net operating loss and tax credit carryovers. The effective tax rate
for 1998 reflects the expected benefits of current year loss carrybacks net of
the establishment of a valuation allowance in 1998 against the beginning of the
year balance of net deferred tax assets. The 1997 tax rate reflects the full
benefit of operating losses at statutory rates plus the benefit of tax credits
generated.

LIQUIDITY AND CAPITAL RESOURCES

     Cash used for operating activities was $67.5 million in 1999 and consisted
primarily of the Company's operating loss of $30.8 million, an increase in
deferred income taxes of $61.7 million and an increase in

                                       23
<PAGE>   24

inventories of $34.7 million. These were partially offset by non cash charges
including depreciation, amortization and write-off of acquired technologies and
by decreases in accounts receivable and prepaid expenses and other and increases
in accounts payable, accrued liabilities and income taxes payable.

     Cash used for operating activities was $9.3 million in 1998, as compared to
$18.8 million in 1997. The Company's operating loss of $113.2 million was offset
by non cash charges including deferred income taxes, depreciation, amortization,
loss on the disposal of equipment, write-off of prepaid production capacity, the
utilization of production capacity rights, write-off of impaired assets and the
write-off of acquired technologies. The Company sold a portion of its interest
in USC during 1998 and recognized a gain of $26.6 million. In addition the
Company recognized $17.5 million in income from their 15.75% equity investment
in USC. The non cash charges were offset by decreases in accounts receivable and
inventories of $36.8 million and $60.5 million, respectively. Accounts
receivable decreased as a result of lower net sales by the Company while
inventories decreased as the result of lower production volumes and charges
taken during 1998 for excess and obsolete inventory, lower of cost or market
reserves and yield losses. Accounts payable decreased as a direct result of
lower inventory purchases.

     Investing activities provided cash of $38.7 million in 1999 and consisted
primarily of maturities of short-term investments of $148.9 million, cash
received from UMC related to the sale of shares of $22.4 million and cash
received from the sale of investment in real estate partnership of $7.8 million,
offset by purchases of short-term investments of $107.7 million, the acquisition
of Diamond, net of cash acquired of $22.5 million and net purchases of property
and equipment of $6.6 million. Investing activities used cash of $38.9 million
in 1998 and consisted primarily of $40.0 million used in a patent purchase and
cross-licensing agreement with Cirrus Logic, Inc., $5.9 million of property and
equipment purchases, $125.4 million of short term investment purchases, offset
by $66.7 million of maturities of short-term investments and $68.0 million from
the sale of a portion of the Company's joint venture in USC. Investing
activities used cash of $6.4 million in 1997 and consisted primarily of $30.3
million of property and equipment purchases, $16.4 million of short-term
investment purchases, offset by $55.7 million of maturities of short-term
investments. The Company expects capital requirements for 2000 to be consistent
with those for 1999.

     Financing activities provided cash of $38.0 million in 1999 and consisted
of sales of common stock, net, including $34.4 million received from the sale of
stock to three foreign investors, and the sale of a warrant to Intel, offset
partially by repayments of notes payable. Financing activities used cash of
$11.3 million in 1998 and consisted primarily of repayments of notes payable and
equipment financing, offset partially by sales of common stock, net. Financing
activities provided cash of $21.1 million in 1997 and consisted primarily of the
sales of common stock pursuant to employee stock option and stock purchase plans
and $10.0 million in borrowings on notes payable. This $10.0 million source of
funds in 1997 was repaid in 1998.

     In 1995, the Company entered into two long-term manufacturing capacity
arrangements. The Company entered into an agreement with UMC and Alliance
Semiconductor Corporation to form USC, a separate Taiwanese company, for the
purpose of building and managing a semiconductor manufacturing facility in the
Science Based Industrial Park in Hsin Chu City, Taiwan, Republic of China. The
Company invested $53.0 million in 1996 and $36.4 million in 1995 for its 23.75%
equity interest. In January 1998, the Company reduced its equity interest to
15.75% through the sale of a portion of its USC shares, and received
approximately $68 million in cash. The facility commenced production utilizing
advanced submicron semiconductor manufacturing processes in late 1996. In
January 2000, the Company's USC shares were exchanged for 252 million UMC
shares. The Company has the right to purchase up to 31.25% of the output from
the foundry. In addition, the Company expanded and formalized its relationship
with TSMC to provide additional capacity over the 1996 to 2000 timeframe. During
the second quarter of 1999, the Company and TSMC agreed to extend the capacity
term of the agreement two years to 2002. The agreement with TSMC requires the
Company to make certain annual advance payments to be applied against the
following year's capacity. The Company has signed promissory notes to secure
these payments, which total $9.6 million as of December 31, 1999 with the final
payment due in 2001.

     Working capital at December 31, 1999 and December 31, 1998 was $100.1
million and $152.2 million, respectively. At December 31, 1999, the Company's
principal sources of liquidity included cash and

                                       24
<PAGE>   25

equivalents of $45.8 million and $58.9 million in short-term investments. At
December 31, 1998, the Company's principal sources of liquidity included cash
and equivalents of $31.0 million and $88.6 million in short-term investments. At
December 31, 1999, the Company had short-term lines of credit and bank credit
facilities totaling $55.7 million, of which approximately $14.0 million was
unused and available. As of December 31, 1999, the Company was in default with
its loan covenants regarding liquidity. The Company obtained a waiver for this
violation. The Company believes that its available funds will satisfy the
Company's projected working capital and capital expenditure requirements for at
least the next 12 months, other than expenditures for future potential
manufacturing agreements.

     In order to obtain an adequate supply of wafers, especially wafers
manufactured using advanced process technologies, the Company has entered into
and will continue to consider various possible transactions, including the use
of "take or pay" contracts that commit the Company to purchase specified
quantities of wafers over extended periods, equity investments in, advances or
issuances of equity securities to wafer manufacturing companies in exchange for
guaranteed production or the formation of joint ventures to own and operate or
construct wafer fabrication facilities. Manufacturing arrangements such as these
may require substantial capital investments, which may require the Company to
seek additional equity or debt financing. There can be no assurance that such
additional financing, if required, will be available when needed or, if
available, will be on satisfactory terms. In addition, the Company may, from
time to time, as business conditions warrant, invest in or acquire businesses,
technology or products that complement the business of the Company.

     The Company is currently a party to certain legal proceedings. Litigation
could result in substantial expense to the Company. See "Item 3. Legal
Proceedings."

YEAR 2000 COMPLIANCE

     In prior years, the Company discussed in detail the nature and progress of
its plans for Year 2000 compliance. In late 1999, the Company completed the
assessment, remediation, testing and contingency plans for its computer systems
to address the Year 2000 issue. The Company believes that the costs for
remediation, testing and implementation expensed in 1999 did not exceed $0.5
million. The Company believes that its products do not require remediation to be
Year 2000 compliant. Accordingly, the Company believes that its products will
not expose it to material Year 2000 related liability.

     The Company is not aware of any material problems resulting from Year 2000
issues, either with its products, its internal systems, or the products or
services of third parties. The Company will continue to monitor its critical
computer applications and those of its suppliers and vendors throughout the year
2000 to ensure that any latent Year 2000 issues that may arise are addressed
promptly.

FACTORS THAT MAY AFFECT OUR RESULTS

THE EXPECTED BENEFITS OF OUR MERGER WITH DIAMOND MULTIMEDIA MAY NOT BE REALIZED.
IF THAT HAPPENS, OUR OPERATING RESULTS MAY SUFFER.

     We merged with Diamond Multimedia in September 1999 expecting that the
merger between the two companies would result in benefits to us including faster
time to market with new products and increased cost efficiencies.

     We will not realize the full benefits of the merger if we do not
effectively integrate Diamond's technologies, operations and personnel with ours
in a timely and efficient manner. The difficulties, costs and delays involved in
integrating Diamond, which may be substantial, may include:

     - Distracting management and other key personnel, particularly senior
       engineers involved in product development and product definition, from
       focusing on our business;

     - Perceived and potential adverse changes in business focus or product
       offerings;

     - Potential incompatibility of business cultures;

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<PAGE>   26

     - Costs and delays in implementing common systems and procedures,
       particularly in integrating different information systems; and

     - Inability to retain and integrate key management, technical, sales and
       customer support personnel.

     If we do not timely and efficiently integrate our technologies, operations
and personnel, our operating results may suffer.

AS A RESULT OF THE MERGER, WE EXPECT THAT SOME OF OUR CUSTOMERS MAY NOT DO
BUSINESS WITH US, WHICH COULD CAUSE A DECLINE IN OUR SALES.

     The consummation of the merger is expected to cause some of our add-in card
and motherboard customers to end or curtail their relationships with us. The
loss of these customers could cause a decline our sales unless new sales
resulting from the integration of Diamond have an offsetting effect. For
example, Creative Technology Ltd., a competitor of Diamond and previously an S3
customer, has discontinued its relationship with us. Additional customers may
discontinue their relationships with us in the future. This may occur because
our products comprise of both graphics chips and graphics boards. Thus, as a
result of the merger, we are competing with those of our current customers,
which are graphics board manufacturers. As a result, we expect that sales to
some of our existing customers will be reduced significantly from prior levels
and that these customers will no longer continue to be significant customers.
Unless we are able to offset the loss of these sales with new customers or sales
of alternative products, our revenues may decline.

WE ARE DEPENDENT ON A LIMITED SOURCE OF GRAPHICS CHIPS AND GRAPHICS BOARDS
BECAUSE S3 AND DIAMOND ARE EACH SUPPLIERS TO EACH OTHER, RESULTING IN HEIGHTENED
RISKS BECAUSE ONE COMPANY'S SUPPLIERS MAY NOT MEET THE OTHER COMPANY'S
REQUIREMENTS.

     As a result of the merger with Diamond, we have become significantly
dependent on our graphics chip design and development capabilities and
significantly dependent on Diamond's graphics board design, manufacturing and
marketing capabilities. This occurred because we are now more restricted in our
ability to select and use products produced by our competitors prior to the
merger. If either our graphics chips or Diamond's graphics boards fail to meet
the requirements of the market and our customers, our relationship with those
customers could be hurt, negatively affecting our financial performance. In
addition, we will be highly dependent on our ability to provide graphics chips
on a timely basis meeting the rigid scheduling and product specification
requirements of OEMs. If our graphics chips are not competitive or not provided
on a timely basis, we will most likely not be able to readily obtain suitable
alternative graphics chips, which would result in our loss of revenue and
customers.

OUR ANNUAL AND QUARTERLY OPERATING RESULTS ARE SUBJECT TO FLUCTUATIONS CAUSED BY
MANY FACTORS, WHICH COULD RESULT IN FAILING TO ACHIEVE OUR REVENUE OR
PROFITABILITY EXPECTATIONS RESULTING IN A DROP IN THE PRICE OF OUR COMMON STOCK.

     Our annual and quarterly results of operations have varied significantly in
the past and are likely to continue to vary in the future due to a number of
factors, many of which are beyond our control. Any one or more of the factors
listed below or other factors could cause us to fail to achieve our revenue or
profitability expectations. The failure to meet market expectations could cause
a drop in our stock price. These factors include:

     - the industry in which we compete is always changing with the constant
       introduction of new technologies, products and methods of doing business;

     - our ability to develop, introduce and market successfully new or enhanced
       products;

     - our ability to introduce and market products in accordance with
       specialized customer design requirements and short design cycles;

     - changes in the relative volume of sales of various products with
       sometimes significantly different margins;

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<PAGE>   27

     - changes in demand for our products and our customers' products;

     - rapid changes in electronic commerce on which we or our customers may not
       capitalize or which erode our traditional business base;

     - frequent gains or losses of significant customers or strategic
       relationships;

     - unpredictable volume and timing of customer orders;

     - the availability, pricing and timeliness of delivery of components for
       our products;

     - the availability of wafer capacity using advanced process technologies;

     - the timing of new product announcements or introductions by us or by our
       competitors;

     - product obsolescence and the management of product transitions;

     - production delays;

     - decreases in the average selling prices of products;

     - seasonal fluctuations in sales; and

     - general economic conditions, including economic conditions in Asia and
       Europe in particular, that could affect the timing of customer orders and
       capital spending and result in order cancellations or rescheduling.

     Some or all of these factors could adversely affect demand for our products
and our future operating results.

     Most of our operating expenses are relatively fixed in the short term. We
may be unable to rapidly adjust spending to compensate for any unexpected sales
shortfall, which could harm our quarterly operating results. Because the lead
times of firm orders are typically short in the graphics industry, we do not
have the ability to predict future operating results with any certainty.
Therefore, sudden changes that are outside our control, such as general economic
conditions, the actions or inaction of competitors, customers, third-party
vendors of operating systems software, and independent software application
vendors, may materially and adversely affect our performance.

     We generally ship more products in the third month of each quarter than in
either of the first two months of the quarter, with levels of shipment in the
third month higher towards the end of the month. This pattern, which is common
in the semiconductor and multimedia communication industries, is likely to
continue and makes future quarterly operating results less predictable.

     As a result of the above factors, you should not rely on period-to-period
comparisons of results of operations as an indication of future performance.

WE EXPERIENCED A NET LOSS FOR THE LAST TWO YEARS AND WE MAY CONTINUE TO
EXPERIENCE NET LOSSES IN THE FUTURE.

     We had a net loss of $30.8 million for 1999 and a net loss of $113.2
million for 1998. These results occurred primarily because we did not offer
competitive products in the high end of the graphics and multimedia accelerator
market. In addition, revenues from graphics accelerators declined in part due to
continued reductions in demand for entertainment specific products. In
particular, Diamond is no longer building and selling high performance 3D-only
products. In addition, demand and pricing for graphics accelerators that combine
2D and 3D display and are targeted specifically for game enthusiasts declined.
Further, revenue for low-end graphic accelerators continued to decline
significantly as more of these market requirements were met by the direct
installation of graphics chips onto PC motherboards. As a result, our sales
consisted of primarily older generation and lower price products that were sold
into markets that had significant price competition. To the extent that we
continue to experience net losses in the future, our operating results will be
adversely affected. We cannot assure you that we will be able to achieve or
maintain profitability.
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<PAGE>   28

IF WE DO NOT CONTINUE TO DEVELOP AND MARKET NEW AND ENHANCED PRODUCTS, WE WILL
NOT BE ABLE TO COMPETE SUCCESSFULLY IN OUR MARKETS.

     The markets for which our products are designed are intensely competitive
and are characterized by short product life cycles, rapidly changing technology,
evolving industry standards and declining average selling prices. As a result,
we cannot succeed unless we consistently develop and market new products. We
believe this will require expenditures for research and development in the
future consistent with our historical research and development expenditures. To
succeed in this environment, we must anticipate the features and functionality
that customers will demand. We must then incorporate those features and
functionality into products that meet the design, performance, quality and
pricing requirements of the personal computer market and the timing requirements
of PC OEMs and retail selling seasons. For example, we have a joint venture with
VIA Technologies to bring integrated graphics and core logic chip sets to the
OEM desktop and notebook PC markets. There can be no assurance that the joint
venture will be successful or that our existing products will be compatible with
new products. We have in the past experienced delays in completing the
development and introduction of new products, as well as compatibility issued
with integrated products and we cannot assure you that we will not experience
similar delays in the future. In the past, our business has been seriously
harmed when we developed products that failed to achieve significant market
acceptance and therefore were unable to compete successfully in our markets.
Such a failure could occur again in the future.

THE DEMAND FOR OUR PRODUCTS HAS HISTORICALLY BEEN WEAKER IN CERTAIN QUARTERS.

     Due to industry seasonality, demand for PCs and PC related products is
strongest during the fourth quarter of each year and is generally slower in the
period from April through August. This seasonality may become more pronounced
and material in the future to the extent that:

     - a greater proportion of our sales consist of sales into the retail/mass
       merchant channel;

     - PCs become more consumer-oriented or entertainment-driven products; or

     - our net revenue becomes increasingly based on entertainment-related
       products.

     Also, to the extent we expand our European sales, we may experience
relatively weak demand in third calendar quarters due to historically weak
summer sales in Europe.

WE OPERATE IN MARKETS THAT ARE INTENSELY AND INCREASINGLY COMPETITIVE.

     The personal computer multimedia and communications markets in which we
compete are intensely competitive and are likely to become more competitive in
the future. Because of this competition, we face a constant and increasing risk
of losing customers to our competitors. The competitive environment also creates
downward pressure on prices and requires higher spending to address the
competition, both of which tend to keep profit margins lower. We believe that
the principal competitive factors for our products are:

     - product performance and quality;

     - conformity to industry standard application programming interfaces, or
       APIs;

     - access to customers and distribution channels;

     - reputation for quality and strength of brand;

     - manufacturing capabilities and cost of manufacturing;

     - price;

     - product support; and

     - ability to bring new products to the market in a timely manner.

     Historically, the gross profit margins on Diamond's products have been
lower than the margins on our products. As a result of the merger, our average
gross margins will likely be lower than they were prior to the merger thereby
decreasing our average gross margins.
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<PAGE>   29

     Many of our current and potential competitors have substantially greater
financial, technical, manufacturing, marketing, distribution and other
resources. These competitors may also have greater name recognition and market
presence, longer operating histories, greater market power and product breadth,
lower cost structures and larger customer bases. As a result, these competitors
may be able to adapt more quickly to new or emerging technologies and changes in
customer requirements. In addition, some of our principal competitors offer a
single vendor solution because they maintain their own semiconductor foundries
and may therefore benefit from certain capacity, cost and technical advantages.
In some markets where we are a relatively new entrant, such as modems, home
networking, sound cards and consumer electronics, including Internet music
players, we face dominant competitors that include 3Com (home networking and
modems), Creative Technologies (sound cards, modems and Internet music players),
Intel (home networking) and Sony (consumer electronic music players). In
addition, the markets in which we compete are expected to become increasingly
competitive as PC products support increasingly more robust multimedia functions
and companies that previously supplied products providing distinct functions
(for example, companies today primarily in the sound, modem, microprocessor or
motherboard markets) emerge as competitors across broader or more integrated
product categories.

     In addition to graphics board manufacturers, our competitors include OEMs
that internally produce graphics chips or integrate graphics chips on the main
computer processing board of their personal computers, commonly known as the
motherboard, and makers of other personal computer components and software that
are increasingly providing graphics or video processing capabilities.

OUR ENTRY INTO NEW PRODUCT MARKETS COULD DIVERT RESOURCES FROM OUR CORE BUSINESS
AND EXPOSE US TO RISKS INHERENT IN NEW MARKETS.

     Our business historically has focused primarily on the design, manufacture
and sale of graphics chips. However, we are now, from time to time, undertaking
new product initiatives, such as the Rio line of digital music players, the
HomeFree family of home networking products market and our web pad. There are
numerous risks inherent in entering into new product markets. These risks
include the reallocation of limited management, engineering and capital
resources to unproven product ventures, a greater likelihood of encountering
technical problems and delays, and a greater likelihood that our new products
will not gain market acceptance. The failure of one or more of such products
could negatively impact our financial results. Adverse effects of new products
may also injure our reputation in our core business and also could negatively
impact our financial results.

WE OPERATE IN THE PERSONAL COMPUTER AND GRAPHICS AND VIDEO CHIP MARKETS, WHICH
ARE RAPIDLY CHANGING, HIGHLY CYCLICAL AND VULNERABLE TO SHARP DECLINES IN DEMAND
AND AVERAGE SELLING PRICES.

     We operate in the personal computer and graphics/video chip markets. These
markets are constantly and rapidly changing and have in the past, and may in the
future, experience significant downturns. These downturns are characterized by
lower product demand and accelerated product price reductions. In the event of a
downturn, we would likely experience significantly reduced demand for our
products. Substantially all of our revenues are currently derived from products
sold for use in or with personal computers. In the near term, we expect to
continue to derive almost all of our revenues from the sale of products for use
in or with personal computers. Changes in demand in the personal computer and
graphics/video chip markets could be large and sudden. Since graphics board and
personal computer manufacturers often build inventories during periods of
anticipated growth, they may be left with excess inventories if growth slows or
if they have incorrectly forecasted product transitions. In such cases, the
manufacturers may abruptly stop purchasing additional inventory from suppliers
like us until the excess inventory has been used. This suspension of purchases
or any reduction in demand for personal computers generally, or for particular
products that incorporate our products, would negatively impact our revenues and
financial results. We may experience substantial period-to-period fluctuations
in results of operations due to these general semiconductor industry conditions.

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<PAGE>   30

WE HAVE ONLY RECENTLY STARTED TO OFFER PRODUCTS INTENDED TO ADDRESS ALL
PERFORMANCE SEGMENTS OF THE COMMERCIAL AND CONSUMER PC MARKET.

     We recently commenced shipments of our Savage2000 product, which is
designed to compete in multiple performance segments of the commercial and
consumer PC markets and to satisfy multiple-function market needs, such as
graphics, video and DVD support. We do not know whether Savage2000 will be able
to compete successfully in those segments. If we are not able to introduce and
successfully market higher performance products, our gross margin and
profitability could be negatively affected.

DEMAND FOR OUR PRODUCTS MAY DECREASE IF THE SAME CAPABILITIES PROVIDED BY OUR
PRODUCTS BECOME AVAILABLE IN OPERATING SYSTEMS OR EMBEDDED IN OTHER PERSONAL
COMPUTER COMPONENTS.

     A majority of our net sales are derived from the sale of graphics boards
and multimedia accelerators for PC subsystems. However, there is a trend within
the industry for lower performance graphics and video functionality to migrate
from the graphics board to other personal computer components or into operating
systems. We expect that additional specialized graphics processing and general
purpose computing capabilities will be integrated into future versions of Intel
and other Pentium-based microprocessors and that standard multimedia
accelerators in the future will likely integrate memory, system logic, audio,
communications or other additional functions. In particular, Intel and others
have announced plans to develop chips that integrate graphics and processor
functions to serve the lower-cost PC market. These could significantly reduce
the demand for our products. Graphics boards are usually used in higher-end
personal computers offering the latest technology and performance features.
However, as graphics functionality becomes technologically stable and widely
accepted by personal computer users, it typically migrates to the personal
computer motherboard. We expect this trend to continue, especially with respect
to low-end graphics boards. In this regard, the MMX instruction set from Intel
and the expanded capabilities provided by the DirectX applications programming
interface from Microsoft have increased the capability of Microsoft's operating
systems to control display features that have traditionally been performed by
graphics boards. As a result of these trends of technology migration, our
success largely depends on our ability to continue to develop products that
incorporate new and rapidly evolving technologies that manufacturers have not
yet fully incorporated onto personal computer motherboards or into operating
systems.

     Although our joint venture with VIA is intended to produce integrated
graphics/core logic accelerator products that provide these functions, we have
traditionally offered only single function graphics accelerator chips or
chipsets. We have and intend to continue to expand the scope of our research and
development efforts to provide integrated graphics/core logic accelerator
products, which will require that we hire engineers skilled in these areas and
promote additional coordination among our design and engineering groups.
Alternatively, we may find it necessary or desirable to license or acquire
technology to enable us to provide these functions, and we cannot assure you
that any such technology will be available for license or purchase on terms
acceptable to us.

     We believe that a large portion of the growth in the sales of personal
computers may be in sealed systems that contain most functionality on a single
systems board and are not upgradeable in the same manner as are most personal
computers. These sealed computers would contain a systems board that could
include CPU, system memory, graphics, audio and Internet or network connectivity
functionality on a single board. Although Diamond acquired Micronics Computers
in 1998 for the purposes of obtaining technical and marketing expertise and
brand acceptance in CPU motherboard design and developing integrated multimedia
system board products, we cannot assure you that a significant market will exist
for low-cost fixed system boards or that the acquisition of Micronics will
enable us to compete successfully in this emerging market or in the current
motherboard market.

IF WE ARE UNABLE TO CONTINUE TO DEVELOP AND MARKET NEW AND ENHANCED PRODUCTS,
OUR AVERAGE SELLING PRICES AND GROSS PROFITS WILL LIKELY DECLINE.

     We must continue to develop new products in order to maintain average
selling prices and gross margins. As the markets for our products continue to
develop and competition increases, we anticipate that product life

                                       30
<PAGE>   31

cycles will shorten and average selling prices will decline. In particular,
average selling prices and, in some cases, gross margins for each of our
products will decline as products mature. A decline in selling prices may cause
the net sales in a quarter to be lower than those of a preceding quarter or
corresponding quarter in a prior year, even if more units were sold during that
quarter than in the preceding or corresponding quarter of a prior year. To avoid
that, we must successfully identify new product opportunities and develop and
bring new higher-end and higher-margin products to market in time to meet market
demand. The availability of new products is typically restricted in volume early
in a product's life cycle. If customers choose to wait for the new version of a
product instead of purchasing the current version, our ability to procure
sufficient volumes of these new products to meet higher customer demand will be
limited. If this happens, our revenues and operating margins could be harmed.

OUR PRODUCTS HAVE SHORT PRODUCT LIFE CYCLES, REQUIRING US TO MANAGE PRODUCT
TRANSITIONS SUCCESSFULLY IN ORDER TO REMAIN COMPETITIVE.

     Our products have short product life cycles. If we fail to introduce new
products successfully within a given time frame, our competitors could gain
market share, which could cause us to lose revenue. Further, continued failure
to introduce competitive new products on time could also damage our brand name,
reputation and relationships with our customers and cause longer-term harm to
our financial condition. Also, we anticipate that the transition of the design
of Diamond's boards based on new graphics chip architectures by us will require
significant effort. Our major OEM customers typically introduce new computer
system configurations as often as twice a year. The life cycles of Diamond's
graphics boards typically range from six to twelve months and the life cycles of
our graphic chips typically range from twelve to eighteen months. Short product
life cycles are the result of frequent transitions in the computer market in
which products rapidly incorporate new features and performance standards on an
industry-wide basis. Our products must be able to support the new features and
performance levels being required by personal computer manufacturers at the
beginning of these transitions. Otherwise, we would likely lose business as well
as the opportunity to compete for new design contracts until the next product
transition. Failing to develop products with required features and performance
levels or a delay as short as a few months in bringing a new product to market
could significantly reduce our revenues for a substantial period.

WE MAY FACE INVENTORY RISKS THAT ARE INCREASED BY A COMBINATION OF SHORT PRODUCT
LIFE CYCLES AND LONG COMPONENT LEAD TIMES.

     The short product life cycles of our board-based products also give rise to
a number of risks involving product and component inventories. These risks are
heightened by the long lead times that are necessary to acquire some components
of our products. We may not be able to reduce our production or inventory levels
quickly in response to unexpected shortfalls in sales. This could leave us with
significant and costly obsolete inventory. Long component lead times could cause
these inventory levels to be higher than they otherwise would be and may also
prevent us from quickly taking advantage of an unexpected new product cycle.
This can lead to costly lost sales opportunities and loss of market share, which
could result in a loss of revenues. For example, the timing and speed of the
PCI-to-AGP bus transition and the SGRAM-to-SDRAM memory transition led to an
excess inventory of PCI and SGRAM-based products at Diamond and in its
distribution channel, which in turn resulted in lower average selling prices,
lower gross margins, end-of-life inventory write-offs, and higher price
protection charges during the second and third quarters of 1998. Further,
declining demand for an excess supply of Monster 3D II and competitive 3D gaming
products in the channel during the third quarter of 1998 resulted in rapidly
declining revenue and prices vis-a-vis the second quarter of 1998, and resulted
in price protection charges for this class of product in the third quarter of
1998. We estimate and accrue for potential inventory write-offs and price
protection charges, but we cannot assure you that these estimates and accruals
will be sufficient in future periods, or that additional inventory write-offs
and price protection charges will not be required. The impact of these charges
on Diamond's operating results in 1998 and the first quarter of 1999 was
material. Any similar occurrence in the future could materially and adversely
affect our operating results because as our subsidiary, Diamond's charges will
be included in our operating results on a going forward basis.

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WE DEPEND ON THIRD PARTIES FOR THE MANUFACTURE OF OUR PRODUCTS.

     We currently rely on two foundries to manufacture all of our products
either in finished form or wafer form. We have a "take or pay" contract with
TSMC and a joint venture foundry, USC. Our agreement with TSMC provides capacity
through 2002 and requires us to make annual advance payments to purchase
specified capacity to be applied against the following year's capacity or to
forfeit advance payments against those amounts. For example, in the fourth
quarter of 1998, we wrote off approximately $4.0 million of the 1998 prepaid
production capacity because it did not fully utilize the capacity related to the
advance payment. As of December 31, 1999, our note payable to TSMC was $9.6
million. If we purchase excess inventories of particular products or choose to
forfeit advance payments, our operating results could be harmed.

     In 1999, UMC, the majority owner of the USC foundry joint venture, merged
USC with UMC. As a result, we lost our ability to influence the USC board and
any veto power we had over actions to be taken by USC. Our relationship with USC
is therefore based on a foundry capacity agreement rather than a joint venture.
Although we are currently unaware of any changes that UMC may propose in the
future to the foundry relationship, we will have less ability to influence USC
if changes adverse to us are made in the future.

     We conduct business with one of our current foundries by delivering written
purchase orders specifying the particular product ordered, quantity, price,
delivery date and shipping terms. This foundry is therefore not obligated to
supply products to us for any specific period, in any specific quantity or at
any specific price, except as may be provided in a particular purchase order. To
the extent a foundry terminates its relationship with us or our supply from a
foundry is interrupted or terminated for any other reason, such as a natural
disaster or an injunction arising from alleged violations of third party
intellectual property rights, we may not have a sufficient amount of time to
replace the supply of products manufactured by that foundry. We may be unable to
obtain sufficient advanced process technology foundry capacity to meet customer
demand in the future. From time to time, we may evaluate potential new sources
of supply. However, the qualification process and the production ramp-up for
additional foundries has in the past taken, and could in the future take, longer
than anticipated. Accordingly, there can be no assurance that such sources will
be able or willing to satisfy our requirements on a timely basis or at
acceptable quality or per unit prices.

     TSMC and USC are both located in the Science-Based Industrial Park in Hsin
Chu City, Taiwan. We currently expect these foundries to supply the substantial
portion of our graphics accelerator chips and S3-VIA joint venture products in
2000 and 2001. Disruption of operations at these foundries for any reason,
including work stoppages, political or military conflicts, earthquakes or other
natural disasters, could cause delays in shipments of our products which could
have a material adverse effect on our operating results. For example, in
September 1999, Taiwan experienced a major earthquake. The earthquake and its
resulting aftershocks caused power outages and significant damage to Taiwan's
infrastructure. The result was delays of shipments of our products from the TSMC
and USC foundries in Taiwan. Any such future delays could have a material
adverse effect on our operating results.

     In addition, as a result of the rapid growth of the semiconductor industry
based in the Science-Based Industrial Park, severe constraints have been placed
on the water and electricity supply in that region. Any shortages of water or
electricity could adversely affect our foundries' ability to supply our
products, which could have a material adverse effect on operating results.

     We rely on independent subcontractors to manufacture, assemble or test
certain of our products. We procure our components, assembly and test services
and assembled products through purchase orders and we do not have specific
volume purchase agreements with each of our subcontractors. Most our
subcontractors could cease supplying the services, products or components at any
time with limited or no penalty. If we need to replace a key subcontractor, we
could incur significant manufacturing set-up costs and delays. Also, we may be
unable to find suitable replacement subcontractors. Our emphasis on maintaining
low internal and channel inventory levels may exacerbate the effects of any
shortage that may result from the use of sole-source subcontractors during
periods of tight supply or rapid order growth. Further, some of our
subcontractors are located outside the United States, which may present
heightened process control, quality control, political, infrastructure,
transportation, tariff, regulatory, legal, import, export, economic or supply
chain management risks.
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WE HAVE SIGNIFICANT PRODUCT CONCENTRATION AND SIGNIFICANTLY DEPEND ON THE HEALTH
OF THE GRAPHICS AND MULTIMEDIA ACCELERATOR MARKET, WHICH MEANS THAT A DECLINE IN
DEMAND FOR A SINGLE PRODUCT, OR IN THE GRAPHICS AND MULTIMEDIA ACCELERATOR
MARKET IN GENERAL, COULD SEVERELY IMPACT OVERALL REVENUES AND FINANCIAL RESULTS.

     Our revenues are dependent on the markets for graphics/video chips for PCs
and on our ability to compete in those markets. Our business would be materially
harmed if we are unsuccessful in selling these graphic chips. Historically, over
75% of the net sales of our subsidiary, Diamond, have come from sales of
graphics and video accelerator subsystems. Although Diamond has introduced audio
subsystems, has entered the PC modem and home networking markets, and has
entered into the PC consumer electronics market with its Rio Internet music
player, graphics and video accelerator subsystems are expected to continue to
account for the majority of our sales for the foreseeable future. A decline in
demand or average selling prices for graphics and video accelerator subsystems,
whether as a result of new competitive product introductions, price competition,
excess supply, widespread cost reduction, technological change, incorporation of
the products' functionality onto personal computer motherboards or otherwise,
would have a material adverse effect on our sales and operating results.

WE MAY NOT BE ABLE TO SUCCESSFULLY MANAGE THE GROWTH AND EXPANSION OF OUR
BUSINESS.

     In the past year, and particularly with the merger with Diamond, the
Company has experienced a significant expansion in the overall level of its
business and the scope of its operations, including manufacturing, research and
development, marketing, technical support, customer service, sales and
logistics. This expansion in scope has resulted in a need for significant
investment in infrastructure, process development and information systems. This
requirement includes, without limitation: securing adequate financial resources
to successfully integrate and manage the growing businesses and acquired
companies; retention of key employees; integration of management information,
product data management, control, accounting, telecommunications and networking
systems; establishment of a significant worldwide web and e-commerce presence;
consolidation of geographically dispersed manufacturing and distribution
facilities; coordination of suppliers; rationalization of distribution channels;
establishment and documentation of business processes and procedures; and
integration of various functions and groups of employees. Each of these
requirements poses significant, material challenges.

     The Company's future operating results will depend in large measure on its
success in implementing operating, manufacturing and financial procedures and
controls, improving communication and coordination among the different operating
functions, integrating certain functions such as sales, procurement and
operations, strengthening management information and telecommunications systems,
and continuing to hire additional qualified personnel in certain areas. There
can be no assurance that the Company will be able to manage these activities and
implement these additional systems, procedures and controls successfully, and
any failure to do so could have a material adverse effect upon the Company's
short-term and long-term operating results.

A SIGNIFICANT PORTION OF OUR SALES ARE CONCENTRATED WITHIN A LIMITED NUMBER OF
CUSTOMERS.

     We expect a significant portion of our future sales to remain concentrated
within a limited number of strategic customers. If we lose one or more of these
customers, our operating results would be harmed.

     In 1999, three customers, IBM Corporation, Dell Computer Corporation and
Synnex Technology, Inc. ("Synnex") accounted for 19%, 10% and 9% respectively,
of net sales. In 1998, three customers, Synnex, IBM Corporation and Promate
Electronics Co., accounted for 39%, 14% and 13%, respectively, of net sales. In
1997, three customers, Synnex, CNW International Limited, and Compaq Computer
Corporation, accounted for 20%, 13% and 12%, respectively, of net sales. Synnex,
CNW International Limited and Promate Electronics Co. are distributors. We
expect a significant portion of our future sales to remain concentrated within a
limited number of strategic customers, who we may be unable to retain. Our
strategic customers may cancel or reschedule orders. Canceled orders may not be
replaced by other sales, adversely impacting our operating results.

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THE MANUFACTURERS ON WHICH WE DEPEND MAY EXPERIENCE MANUFACTURING YIELD PROBLEMS
THAT COULD INCREASE OUR PER UNIT COSTS AND OTHERWISE JEOPARDIZE THE SUCCESS OF
OUR PRODUCTS.

     Our primary products, graphics chips, are difficult to manufacture. The
production of graphic chips requires a complex and precise process that often
presents problems that are difficult to diagnose and time-consuming or expensive
to solve. As a result, companies like us often experience problems in achieving
acceptable wafer manufacturing yields. Our chips are manufactured from round
wafers made of silicon. During manufacturing, each wafer is processed to contain
numerous individual integrated circuits, or chips. We may reject or be unable to
sell a percentage of wafers or chips on a given wafer because of:

     - minute impurities,

     - difficulties in the fabrication process,

     - defects in the masks used to print circuits on a wafer,

     - electrical performance,

     - wafer breakage, or

     - other factors.

     We refer to the proportion of final good chips that have been processed,
assembled and tested relative to the gross number of chips that could be
constructed from the raw materials as our manufacturing yields. These yields
reflect the quality of a particular wafer. Depending on the specific product, in
the past, we negotiated with our manufacturers to pay either an agreed upon
price for all wafers or a price that is typically higher for only wafers of
acceptable quality. If the payment terms for a specific product require us to
pay for all wafers, and if yields associated with that product are poor, we bear
the risk of those poor manufacturing yields.

OUR SEMICONDUCTOR, SEMICONDUCTOR-BASED OR SOFTWARE PRODUCTS COULD HAVE DESIGN
DEFECTS.

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

     Additionally, new versions or upgrades to operating systems, independent
software vendor titles or applications may require upgrades to the Company's
software products to maintain compatibility with such new versions or upgrades.
There can be no assurance that the Company will be successful in developing new
versions or enhancements to its software or that the Company will not experience
delays in the upgrade of its software products. In the event that the Company
experiences delays or is unable to maintain compatibility

                                       34
<PAGE>   35

with operating systems and independent software vendor titles or applications,
the Company's business, financial condition and results of operations could be
materially adversely affected.

WE ARE SUBJECT TO RISKS RELATING TO PRODUCT RETURNS AND PRICE PROTECTION.

     We often grant limited rights to customers to return unsold inventories of
our products in exchange for new purchases, also known as "stock rotation." We
also often grant price protection on unsold inventory, which allows customers to
receive a price adjustment on existing inventory when our published price is
reduced. Also, some of our retail customers will readily accept returned
products from their own retail customers. These returned products are then
returned to us for credit. We estimate returns and potential price protection on
unsold inventory in our distribution channel. We accrue reserves for estimated
returns, including warranty returns and price protection, and since the fourth
quarter of 1998, we reserve the gross margin associated with channel inventory
levels that exceed four weeks of demand. We may be faced with further
significant price protection charges as our competitors move to reduce channel
inventory levels of current products, such as our Monster Fusion, as new product
introductions are made.

WE DEPEND ON SALES THROUGH DISTRIBUTORS. IF RELATIONSHIPS WITH OR SALES THROUGH
DISTRIBUTORS DECLINE, OUR OPERATING RESULTS WILL BE HARMED.

     We sell our products through a network of domestic and international
distributors, and directly to major retailers/mass merchants, value-added
resellers and OEM customers. Our future success is dependent on the continued
viability and financial stability of our customer base. Computer distribution
and retail channels historically have been characterized by rapid change,
including periods of widespread financial difficulties and consolidation and the
emergence of alternative sales channels, such as direct mail order, telephone
sales by PC manufacturers and electronic commerce on the worldwide web. The loss
of, or a reduction in, sales to certain of our key distribution customers as a
result of changing market conditions, competition or customer credit problems
could materially and adversely affect our operating results. Likewise, changes
in distribution channel patterns, such as:

     - increased electronic commerce via the Internet,

     - increased use of mail-order catalogues,

     - increased use of consumer-electronics channels for personal computer
       sales, or

     - increased use of channel assembly to configure PC systems to fit
       customers' requirements could affect us in ways not yet known. For
       example, the rapid emergence of Internet-based e-commerce, in which
       products are sold direct to consumers at low prices, is putting
       substantial strain on some of our traditional distribution channels.

     Inventory levels of our products in the two-tier distribution channels
generally are maintained in a range of one to two months of customer demand.
These channel inventory levels tend toward the low end of the months-of-supply
range when demand is stronger, sales are higher and products are in short
supply. Conversely, during periods when demand is slower, sales are lower and
products are abundant, channel inventory levels tend toward the high end of the
months-of-supply range. Frequently, in these situations, we attempt to ensure
that distributors devote a greater degree of their working capital, sales and
logistics resources to our products instead of to our competitors. Similarly,
our competitors attempt to ensure that their own products are receiving a
disproportionately higher share of the distributors' working capital and
logistics resources. In an environment of slower demand and abundant supply of
products, price declines and channel promotional expenses are more likely to
occur and, should they occur, are more likely to have a significant impact on
our operating results. Further, in an event like this, high channel inventory
levels may result in substantial price protection charges. These price
protection charges have the effect of reducing net sales and gross profit.
Consequently, in taking steps to bring our channel inventory levels down to a
more desirable level, we may cause a shortfall in net sales during one or more
accounting periods. These efforts to reduce channel inventory might also result
in price protection charges if prices are decreased to move product out to final
consumers, having a further adverse impact on operating results. We accrue for
potential price protection

                                       35
<PAGE>   36

charges on unsold channel inventory. We cannot assure you, however, that any
estimates, reserves or accruals will be sufficient or that any future price
reductions will not seriously harm our operating results.

WE RELY ON INTELLECTUAL PROPERTY AND OTHER PROPRIETARY INFORMATION THAT MAY NOT
BE ADEQUATELY PROTECTED AND THAT MAY BE EXPENSIVE TO PROTECT.

     The industry in which we compete is characterized by vigorous protection
and pursuit of intellectual property rights. We rely heavily on a combination of
patent, trademark, copyright, and trade secret laws, employee and third-party
nondisclosure agreements and licensing arrangements to protect our intellectual
property. If we are unable to adequately protect our intellectual property, our
business may suffer from the piracy of our technology and the associated loss of
sales. Also, the protection provided to our proprietary technology by the laws
of foreign jurisdictions, many of which offer less protection than the United
States, may not be sufficient to protect our technology. It is common in the
personal computer industry for companies to assert intellectual property
infringement claims against other companies. Therefore, our products may also
become the target of infringement claims. These infringement claims or any
future claims could cause us to spend significant time and money to defend our
products, redesign our products or develop or license a substitute technology.
We may be unsuccessful in acquiring or developing substitute technology and any
required license may be unavailable on commercially reasonable terms, if at all.
In addition, an adverse result in litigation could require us to pay substantial
damages, cease the manufacture, use, sale, offer for sale and importation of
infringing products, or discontinue the use of certain processes. Any of those
events could materially harm our business. Litigation by or against us could
result in significant expense to us and could divert the efforts of our
technical and management personnel, regardless of the outcome of such
litigation. However, even if claims do not have merit, we may be required to
dedicate significant management time and expense to defending ourselves if we
are directly sued, or assisting our OEM customers in their defense of these or
other infringement claims pursuant to indemnity agreements. This could have a
negative effect on our financial results. For example, Intel Corporation is
currently in litigation with VIA with whom we recently entered into a joint
venture to bring high-performance integrated graphics and core logic chip sets
to the volume OEM desktop and notebook PC markets. The result of such litigation
could have an adverse effect on the Company.

OUR PRODUCTS DEPEND UPON THIRD-PARTY CERTIFICATIONS, WHICH MAY NOT BE GRANTED
FOR FUTURE PRODUCTS, RESULTING IN PRODUCT SHIPMENT DELAYS AND LOST SALES.

     We submit most of our products for compatibility and performance testing to
the Microsoft Windows Hardware Quality Lab because our OEM customers typically
require our products to have this certification prior to making volume
purchases. This certification typically requires up to several weeks to complete
and entitles us to claim that a particular product is "Designed for Microsoft
Windows." We may not receive this certification for future products in a timely
fashion, or at all, which could result in product shipment delays and lost
sales.

WE MAY NOT BE ABLE TO RETAIN OR INTEGRATE KEY PERSONNEL, WHICH MAY PREVENT US
FROM SUCCEEDING.

     We may not be able to retain our key personnel or attract other qualified
personnel in the future. Our success will depend upon the continued service of
key management personnel. The loss of services of any of the key members of our
management team or our failure to attract and retain other key personnel could
disrupt our operations and have a negative effect on employee productivity and
morale, decreasing production and harming our financial results. In addition,
the competition to attract, retain and motivate qualified technical, sales and
operations personnel is intense. We have at times experienced, and continue to
experience, difficulty recruiting qualified software and hardware development
engineers.

                                       36
<PAGE>   37

WE DEPEND ON A LIMITED NUMBER OF THIRD PARTY DEVELOPERS AND PUBLISHERS THAT
DEVELOP GRAPHICS SOFTWARE PRODUCTS THAT WILL OPERATE WITH AND FULLY UTILIZE THE
CAPABILITIES OF OUR PRODUCTS TO GENERATE DEMAND FOR OUR PRODUCTS.

     Only a limited number of software developers are capable of creating high
quality entertainment software. Because competition for these resources is
intense and is expected to increase, a sufficient number of high quality,
commercially successful software titles compatible with our products may not be
developed. We believe that the availability of numerous high quality,
commercially successful software entertainment titles and applications
significantly affects sales of multimedia hardware to the PC-based interactive
3D entertainment market. We depend on third party software developers and
publishers to create, produce and market software titles that will operate with
our 3D graphics accelerators. If a sufficient number of successful software
titles are not developed, our product sales and revenues could be negatively
impacted. In addition, the development and marketing of game titles that do not
fully demonstrate the technical capabilities of our products could create the
impression that our technology offers only marginal or no performance
improvements over competing products. Either of these effects could have an
adverse effect on our product sales and financial results.

WE DEPEND ON A LIMITED NUMBER OF SUPPLIERS FROM WHOM WE DO NOT HAVE A GUARANTEE
OF ADEQUATE SUPPLIES, INCREASING THE RISK THAT A LOSS OF OR PROBLEMS WITH A
SINGLE SUPPLIER COULD RESULT IN IMPAIRED MARGINS, REDUCED PRODUCTION VOLUMES,
STRAINED CUSTOMER RELATIONS AND LOSS OF BUSINESS.

     We obtain several of the components used in our products from single or
limited sources. If component manufacturers do not allocate a sufficient supply
of components to meet our needs or if current suppliers do not provide
components of adequate quality or compatibility, we may have to obtain these
components from distributors or on the spot market at a higher cost. We rarely
have guaranteed supply arrangements with our suppliers, and suppliers may not be
able to meet our current or future component requirements. If we are forced to
use alternative suppliers of components, we may have to alter our product
designs to accommodate these components. Alteration of product designs to use
alternative components could cause significant delays and could require product
recertification by our OEM customers or reduce our production of the related
products. In addition, from time to time we have experienced difficulty meeting
certain product shipment dates to customers for various reasons. These reasons
include component delivery delays, component shortages, system compatibility
difficulties and component quality deficiencies. Delays in the delivery of
components, component shortages, system compatibility difficulties and supplier
product quality deficiencies will continue to occur in the future. These delays
or problems have in the past and could in the future result in impaired margins,
reduced production volumes, strained customer relations and loss of business.
For example, DRAM and flash memory components, which are used in our graphics
boards and Rio digital audio players, significantly increased in price in
September 1999 due in part to supply interruptions arising from the earthquake
in Taiwan. In addition, industry-wide demand for flash memory components has
increased dramatically, causing increases in price and shortages in supply.
These price increases may have an adverse impact on our gross margin in future
periods. Also, in an effort to avoid actual or perceived component shortages, we
may purchase more of certain components than we otherwise require. Excess
inventory resulting from such over-purchases, obsolescence or a decline in the
market value of such inventory could result in inventory write-offs, which would
have a negative effect on our financial results as happened in the first and
second quarters of 1998. Similarly, Diamond's perception of component shortages
caused Diamond to over-purchase certain components and pay surcharges for
components that subsequently declined in value in the second, third and fourth
quarters of 1998. In addition, our inventory sell-offs or sell-offs by our
competitors could trigger channel price protection charges, further reducing our
gross margins and profitability, as occurred with the Monster 3D II product line
in the third and fourth quarters of 1998.

WE MAY EXPERIENCE PRODUCT DELIVERY DELAYS DUE TO THE INADEQUACY OR
INCOMPATIBILITY OF SOFTWARE DRIVERS. SUCH DELAYS COULD HURT OUR SALES.

     Some components of our products require software drivers in order for those
components to work properly in a PC. These software drivers are essential to the
performance of nearly all of our products and must be

                                       37
<PAGE>   38

compatible with the other components of the graphics board and PC in order for
the product to work. Some of these products that include software drivers are
among those products based on components, including software drivers, that are
supplied by a limited number of suppliers. From time to time, we have
experienced product delivery delays due to inadequacy or incompatibility of
software drivers either provided by component suppliers or developed internally
by them. These delays could cause us to lose sales, revenues and customers.
Software driver problems will continue to occur in the future, and those
problems could negatively affect our operating results.

WE HAVE SIGNIFICANT EXPOSURE TO INTERNATIONAL MARKETS.

     Export sales accounted for 70%, 89% and 70% of our net sales in 1999, 1998
and 1997, respectively. We expect that export sales will continue to represent a
significant portion of net sales, although there can be no assurance that export
sales, as a percentage of net sales, will remain at current levels. Diamond's
net sales in Europe accounted for 36% and 26% of total net sales during 1998 and
1997, respectively. Diamond's other international net sales accounted for 10%
and 12% of total net sales for it during 1998 and 1997, respectively. In
addition, a substantial proportion of our products are manufactured, assembled
and tested by independent third parties in Asia. As a result, we are subject to
the risks of conducting business internationally, including:

     - unexpected changes in, or impositions of, legislative or regulatory
       requirements;

     - fluctuations in the U.S. dollar, which could increase the price in local
       currencies of our products in foreign markets or increase the cost of
       wafers and components purchased by us;

     - delays resulting from difficulty in obtaining export licenses for certain
       technology;

     - tariffs and other trade barriers and restrictions;

     - potentially longer payment cycles;

     - greater difficulty in accounts receivable collection;

     - potentially adverse tax treatment; and

     - the burdens of complying with a variety of foreign laws.

     In the past, we have experienced an adverse impact associated with the
economic downturn in Asia that contributed to decreases in net sales. In
addition, our international operations are subject to general geopolitical
risks, such as political and economic instability and changes in diplomatic and
trade relationships. The People's Republic of China and Taiwan have in the past
experienced and are currently experiencing strained relations, and a worsening
of relations or the development of hostilities between them could disrupt
operations at our foundries and affect our Taiwanese customers.

WE HAVE A SIGNIFICANT LEVEL OF DEBT.

     At December 31, 1999, we had total debt and other long-term liabilities
outstanding of $115.5 million. The degree to which we are leveraged could
adversely affect our ability to obtain additional financing for working capital
or other purposes and could make us more vulnerable to economic downturns and
competitive pressures. Our significant leverage could also adversely affect our
liquidity, as a substantial portion of available cash from operations may have
to be applied to meet debt service requirements. In the event of a cash
shortfall, we could be forced to reduce other expenditures to be able to meet
such debt service requirements.

OUR STOCK PRICE IS HIGHLY VOLATILE AND WE EXPECT THAT OUR STOCK PRICE WILL
CONTINUE TO BE HIGHLY VOLATILE.

     The market price of our common stock has been highly volatile, like that of
the common stock of many other semiconductor companies. We expect our common
stock to remain volatile. This volatility may result from:

     - general market conditions and market conditions affecting technology and
       semiconductor stocks generally;

                                       38
<PAGE>   39

     - actual or anticipated fluctuations in our quarterly operating results;

     - announcements of design wins, technological innovations, acquisitions,
       investments or business alliances, by us or our competitors; and

     - the commencement of, developments in or outcome of litigation.

     The market price of our common stock also has been and is likely to
continue to be significantly affected by expectations of analysts and investors,
especially if our operating results do not meet those expectations. Reports and
statements of analysts do not necessarily reflect our views. The fact that we
have in the past met or exceeded analyst or investor expectations does not
necessarily mean that we will do so in the future.

     In the past, following periods of volatility in the market price of a
particular company's securities, securities class action litigation has often
been brought. This litigation could result in substantial costs and a diversion
of our management's attention and resources. We are currently involved in
securities class action litigation and Diamond is also involved in similar
proceedings.

WE ARE PARTY TO LEGAL PROCEEDINGS ALLEGING SECURITIES VIOLATIONS THAT COULD HAVE
A NEGATIVE FINANCIAL IMPACT ON US.

     Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of our common stock at various times
between April 18, 1996 and November 3, 1997. The complaints name us as
defendants as well as certain of our officers and former officers and certain of
our directors, asserting that we and they violated federal and state securities
laws by misrepresenting and failing to disclose certain information about our
business. In addition, certain shareholders have filed derivative actions in the
state courts of California and Delaware seeking recovery on our behalf,
alleging, among other things, breach of fiduciary duties by such individual
defendants. The plaintiffs in the derivative action in Delaware have not taken
any steps to pursue their case. The derivative cases in California state court
have been consolidated, and plaintiffs have filed a consolidated amended
complaint. The court has entered a stipulated order in those derivative cases
suspending court proceedings and coordinating discovery in them with discovery
in the class actions in California state courts. On plaintiffs' motion, the
federal court has dismissed the federal class actions without prejudice. The
class actions in California state court have been consolidated, and plaintiffs
have filed a consolidated amended complaint. The Company has answered that
complaint. Discovery is pending. While our management intends to defend the
actions against us vigorously, there can be no assurance that an adverse result
or settlement with regards to these lawsuits would not have a material adverse
effect on our financial condition or results of operations.

     We are also defending several putative class action lawsuits naming Diamond
which were filed in June and July 1996 and June 1997 in the California Superior
Court for Santa Clara County and the U.S. District Court for the Northern
District of California. Certain former executive officers and directors of
Diamond are also named as defendants. The plaintiffs purport to represent a
class of all persons who purchased Diamond's Common Stock between October 18,
1995 and June 20, 1996 (the "Class Period"). The complaints allege claims under
the federal securities laws and California law. The plaintiffs allege that
Diamond and the other defendants made various material misrepresentations and
omissions during the Class Period. The complaints do not specify the amount of
damages sought. On March 24, 2000, the District Court for the Northern District
of California dismissed the federal action without prejudice. We believe that we
have good defenses to the claims alleged in the California Superior Court
lawsuit and will defend ourselves vigorously against this action. No trial date
has been set for this action. The ultimate outcome of this action cannot be
presently determined. Accordingly, no provision for any liability or loss that
may result from adjudication or settlement thereof has been made in the
accompanying consolidated financial statements.

     In addition, we have been named, with Diamond, as a defendant in litigation
relating to the merger. On August 4, 1999, two alleged stockholders of Diamond
filed a lawsuit, captioned Strum v. Schroeder, et al., in the Superior Court of
the State of California for the County of Santa Clara. Plaintiffs, on behalf of
themselves and a class of all former Diamond stockholders similarly situated
whom they purportedly represent, challenge

                                       39
<PAGE>   40

the terms of the merger. The complaint names Diamond, the former directors of
Diamond and us as defendants. The complaint alleges generally that Diamond's
directors breached their fiduciary duties to stockholders of Diamond and seeks
rescission and the recovery of unspecified damages, fees and expenses. While our
management intends to defend the actions against us vigorously, there can be no
assurance that an adverse result or settlement with regards to these lawsuits
would not have a material adverse effect on our financial condition or results
of operations.

     We have also received from the SEC a request for information relating to
our financial restatement announcement in November 1997. We have responded and
intend to continue to respond to the SEC requests.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

INVESTMENT PORTFOLIO

     The Company does not use derivative financial instruments in its investment
portfolio. The Company places its investments in instruments that meet high
credit quality standards, as specified in the Company's investment policy. The
Company also limits the amount of credit exposure to any one issue, issuer or
type of investment. The Company does not expect any material loss with respect
to its investment portfolio.

     The table below summarizes the Company's investment portfolio. The table
represents principal cash flows and related average fixed interest rates by
expected maturity date. The Company's policy requires that all investments
mature within twenty months.

     Principal (Notional) Amounts Maturing in 2000 in U.S. Dollars:

<TABLE>
<CAPTION>
                                                                 FAIR VALUE AT
                                                               DECEMBER 31, 1999
                                                             ----------------------
                                                                 (IN THOUSANDS,
                                                             EXCEPT INTEREST RATES)
<S>                                                          <C>
At December 31, 1999:
Cash and equivalents.......................................         $ 45,825
Weighted average interest rate.............................             4.94%
Short-term investments.....................................         $ 58,918
Weighted average interest rate.............................             6.48%
Total portfolio............................................         $104,743
Weighted average interest rate.............................             5.81%
</TABLE>

CONVERTIBLE SUBORDINATED NOTES

     In September 1996, the Company completed a private placement of $103.5
million aggregate principal amount of convertible subordinated notes. The notes
mature in 2003. Interest is payable semi-annually at 5 3/4% per annum. The notes
are convertible at the option of the note holders into the Company's common
stock at an initial conversion price of $19.22 per share, subject to adjustment.
Beginning in October 1999, the notes are redeemable at the option of the Company
at an initial redemption price of 102% of the principal amount. The fair value
of the convertible subordinated notes at December 31, 1999 was approximately
$96.13 million.

IMPACT OF FOREIGN CURRENCY RATE CHANGES

     The Company invoices its customers in US dollars for all products. The
Company is exposed to foreign exchange rate fluctuations as the financial
results of its foreign subsidiaries are translated into US dollars in
consolidation. The foreign subsidiaries maintain their accounts in the local
currency of the foreign location in order to centralize the foreign exchange
risk with the parent company. To date this risk has not been material.

     The effect of foreign exchange rate fluctuations on the Company's financial
statements for the years ended December 31, 1999 and 1998 was not material. From
time to time the Company uses foreign exchange

                                       40
<PAGE>   41

forward contracts as a means for hedging assets or liabilities denominated in
foreign currencies. As of December 31, 1999, the Company held the following
forward exchange contracts:

<TABLE>
<CAPTION>
                                                     MATURITY
                                                       DATE         NOTIONAL    FAIR VALUE
                                                   -------------    --------    ----------
                                                                        (IN THOUSANDS)
<S>                                                <C>              <C>         <C>
Foreign Currency Forward Exchange Contracts:
275,905,000 New Taiwan Dollars...................  April 3, 2000     $8,489       $(200)
275,905,000 New Taiwan Dollars...................   July 5, 2000     $8,466       $(186)
</TABLE>

                                       41
<PAGE>   42

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

         INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF S3 INCORPORATED

<TABLE>
<CAPTION>
                                                              PAGE(S)
                                                              -------
<S>                                                           <C>
Report of Ernst & Young LLP, Independent Auditors...........    43
Report of Deloitte & Touche LLP, Independent Auditors.......    44
Consolidated Statements of Operations for the years ended
  December 31, 1999, 1998 and 1997..........................    45
Consolidated Balance Sheets as of December 31, 1999 and
  1998......................................................    46
Consolidated Statements of Stockholders' Equity for the
  years ended December 31, 1999, 1998 and 1997..............    47
Consolidated Statements of Cash Flows for the years ended
  December 31, 1999, 1998 and 1997..........................    48
Notes to Consolidated Financial Statements..................    49
Selected Quarterly Consolidated Financial Data
  (Unaudited)...............................................    69
</TABLE>

                                       42
<PAGE>   43

               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
S3 Incorporated

     We have audited the accompanying consolidated balance sheet of S3
Incorporated as of December 31, 1999, and the related consolidated statements of
operations, stockholders' equity and cash flows for the year then ended. Our
audit also included the financial statement schedule for the year ended December
31, 1999 listed in the Index at Item 14(a)(2). 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
audit.

     We conducted our audit 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 our audit provides 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
S3 Incorporated at December 31, 1999, and the consolidated results of its
operations and its cash flows for the year then ended, 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
January 31, 2000

                                       43
<PAGE>   44

             REPORT OF DELOITTE & TOUCHE LLP, INDEPENDENT AUDITORS

Board of Directors and Stockholders
S3 Incorporated:

     We have audited the accompanying consolidated statements of operations,
stockholders' equity and cash flows of S3 Incorporated and subsidiaries for the
year ended December 31, 1997. Our audit also included the financial statement
schedule at Item 14(a)(2) for the year ended December 31, 1997. These financial
statements and financial statement schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audit. We did
not audit the financial statements of United Semiconductor Corporation ("USC"),
the Company's investment in which is accounted for by use of the equity method.
The Company's equity ($19,012,000) of USC's net income (after investor's
applicable taxes) for the year ended December 31, 1997 is included in the
accompanying financial statements. The 1997 financial statements of USC were
audited by other auditors whose report was furnished to us, and our opinion,
insofar as it relates to the amount included for such company, is based solely
on the report of such other auditors.

     We conducted our audit 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 audit and the report of other auditors provide a reasonable
basis for our opinion.

     In our opinion, based on our audit and the report of the other auditors,
such 1997 consolidated financial statements present fairly, in all material
respects, the results of operations and cash flows of S3 Incorporated and
subsidiaries for the year ended December 31, 1997 in conformity with generally
accepted accounting principles. Also, in our opinion, the financial statement
schedule for the year ended December 31, 1997, when considered in relation to
the basic consolidated financial statements taken as a whole, presents fairly in
all material respects the information set forth therein.

                                          DELOITTE & TOUCHE LLP

San Jose, California
January 23, 1998

                                       44
<PAGE>   45

                                S3 INCORPORATED

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                           ----------------------------------
                                                             1999         1998         1997
                                                           ---------    ---------    --------
<S>                                                        <C>          <C>          <C>
Net sales................................................  $ 352,583    $ 224,639    $436,359
Cost of sales............................................    307,161      226,711     301,185
                                                           ---------    ---------    --------
Gross margin (loss)......................................     45,422       (2,072)    135,174
Operating expenses:
  Research and development...............................     73,896       78,566      78,612
  Selling, marketing and administrative..................     52,832       41,926      55,879
  Other operating expense................................      6,700       41,335      17,180
  Amortization of goodwill and intangibles related to the
     Diamond acquisition.................................     12,156           --          --
                                                           ---------    ---------    --------
          Total operating expenses.......................    145,584      161,827     151,671
                                                           ---------    ---------    --------
Loss from operations.....................................   (100,162)    (163,899)    (16,497)
  Gain on sale of joint venture..........................     22,433       26,561          --
  Interest income........................................      5,258        7,253       5,295
  Interest expense.......................................     (7,205)      (6,235)     (6,477)
  Other income (expense).................................      1,034       (6,309)       (952)
                                                           ---------    ---------    --------
Loss before income taxes and equity in income of
  manufacturing joint venture and minority interest in
  Rioport................................................    (78,642)    (142,629)    (18,631)
Benefit for income taxes.................................    (47,916)     (11,956)     (8,497)
                                                           ---------    ---------    --------
Loss before equity in income of manufacturing joint
  venture and minority interest in Rioport...............    (30,726)    (130,673)    (10,134)
Equity in income from manufacturing joint venture........      4,588       17,469      19,012
Minority interest in Rioport.............................     (4,642)          --          --
                                                           ---------    ---------    --------
Net income (loss)........................................  $ (30,780)   $(113,204)   $  8,878
                                                           =========    =========    ========
Per share amounts:
  Basic..................................................  $   (0.52)   $   (2.22)   $   0.18
  Diluted................................................  $   (0.52)   $   (2.22)   $   0.17
Shares used in computing per share amounts:
  Basic..................................................     59,244       51,078      49,519
  Diluted................................................     59,244       51,078      51,740
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       45
<PAGE>   46

                                S3 INCORPORATED

                          CONSOLIDATED BALANCE SHEETS
                (IN THOUSANDS, EXCEPT SHARES AND PER SHARE DATA)

                                     ASSETS

<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              --------------------
                                                                1999        1998
                                                              --------    --------
<S>                                                           <C>         <C>
Current assets:
  Cash and equivalents......................................  $ 45,825    $ 31,022
  Short-term investments....................................    58,918      88,553
  Accounts receivable (net of allowances of $19,298 in 1999
     and $6,525
     in 1998)...............................................    78,312      23,864
  Inventories...............................................    97,161      11,383
  Production capacity rights................................    14,277      15,709
  Taxes receivable..........................................     4,321      20,203
  Deferred income taxes.....................................    19,658          --
  Prepaid expenses and other................................     6,181       6,444
                                                              --------    --------
          Total current assets..............................   324,653     197,178
Property and equipment -- net...............................    34,404      22,392
Investments.................................................    92,763      88,056
Deferred taxes..............................................    56,458          --
Goodwill and intangible assets..............................   199,139          --
Other assets................................................    15,230      18,175
                                                              --------    --------
          Total.............................................  $722,647    $325,801
                                                              ========    ========

                       LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
  Accounts payable..........................................  $117,539    $ 16,315
  Notes payable.............................................    51,261      14,400
  Accrued compensation and benefits.........................     9,167       6,491
  Accrued liabilities.......................................    30,803       5,823
  Taxes payable.............................................     5,781          --
  Deferred revenue..........................................     9,953       1,905
                                                              --------    --------
          Total current liabilities.........................   224,504      44,934
Other liabilities...........................................    12,010      13,837
Convertible subordinated notes..............................   103,500     103,500
Commitments and contingencies (Notes 8 and 12)
Stockholders' equity:
  Preferred stock, $.0001 par value; 5,000,000 shares
     authorized; none outstanding...........................        --          --
  Common stock, $.0001 par value; 175,000,000 shares
     authorized; 78,139,745, and 51,716,171, shares
     outstanding in 1999 and 1998
     respectively...........................................         8           5
  Additional paid-in capital................................   434,330     191,642
  Accumulated other comprehensive loss......................    (7,563)    (14,755)
  Accumulated deficit.......................................   (44,142)    (13,362)
                                                              --------    --------
          Total stockholders' equity........................   382,633     163,530
                                                              --------    --------
          Total.............................................  $722,647    $325,801
                                                              ========    ========
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       46
<PAGE>   47

                                S3 INCORPORATED

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                         (IN THOUSANDS, EXCEPT SHARES)

<TABLE>
<CAPTION>
                                                                                  ACCUMULATED
                                                                                     OTHER         RETAINED
                                                 COMMON STOCK       ADDITIONAL   COMPREHENSIVE     EARNINGS
                                              -------------------    PAID-IN        INCOME       (ACCUMULATED
                                                SHARES     AMOUNT    CAPITAL        (LOSS)         DEFICIT)       TOTAL
                                              ----------   ------   ----------   -------------   ------------   ---------
<S>                                           <C>          <C>      <C>          <C>             <C>            <C>
BALANCE AT DECEMBER 31, 1996................  48,331,794     $5      $169,406      $    (54)      $  90,964     $ 260,321
  Comprehensive loss:
    Net income..............................          --     --            --            --           8,878         8,878
    Other comprehensive loss, net of tax:
      Change in unrealized gain on
        investments.........................          --     --            --         3,720              --         3,720
      Change in foreign currency translation
        adjustment..........................          --     --            --       (19,944)             --       (19,944)
                                                                                                                ---------
    Other comprehensive loss................                                                                      (16,224)
                                                                                                                ---------
  Comprehensive loss........................                                                                       (7,346)
  Exercise of stock options.................   1,703,768     --         8,796            --              --         8,796
  Employee stock purchase plan..............     414,646     --         3,180            --              --         3,180
  Tax benefit of stock option
    transactions............................          --     --         3,825            --              --         3,825
  Stock compensation plan...................      99,071     --         2,064            --              --         2,064
                                              ----------     --      --------      --------       ---------     ---------
BALANCE AT DECEMBER 31, 1997................  50,549,279      5       187,271       (16,278)         99,842       270,840
  Comprehensive loss:
    Net loss................................          --     --            --            --        (113,204)     (113,204)
    Other comprehensive income, net of tax:
      Change in unrealized loss on
        investments.........................          --     --            --        (5,995)             --        (5,995)
      Change in foreign currency translation
        adjustment..........................          --     --            --         7,518              --         7,518
                                                                                                                ---------
    Other comprehensive income..............                                                                        1,523
                                                                                                                ---------
  Comprehensive loss........................                                                                     (111,681)
  Exercise of stock options.................     560,546     --         1,984            --              --         1,984
  Employee stock purchase plan..............     606,346     --         2,387            --              --         2,387
                                              ----------     --      --------      --------       ---------     ---------
BALANCE AT DECEMBER 31, 1998................  51,716,171      5       191,642       (14,755)        (13,362)      163,530
  Comprehensive loss:
    Net loss................................          --     --            --            --         (30,780)      (30,780)
    Other comprehensive income, net of tax:
      Change in unrealized loss on
        investments.........................          --     --            --         3,132              --         3,132
      Change in foreign currency translation
        adjustment..........................          --     --            --         4,060              --         4,060
                                                                                                                ---------
    Other comprehensive income..............                                                                        7,192
                                                                                                                ---------
  Comprehensive loss........................          --     --            --            --              --       (23,588)
  Private issuance..........................   3,423,000      1        34,438            --              --        34,439
  Exercise of stock options.................   3,390,645     --        18,155            --              --        18,155
  Employee stock purchase plan..............     895,491     --         2,294            --              --         2,294
  Diamond acquisition.......................  18,714,438      2       183,923            --              --       183,925
  Sale of warrant...........................          --     --           990            --              --           990
  Tax benefit of stock option
    transactions............................          --     --         2,888            --              --         2,888
                                              ----------     --      --------      --------       ---------     ---------
BALANCE AT DECEMBER 31, 1999................  78,139,745     $8      $434,330      $ (7,563)      $ (44,142)    $ 382,633
                                              ==========     ==      ========      ========       =========     =========
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       47
<PAGE>   48

                                S3 INCORPORATED

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                     YEAR ENDED DECEMBER 31,
                                                                ----------------------------------
                                                                  1999         1998         1997
                                                                ---------    ---------    --------
<S>                                                             <C>          <C>          <C>
OPERATING ACTIVITIES
  Net income (loss).........................................    $ (30,780)   $(113,204)   $  8,878
  Adjustments to reconcile net income (loss) to net cash
    used for operating activities:
    Deferred income taxes...................................      (61,669)      15,453       5,432
    Depreciation............................................       19,530       18,844      15,504
    Amortization............................................       12,156        8,347       2,987
    Write-off of prepaid production capacity................           --        4,000          --
    Utilization of production capacity rights...............           --        4,291      (2,400)
    Loss on disposal of property and equipment..............           --       11,308       2,214
    Write-off of impaired assets............................           --       27,226      17,180
    Write-off of acquired technologies......................        6,700        8,000          --
    Gain on sale of shares of joint venture.................      (22,433)     (26,561)         --
    Stock compensation......................................           --           --       2,064
    Equity in income from joint venture.....................       (4,588)     (17,469)    (30,962)
    Minority interest.......................................        4,642           --          --
    Changes in assets and liabilities:
      Accounts receivable...................................        3,921       36,849      15,407
      Inventories...........................................      (34,704)      60,499     (18,416)
      Prepaid expenses and other............................        3,655        1,158     (25,451)
      Accounts payable......................................        5,919      (26,573)     (8,341)
      Accrued compensation and benefits.....................       (2,395)      (2,397)     (1,574)
      Accrued liabilities...................................        7,492        1,515       3,362
      Deferred revenue......................................         (190)      (9,015)     (1,192)
      Income taxes payable..................................       25,225      (11,576)     (3,536)
                                                                ---------    ---------    --------
         Net cash used for operating activities.............      (67,519)      (9,305)    (18,844)
                                                                ---------    ---------    --------
INVESTING ACTIVITIES
  Property and equipment purchases, net.....................       (6,614)      (5,916)    (30,299)
  Purchases of short-term investments.......................     (107,747)    (125,406)    (16,404)
  Sales of short-term investments...........................      148,937           --          --
  Maturities of short-term investments......................           --       66,691      55,705
  Investment in real estate partnership.....................        7,812           --          --
  Sale of joint venture.....................................       22,433       68,025          --
  Merger with Diamond Multimedia............................      (22,521)          --          --
  Equity investment in technology company...................           --           --      (5,000)
  Purchase of technology....................................           --      (40,000)         --
  Other assets..............................................       (3,642)      (2,276)    (10,412)
                                                                ---------    ---------    --------
         Net cash from (used for) investing activities......       38,658      (38,882)     (6,410)
                                                                ---------    ---------    --------
FINANCING ACTIVITIES
  Sale of common stock, net.................................       57,779        4,371      11,976
  Sale of warrant...........................................          990           --          --
  Net borrowings (repayments) of notes payable..............      (20,752)     (10,000)     10,000
  Net borrowings (repayments) on equipment financing........           --       (5,646)       (854)
                                                                ---------    ---------    --------
  Net cash provided by (used for) financing activities......       38,017      (11,275)     21,122
                                                                ---------    ---------    --------
Effect of exchange rate changes.............................        5,647           --          --
                                                                ---------    ---------    --------
Net increase (decrease) in cash and equivalents.............       14,803      (59,462)     (4,132)
Cash and equivalents at beginning of period.................       31,022       90,484      94,616
                                                                ---------    ---------    --------
Cash and equivalents at end of period.......................    $  45,825    $  31,022    $ 90,484
                                                                =========    =========    ========
SUPPLEMENTAL CASH FLOW INFORMATION
  Interest paid.............................................    $   7,524    $   6,235    $  6,665
  Income taxes paid (refunded), net.........................    $ (20,022)   $ (15,900)   $ 10,119
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       48
<PAGE>   49

                                S3 INCORPORATED

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

  Organization

     S3 Incorporated ("S3" or the "Company") was incorporated on January 9, 1989
and is a leading supplier of high performance multimedia accelerator solutions,
connectivity products for the digital home and products for acquiring, managing
and experiencing music and spoken audio programming from the Internet. The
Company's products are used in, and its business is dependent on, the personal
computer industry and the development of the Internet with sales primarily in
the U.S., Asia and Europe (see Note 11). Its products are manufactured,
assembled and tested by independent wafer foundries and contract manufacturers.

  Basis of Presentation

     The consolidated financial statements include the accounts of S3 and its
wholly-owned subsidiaries. All significant inter-company balances and
transactions have been eliminated. Investments in entities in which the Company
does not have control, but has the ability to exercise significant influence
over operating and financial policies are accounted for by the equity method.

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities; the
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. Significant estimates include allowances for doubtful accounts
and customer returns, deferred tax assets, the useful lives of fixed assets and
intangible assets, inventory and other reserves. Actual results could differ
from those estimates, and such differences may be material to the financial
statements.

  Cash, Cash Equivalents and Short-Term Investments

     The Company considers all highly liquid investments with a remaining
maturity of 90 days or less at the time of purchase to be cash equivalents. Cash
equivalents are carried at cost, which approximates fair value. The Company's
short-term investments primarily comprise readily marketable debt and equity
securities with remaining maturities of more than 90 days at the time of
purchase.

     The Company has classified its entire investment portfolio as
available-for-sale. Available-for-sale securities are classified as cash
equivalents or short-term investments and are stated at fair value with
unrealized gains and losses included in accumulated other comprehensive income
(loss). The amortized cost of debt securities is adjusted for amortization of
premiums and accretion of discounts to maturity. Such amortization and accretion
are included in interest income. Realized gains and losses are included in other
income (expense). The cost of securities sold is based on the specific
identification method.

  Fair Value of Financial Instruments

     The carrying value of cash and cash equivalents approximates fair value.
The fair values of short-term investments, convertible subordinated notes and
foreign currency forward exchange contracts are estimated based on quoted market
prices.

  Derivative Financial Instruments

     The Company periodically enters forward foreign exchange contracts
primarily to hedge the value of accounts receivable denominated in foreign
currencies against fluctuations in exchange rates until such receivables are
collected. The Company does not enter into forward foreign exchange contracts
for speculative or trading purposes. The Company's accounting policies for these
contracts are based on the Company's

                                       49
<PAGE>   50
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

designation of the contracts as hedges of firm foreign currency commitments.
Gains and losses on forward foreign exchange contracts are deferred and
recognized in income in the same period as losses and gains on the underlying
transactions are recognized and generally offset. As of December 31, 1999, the
Company had two foreign exchange forward contracts outstanding. Each contract
allows the Company to sell 275,905,000 New Taiwanese Dollars. These contracts
expire on April 3, 2000 and July 5, 2000.

  Inventories

     Inventories consist of raw materials, work in process and finished goods
and are stated at the lower of cost (first-in, first-out) or market. The
Company's products typically experience short product life cycles and the
Company estimates the market value of its inventory based on anticipated selling
prices adjusted for completion and selling costs. Should the Company experience
a substantial unanticipated decline in the selling price of its products and/or
demand thereof, a material valuation adjustment and corresponding charge to
operations could result.

     Required payments under a wafer supply agreement to secure future
production capacity are capitalized and amortized to inventory costs as the
related product is received.

     Inventories consist of:

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           ------------------
                                                            1999       1998
                                                           -------    -------
                                                             (IN THOUSANDS)
<S>                                                        <C>        <C>
Raw materials............................................  $40,132    $    --
Work in process..........................................   10,418      6,340
Finished goods...........................................   46,611      5,043
                                                           -------    -------
          Total..........................................  $97,161    $11,383
                                                           =======    =======
</TABLE>

  Property and Equipment

     Property and equipment are stated at cost. Depreciation is computed using
the straight-line method over estimated useful lives of three to seven years for
machinery and equipment and five to seven years for furniture and fixtures.
Leasehold improvements are amortized using the straight-line method over the
shorter of the lease term or the assets' useful lives.

     Property and equipment consist of:

<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                         --------------------
                                                           1999        1998
                                                         --------    --------
                                                            (IN THOUSANDS)
<S>                                                      <C>         <C>
Machinery and equipment................................  $ 78,271    $ 37,718
Furniture and fixtures.................................     7,924       3,622
Leasehold improvements.................................     9,490       4,347
                                                         --------    --------
          Total........................................    95,685      45,687
Accumulated depreciation and amortization..............   (61,281)    (23,295)
                                                         --------    --------
Property and equipment, net............................  $ 34,404    $ 22,392
                                                         ========    ========
</TABLE>

  Long-Lived Assets

     The Company recognizes impairment losses on long-lived assets used in
operations when indicators of impairment are present and the undiscounted cash
flows estimated to be generated by those assets are less than the assets'
carrying amounts. The impairment loss is measured by comparing the fair value of
the asset to

                                       50
<PAGE>   51
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

its carrying amount. The Company annually evaluates the recoverability of its
long-lived assets based on the estimated future undiscounted cash flows. See
Note 13 for further discussion of impairment charges.

  Foreign Currency Translation

     The Company translates the accounts of its foreign subsidiaries using the
local currency as the functional currency. Consequently, the assets and
liabilities of the Company's subsidiaries and joint venture are translated into
U.S. dollars at current exchange rates and revenues and expenses are translated
at average monthly exchange rates. The resulting translation adjustments are
recorded as a separate component of accumulated other comprehensive income
(loss).

  Revenue Recognition

     Revenue from product sales made directly to customers is generally
recognized upon shipment. Accruals for estimated sales returns and allowances
are recorded at the time of sale. Certain of the Company's sales are made to
distributors under agreements allowing price protection and rights of return on
unsold products by the distributors. The Company defers recognition of revenue
on such sales until the product is sold by the distributors.

  Concentration of Credit Risk

     Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of cash equivalents, short-term
investments, trade accounts receivable and foreign exchange contracts. The
Company invests only in high credit quality short-term debt instruments and
limits the amount of credit exposure to any one entity. A majority of the
Company's trade receivables result from sales to manufacturers in the computer
industry. Three customers combined accounted for greater than 52% of the
Company's accounts receivable balance at December 31, 1999. The Company performs
ongoing credit evaluations of its customers' financial condition and limits the
amount of credit extended when deemed necessary but generally requires no
collateral. The Company maintains reserves for potential credit losses, and all
such losses to date have been within management's expectations.

  Research and Development Expenses

     Research and development is expensed as incurred. To the extent research
and development costs include the development of computer software, the Company
believes that software development is an integral part of the semiconductor
design and expenses all such costs as incurred.

  Income Taxes

     The Company accounts for income taxes using the asset and liability
approach.

  Stock-Based Compensation

     The Company accounts for stock-based awards to employees using the
intrinsic value method. The Company adopted the disclosure of pro forma net
income (loss) and earnings (loss) per share as if the Company adopted the fair
value-based method in measuring compensation expense as of the beginning of
fiscal 1995.

  Recently Issued Accounting Standards

     In June 1998, the Financial Accounting Standards Board issued Statement No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133")
which provides a comprehensive and
                                       51
<PAGE>   52
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

consistent standard for the recognition and measurement of derivatives and
hedging activities. The statement, as amended, is effective for fiscal years
commencing after June 15, 2000. The Company will does not believe that SFAS 133
will have a material impact on earnings or the financial condition of the
Company.

     In December 1999, the Securities and Exchange Commission (the "SEC") issued
SEC Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in
Financial Statements." SAB 101 summarizes certain of the SEC's views in applying
generally accepted accounting principles to revenue recognition in financial
statements. The Company has not completed its review of SAB 101 and has not
determined the financial impact on the Company's consolidated results of
operations. The Company will adopt SAB 101 in the second quarter of fiscal 2000.

  Reclassifications

     Certain prior year amounts have been reclassified to conform to the current
year presentation. Such reclassifications had no effect on net income (loss) or
stockholders' equity.

 2. BUSINESS COMBINATIONS

     On September 24, 1999, the Company completed the acquisition of all of the
outstanding common stock of Diamond Multimedia Systems, Inc. ("Diamond").
Diamond designs, develops, manufactures and markets multimedia and connectivity
products for personal computers. The transaction was accounted for as a purchase
and, accordingly, the results of operations of Diamond and the estimated fair
value of assets acquired and liabilities assumed are included in the Company's
consolidated financial statements as of September 24, 1999, the effective date
of the purchase, through the end of the fiscal year.

     Pursuant to the Merger Agreement, each share of Diamond common stock was
converted into the right to receive 0.52 shares of the Company's common stock.
No fractional shares were issued. Stockholders otherwise entitled to a
fractional share received cash on the effective date of the merger. In addition,
each option and right to acquire Diamond common stock granted under Diamond's
stock-based incentive plans was converted into an option to purchase Company
common stock. Approximately 18.7 million common shares of S3 stock were issued
to Diamond shareholders and approximately 1.3 million options were assumed.

     The purchase price of $216.9 million includes $172.2 million of stock
issued at fair value (fair value being determined as the average price of the S3
stock for a period three days before and after the announcement of the merger),
$11.7 million in Diamond stock option costs (being determined under both the
Black-Scholes formula and in accordance with the Merger Agreement), cash paid to
Diamond of $20.0 million and $13.0 million in estimated expenses of the
transaction. The purchase price was allocated as follows: $1.2 million to the
estimated fair value of Diamond net liabilities assumed (as of September 24,
1999), $6.7 million to purchased in-process research and development, $6.8
million to purchased existing technology, $11.4 million to trade names, $5.5
million to workforce-in-place, $12.5 million to Diamond distribution channel
relationships and $172.8 million to goodwill. Goodwill is recorded as a result
of consideration paid in excess of the fair value of net tangible and intangible
assets acquired. Goodwill and identified acquisition related intangible assets
are amortized on a straight-line basis over the periods indicated below. The
allocation of the purchase price to intangibles was based upon management's
estimates. The purchase price and the related allocation are subject to further
refinement and change over the initial year of combined operations.

     Management has completed its integration plans related to Diamond. The
integration plans include initiatives to combine the operations of Diamond and
S3 and consolidate duplicative operations. Areas where management estimates may
be revised primarily relate to employee severance and relocation costs and other
exit costs. Adjustments to accrued integration costs related to Diamond will be
recorded as adjustments to the fair value of net assets in the purchase price
allocation. Accrued integration charges included $3.1 million

                                       52
<PAGE>   53
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

related to involuntary employee separation and relocation benefits for employees
and $1.5 million in other exit costs primarily relating to the closing or
consolidation of facilities and the termination of certain contractual
relationships. The accruals recorded related to the integration of Diamond are
based upon management's current estimate of integration costs.

     The intangible assets and goodwill acquired have estimated useful lives and
estimated first year amortization, as follows (dollars in thousands):

<TABLE>
<CAPTION>
                                                                                      CALCULATED
                                                                       ESTIMATED      FIRST YEAR
                                                           AMOUNT     USEFUL LIFE    AMORTIZATION
                                                          --------    -----------    ------------
<S>                                                       <C>         <C>            <C>
Purchased existing technology...........................  $  6,800    2 - 4 years      $ 2,708
Tradenames..............................................    11,400       7 years         1,629
Workforce-in-place......................................     5,500       4 years         1,375
Diamond distribution channel relationships..............    12,500       5 years         2,500
Goodwill................................................   172,774       5 years        34,555
</TABLE>

     The value assigned and written off as purchased in-process research and
development ("IPR&D") of $6.7 million was determined by identifying research
projects in areas for which technological feasibility had not been established.
The value was determined by estimating the expected cash flows from the projects
once commercially viable, discounting the net cash flows back to their present
value and then applying a percentage of completion to the calculated value as
defined below.

     The net cash flows from the identified projects are based on our estimates
of revenues, cost of sales, research and development costs, selling, general and
administrative costs, royalty costs and income taxes from those projects. These
estimates are based on the assumptions mentioned below. The research and
development costs included in the model reflect costs to sustain projects, but
exclude costs to bring in-process projects to technological feasibility.

     The estimated revenues are based on management projections of each
in-process project and the business projections were compared and found to be in
line with industry analysts' forecasts of growth in substantially all of the
relevant markets. Estimated total revenues from the IPR&D product areas are
expected to peak in the year 2000 and decline over the following two years as
other new products are expected to become available. These projections are based
on our estimates of market size and growth, expected trends in technology and
the nature and expected timing of new project introductions by our competitors
and us.

     Projected gross margins approximate Diamond's recent historical performance
and are in line with comparable industry margins. The estimated selling, general
and administrative costs are consistent with Diamond's historical cost
structure, which is in line with industry averages. Research and development
costs are consistent with Diamond's historical cost structure.

     The discount rate used in discounting the net cash flows from IPR&D ranged
from 25% to 35%. Relatively high discount rates were used to reflect the
inherent uncertainties surrounding the successful development of the IPR&D,
market acceptance of the technology, the useful life of such technology and the
uncertainty of technological advances that could potentially impact the
estimates described above.

     The percentage of completion for each project was determined using costs
incurred to date on each project as compared to the remaining research and
development to be completed to bring each project to technological feasibility.
The percentage of completion varied by individual project ranging from 20% to
60%.

     If the projects discussed above are not successfully developed, the sales
and profitability of the combined company may be adversely affected in future
periods.

                                       53
<PAGE>   54
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

 3. FINANCIAL INSTRUMENTS

     The following is a summary of available-for-sale securities:

<TABLE>
<CAPTION>
                                            AMORTIZED     MARKET      UNREALIZED        UNREALIZED
                                              COST        VALUE      HOLDING GAINS    HOLDING LOSSES
                                            ---------    --------    -------------    --------------
                                                                 (IN THOUSANDS)
<S>                                         <C>          <C>         <C>              <C>
DECEMBER 31, 1999:
Corporate Debt Securities:
  Money market mutual funds...............  $ 13,240     $ 13,240       $   --           $    --
  Commercial paper........................       894          897            3
  Corporate bonds.........................    23,141       22,797           --              (344)
  Municipal bonds.........................     1,829        1,815           --               (14)
  Market auction preferreds...............     7,000        7,000           --                --
  Certificates of deposit.................     5,024        5,000           --               (24)
                                            --------     --------       ------           -------
          Total Corporate Debt
            Securities....................    51,128       50,749            3              (382)
Corporate Equity Securities...............    19,038       20,462        2,231              (807)
U.S. Government Securities................     8,901        8,844           --               (57)
                                            --------     --------       ------           -------
                                            $ 79,067     $ 80,055       $2,234           $(1,246)
                                            ========     ========       ======           =======
Included in short-term investments........  $ 57,933     $ 58,918       $2,231           $(1,246)
Included in cash and cash equivalents.....    21,134       21,137            3                --
                                            --------     --------       ------           -------
                                            $ 79,067     $ 80,055       $2,234           $(1,246)
                                            ========     ========       ======           =======
DECEMBER 31, 1998:
Corporate Debt Securities:
  Money market mutual funds...............  $ 15,645     $ 15,645       $   --           $    --
  Commercial paper........................     5,475        5,470           --                (5)
  Corporate bonds.........................    35,802       35,860           68               (10)
  Municipal bonds.........................     5,000        5,000           --                --
  Market auction preferreds...............    25,500       25,500           --                --
  Certificates of deposit.................    19,002       19,016           16                (2)
                                            --------     --------       ------           -------
          Total Corporate Debt
            Securities....................   106,424      106,491           84               (17)
Corporate Equity Securities...............     6,600        4,204           --            (2,396)
                                            --------     --------       ------           -------
                                            $113,024     $110,695       $   84           $(2,413)
                                            ========     ========       ======           =======
Included in short-term investments........  $ 90,881     $ 88,553       $   84           $(2,412)
Included in cash and cash equivalents.....    22,143       22,142           --                (1)
                                            --------     --------       ------           -------
                                            $113,024     $110,695       $   84           $(2,413)
                                            ========     ========       ======           =======
</TABLE>

                                       54
<PAGE>   55
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

  Fair Value Disclosures

     The carrying values and fair values of the Company's financial instruments
are as follows:

<TABLE>
<CAPTION>
                                                   DECEMBER 31, 1999          DECEMBER 31, 1998
                                                -----------------------    -----------------------
                                                CARRYING     ESTIMATED     CARRYING     ESTIMATED
                                                 AMOUNT      FAIR VALUE     AMOUNT      FAIR VALUE
                                                ---------    ----------    ---------    ----------
                                                                  (IN THOUSANDS)
<S>                                             <C>          <C>           <C>          <C>
Cash and cash equivalents.....................  $  45,825     $ 45,825     $  31,022     $ 31,022
Short-term investments........................     58,918       58,918        88,553       88,553
Convertible subordinated notes................   (103,500)     (96,131)     (103,500)     (76,750)
Foreign currency forward exchange contracts...         --         (386)           --           25
</TABLE>

 4. INVESTMENTS

  Investment in USC

     During 1995, the Company entered into two long-term manufacturing capacity
arrangements. The Company entered into an agreement with United Microelectronics
Corporation ("UMC") and Alliance Semiconductor Corporation to form United
Semiconductor Corporation ("USC"), a separate Taiwanese company, for the purpose
of building and managing a semiconductor manufacturing facility in Taiwan,
Republic of China. The Company invested a total of $89.4 million for its equity
interest of 23.75%. On December 31, 1998, the Company entered into an agreement
with UMC to sell to UMC 80 million shares of stock of USC for a purchase price
of 2.4 billion New Taiwan dollars. The Company received the purchase price
(approximately $68.0 million in cash) in January 1999 upon closing. As a result
of the January 1999 sale to UMC, S3's percentage ownership in USC decreased to
15.75% and altered its method of accounting for its interest in the joint
venture from the equity method to the cost method. The Company has the right to
purchase up to 31.25% of the output from the foundry.

     In June of 1999, the Company announced that it would receive $42.0 million
for a patent license and release of contingencies on the previous USC stock sale
from UMC. Payments are being received over five fiscal quarters beginning in the
quarter ended June 30, 1999. Under the terms of the agreement, S3 will license
UMC 29 patents covering multimedia products and integrated circuit manufacturing
technology for use in products manufactured by UMC. In addition, the Company
agreed to release UMC from contingencies associated with the sale of 80 million
shares of stock of USC in January 1998. The Company agreed to waive rights to
its USC board seat and determined that it no longer could exercise significant
influence over the financial and operating decisions of USC. Accordingly, in
June 1999 the Company ceased accounting for its investment in USC using the
equity method of accounting.

     In June 1999 UMC announced that it would provide one share of UMC for every
share of USC stock. The expected transaction was a result of UMC's foundry
consolidation plans whereby USC, United Integrated Circuits Corporation
("UICC"), United Silicon Incorporated ("USIC") and UTEK Semiconductor
Corporation ("UTEK"), were merged into UMC.

     As the Company currently owns 252 million shares of USC, this will result
in the transfer of 252 million UMC shares of stock to the Company. The
transaction was approved by UMC shareholders at the end of July 1999. The final
share transfer occurred in January 2000. As the shares owned in UMC are publicly
traded and the Company is accounting for its investment on the cost basis, the
investment will be adjusted to market value beginning in the first quarter of
2000, in accordance with SFAS 115.

                                       55
<PAGE>   56
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

  Interest in Partnership

     In 1995, the Company entered into a limited partnership arrangement (the
"partnership") with a developer to obtain a ground lease and develop and operate
the Company's current Santa Clara facilities. The Company invested $2.1 million
for a 50% limited partnership interest. On June 29, 1999, the Company entered
into an agreement to assign to the general partner the Company's entire interest
in the partnership for $7.8 million. The gain on the assignment of the Company's
partnership interest is being recognized over the term of the facilities lease,
which expires in 2008.

  Investments in OneStep, LLC and Rioport.com, Inc.

     In July 1999, the Company acquired OneStep, LLC, a software development
company that supplies the Rio Audio Manager to RioPort.com, Inc. for $10.9
million in cash. The Rio Audio Manager is designed to allow audio enthusiasts to
easily acquire, create, organize and playback music or spoken audio programming
in one simple application.

     In October 1999, S3 caused RioPort.com, Inc., which was a wholly owned
subsidiary, to sell shares of its preferred stock to third party investors.
RioPort.com is developing an integrated platform for acquiring, managing and
experiencing music and spoken audio programming from the Internet. As a result,
the Company retains a minority investment in RioPort.com, Inc. and accounts for
its investment using the equity method of accounting. In addition, in November
1999, the Company received $10.9 million for the sale of OneStep, LLC to
RioPort.com, Inc.

  Investment in S3-VIA, Inc.

     In November 1999, the Company established a joint venture with VIA
Technologies, Inc. to bring high-performance integrated graphics and core logic
chip sets to the volume OEM desktop and notebook PC markets. The newly formed
S3-VIA, Inc. will have joint funding, exclusive access to both companies'
technology and distribution rights for developed products between S3 and VIA.
The Company owns 50.1% of the voting common stock of the joint venture.
Accordingly, the Company consolidates the accounts of S3-VIA, Inc. in its
consolidated financial statements.

 5. CONVERTIBLE SUBORDINATED NOTES

     In September 1996, the Company completed a private placement of $103.5
million of convertible subordinated notes. The notes mature in 2003. Interest is
payable semi-annually at 5  3/4% per annum. The notes are convertible at the
option of the note holders into the Company's common stock at an initial
conversion price of $19.22 per share, subject to adjustment. Beginning in
October 1999, the notes are redeemable at the option of the Company at an
initial redemption price of 102% of the principal amount. The Company has
reserved 5,385,015 shares of common stock (plus such additional number of shares
that may be required pursuant to the operation of anti-dilution provisions) for
the conversion of these notes. Offering costs of approximately $3.4 million are
included in other assets and are amortized on a straight-line basis over the
term of the notes. The fair value of the convertible subordinated notes at
December 31, 1999 was approximately $96.1 million.

 6. LINE OF CREDIT AND NOTES PAYABLE

     In 1995 the Company expanded and formalized its relationship with Taiwan
Semiconductor Manufacturing Company (TSMC) to provide additional capacity over
the 1996 to 2000 timeframe. The agreement with TSMC requires the Company to make
certain annual advance payments to be applied against the following year's
capacity. The Company has signed promissory notes to secure these payments over
the term of the

                                       56
<PAGE>   57
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

agreement. The notes bear interest at 10% per annum commencing on the individual
note's maturity dates if such notes are not paid. At December 31, 1999, the
remaining advance payments totaled $14.3 million and the corresponding
promissory notes totaled $9.6 million. During the second quarter of 1998, the
Company and TSMC agreed to extend the term of the agreement two years to 2002.
The corresponding notes payable were extended with the final payment due in
2001.

     At December 31, 1999, the Company has a $50.0 million domestic bank
facility permitting borrowings at the prime rate. This bank facility expires
January 2001. The covenants covering this debt agreement pertain to minimum
levels of collateral coverage and tangible net worth, quarterly profitability
and minimum levels of liquidity. As of December 31, 1999, the Company was in
default with its loan covenants regarding liquidity. The Company obtained a
waiver for this violation. Additionally, the Company has credit facilities under
foreign lines of credit. The Company has a foreign line of credit of 10 million
DeutscheMarks (approximately $5.1 million at December 31, 1999). The Company
also has a foreign line of credit of 400,000 British Pounds (approximately
$647,000 at December 31, 1999). Borrowings, included in Notes Payable, were
$41.7 million under these facilities at December 31, 1999.

     As of December 31, 1999, the Company's future payments on debt related to
notes payable, lines of credit and capital lease obligations are due in 2000,
therefore all amounts have been classified as current.

 7. STOCKHOLDERS' EQUITY

  Preferred Stock

     The number of shares of preferred stock authorized to be issued is
5,000,000 with a par of $0.0001 per share. The preferred stock may be issued
from time to time in one or more series. The Board of Directors is authorized to
provide rights, preferences, privileges and restrictions of the shares of such
series. As of December 31, 1999, no shares of preferred stock had been issued.

  Stockholder Rights Plan

     On May 14, 1997, the Board adopted a Stockholder Rights Plan. To implement
the plan, S3's Board declared a dividend of one preferred stock purchase right
(a "Right") for each outstanding share of S3 common stock held of record on June
1, 1997. Each Right represents a contingent right to purchase, under certain
circumstances, a fractional share of a newly created series of S3 preferred
stock. The Rights would become exercisable and trade independently from S3
common stock upon the public announcement of the acquisition by a person or
group of 15 percent or more of S3's common stock, or ten days after commencement
of a tender or exchange offer for S3 common stock that would result in the
acquisition of 15 percent or more of S3's common stock. In the event one of the
limited conditions is triggered, each Right entitles the registered holder to
purchase one one-thousandth of a share of Preferred Stock at an exercise price
of $85.00 per right. The Board of Directors may redeem the Rights at $0.01 per
Right pursuant to the plan. The Rights expire May 14, 2007.

  Employee Stock Purchase Plans

     Under the terms of the Merger Agreement with Diamond, the Company assumed
Diamond's 1995 Employee Stock Purchase Plan (the "1995 Purchase Plan"). Upon
consummation of the Merger, each 1995 Purchase Plan option was converted into a
right to purchase shares of S3's stock. The Company reserved 52,000 shares of
common stock for the offering period in effect at the date of the merger. This
offering period concluded on October 31, 1999 and no new offering periods will
be commenced under the 1995 Purchase Plan. The Company's 1993 Employee Stock
Purchase Plan permits eligible employees to purchase shares at a price equal to
85% of the lower of the fair market value at the beginning or end of the
purchase period. At

                                       57
<PAGE>   58
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

December 31, 1999, 2,513,660 shares have been issued under the plans and 338,340
shares have been reserved for further issuance.

  Stock Plans

     The 1989 Stock Plan of S3 Incorporated (the "1989 Option Plan") was
established for the grant of incentive or nonstatutory stock options and the
direct award or sale of shares to employees, directors and consultants.
Incentive stock options must be granted at not less than fair market value at
the date of grant. The exercise price of nonstatutory options and the share
price for shares sold generally may be no less than 85% of fair market value at
the date of the grant or sale. In connection with the merger with Diamond, each
outstanding Diamond stock option was assumed by S3 and converted into an option
to acquire shares of S3 common stock on the same terms and conditions (including
any provisions for acceleration) as were applicable to that stock option under
the applicable Diamond stock option plan in effect prior to the merger. At
December 31, 1999, 34,886,948 shares of common stock have been authorized for
issuance under the plans, 20,455,095 shares of common stock are reserved for
issuance under the plans and 3,250,896 shares were available for future grant.

     A summary of stock option activity is as follows:

<TABLE>
<CAPTION>
                                                              NUMBER OF     WEIGHTED AVERAGE
                                                                SHARES      PRICE PER SHARE
                                                              ----------    ----------------
<S>                                                           <C>           <C>
BALANCE, DECEMBER 31, 1996..................................   8,920,099         $ 9.06
Options granted.............................................  11,950,388           7.77
Options exercised...........................................  (1,703,768)          5.16
Options cancelled...........................................  (9,114,879)         11.17
                                                              ----------         ------
BALANCE, DECEMBER 31, 1997..................................  10,051,840           6.28
Options granted.............................................   9,609,391           4.26
Options exercised...........................................    (560,546)          3.57
Options cancelled...........................................  (4,057,968)          7.09
                                                              ----------         ------
BALANCE, DECEMBER 31, 1998..................................  15,042,717           4.86
Options granted.............................................   7,920,117           8.50
Options exercised...........................................  (3,390,645)          5.24
Options cancelled...........................................  (2,367,990)          6.51
                                                              ----------         ------
BALANCE, DECEMBER 31, 1999..................................  17,204,199         $ 6.22
                                                              ==========         ======
</TABLE>

     Options to purchase 6,729,122, 4,400,697, and 2,284,502 shares were
exercisable at December 31, 1999, 1998 and 1997, respectively, with a weighted
average exercise price of $5.24, $5.89 and $7.16, respectively.

     Options generally vest over a period of four years and generally become
exercisable beginning either six months or one year from the date of employment
or grant. Options generally expire ten years from the date of grant. The Company
repriced options related to 6,520,033 shares to $5.125, the fair market value on
December 18, 1997. The repriced options are treated as cancelled and regranted,
however, they retained their original vesting terms and expiration dates. All
replacement options were subject to a one-year blackout on exercise (with the
exception of those options held by employees whose employment was terminated on
January 20, 1998 as part of a reduction in force announced by the Company). With
regard to other employees whose employment was not terminated on January 20,
1998, if their employment was terminated prior to the end of the blackout
period, any repriced options were forfeited.

                                       58
<PAGE>   59
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

     In October 1998, the Company entered into an employment agreement with
Kenneth F. Potashner, pursuant to which Mr. Potashner is employed as the
President, Chief Executive Officer and Chairman of the Board. Mr. Potashner
received two options to purchase an aggregate of 4,500,000 shares of the Common
Stock of the Company. One option for 1,500,000 shares vested in 1999. The second
option for 3,000,000 shares vests over a four year period in accordance with the
following schedule: 750,000 shares vest on the first anniversary of Mr.
Potashner's employment with the Company; thereafter, the options shall vest in
equal monthly installments of 62,500 shares.

  Stock Compensation Arrangement

     Pursuant to an incentive compensation plan for certain employees, the
Company issued 99,071 shares of common stock on June 30, 1997. The Company
accrued the related compensation cost ratably over the vesting periods.

  Stock-Based Compensation

     Under APB 25, the Company generally recognizes no compensation expense with
respect to stock-based awards to employees. Pro forma information regarding net
income (loss) and net income (loss) per share is required by SFAS 123 for awards
granted after December 31, 1994, as if the Company had accounted for its
stock-based awards to employees under the fair value method. The fair value of
the Company's stock-based awards to employees was estimated using the
Black-Scholes option valuation model. The Black-Scholes option valuation model
was developed for use in estimating fair value of traded options that have no
vesting restrictions and are fully transferable. 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 following table summarizes significant ranges of outstanding and
exercisable options at December 31, 1999:

<TABLE>
<CAPTION>
                             OPTIONS OUTSTANDING
                     ------------------------------------    OPTIONS EXERCISABLE
                                    WEIGHTED                ----------------------
                                     AVERAGE     WEIGHTED                 WEIGHTED
                                    REMAINING    AVERAGE                  AVERAGE
     RANGE OF          NUMBER      CONTRACTUAL   EXERCISE     NUMBER      EXERCISE
  EXERCISE PRICES    OUTSTANDING   LIFE (YRS)     PRICE     EXERCISABLE    PRICE
  ---------------    -----------   -----------   --------   -----------   --------
<S>                  <C>           <C>           <C>        <C>           <C>
$0.12 - $ 4.38        5,156,950       7.54        $3.35      2,283,414     $3.26
 4.44 -   5.75        4,494,660       7.63         5.22      2,715,861      5.25
 5.78 -   9.31        4,690,320       8.47         7.16      1,385,393      6.15
 9.44 -  36.66        2,862,269       9.33        11.39        344,454     14.65
                     ----------       ----        -----      ---------     -----
$0.12 - $36.66       17,204,199       8.12        $6.22      6,729,122     $5.24
                     ==========       ====        =====      =========     =====
</TABLE>

                                       59
<PAGE>   60
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

     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>
                                             STOCK OPTION PLAN         EMPLOYEE STOCK PURCHASE PLAN
                                         --------------------------    -----------------------------
                                         1999     1998       1997       1999       1998       1997
                                         ----    -------    -------    -------    -------    -------
<S>                                      <C>     <C>        <C>        <C>        <C>        <C>
Expected life from vest date...........  0.5 yrs 0.5 yrs    0.5 yrs    0.0 yrs    0.0 yrs    0.0 yrs
Volatility.............................    83%        84%        69%        83%        84%        65%
Risk-free interest rate................   5.4%       4.9%       5.9%       4.9%       5.0%       5.5%
</TABLE>

     The weighted-average estimated fair value of stock options granted during
1999, 1998 and 1997 was $4.95, $2.21, and $3.53 per share, respectively. The
weighted-average estimated fair value of shares purchased under the Purchase
Plan during 1999, 1998 and 1997 was $2.87, $3.46 and $5.17 and per share,
respectively.

     For pro forma purposes, the estimated fair value of the Company's
stock-based awards to employees is generally amortized over the vesting period
of four years (for options) and the offering period (for stock purchases under
the Purchase Plan). The Company's pro forma information is as follows:

<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                     -----------------------------------------
                                                        1999            1998           1997
                                                     -----------    ------------    ----------
                                                     (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                  <C>            <C>             <C>
Pro forma net loss.................................   $(42,178)      $(127,967)      $(7,575)
Pro forma per share amounts:
  Basic............................................   $  (0.71)      $   (2.51)      $ (0.15)
  Diluted..........................................   $  (0.71)      $   (2.51)      $ (0.15)
</TABLE>

  Intel Warrant

     In December 1998, the Company entered into an agreement pursuant to which
it agreed to issue to Intel Corporation a warrant to purchase 1,000,000 shares
of the Company's Common Stock at an exercise price of $9.00 per share. The
purchase price for the warrant was $990,000. In February 2000, Intel exercised
its warrant and paid the exercise price using some of the shares of the
Company's Common Stock it would have otherwise received upon exercise, acquiring
429,477 shares of Common Stock.

 8. LEASES AND COMMITMENTS

  Operating Leases

     The Company occupies facilities in several countries including the U.S.,
Canada, France, Germany, Hong Kong, Japan, Korea, Singapore, Taiwan and the
United Kingdom and is obligated under leases expiring through 2008. Under the
leases, the Company is responsible for insurance, maintenance and property
taxes. During 1995, the Company entered into a limited partnership arrangement
with a developer to obtain a ground lease and develop and operate the Company's
Santa Clara, California facilities. In January 1997, prior to the expiration of
the lease terms of the previous facilities, the Company relocated its principal
administrative facilities to the new Santa Clara facilities at which time the
Company's minimum operating lease payment of $369,000 commenced for the initial
12 year term. During 1997, the Company sublet a portion of its previous
facilities for the remaining lease terms and negotiated a lease termination on
the other two previous facilities. During 1998, the Company sublet a portion of
its current facilities through 2008.

                                       60
<PAGE>   61
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

     Future minimum annual payments under operating leases, without
consideration of subleases, are as follows:

<TABLE>
<CAPTION>
                                                        OPERATING LEASES
                                                        ----------------
                                                         (IN THOUSANDS)
<S>                                                     <C>
2000..................................................      $11,379
2001..................................................        8,161
2002..................................................        6,267
2003..................................................        5,370
2004..................................................        5,270
Thereafter............................................       19,996
                                                            -------
          Total minimum lease payments................      $56,443
                                                            =======
</TABLE>

     The total of minimal rentals to be received in the future under
non-cancelable subleases is $39.8 million as of December 31, 1999.

     Rent expense for 1999, 1998 and 1997, was $10.1 million, $8.9 million and
$7.1 million, respectively. Sublease income for 1999, 1998 and 1997 was $4.4
million, $2.6 million and $1.5 million, respectively. Net rent expense for 1999,
1998 and 1997 was $5.7 million, $6.3 million and $5.6 million, respectively.

 9. INCOME TAXES

     The provision (benefit) for income taxes consists of:

<TABLE>
<CAPTION>
                                                         YEARS ENDED DECEMBER 31,
                                                      -------------------------------
                                                        1999        1998       1997
                                                      --------    --------    -------
                                                              (IN THOUSANDS)
<S>                                                   <C>         <C>         <C>
CURRENT TAX EXPENSE (BENEFIT):
  Federal...........................................  $     --    $(20,802)   $(6,102)
  State.............................................        --          --      4,123
  Foreign...........................................       618          --         --
                                                      --------    --------    -------
                                                           618     (20,802)    (1,979)
                                                      --------    --------    -------
DEFERRED TAX EXPENSE (BENEFIT):
  Federal...........................................   (43,173)      4,995     (3,248)
  State.............................................    (5,361)      3,851     (3,270)
                                                      --------    --------    -------
                                                       (48,534)      8,846     (6,518)
                                                      --------    --------    -------
          Total.....................................  $(47,916)   $(11,956)   $(8,497)
                                                      ========    ========    =======
</TABLE>

     The tax benefits resulting from disqualifying dispositions of shares
acquired under the Company's incentive stock option plan and from the exercise
of non-qualified stock options reduced taxes currently payable as shown by
$2,888,000 in 1999 and $3,825,000 in 1997 which is reflected as additional
paid-in capital. There was no tax benefit in 1998 associated with stock option
activity.

                                       61
<PAGE>   62
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

     The difference between the provision (benefit) for taxes on income and the
amount computed by applying the federal statutory income tax rate to income
(loss) before taxes is explained below:

<TABLE>
<CAPTION>
                                                            YEARS ENDED DECEMBER 31,
                                                          -----------------------------
                                                            1999       1998      1997
                                                          --------   --------   -------
                                                                 (IN THOUSANDS)
<S>                                                       <C>        <C>        <C>
Tax computed at 35%.....................................  $(27,542)  $(49,920)  $(6,521)
Nondeductible goodwill..................................     4,269         --        --
State income taxes, net of federal effect...............        --         --       554
Tax credits.............................................        --     (2,800)   (2,200)
Valuation allowance for tax losses and credits..........   (24,643)    40,729        --
Other...................................................        --         35      (330)
                                                          --------   --------   -------
Benefit for income taxes................................  $(47,916)  $(11,956)  $(8,497)
                                                          ========   ========   =======
Effective tax rate......................................      60.9%       8.4%     45.6%
                                                          ========   ========   =======
</TABLE>

     Significant components of the Company's deferred income tax asset are as
follows:

<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
                                                                --------------------
                                                                  1999        1998
                                                                --------    --------
                                                                   (IN THOUSANDS)
<S>                                                             <C>         <C>
Deferred tax assets:
  Reserves not currently deductible.........................    $ 10,255    $ 10,682
  Accrued liabilities.......................................       4,326          --
  Deferred revenue..........................................       4,978          --
  Compensation expense not currently deductible.............       3,726       4,185
  Depreciation/Amortization.................................      11,874      16,851
  Foreign net operating loss carryforwards..................       9,023          --
  Federal net operating loss carryforwards..................     101,277       5,478
  State net operating loss carryforwards....................       4,702       1,534
  Federal credit carryforwards..............................       8,275       6,410
  State credit carryforwards................................       3,650       3,231
  Other.....................................................       7,785          --
                                                                --------    --------
          Total deferred tax assets.........................     169,871      48,371
  Valuation allowance for deferred tax assets...............     (60,868)    (40,729)
                                                                --------    --------
     Net deferred tax assets................................     109,003       7,642
                                                                --------    --------
Deferred tax liabilities:
  Earnings from foreign joint venture.......................     (12,900)     (7,642)
  Purchased intangibles.....................................     (17,122)         --
  Other.....................................................      (2,865)         --
                                                                --------    --------
          Total deferred tax liabilities....................     (32,887)     (7,642)
                                                                --------    --------
     Net deferred tax asset.................................    $ 76,116    $     --
                                                                ========    ========
</TABLE>

     The foreign net operating loss carryforwards do not expire. The federal net
operating loss and credit carryforwards expire beginning in 2018 and 2011,
respectively. The state net operating loss and credit carryforwards expire
beginning in 2002 and 2004, respectively.

                                       62
<PAGE>   63
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

     All of the valuation allowance at December 31, 1999 relates to tax
carryforwards of a purchased subsidiary, the realization of which will first
reduce goodwill, then other non-current intangible assets related to the
acquisition.

10. EMPLOYEE BENEFIT PLANS

     The Company implemented a non-qualified cash profit sharing plan in 1994
under which all employees of the Company, including officers are eligible to
receive, on an annual basis, an equal cash bonus based on pretax profits,
prorated for service with the Company. No payments were made under this plan for
1999, 1998 or 1997.

     As part of his employment agreement, the President and CEO of the Company
is eligible for a one-time "special cash bonus" on the third anniversary of the
date of his employment in the event that the Company's Common Stock has not
achieved a $4.67 per share increase in value as determined from the date of the
President and CEO's date of employment. The one-time special cash bonus, if
payable, will be equal to $7,000,000 less an amount which adjusts for any
increase in the share price of the Company's Common Stock above the exercise
price per share of the 1,500,000 Share Option granted to the President and CEO
pursuant to his employment agreement with the Company. The one-time special cash
bonus may also be payable in the event the President and CEO's employment is
terminated without cause. If employment is terminated without cause, the
one-time special cash bonus will be calculated and paid as of the date of the
termination. The Company will continue to pay the President and CEO his maximum
bonus for twelve months following his termination. During such twelve-month
period, the vesting on the 3,000,000 Share Option will continue (See Note 7). If
termination without cause occurs following a change in control of the Company,
the twelve-month period for compensation and benefit continuation will be
extended to eighteen months, and Mr. Potashner will receive an additional cash
payment to the extent that the sum of his continued compensation, special cash
payment and the net exercise value of the 3,000,000 Share Option does not exceed
$10,000,000.

     In November 1998, the Company instituted a bonus plan for certain key
individuals that provides for cash payments of $3.0 million and a contingent
payment of $8.0 million upon the initial public offering of its investment in
USC. These payments will be paid out if the individuals meet certain employment
milestones.

     The Company has a 401(k) tax-deferred savings plan whereby all employees
meeting certain age and service requirements may contribute up to 20% of their
eligible compensation (up to a maximum allowed under IRS rules). The Company, at
the discretion of the Board of Directors, may make contributions. No
contributions by the Company have been made to the plan since its inception.

11. EXPORT SALES AND SIGNIFICANT CUSTOMERS

     The Company reports financial and descriptive information about operating
segments for which separate financial information is made available to and
evaluated regularly by the chief operating decision maker, its Chief Executive
Officer ("CEO"). During 1999, the CEO reviewed financial information presented
on a consolidated basis for purposes of making operating decisions and assessing
financial performance, as such the Company operated in 1999 as one operating
segment.

     The Company's primary operations are located in the United States. The
Company sells its products into the personal computer market primarily in the
U.S., Asia and Europe. Export sales accounted for 70%, 89% and 70% of net sales
in 1999, 1998 and 1997, respectively. Approximately 35%, 29% and 28% of export
sales in 1999, 1998 and 1997, respectively, were to affiliates of United States
customers. In 1999, 8% and 16% of export sales were shipped to Hong Kong and
Taiwan, respectively. In 1998, 18% and 55% of export sales were shipped to Hong
Kong and Taiwan, respectively. In 1997, 14% and 53% of export sales were shipped
to Hong Kong and Taiwan, respectively. Three customers accounted for 19%, 10%
and 9%, respectively, of net sales in

                                       63
<PAGE>   64
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

1999. Three customers accounted for 39%, 14% and 13%, respectively, of net sales
in 1998. Three customers accounted for 20%, 13% and 12%, respectively, of net
sales in 1997.

12. CONTINGENCIES

     The semiconductor and personal computing products industries are
characterized by frequent litigation regarding patent and other intellectual
property rights. The Company is party to various claims of this nature. Although
the ultimate outcome of these matters is not presently determinable, management
believes that the resolution of all such pending matters will not have a
material adverse effect on the Company's financial position or results of
operations.

     Since November 1997, a number of complaints have been filed in federal and
state courts seeking unspecified damages on behalf of an alleged class of
persons who purchased shares of the Company's common stock at various times
between April 18, 1996 and November 3, 1997. The complaints name as defendants
the Company, certain of its officers and former officers, and certain directors
of the Company, asserting that they violated federal and state securities laws
by misrepresenting and failing to disclose certain information about the
Company's business. In addition, certain stockholders have filed derivative
actions in the state courts of California and Delaware seeking recovery on
behalf of the Company, alleging, among other things, breach of fiduciary duties
by such individual defendants. The plaintiffs in the derivative action in
Delaware have not taken any steps to pursue their case. The derivative cases in
California state court have been consolidated, and plaintiffs have filed a
consolidated amended complaint. The court has entered a stipulated order in
those derivative cases suspending court proceedings and coordinating discovery
in them with discovery in the class actions in California state courts. On
plaintiffs' motion, the federal court has dismissed the federal class actions
without prejudice. The class actions in California state court have been
consolidated, and plaintiffs have filed a consolidated amended complaint. The
Company has answered that complaint. Discovery is pending. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regards to these lawsuits
would not have a material adverse effect on the Company's financial condition or
results of operations.

     The Company has received from the United States Securities and Exchange
Commission a request for information relating to the Company's restatement
announcement in November 1997. The Company has responded and intends to continue
to respond to such requests.

     The Company is also defending several putative class action lawsuits naming
Diamond, which were filed in June and July 1996 and June 1997 in the California
Superior Court for Santa Clara County and the U.S. District Court for the
Northern District of California. Certain former executive officers and directors
of Diamond are also named as defendants. The plaintiffs purport to represent a
class of all persons who purchased Diamond's Common Stock between October 18,
1995 and June 20, 1996 (the "Class Period"). The complaints allege claims under
the federal securities laws and California law. The plaintiffs allege that
Diamond and the other defendants made various material misrepresentations and
omissions during the Class Period. The complaints do not specify the amount of
damages sought. On March 24, 2000, the District Court for the Northern District
of California dismissed the federal action without prejudice. The Company
believes that it has good defenses to the claims alleged in the California
Superior Court lawsuit and will defend itself vigorously against this action. No
trial date has been set for this action.

     In addition, the Company has been named, with Diamond, as a defendant in
litigation relating to the merger. On August 4, 1999, two alleged stockholders
of Diamond filed a lawsuit, captioned Strum v. Schroeder, et al., in the
Superior Court of the State of California for the County of Santa Clara.
Plaintiffs, on behalf of themselves and a class of all former Diamond
stockholders similarly situated whom they purportedly represent, challenge the
terms of the merger. The complaint names Diamond, the former directors of
Diamond and the Company as defendants. The complaint alleges generally that
Diamond's directors breached
                                       64
<PAGE>   65
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

their fiduciary duties to stockholders of Diamond and seeks rescission and the
recovery of unspecified damages, fees and expenses. The Company believes, as do
the individual defendants, that it has meritorious defenses to the lawsuit and
the Company and the individual defendants intend to defend the suit vigorously.

     On April 23, 1999, 3Dfx Interactive, Inc. ("3Dfx") filed a lawsuit against
Diamond for breach of contract based upon unpaid invoices in the amount of
$3,895,225. On June 4, 1999 the Company filed an answer and cross-complaint
alleging breach of contract, breach of the implied covenant of good faith and
fair dealing, breach of implied warranty and negligence. On February 10, 2000,
this matter was settled. As part of the settlement, the Company paid $1,950,000
to 3Dfx. This amount was accrued at December 31, 1999.

     Sega initiated a claim for arbitration in Tokyo, Japan against Diamond in
December 1998. The claim arises out of an agreement entered into between Sega
and Diamond in September 1995, in which Sega agreed to provide Diamond with Sega
game software that Diamond would bundle with its 3-D graphics board "The Edge."
Sega claims that Diamond breached the parties' agreement by failing to pay Sega
a contractual minimum royalty fee for the games as set forth in the agreement.
Sega claims as damages $3,800,000 in unpaid royalties and pre-judgment interest.
On May 28, 1999, Diamond responded to Sega's claims by filing an answer in which
it denied the material allegations of Sega's claims. The parties have filed
additional briefs in support of their claims and defenses. An evidentiary
hearing on this action has not yet been scheduled. The Company contests the
material allegations of Sega's claims. In addition, the Company has pleaded that
Sega's failure to provide it with 3-D optimized game software on a timely basis
adversely affected sales of The Edge. The Company claims that these lost sales
and profits should provide an offset to Sega's claims in the arbitration and
intends to defend the suit vigorously.

     C3 Sales, Inc. ("C3") filed suit against S3 on October 6, 1999 in the
Harris County (Houston), Texas District Court. The petition sought a judicial
declaration that a Sales Representative Agreement entered into between C3 and S3
on May 19, 1999 was a valid contract that governed the relationship between the
two parties. On November 8, 1999, S3 answered acknowledging that the May 19,
1999 agreement was a contract between the two parties. C3 failed to respond to
informal requests by S3 to dismiss the declaratory relief action on grounds that
no justiciable controversy existed between the parties. On December 3, 1999, S3
filed a summary judgment motion seeking judgment against C3 on the grounds that
no issues of material fact remain to be determined regarding the declaratory
judgment sought by C3. C3 responded by filing an amended petition raising new
matters. Specifically, C3's new claims allege that the Sales Representative
Agreement applies to Diamond products, and that certain commissions due under
the agreement have not been paid. S3 intends to defend this action vigorously.

     On January 6, 2000, PhoneTel Communications, Inc. ("PhoneTel") filed a
complaint for patent infringement against a group of defendants, including
Diamond, in the United States District Court for the Northern District of Texas.
PhoneTel generally alleges that Diamond and the other defendants are infringing
its two patents by making, using, selling, offering to sell and/or importing
digital synthesizers, personal computers, sound cards, or console game systems.
PhoneTel does not specify which Diamond products allegedly infringe its patents.
S3 filed Diamond's answer to the complaint on March 28, 2000. S3 believes that
the complaint is without merit and will vigorously defend itself against the
allegations made in the complaint.

     The ultimate outcome of these actions cannot be presently determined.
Accordingly, no provision for any liability or loss that may result from
adjudication or settlement of the lawsuits has been made in the accompanying
consolidated financial statements.

                                       65
<PAGE>   66
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

13. OTHER OPERATING EXPENSES

     Other operating expense is as follows:

<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,
                                                         ----------------------------
                                                          1999      1998       1997
                                                         ------    -------    -------
                                                                (IN THOUSANDS)
<S>                                                      <C>       <C>        <C>
Write-off of acquired technologies...................    $6,700    $ 8,000    $    --
Impairment of long-lived assets......................        --     27,226     17,180
Restructuring........................................        --      6,109         --
                                                         ------    -------    -------
          Total......................................    $6,700    $41,335    $17,180
                                                         ======    =======    =======
</TABLE>

     The Company recorded a non-recurring charge of $6.7 million related to the
purchase of Diamond on September 24, 1999. The value assigned to purchased
in-process research and development was determined through valuation techniques
generally used by appraisers in the high-technology industry and was immediately
expensed in the period of acquisition because technological feasibility had not
been established and no alternative use had been identified. The charge is
discussed in more detail in Note 2.

     In January 1998, the Company entered into a $40.0 million technology
exchange with Cirrus Logic, Inc. to obtain graphic functionality technologies.
As a result of the exchange, the Company acquired the technology covered by 10
graphic patents and 25 graphic patent applications, as well as cross-licensed
Cirrus Logic's remaining patents. Under the terms of the cross-licensing
provisions, the Company and Cirrus Logic have a perpetual license to each
other's graphic patents and additional licenses with respect to the other
party's patents for agreed upon periods of time. The Company wrote-off $8.0
million of the value of the acquired technologies that were not realizable based
on estimated cash flows from the sale of products currently sold by the Company.
The remaining $32.0 million intangible asset was being amortized to cost of
sales based on the estimated lives of the currently utilized core technologies,
which was generally five years.

     However, during the fourth quarter of 1998, management reevaluated the
carrying value of the intangible assets recorded in connection with the
technology exchange with Cirrus Logic, Inc., and related to the patents obtained
from Brooktree, as well as other long-lived assets, including property and
equipment. This revaluation was necessitated by management's determination based
on recent results of operations that the future expected sales and cash flows
for the Company's operations would be substantially lower than had been
previously expected by management. Expected undiscounted future cash flows were
not sufficient to recover the carrying value of such assets. Accordingly, an
impairment loss of $27.2 million, representing the excess of the carrying value
over the estimated fair value of the assets, was recognized for write-downs of a
substantial portion of the intangible assets. The estimated fair value of the
intangible assets was based on management's best estimate of the patent
portfolio based on a comparison to other graphics technology portfolios in the
marketplace. The Company determined that no write-down of property and equipment
was necessary at December 31, 1998 based on its estimate of the fair value of
such assets. Due to technological changes in the graphics marketplace, the
Company concluded it should accelerate its amortization of its remaining patent
portfolio, of approximately $4.0 million, over the current estimated life of the
currently utilized core technologies, which is two years.

     In July 1998, the Company implemented a restructuring plan in order to
align resources with a new business model and to lower the Company's overall
cost structure. In connection with the restructuring, the Company reduced its
headcount and consolidated facilities. Restructuring expense of $6.1 million was
recognized in the third quarter of 1998. As of December 31, 1999, all severance
packages have been paid and there is no remaining balance in the restructuring
reserve. There were no material adjustments to this reserve in 1999.

                                       66
<PAGE>   67
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

     During the fourth quarter of 1997, the Company wrote-off approximately
$17.2 million of intangible assets including certain license, patents and other
technology, as a result of management's decision to focus attention on the core
graphics business. As a result of this decision, no future cash flows were
expected related to these assets.

14. EARNINGS (LOSS) PER SHARE

     When computing diluted earnings per share, the Company includes only
potential common shares that are dilutive. Exercise of approximately 17,204,000
options in 1999, 15,042,000 options in 1998 and the conversion of approximately
5,385,000 convertible securities in 1999 and 1998 is not assumed because the
result would have been anti-dilutive.

     The following table sets forth the computation of basic and diluted
earnings per share:

<TABLE>
<CAPTION>
                                                              YEARS ENDED DECEMBER 31,
                                                      ----------------------------------------
                                                         1999            1998          1997
                                                      -----------    ------------    ---------
                                                      (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                   <C>            <C>             <C>
Numerator
  Net income (loss)
     Basic..........................................   $(30,780)      $(113,204)      $8,878
                                                       ========       =========       ======
     Diluted........................................   $(30,780)      $(113,204)      $8,878
                                                       ========       =========       ======
Denominator
  Denominator for basic earnings (loss) per share...     59,244          51,078       49,519
  Common stock equivalents..........................         --              --        2,221
                                                       --------       ---------       ------
  Denominator for diluted earnings (loss) per
     share..........................................     59,244          51,078       51,740
                                                       ========       =========       ======
Basic earnings (loss) per share.....................   $  (0.52)      $   (2.22)      $ 0.18
Diluted earnings (loss) per share...................   $  (0.52)      $   (2.22)      $ 0.17
</TABLE>

15. COMPREHENSIVE INCOME (LOSS)

     The following are the components of accumulated other comprehensive loss,
net of tax:

<TABLE>
<CAPTION>
                                                                       DECEMBER 31,
                                                              -------------------------------
                                                               1999        1998        1997
                                                              -------    --------    --------
                                                                      (IN THOUSANDS)
<S>                                                           <C>        <C>         <C>
Unrealized gain (loss) on investments.......................  $   803    $ (2,329)   $  3,666
Foreign currency translation adjustments....................   (8,366)    (12,426)    (19,944)
                                                              -------    --------    --------
  Accumulated other comprehensive loss......................  $(7,563)   $(14,755)   $(16,278)
                                                              =======    ========    ========
</TABLE>

                                       67
<PAGE>   68
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

     The following schedule of other comprehensive income (loss) shows the gross
current-period gain (loss) and the reclassification adjustment. Due to the
Company's 1998 and 1997 operating losses, tax amounts were nominal.

<TABLE>
<CAPTION>
                                                          YEARS ENDED DECEMBER 31,
                                                        -----------------------------
                                                         1999      1998        1997
                                                        ------    -------    --------
                                                               (IN THOUSANDS)
<S>                                                     <C>       <C>        <C>
Unrealized gain (loss) on investments
  Unrealized gain (loss) on available-for-sale
     securities.......................................  $3,076    $(5,967)   $  3,715
  Less: reclassification adjustment for (gain) loss
     realized in net income...........................      56        (28)          5
                                                        ------    -------    --------
Net unrealized gain (loss) on investments.............   3,132     (5,995)      3,720
Foreign currency translation adjustments..............   4,060      7,518     (19,944)
                                                        ------    -------    --------
Other comprehensive income (loss).....................  $7,192    $ 1,523    $(16,224)
                                                        ======    =======    ========
</TABLE>

16. SUBSEQUENT EVENT

     On February 18, 2000, Via Technologies, Inc. purchased from the Company
10,775,000 shares of the Company's Common Stock for an aggregate purchase price
of $145,462,500.

                                       68
<PAGE>   69
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

         SELECTED QUARTERLY CONSOLIDATED FINANCIAL DATA (UNAUDITED)(1)

<TABLE>
<CAPTION>
                                                   FOURTH      THIRD       SECOND      FIRST
                                                  QUARTER     QUARTER     QUARTER     QUARTER
                                                  --------    --------    --------    --------
                                                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                               <C>         <C>         <C>         <C>
YEAR ENDED DECEMBER 31, 1999
Net sales.......................................  $180,546    $ 70,484    $ 57,253    $ 44,300
Gross margin....................................     2,930      15,688      16,537      10,267
Loss from operations(2).........................   (56,765)    (18,383)     (9,456)    (15,558)
Net income (loss)(3)............................    (6,903)    (11,098)      1,100     (13,879)
Per share amounts:
  Basic.........................................  $  (0.09)   $  (0.20)   $   0.02    $  (0.27)
  Diluted(4)....................................  $  (0.09)   $  (0.20)   $   0.02    $  (0.27)
Shares used in computing per share amounts:
  Basic.........................................    77,121      55,419      53,164      51,856
  Diluted(4)....................................    77,121      55,419      57,588      51,856
Stock prices:(5)
High............................................  $  11.56    $  12.41    $   9.75    $   9.19
Low.............................................  $   8.38    $   8.94    $   6.47    $   6.44
YEAR ENDED DECEMBER 31, 1998
Net sales.......................................  $ 41,547    $ 47,286    $ 53,299    $ 82,507
Gross margin (loss).............................   (16,322)     (7,920)      6,492      15,678
Loss from operations(2).........................   (70,760)    (43,805)    (22,485)    (26,849)
Net income (loss)(3)............................  $(70,290)   $(35,401)   $(11,634)   $  4,121
Per share amounts:
  Basic.........................................  $  (1.36)   $  (0.69)   $  (0.23)   $   0.08
  Diluted(4)....................................  $  (1.36)   $  (0.69)   $  (0.23)   $   0.08
Shares used in computing per share amounts:
  Basic.........................................    51,554      51,174      50,985      50,601
  Diluted(4)....................................    51,554      51,174      50,985      52,148
Stock prices:(5)
  High..........................................  $   8.25    $   5.38    $   7.97    $   7.88
  Low...........................................  $   2.00    $   2.81    $   5.00    $   4.94
</TABLE>

---------------
(1) The preceding table presents selected unaudited consolidated financial
    results for each of the eight quarters in the two-year period ended December
    31, 1999. In the Company's opinion, this unaudited information has been
    prepared on the same basis as the audited information and includes all
    adjustments (consisting of only normal recurring adjustments) necessary for
    a fair statement of the financial information for the periods presented.

(2) Loss from operations for 1999 includes a write-off of acquired technologies
    of $6.7 million in the fourth quarter of 1999. Loss from operations for 1998
    includes a write-off of acquired technologies of $8.0 million in the first
    quarter of 1998, a charge for impairment of long-lived assets of $27.2
    million in the fourth quarter of 1998 and a restructuring charge of $6.1
    million in the third quarter of 1998.

(3) Net income (loss) includes gain on sale of joint venture of $7.2 million in
    the second quarter of 1999, $7.5 million in the third quarter of 1999 and
    $7.8 million in the fourth quarter of 1999. Net income (loss) includes gain
    on sale of joint venture of $26.6 million in the first quarter of 1998.

                                       69
<PAGE>   70
                                S3 INCORPORATED

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                  YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

(4) Diluted earnings per share includes the effect of incremental shares
    issuable upon the conversion of the convertible subordinated notes, the
    dilutive effect of outstanding options and an adjustment to net income for
    the interest expense (net of income taxes) related to the notes unless the
    impact of such conversion is anti-dilutive. The effect of the conversion was
    anti-dilutive in all quarters of 1999 and 1998.

(5) The Company's common stock trades on the Nasdaq National Market under the
    symbol SIII. The table indicates the range of the high and low closing
    prices, as reported by Nasdaq.

     At December 31, 1999, there were approximately 1,034 stockholders of record
of the Company's common stock and approximately 40,000 beneficial stockholders.
The Company has never declared or paid cash dividends on its capital stock and
does not anticipate paying any cash dividends in the foreseeable future. The
Company currently intends to retain future earnings for the development of its
business.

                                       70
<PAGE>   71

ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
       DISCLOSURE.

     On March 31, 1998, the Company informed Deloitte & Touche LLP ("Deloitte"),
its former independent accountants, that effective immediately they had been
dismissed as the Company's principal independent accountants. During the
Company's fiscal year ended December 31, 1996 and through March 31, 1998, there
were no disagreements with Deloitte on any matter of accounting principles or
practices, financial statement disclosure, or auditing scope or procedure which,
if not resolved to Deloitte's satisfaction, would have caused them to make
reference to the subject matter of such disagreement in connection with their
Report on the financial statement for such periods, except as follows: in
connection with the audit of the Company's financial statements for the year
ended December 31, 1997, there was a disagreement between Deloitte and the
Company regarding the appropriate period in which to recognize the gain on the
sale of stock of an investee. Deloitte believed that recognition of such gain
should be deferred until the period in which the exchange actually occurred
(first quarter of 1998) while the Company initially believed that recognition of
such gain was appropriate in the period the irrevocable contract was signed
(fourth quarter of 1997). Recognition of the gain was deferred as proposed by
Deloitte. On January 21, 1998, Deloitte discussed this disagreement with the
Audit Committee of the Company. The Company has authorized Deloitte to respond
fully to the inquiries of the successor accountant concerning the subject matter
of such disagreement.

     Deloitte's Report dated January 23, 1998 on the Company's financial
statements for the year ended December 31, 1997 did not contain an adverse
opinion or a disclaimer of opinion, and such Report was not qualified or
modified as to uncertainty, audit scope or accounting principles.

     The decision to dismiss Deloitte was recommended by the Company's Audit
Committee and approved by its Board of Directors.

     On April 13, 1998, the Company engaged the firm of Ernst & Young LLP as
accountants to audit the Company's financial statements commencing with its 1998
fiscal year.

     The Company did not, during its fiscal year ended December 31, 1997 and
through April 13, 1998 consult with or receive any written or oral advice from
Ernst & Young LLP regarding (i) any matter, including the application of
accounting principles to a specified transaction or the type of audit opinion
that might be rendered on the Company's financial statements, which advice was
an important factor considered by the Company in reaching a decision as to such
accounting, auditing or financial reporting issue or (ii) any disagreement with
Deloitte, its former accountants, or any reportable event.

     During the Company's fiscal years ended December 31, 1997, 1998 and 1999
there have been no reportable events.

                                    PART III

     Certain information required by Part III is incorporated by reference from
the Company's definitive Proxy Statement to be filed with the Securities and
Exchange Commission in connection with the solicitation of proxies for the
Company's 2000 Annual Meeting of Stockholders (the "Proxy Statement").

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

     The information required by this section is incorporated by reference from
the information in the section entitled "Proposal 1 -- Election of Directors" in
the Proxy Statement. The required information concerning executive officers of
the Company is contained in the section entitled "Executive Officers of the
Registrant" in Part I of this Form 10-K.

     Item 405 of Regulation S-K calls for disclosure of any known late filing or
failure by an insider to file a report required by Section 16 of the Exchange
Act. This disclosure is contained in the section entitled "Section 16(a)
Beneficial Ownership Reporting Compliance" in the Proxy Statement and is
incorporated herein by reference.

                                       71
<PAGE>   72

ITEM 11. EXECUTIVE COMPENSATION.

     The information required by this section is incorporated by reference from
the information in the sections entitled "Proposal 1 -- Election of
Directors -- Directors' Compensation", "Executive Compensation" and "Stock Price
Performance Graph" in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

     The information required by this section is incorporated by reference from
the information in the section entitled "Proposal 1 -- Election of
Directors -- Security Ownership of Certain Beneficial Owners and Management" in
the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     Not applicable.

                                    PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

     (a) The following documents are filed as a part of this Form 10-K:

          (1) FINANCIAL STATEMENTS:

          Reference is made to the Index to Consolidated Financial Statements of
     S3 Incorporated under Item 8 in Part II of this Form 10-K.

          (2) FINANCIAL STATEMENT SCHEDULES:

          The following financial statement schedule of S3 Incorporated for the
     years ended December 31, 1999, 1998 and 1997 is filed as part of this
     Report and should be read in conjunction with the Consolidated Financial
     Statements of S3 Incorporated.

<TABLE>
<CAPTION>
                                                              REFERENCE
                                                                PAGE
                                                              ---------
<S>                                                           <C>
Schedule II -- Valuation and Qualifying Accounts............     75
</TABLE>

          All other schedules are omitted because they are not applicable or the
     required information is shown in the financial statements or notes thereto.

          (3) EXHIBITS:

          The exhibits listed below are required by Item 601 of Regulation S-K.
     Each management contract or compensatory plan or arrangement required to be
     filed as an exhibit to this Form 10-K has been identified.

<TABLE>
<CAPTION>
EXHIBIT
 NUMBER   NOTES                     DESCRIPTION OF DOCUMENT
-------   -----                     -----------------------
<S>       <C>     <C>
3(i).1     (1)    Restated Certificate of Incorporation.
3(i).2     (6)    Certificate of Amendment of Restated Certificate of
                  Incorporation.
3(i).3    (10)    Certificate of Designation of Series A Participating
                  Preferred Stock.
3(i).4    (12)    Certificate of Amendment of Restated Certificate of
                  Incorporation.
3(i).5    (18)    Certificate of Amendment of Restated Certificate of
                  Incorporation.
3(ii)     (10)    Amended and Restated Bylaws.
4.1        (1)    Specimen common stock certificate.
</TABLE>

                                       72
<PAGE>   73

<TABLE>
<CAPTION>
EXHIBIT
 NUMBER   NOTES                     DESCRIPTION OF DOCUMENT
-------   -----                     -----------------------
<S>       <C>     <C>
4.2        (8)    Indenture, dated as of September 12, 1996 between Registrant
                  and State Street Bank and Trust Company of California, N.A.,
                  as Trustee, including form of Note.
4.3        (9)    Rights Agreement dated as of May 14, 1997 between S3
                  Incorporated and The First National Bank of Boston, Rights
                  Agent.
10.1*     (12)    1989 Stock Plan of S3 Incorporated (Amended and Restated as
                  of December 14, 1998) (the "1989 Plan").
10.2*     (12)    Form of Incentive Stock Option Agreement under the 1989
                  Plan.
10.3*      (1)    Form of common stock Purchase Agreement under the 1989 Plan.
10.4*      (2)    S3 Incorporated 1993 Employee Stock Purchase Plan.
10.5*     (19)    1992 Stock Plan of Diamond Multimedia Systems, Inc.
                  ("Diamond") and form of Stock Option Agreement.
10.6*     (19)    1994 Stock Plan of Diamond and form of Stock Option
                  Agreement.
10.7*     (19)    1995 Director Option Plan of Diamond and form of Stock
                  Option Agreement.
10.8*     (20)    1998 Stock Plan of Diamond and form of Stock Option
                  Agreement.
10.9       (1)    Form of Indemnification Agreement between the Registrant and
                  its directors.
10.10      (7)    Lease between Mission Real Estate, L.P. and Registrant dated
                  November 29, 1995.
10.11      (3)    Office Lease dated May 13, 1993, between the Registrant and
                  San Tomas No. 2 Limited Partnership.
10.12      (3)    First Amendment of Office Lease dated September 9, 1993,
                  between the Registrant and San Tomas No. 2 Limited
                  Partnership.
10.13      (5)    Foundry Venture Agreement among Registrant, Alliance
                  Semiconductor Corporation and United Microelectronics
                  Corporation dated as of July 8, 1995.
10.14      (4)    Office Lease dated March 30, 1994, between the Registrant
                  and San Tomas No. 1 Limited Partnership.
10.15      (4)    Second Amendment of Office Lease dated March 30, 1994,
                  between the Registrant and San Tomas No. 2 Limited
                  Partnership.
10.16     (19)    Lease dated November 19, 1999, between Diamond and Montague
                  LLC.
10.17     (19)    Lease dated December 26, 1995, between NL Properties, Inc.
                  and Diamond.
10.18     (22)    Sublease dated May 12, 1998 between Reed Elsevier, Inc. and
                  Diamond.
10.19*    (11)    Employment Agreement between Registrant and Terry N. Holdt
                  dated December 18, 1997.
10.20*    (13)    Employment Agreement between Registrant and Kenneth F.
                  Potashner, dated October 30, 1998.
10.21*    (14)    Employment Agreement between Registrant and Ronald T. Yara,
                  dated November 20, 1998.
10.22*    (15)    Involuntary Termination Agreement between Registrant and
                  Paul G. Franklin, dated September 22, 1998.
10.23*    (16)    Involuntary Termination Agreement between Registrant and
                  Walter D. Amaral, dated September 30, 1998.
10.24*            Involuntary Termination Agreement between Registrant and
                  Andy Wolfe, dated September 22, 1998.
</TABLE>

                                       73
<PAGE>   74

<TABLE>
<CAPTION>
EXHIBIT
 NUMBER   NOTES                     DESCRIPTION OF DOCUMENT
-------   -----                     -----------------------
<S>       <C>     <C>
10.25     (18)    Agreement and Plan of Merger dated as of June 21, 1999
                  between Registrant and Diamond.
10.26     (21)    Amendment No. 1 to Agreement and Plan of Merger, dated as of
                  September 15, 1199, by and among Registrant, Diamond and
                  Denmark Acquisition Sub, Inc., a Delaware corporation and
                  wholly owned subsidiary of Registrant.
12.1              Statement of Computation of Ratio of Earnings to Fixed
                  Charges.
16.1      (17)    Letter of Deloitte and Touche LLP regarding change in
                  certifying public accountant.
21.1              Significant subsidiaries of Registrant.
23.1              Consent of Ernst and Young LLP, Independent Auditors (San
                  Jose, California).
23.2              Consent of Deloitte and Touche LLP (San Jose, California).
24.1              Power of Attorney (see page 76 of this Form 10-K).
27.1              Financial Data Schedule.
</TABLE>

---------------
  *  Indicates management contract or compensatory plan or arrangement.

 (1) Incorporated by reference to the Registrant's Registration Statement on
     Form S-1 (File No. 33-57114).

 (2) Incorporated by reference to Exhibit 10.15 to the Registrant's Registration
     Statement on Form S-8 (File No. 33-65186).

 (3) Incorporated by reference to the exhibit of the same number to the
     Registrant's Annual Report on Form 10-K for the year ended December 31,
     1993.

 (4) Incorporated by reference to the exhibit of the same number to the
     Registrant's Annual Report on Form 10-K for the year ended December 31,
     1994.

 (5) Incorporated by reference to the exhibit of the same number to the
     Registrant's Current Report on Form 8-K filed July 25, 1995.

 (6) Incorporated by reference to the exhibit of the same number to the
     Registrant's Annual Report on Form 10-K for the year ended December 31,
     1995.

 (7) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1995.

 (8) Incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report
     on Form 10-Q for the quarter ended September 30, 1996.

 (9) Incorporated by reference to Exhibit 4.2 to Registrant's Quarterly Report
     on Form 10-Q for the quarter ended September 30, 1996.

(10) Incorporated by reference to the exhibit of the same number to Registrant's
     Quarterly Report on Form 10-Q for the quarter ended June 30, 1997.

(11) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1997.

(12) Incorporated by reference to the exhibit of the same number to the
     Registrant's Annual Report on Form 10-K for the year ended December 31,
     1997.

(13) Incorporated by reference to Exhibit 10.3 to the Registrant's Annual Report
     on Form 10-K for the year ended December 31, 1997.

(14) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1997.

                                       74
<PAGE>   75

(15) Incorporated by reference to Exhibit 10.15 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1997.

(16) Incorporated by reference to Exhibit 10.16 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1997.

(17) Incorporated by reference to Exhibit 16 to the Registrant's Current Report
     on Form 8-K filed April 7, 1998.

(18) Incorporated by Reference to Registrant's Registration Statement on Form
     S-4 (File No. 333-85323).

(19) Incorporated by reference to Diamond's Registration Statement on Form S-1
     (File No. 33-89386).

(20) Incorporated by reference to Diamond's Registration Statement on Form S-8
     (File No. 333-11147).

(21) Incorporated by reference to Exhibit 2.2 of the Registrant's Current Report
     on Form 8-K filed September 30, 1999

(22) Incorporated by reference to Exhibit 10.17 Diamond's Annual Report on Form
     10-K, for the year ended December 31, 1998, as amended.

(b) Reports on Form 8-K:

     The Company did not file any reports on Form 8-K during the three months
ended December 31, 1999.

                                       75
<PAGE>   76

                                                                     SCHEDULE II

                       VALUATION AND QUALIFYING ACCOUNTS
                  YEAR ENDED DECEMBER 31, 1999, 1998 AND 1997
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                      BALANCE AT    CHARGED TO      REVERSALS                    BALANCE AT
                                      BEGINNING      COSTS AND     TO COSTS AND                    END OF
            DESCRIPTION               OF PERIOD     EXPENSES(1)      EXPENSES      DEDUCTIONS      PERIOD
            -----------               ----------    -----------    ------------    ----------    ----------
<S>                                   <C>           <C>            <C>             <C>           <C>
Allowance for doubtful accounts:
     1999...........................    $2,296        $ 2,699        $   (384)      $ (1,049)     $ 3,562
     1998...........................     1,507            600              --             89        2,296
     1997...........................     1,438          1,200              --         (1,131)       1,507

Sales returns and allowances:
     1999...........................    $4,229        $24,850        $(10,665)      $ (2,678)     $15,736
     1998...........................     4,157          1,453            (631)          (750)       4,229
     1997...........................     1,210          4,680              --         (1,733)       4,157
</TABLE>

(1) For 1999, includes $2,600 of allowance for doubtful accounts and $11,398 of
    sales returns and allowances related to valuation of account balances of
    Diamond, which was acquired during the year.

                                       76
<PAGE>   77

                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on March 29, 2000.

                                          S3 INCORPORATED
                                          (Registrant)

                                          By:   /s/ KENNETH F. POTASHNER
                                            ------------------------------------
                                                    Kenneth F. Potashner
                                                         President
                                                  Chief Executive Officer
                                                   Chairman of the Board
March 29, 2000

                               POWER OF ATTORNEY

     KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Kenneth F. Potashner, Walter D. Amaral,
and Terry Holdt, and each of them, his or her true and lawful attorneys-in-fact,
each with full power of substitution, for him or her in any and all capacities,
to sign any amendments to this report on Form 10-K and to file the same, with
exhibits thereto and other documents in connection therewith, with the
Securities and Exchange Commission, hereby ratifying and confirming all that
each of said attorneys-in-fact or their substitute or substitutes may do or
cause to be done by virtue hereof.

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

<TABLE>
<CAPTION>
                       SIGNATURE                                      TITLE                   DATE
                       ---------                                      -----                   ----
<S>                                                       <C>                            <C>

                /s/ KENNETH F. POTASHNER                           President,            March 29, 2000
--------------------------------------------------------     Chief Executive Officer
                  Kenneth F. Potashner                        Chairman of the Board

                  /s/ WALTER D. AMARAL                    Senior Vice President & Chief  March 29, 2000
--------------------------------------------------------        Financial Officer
                    Walter D. Amaral                        (Principal Financial and
                                                               Accounting Officer)

                   /s/ TERRY N. HOLDT                      Vice Chairman of the Board    March 29, 2000
--------------------------------------------------------
                     Terry N. Holdt

                   /s/ ROBERT P. LEE                                Director             March 29, 2000
--------------------------------------------------------
                     Robert P. Lee

                 /s/ CARMELO J. SANTORO                             Director             March 29, 2000
--------------------------------------------------------
                   Carmelo J. Santoro

                                                                    Director
--------------------------------------------------------
                   James T. Schraith

                 /s/ WILLIAM SCHROEDER                              Director             March 29, 2000
--------------------------------------------------------
                   William Schroeder
</TABLE>

                                       77
<PAGE>   78

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER    NOTES                     DESCRIPTION OF DOCUMENT
-------   -----                     -----------------------
<S>       <C>     <C>
 3(i).1    (1)    Restated Certificate of Incorporation.
 3(i).2    (6)    Certificate of Amendment of Restated Certificate of
                  Incorporation.
 3(i).3   (10)    Certificate of Designation of Series A Participating
                  Preferred Stock.
 3(i).4   (12)    Certificate of Amendment of Restated Certificate of
                  Incorporation.
 3(i).5   (18)    Certificate of Amendment of Restated Certificate of
                  Incorporation.
 3(ii)    (10)    Amended and Restated Bylaws.
 4.1       (1)    Specimen common stock certificate.
 4.2       (8)    Indenture, dated as of September 12, 1996 between Registrant
                  and State Street Bank and Trust Company of California, N.A.,
                  as Trustee, including form of Note.
 4.3       (9)    Rights Agreement dated as of May 14, 1997 between S3
                  Incorporated and The First National Bank of Boston, Rights
                  Agent.
10.1*     (12)    1989 Stock Plan of S3 Incorporated (Amended and Restated as
                  of December 14, 1998) (the "1989 Plan").
10.2*     (12)    Form of Incentive Stock Option Agreement under the 1989
                  Plan.
10.3*      (1)    Form of common stock Purchase Agreement under the 1989 Plan.
10.4*      (2)    S3 Incorporated 1993 Employee Stock Purchase Plan.
10.5*     (19)    1992 Stock Plan of Diamond Multimedia Systems, Inc.
                  ("Diamond") and form of Stock Option Agreement.
10.6*     (19)    1994 Stock Plan of Diamond and form of Stock Option
                  Agreement.
10.7*     (19)    1995 Director Option Plan of Diamond and form of Stock
                  Option Agreement.
10.8*     (20)    1998 Stock Plan of Diamond and form of Stock Option
                  Agreement.
10.9       (1)    Form of Indemnification Agreement between the Registrant and
                  its directors.
10.10      (7)    Lease between Mission Real Estate, L.P. and Registrant dated
                  November 29, 1995.
10.11      (3)    Office Lease dated May 13, 1993, between the Registrant and
                  San Tomas No. 2 Limited Partnership.
10.12      (3)    First Amendment of Office Lease dated September 9, 1993,
                  between the Registrant and San Tomas No. 2 Limited
                  Partnership.
10.13      (5)    Foundry Venture Agreement among Registrant, Alliance
                  Semiconductor Corporation and United Microelectronics
                  Corporation dated as of July 8, 1995.
10.14      (4)    Office Lease dated March 30, 1994, between the Registrant
                  and San Tomas No. 1 Limited Partnership.
10.15      (4)    Second Amendment of Office Lease dated March 30, 1994,
                  between the Registrant and San Tomas No. 2 Limited
                  Partnership.
10.16     (19)    Lease dated November 19, 1999, between Diamond and Montague
                  LLC.
10.17     (19)    Lease dated December 26, 1995, between NL Properties, Inc.
                  and Diamond.
10.18     (22)    Sublease dated May 12, 1998 between Reed Elsevier, Inc. and
                  Diamond.
10.19*    (11)    Employment Agreement between Registrant and Terry N. Holdt
                  dated December 18, 1997.
10.20*    (13)    Employment Agreement between Registrant and Kenneth F.
                  Potashner, dated October 30, 1998.
</TABLE>

                                       78
<PAGE>   79

<TABLE>
<CAPTION>
EXHIBIT
NUMBER    NOTES                     DESCRIPTION OF DOCUMENT
-------   -----                     -----------------------
<S>       <C>     <C>
10.21*    (14)    Employment Agreement between Registrant and Ronald T. Yara,
                  dated November 20, 1998.
10.22*    (15)    Involuntary Termination Agreement between Registrant and
                  Paul G. Franklin, dated September 22, 1998.
10.23*    (16)    Involuntary Termination Agreement between Registrant and
                  Walter D. Amaral, dated September 30, 1998.
10.24*            Involuntary Termination Agreement between Registrant and
                  Andy Wolfe, dated September 22, 1998.
10.25     (18)    Agreement and Plan of Merger dated as of June 21, 1999
                  between Registrant and Diamond.
10.26     (21)    Amendment No. 1 to Agreement and Plan of Merger, dated as of
                  September 15, 1199, by and among Registrant, Diamond and
                  Denmark Acquisition Sub, Inc., a Delaware corporation and
                  wholly owned subsidiary of Registrant.
12.1              Statement of Computation of Ratio of Earnings to Fixed
                  Charges.
16.1      (17)    Letter of Deloitte and Touche LLP regarding change in
                  certifying public accountant.
21.1              Significant subsidiaries of Registrant.
23.1              Consent of Ernst and Young LLP, Independent Auditors (San
                  Jose, California).
23.2              Consent of Deloitte and Touche LLP (San Jose, California).
24.1              Power of Attorney (see page 76 of this Form 10-K).
27.1              Financial Data Schedule.
</TABLE>

---------------
  *  Indicates management contract or compensatory plan or arrangement.

 (1) Incorporated by reference to the Registrant's Registration Statement on
     Form S-1 (File No. 33-57114).

 (2) Incorporated by reference to Exhibit 10.15 to the Registrant's Registration
     Statement on Form S-8 (File No. 33-65186).

 (3) Incorporated by reference to the exhibit of the same number to the
     Registrant's Annual Report on Form 10-K for the year ended December 31,
     1993.

 (4) Incorporated by reference to the exhibit of the same number to the
     Registrant's Annual Report on Form 10-K for the year ended December 31,
     1994.

 (5) Incorporated by reference to the exhibit of the same number to the
     Registrant's Current Report on Form 8-K filed July 25, 1995.

 (6) Incorporated by reference to the exhibit of the same number to the
     Registrant's Annual Report on Form 10-K for the year ended December 31,
     1995.

 (7) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1995.

 (8) Incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report
     on Form 10-Q for the quarter ended September 30, 1996.

 (9) Incorporated by reference to Exhibit 4.2 to Registrant's Quarterly Report
     on Form 10-Q for the quarter ended September 30, 1996.

(10) Incorporated by reference to the exhibit of the same number to Registrant's
     Quarterly Report on Form 10-Q for the quarter ended June 30, 1997.

(23) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1997.

(24) Incorporated by reference to the exhibit of the same number to the
     Registrant's Annual Report on Form 10-K for the year ended December 31,
     1997.

                                       79
<PAGE>   80

(25) Incorporated by reference to Exhibit 10.3 to the Registrant's Annual Report
     on Form 10-K for the year ended December 31, 1997.

(26) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1997.

(27) Incorporated by reference to Exhibit 10.15 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1997.

(28) Incorporated by reference to Exhibit 10.16 to the Registrant's Annual
     Report on Form 10-K for the year ended December 31, 1997.

(29) Incorporated by reference to Exhibit 16 to the Registrant's Current Report
     on Form 8-K filed April 7, 1998.

(30) Incorporated by Reference to Registrant's Registration Statement on Form
     S-4 (File No. 333-85323).

(31) Incorporated by reference to Diamond's Registration Statement on Form S-1
     (File No. 33-89386).

(32) Incorporated by reference to Diamond's Registration Statement on Form S-8
     (File No. 333-11147).

(33) Incorporated by reference to Exhibit 2.2 of the Registrant's Current Report
     on Form 8-K filed September 30, 1999

(34) Incorporated by reference to Exhibit 10.17 Diamond's Annual Report on Form
     10-K, for the year ended December 31, 1998, as amended.

                                       80