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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, 1998
 
                                       OR
 
      [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
       SECURITIES EXCHANGE ACT OF 1934
 
       FOR THE TRANSITION PERIOD FROM                TO                .
 
                         COMMISSION FILE NUMBER 0-21126
 
                                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                              95054
           SANTA CLARA, CALIFORNIA                              (ZIP CODE)
  (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
</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 $420,458,976 as of March 1, 1999, 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.
 
     51,848,023 shares of the Registrant's Common stock, $.0001 par value, were
outstanding at March 1, 1999.
 
                      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 1999 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....................................................    1
Item 2.   Properties..................................................    8
Item 3.   Legal Proceedings...........................................    9
Item 4.   Submission of Matters to a Vote of Security Holders.........    9
 
                               PART II
 
Item 5.   Market For Registrant's Common Equity and Related
          Stockholder Matters.........................................   10
Item 6.   Selected Consolidated Financial Data........................   11
Item 7.   Management's Discussion and Analysis of Financial Condition
          and
          Results of Operations.......................................   12
Item 7A.  Quantitative and Qualitative Disclosure About Market Risk...   26
Item 8.   Financial Statements and Supplementary Data.................   28
Item 9.   Changes in and Disagreements With Accountants on Accounting
          and Financial Disclosure....................................   72
 
                               PART III
 
Item 10.  Directors and Executive Officers of the Registrant..........   72
Item 11.  Executive Compensation......................................   73
Item 12.  Security Ownership of Certain Beneficial Owners and
          Management..................................................   73
Item 13.  Certain Relationships and Related Transactions..............   73
 
                               PART IV
 
Item 14.  Exhibits, Financial Statement Schedules and Reports on Form
          8-K.........................................................   73
 
SIGNATURES............................................................   77
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                                     PART I
 
ITEM 1. BUSINESS.
 
     When used in this Report, 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, 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 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 such statement is based.
 
GENERAL
 
     S3(R) Incorporated ("S3" or the "Company") is a leading supplier of
multimedia acceleration hardware and its associated software for the PC market.
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 of today's advanced multimedia user interface and
applications. By complementing the computing power of the general purpose CPU,
the Company's integrated software and silicon-based accelerator solutions
significantly improve the multimedia performance of PCs while reducing overall
system cost and complexity. S3 has been a pioneer in graphics acceleration since
1991, when it was the first company to ship in volume a single chip graphics
accelerator with a local bus interface. S3 has since delivered new generations
of high performance accelerator solutions from the first 32-bit and 64-bit
graphics accelerator families to the first 128-bit, full-featured integrated
two-dimensional ("2D") and three-dimensional ("3D") graphics and video
accelerator specifically designed for today's 3D and digital versatile disc
("DVD")-based applications. As the demand for greater multimedia capabilities in
PCs increases, particularly the demand for 2D/3D technology, the Company 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 original equipment PC
manufacturers ("OEMs") and add-in card and motherboard manufacturers.
 
     S3 was incorporated on January 9, 1989 in the State of Delaware. The
Company operates in one principal industry segment.
 
MARKETS AND RECENT DEVELOPMENTS
 
     S3 supplies integrated 2D, 3D and video accelerators for the desktop and
mobile markets. The desktop market is the largest segment of the PC industry for
the Company's accelerator products and is characterized by intense competition
and rapid technological advances. In 1998, S3 introduced the Savage3D
accelerator. With the Savage3D chip, the Company redesigned its 3D architecture
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 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 for the first time on the PC. Rapidly gaining industry support, S3TC
has been widely adopted for use in 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
 
---------------
 
    1The software titles set forth above may be trademarks or registered
trademarks of their respective owners.
                                        1
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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.
 
     The Company entered into the mobile market with the introduction of the
Aurora64V+ product. The Company's mobile strategy is to combine the same level
of 2D, 3D and video capabilities found in S3's desktop accelerators with
advanced power management and flat panel display support. S3's second-generation
mobile product, the ViRGE/MX accelerator, brings powerful capabilities to
notebook PC users that exceeds the performance and functionality levels of core
feature available for the mobile PC platform by providing industry-first
technologies such as fully-integrated TV-out, DuoView dual display capability
and AGP support.
 
     In December 1998, S3 announced a long-term strategic relationship with
Intel Corporation ("Intel"). The agreements with Intel include a 10-year
cross-license agreement for all S3 and Intel patents for the development of
certain semiconductor products, a bus license for current and future Intel
general purpose processors, and the selection of S3 as an Intel Accelerated
Graphics Port ("AGP") 4X validation partner. S3 had previously acquired certain
patents and patent applications from Cirrus Logic Inc. to which Intel already
had a license. The graphics industry is transitioning from 2X AGP to 4X AGP and
the Company intends to take advantage of this opportunity to create a
differentiating advantage in graphics as well as to create major opportunities
outside the traditional desktop and mobile space. To do this, the Company
intends to pursue an integration strategy that involves both integrating core
logic and graphics.
 
     In February 1999, S3 introduced the second generation of the Savage family.
The Savage4 accelerator features industry-first 4X AGP, S3TC and advanced
digital flat panel display support.
 
PRODUCTS
 
     S3's product 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 has developed a series of advanced
graphics and video accelerators for use by mainstream multimedia computer
suppliers in high performance, cost effective products for the business, home
and mobile markets. All of S3's accelerator solutions are designed to complement
the CPU by executing those functions most appropriate to a dedicated accelerator
while allowing the CPU to execute the more general purpose computing functions.
The Company's graphics and video accelerator product line includes a broad array
of products to support PC add-in card, 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 high-end mobile and
desktop 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.
 
  GRAPHICS AND VIDEO ACCELERATOR PRODUCTS
 
     ViRGE/MX. ViRGE/MX is the second generation 3D graphics accelerator for
notebook PCs, which combines the same level of 2D/3D video acceleration found in
the Company's desktop accelerators with advanced power management and flat panel
display support. The product features DuoView, integrated TV-out and a full set
of 3D rendering, including MIP mapping, tri-linear filtering and perspective
correction textures. The product also supports the AGP standard.
 
     Trio3D. Trio3D is the third generation of the Trio family of accelerators.
It 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 ("VIP") 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 allows for 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 support for AGP
standard and is designed to be pin-compatible with existing Trio and ViRGE-based
designs. In addition,
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Trio3D's software compatibility with previous generations of S3 products is
intended to enable faster time-to-market for manufacturers.
 
     Savage3D. Savage3D is the first generation of a newly designed multimedia
solution for 2D, 3D and DVD/video acceleration. It features a 128-bit single
cycle trilinear architecture, support for 4X AGP and Microsoft-endorsed texture
compression technology. The single trilinear filtering enables the high 3D
graphics performance. Savage3D is the first 3D accelerator to utilize S3TC, a
Microsoft-endorsed texture compression technology. Savage3D produces images
through its true color rendering, which enables the use of 16 million colors and
is optimized for full 2X AGP. Savage3D is pin-compatible with the Trio3D.
 
     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, 32 MB 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
industry-first 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.
 
  SOFTWARE
 
     The Company believes that a complete solution for its customers 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
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 emerged as the standard API for high-performance 3D
graphics. S3 intends to support its proprietary API, OpenGL, Direct3D and
third-party APIs based on market acceptance of such APIs and S3's needs to
support and promote new features of future accelerators. S3 has developed an
OpenGL driver for the ViRGE, Trio and Savage family of 2D/3D accelerators to
support CAD/engineering, modeling/rendering and other high-end 3D applications
traditionally supported on workstation platforms. In August 1997, the Company
and Silicon Graphics announced a long term licensing agreement whereby S3 will
distribute OpenGL. The Company will provide its OEM customers with source and
object code for OpenGL, a proven, highly versatile 2D and 3D graphics API that
enables PC, workstation and supercomputing hardware vendors to provide
high-performance graphics solutions.
 
  FUTURE ACCELERATORS AND SOFTWARE
 
     The Company has in development several graphics and video accelerators and
related software products for currently scheduled introduction throughout 1999.
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. The Company analyzes and uses industry tools such as
Ziff Davis 3-D benchmark, 3-D
 
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<PAGE>   6
 
Winbench 98 and other independent benchmarking software in its efforts to
provide the highest level of accelerator and feature compliance. In future
products, the Company plans to be fully compliant with the graphics initiative
from Intel for AGP as defined by the PC98 and PC99 system design guides, which
are a reference for designing PCs and peripherals for the Microsoft Windows
family of operating systems and are primarily driven by Microsoft, Intel and
other industry leaders.
 
     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 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.
 
SALES, MARKETING AND DISTRIBUTION
 
     S3 markets and distributes its products 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 pursuant to which certain finished products are
shipped 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 Santa Clara, California facility for
repackaging and reshipment.
 
     The Company sells multimedia accelerators to original equipment
manufacturers, third party subsystem manufacturers, motherboard manufacturers
and distributors. Sales to these customers are typically made pursuant to
specific purchase orders, which are cancelable without significant penalties. In
1998, three customers, Synnex Technology, Inc. ("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. In 1996, two customers, Diamond Multimedia Systems, Inc., and Synnex,
accounted for 16% and 15%, respectively, of net sales. Synnex, CNW International
Limited and Promate Electronics Co. are distributors. The Company expects a
significant portion of its future sales 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
Company's operating results. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Factors That May Affect Our
Results -- We Have Significant Exposure to International Markets."
 
     Export sales accounted for 89%, 70% and 58%, of net sales in 1998, 1997 and
1996 respectively. Approximately 29% of export sales in 1998 were to affiliates
of United States customers. Due to its export sales, the Company is subject to
the risks of conducting business internationally, including those set forth
under " Management's Discussion and Analysis of Financial Condition and Results
of Operations -- Factors That May Affect Our Results -- We Have Significant
Exposure to International Markets."
 
CUSTOMER SUPPORT AND SERVICE
 
     The Company believes that customer service and technical support are
important competitive factors in the accelerator market. The Company provides
technical support for customers in major markets in North
 
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America, Europe and Asia. Distributors and manufacturers' representatives
supplement the Company's efforts by providing additional customer service and
technical support for the Company's products. The Company also provides several
other types of technical support, including software distribution through the
World Wide Web, product demonstration software, evaluation boards and
application notes.
 
     The Company works closely with its 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 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.
 
MANUFACTURING AND DESIGN METHODOLOGY
 
     The Company currently relies on two independent foundries to manufacture
all of its products. The Company's strategy is to utilize a number of 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 to construct an in-house wafer fabrication
facility and is a well entrenched 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 ("CMOS") process with line geometries as
small as 0.25 micron. The Company will utilize a six level metal CMOS process
with 0.18 micron line geometries for certain of its products scheduled for 1999
production. 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. The
Company conducts business with one of its current foundry suppliers by
delivering written purchase orders specifying the particular product ordered,
quantity, price, delivery date and shipping terms and, therefore, this foundry
is not obligated to supply products to the Company for any specific period, in
any specific quantity or at any specified price, except as may be provided in a
particular purchase order. 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.
 
     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
("BGA") 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 United Microelectronics
Co., Ltd. ("UMC") and Alliance Semiconductor Corporation to form United
Semiconductor Corporation ("USC"), a separate Taiwanese company, for the
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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 3 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
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Factors That May Affect Our Results -- We are a Fabless
Semiconductor Company and Depend on Independent Foundries for the Manufacture of
Our Products."
 
     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.
 
     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.
 
RESEARCH AND DEVELOPMENT
 
     The Company believes that continued timely development and introduction of
new products are essential to maintaining its competitive position. The Company
currently conducts most of its product development effort in-house and, at
December 31, 1998, had a staff of 276 research and development personnel, of
whom approximately 34% are involved in software development. The Company also
employs outside consultants to assist with software testing. The Company is
focusing its current development efforts primarily on the development of
enhanced versions of its existing family of graphics and multimedia accelerators
and adding new functionality to its products for business desktop, mobile and
home PC markets. In addition, the Company intends to continue to devote
significant resources to the development of a broad range of high-performance
software drivers to support its products. During 1998, 1997 and 1996, the
Company spent approximately $78.6 million, $78.6 million and $63.4 million,
respectively, on research and development activities.
 
COMPETITION
 
     The markets in which the Company competes are extremely competitive and the
Company expects that competition will increase. The principal factors of
competition in the Company's markets include performance, product features,
product availability, price, quality, timing of new product introductions by the
Company and its competitors, the emergence of new graphics and PC standards and
customer support. Price competition in the industry is intense and may increase,
which may have a material adverse effect on the
 
                                        6
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Company's operating results. There can be no assurance that the Company will be
able to compete successfully as to price or any of these other factors.
 
     The market for the Company's products 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 and Trident
Microsystems, Inc. The Company's principal competitors in the multimedia market
include the companies named in the preceding sentence and 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 is 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 1999 and
future periods could be materially and adversely affected. The Company's current
products do not address the high performance segment of the market, which has
resulted in substantial pricing and margin pressures on the Company's products
and adversely affected the Company's recent results of operations. The entry of
additional competitors into the 2D/3D accelerator market has resulted in and is
expected to continue to result in pricing pressures on average selling prices of
the Company's products. 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.
Furthermore, the need of PC manufacturers to rapidly introduce a variety of
products aimed at different segments of the PC market may lead to the shift by
such system OEMs to the purchase of graphics and multimedia add-in cards
provided by others. Certain of the Company's competitors supply both add-in
cards and accelerator chips, which may provide those competitors with an
advantage over suppliers such as the companies that supply only accelerator
chips. 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 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, 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 has filed several United States patent applications for its
technology and to date has been issued 16 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, 11 of these patent
applications have become issued patents. The Company attempts to protect its
trade secrets and other proprietary 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.
 
                                        7
<PAGE>   10
 
     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. A U.S. trademark registration has been issued to the
Company for the marks S3, S3 (stylized), S3 ON BOARD, S3 ON BOARD and Design,
S3D(stylized), Trio, True Acceleration and ViRGE.
 
     The S3 corporate logo, the Aurora family of marks, Cooperative Accelerator
Architecture, Burst Command Interface, DuoView, InfiniPatch, InfiniRate,
Innovations In Acceleration, No Compromise Acceleration, No Compromise
Integration, QuickRamp, RIO!, S3FM, S3RAM, S3S, SAVAGE3D, SAVAGE4, Scenic
Highway, Sight. Sound. Speed., Silicon Film, SmartFilter, Streams Processor, the
Trio family of marks, TV-Tuner and the ViRGE family of marks are trademarks of
the Company. 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. Other
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 industry, is
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 the foregoing factors, the Company does not believe that backlog at
any given time is a meaningful indicator of future sales.
 
EMPLOYEES
 
     At December 31, 1998, the Company employed 434 individuals, of whom 34 were
employed in operations, 276 in research and development, 61 in sales, marketing
and technical support and 63 in administration and other support functions.
Competition for personnel in the semiconductor, software and the PC industry in
general is intense. 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.
 
     In December 1995, the Company entered into a limited partnership
arrangement with a developer to obtain a ground lease and develop and operate
the Company's future Santa Clara facilities. In January 1997, the Company
relocated its principal administrative, sales, marketing, research and
development facility consisting of approximately 300,000 square feet of space in
two buildings located in Santa Clara, California, the initial phase of the
development. This space is leased for an initial 12-year term. In October 1998,
the Company sublet one of the buildings for the remaining term of the lease. The
Company had an option, which expired in January 1999, to build an additional two
buildings comprising approximately 300,000 square feet. In January 1999, the
Company entered into a demand for arbitration related to the option. The demand
for arbitration arose out of the disputed exercise date of the option. The
Company believes that it exercised the option in December 1998 and the developer
believes that the Company's option was not exercised.
 
     The Company has vacated its previous Santa Clara facilities prior to the
expiration of their lease terms in order to occupy the new facilities. The
previous facilities consisted of approximately 159,000 square feet in
                                        8
<PAGE>   11
 
four buildings in Santa Clara, California. The Company has sublet two of the
buildings and terminated the leases on the remaining two buildings. The Company
also leases office space in Texas, Hong Kong, Japan, Taiwan and a warehouse in
Singapore in order to provide sales, distribution and technical support to
customers in the United States and Asia. The facilities leased are currently
sufficient for the Company's operations.
 
     In connection with the Company's investment in the real estate partnership,
in February 1997 the real estate partnership obtained permanent nonrecourse
financing for the construction of the Santa Clara facilities. The Company is not
a guarantor on the permanent financing.
 
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 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 semiconductor industry is 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.
 
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, 1999
are as follows:
 
<TABLE>
<CAPTION>
             NAME                AGE
             ----                ---
<S>                              <C>   <C>
Kenneth F. Potashner             41    President and Chief Executive Officer,
                                       Chairman of the Board
Walter D. Amaral                 47    Sr. Vice President Finance, Chief Financial
                                       Officer
Daniel A. Karr                   39    Vice President of Sales
Paul G. Franklin                 55    Sr. Vice President of Operations
</TABLE>
 
     Mr. Kenneth F. Potashner joined the Company as Chairman of the Board, Chief
Executive Officer and President of the Company in November 1998. From April 1996
to November 1998, Mr. Potashner served as President, Chief Executive Officer and
Chairman of Maxwell Technologies, Inc., an electronics computer company. Mr.
Potashner served as Executive Vice President, Operations and General Manager of
the Disk
 
                                        9
<PAGE>   12
 
Driver Operations at Conner Peripherals, Inc. from 1994 to 1996. Prior to 1994,
Mr. Potashner held various management positions at Quantum Corporation, Digital
Equipment Corporation and Texas Instruments Incorporated. Mr. Potashner holds a
B.S.E.E. from Lafayette College and an M.S.E.E. from Southern Methodist
University. Mr. Potashner is also a member of the Board of Directors of Maxwell
Technologies, Inc., Newport Corporation and High Technology Solutions.
 
     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. Karr, Vice President of Sales, joined the Company in April 1996. From
January 1988 to April 1996, Mr. Karr held various positions at Cirrus Logic,
Inc., a manufacturer of integrated circuits, where he was most recently Sales
Director. From May 1985 to January 1988, Mr. Karr held marketing and technical
support positions at Adaptec, Inc., a supplier of bandwidth management
solutions, where he was most recently Product Manager. Mr. Karr earned a B.A. in
Physics and Mathematics from Linfield College.
 
     Mr. Franklin, Senior Vice President of Operations, 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.
 
                                    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.
 
     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. The warrant expires in December
2000. 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 the purchaser represented that it was an
"accredited investor" as such term is defined in rules of the SEC promulgated
under the Act.
 
                                       10
<PAGE>   13
 
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
 
<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,
                                             -----------------------------------------------------
                                               1998        1997       1996       1995       1994
                                             ---------   --------   --------   --------   --------
                                              (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND RATIOS)
<S>                                          <C>         <C>        <C>        <C>        <C>
STATEMENT OF INCOME DATA
Net sales..................................  $ 224,639   $436,359   $439,243   $316,309   $140,309
Gross margin (loss)........................     (2,072)   135,174    168,876    126,542     42,334
Research and development expenses..........     78,566     78,612     63,382     42,080     17,913
Selling, marketing and administrative
  expenses.................................     41,926     55,879     48,800     33,510     18,310
Other operating expense(1).................     41,335     17,180         --         --         --
Income (loss) from operations..............   (163,899)   (16,497)    56,694     50,952      6,111
Net income (loss)..........................  $(113,204)  $  8,878   $ 41,588   $ 35,374   $  5,502
Net income per share
  Basic....................................  $   (2.22)  $   0.18   $   0.88   $   0.83   $   0.15
  Diluted(2)...............................  $   (2.22)  $   0.17   $   0.81   $   0.75   $   0.14
Shares used in computing per share amounts:
  Basic....................................     51,078     49,519     47,460     42,691     36,032
  Diluted(2)...............................     51,078     51,740     52,451     47,013     39,621
Ratio of earnings to fixed charges(3)......         --         --      23.68x        --     165.98x
BALANCE SHEET DATA
Cash and equivalents.......................  $  31,022   $ 90,484   $ 94,616   $ 69,289   $ 25,772
Short-term investments.....................     88,553     27,186     62,768     24,630      8,800
Working capital............................    152,244    209,993    225,550    144,620     59,727
Total assets...............................    325,801    492,854    485,172    321,643     89,460
Long-term obligations......................     13,837     27,070     20,852     24,761        813
Convertible subordinated notes.............    103,500    103,500    103,500         --         --
Stockholders' equity.......................  $ 163,530   $270,840   $260,321   $205,864   $ 68,878
</TABLE>
 
---------------
(1) 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.
 
(2) 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 1998.
 
(3) For purposes of calculating the ratio of earnings to fixed charges, (i)
    earnings consist of consolidated income before income taxes and equity in
    net income of joint venture plus fixed charges and (ii) fixed charges
    consist of interest expense incurred 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, 1998 and 1997, as evidenced by the less than 1:1 coverage
    ratio. Additional earnings of $142.6 million and $18.6 million were
    necessary to provide a 1:1 coverage ratio for December 31, 1998 and 1997,
    respectively. The Company had no fixed charges in 1995.
 
                                       11
<PAGE>   14
 
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.
 
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,
                                                      --------------------------
                                                       1998      1997      1996
                                                      ------    ------    ------
<S>                                                   <C>       <C>       <C>
Net sales...........................................  100.0%    100.0%    100.0%
Cost of sales.......................................  100.9      69.0      61.6
                                                      -----     -----     -----
Gross margin (loss).................................   (0.9)     31.0      38.4
Operating expenses:
  Research and development..........................   35.0      18.0      14.4
  Selling, marketing and administrative.............   18.7      12.8      11.1
  Other operating expense...........................   18.4       4.0        --
                                                      -----     -----     -----
          Total operating expenses..................   72.1      34.8      25.5
                                                      -----     -----     -----
Income (loss) from operations.......................  (73.0)     (3.8)     12.9
  Gain on sale of joint venture.....................   11.8        --        --
  Other income (expense)............................   (2.3)     (0.5)      0.5
                                                      -----     -----     -----
Income (loss) before income taxes and equity in
  income of manufacturing joint venture.............  (63.5)     (4.3)     13.4
Provision (benefit) for income taxes................   (5.3)     (2.0)      4.5
                                                      -----     -----     -----
Income (loss) before equity in income of
  manufacturing joint venture.......................  (58.2)     (2.3)      8.9
Equity in income from manufacturing joint venture...    7.8       4.3       0.6
                                                      -----     -----     -----
Net income (loss)...................................  (50.4)%     2.0%      9.5%
                                                      =====     =====     =====
</TABLE>
 
NET SALES
 
     The Company's net sales to date have been generated from the sale of its
graphics and multimedia accelerators. The Company's products are used in, and
its business is dependent on, the personal computer industry with sales
primarily in the U.S., Asia and Europe. Net sales were $224.6 million in 1998, a
decrease of 49% from $436.4 million in 1997. Net sales for 1998 consisted
primarily of the Company's 2D and 3D products. 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. The Company's Savage4
family of products is expected to address the mainstream graphics market.
 
                                       12
<PAGE>   15
 
     Net sales were $436.4 million in 1997, a 1% decrease from $439.2 million in
1996. Net sales for 1997 consisted primarily of the Company's ViRGE and Trio
families of integrated accelerators. The decrease in sales from 1996 to 1997 was
a result of declining unit average selling prices due to aggressive pricing from
certain of the Company's competitors as well as the sale of older generation
products, offset by an increase in unit shipments.
 
     The Company's ViRGE family of 2D/3D and Trio 3D accelerators continue to
experience decreases in average selling prices. As a result of the entry of
competitors into the 3D acceleration market, the Company has experienced and
anticipates that it may continue to experience increased pricing pressures on
average selling prices for the ViRGE family of 2D/3D and Trio 3D accelerators.
If the Company is unable to introduce and successfully market higher performance
products, if the Company's products do not achieve market acceptance or if the
pricing pressures increase above normal anticipated levels, the Company's
operating results could be adversely affected.
 
     Export sales accounted for 89%, 70% and 58% of net sales in 1998, 1997 and
1996 respectively. Approximately 29% of export sales in 1998 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
assurance 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 39%, 14% and 13% of net sales in 1998. Three
customers accounted for 20%, 13% and 12% of net sales in 1997. Two customers
accounted for 16% and 15% of net sales in 1996. 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. The Company's largest customer in 1998
was the Company's largest Asian distributor, and more than 50% of the Company's
1998 net sales were made through distributors.
 
GROSS MARGIN
 
     The Company had a negative gross margin percentage of 1% in 1998 and gross
margin percentages of 31% and 38% in 1997 and 1996, respectively. The negative
gross margin in 1998 was impacted by decreases in overall average selling prices
of the ViRGE and Trio family of accelerators. Also impacting 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.
 
     The gross margin in 1997 was impacted by decreases in overall average
selling prices of the 64-bit Trio family and ViRGE family of accelerators, which
resulted in part from the increased proportion of the Company's export sales to
Asian customers and the substantial price competition experienced in the Asian
market. In addition, the Company did not offer products addressing the high
performance 3D acceleration market, which adversely affected the Company's gross
margin. These factors were offset in part by the decrease in unit average costs
resulting from the Company's foundries' conversion to 8-inch wafer utilizing .35
micron technology.
 
     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.
The Company expects gross margin to increase in 1999 as the result of new
product introductions.
 
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
 
                                       13
<PAGE>   16
 
expenses were $78.6 million in 1998, $78.6 million in 1997 and $63.4 million in
1996. 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. The increase in research and development
expenses from 1996 to 1997 reflect additions to the Company's engineering staff
and initial product verification and nonrecurring engineering expenses related
to the introduction of new products, including product development for the
desktop, mobile and home PC markets. The Company expects research and
development expenses in absolute dollars to decrease in 1999.
 
SELLING, MARKETING AND ADMINISTRATIVE EXPENSES
 
     Selling, marketing and administrative expenses were $41.9 million in 1998,
$55.9 million in 1997 and $48.8 million in 1996. Selling, marketing and
administrative headcount decreased by 33% and commission expense decreased by
approximately $7.0 million from 1997 to 1998. From 1996 to 1997 selling,
marketing and administrative headcount increased by 8% and marketing spending
increased $3.2 million which included costs associated with the introduction of
new products.
 
OTHER OPERATING EXPENSE
 
     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 until the fourth quarter of 1998.
 
     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 and 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. Severance and related benefits
represented the reduction of approximately 70 employees, of which 69 have been
paid and separated from the Company as of
 
                                       14
<PAGE>   17
 
December 31, 1998. All severance packages will be 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's plan to vacate one of two leased buildings at the
Company's headquarters facility and include leasehold improvements, furniture,
fixtures and network costs. The Company plans to complete its move by the end of
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 was $26.6 million.
 
OTHER INCOME (EXPENSE), NET
 
     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. Other expense, net, decreased in 1997 to
$2.1 million of expense from $2.2 million of income in 1996. The decrease is
attributable to the interest expense incurred on $103.5 million aggregate
principal amount of convertible subordinated notes, which were issued by the
Company in September 1996, as well as lower average cash and short-term
investments balances, which resulted in a decrease in interest income.
 
INCOME TAXES
 
     The Company's effective tax rate for 1998 was a benefit of 8.4%, compared
to the 46% and 34% effective tax rates for 1997 and 1996, respectively. 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 and equivalents and short-term investments increased in 1998 by $1.9
million to $119.6 million from $117.7 million at the end of 1997. The Company
used $9.3 million for operating activities and used $38.9 million for investing
activities in 1998. In addition, the Company used $11.3 million of cash for
financing activities.
 
     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.
                                       15
<PAGE>   18
 
     Cash used for operating activities was $18.8 million in 1997, as compared
to cash provided by operating activities of $34.2 million in 1996. The decrease
in 1997 was due to lower net income, an increase in inventories, prepaid
expenses and other and a decrease in accounts payable, partially offset by a
write-off of impaired assets and a decrease in accounts receivable. The increase
in inventories was due to the Company's effort to reduce the amount of inventory
in the channel, which resulted in increased inventories on hand at December 31,
1997. The decrease in accounts receivable was a result of lower sales in the
fourth quarter of 1997 as compared to the fourth quarter of 1996.
 
     Investing activities for the years ended December 31, 1998, 1997 and 1996
used $38.9 million, $6.4 million and $120.5 million, respectively. The primary
investing activities in 1998 included $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. The
Company's primary investing activities in 1997 included $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
primary investing activities in 1996 included $23.4 million of property and
equipment purchases, $74.8 million of short term investment purchases and a
$53.0 million investment in the USC joint venture offset by $36.6 million of
maturities of short term investments. The Company expects capital requirements
for 1999 to be consistent with those for 1998.
 
     Financing activities used cash of $11.3 million in 1998 and provided cash
of $21.1 million and $111.6 million in 1997 and 1996, respectively. The decrease
in 1998 was primarily the result of the $10.0 million repayment of notes
payable. Financing activities in 1997 included the sales of common stock
pursuant to employee stock option and stock purchase plans as well as $10.0
million in borrowings on notes payable. This $10.0 million source of funds in
1997 was repaid in 1998. The increase in 1996 primarily reflects the offering of
$103.5 million aggregate principal amount of convertible subordinated notes
completed in September 1996. Net proceeds from the sale of the notes were
approximately $100.1 million.
 
     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. 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. As a result
of the January 1998 sale to UMC, S3's percentage ownership in USC decreased to
15.75%. Under the terms of the agreement, if at any time a "Liquidity Event"
occurs, S3 will be entitled to receive, in addition to the initial payment of
2.4 billion New Taiwan dollars, a contingent payment of up to 19 New Taiwan
dollars per share, or up to an additional 1.5 billion New Taiwan dollars
(approximately U.S. $46.6 million at exchange rates prevailing on December 31,
1998). A "Liquidity Event" is defined as any event by which UMC, or its
successor, will have the opportunity to receive value from transfer of its
ownership of shares of stock in USC in an arms-length transaction other than by
way of transfer to employees for incentives, whether or not UMC or its
successor, in fact, participates in such opportunity. A Liquidity Event will
include, for example, completion of a public offering of USC securities on a
recognized securities exchange; a sale of USC stock owned by UMC (or by a UMC
successor) in an arms-length transaction; or a sale of all or substantially all
of the assets of USC. The facility commenced production utilizing advanced
submicron semiconductor manufacturing processes in late 1996. 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. 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 $14.4 million as of December 31, 1998,
over the term of the agreement. The Company made no payments in 1998, and paid
$9.6 million in 1997 and $7.2 million in 1996. See Note 5 of Notes to
Consolidated Financial Statements.
 
                                       16
<PAGE>   19
 
     Working capital at December 31, 1998 and December 31, 1997 was $152.2
million and $210.0 million, respectively. 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, 1997, the Company's
principal sources of liquidity included cash and equivalents of $90.5 million
and $27.2 million in short-term investments. Additionally, the Company had a
$75.0 million unsecured revolving line of credit at December 31, 1997. The line
of credit was cancelled during 1998. In addition, the Company had available two
separate secured equipment lines of credit totaling $10.0 million. The Company
terminated these lines during 1998. The Company had $5.6 million outstanding
under these secured equipment lines of credit at December 31, 1997. The Company
was required to maintain certain financial covenants in connection with these
lines of credit. See Note 5 of Notes to Consolidated Financial Statements. 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
 
     As a result of computer programs being written using two digits, rather
than four, to represent year dates, the performance of the Company's computer
systems and those of its suppliers and customers in the Year 2000 is uncertain.
Any computer programs that have time-sensitive software may recognize a date
using "00" as the year 1900 rather than the year 2000. This could result in a
system failure or miscalculations causing disruptions of operations, including,
among other things, a temporary inability to process transactions, send invoices
or engage in other normal business activities.
 
     The Company's plans to address the Year 2000 issue involve the following
phases: (i) inventory/risk assessment, (ii) remediation, (iii) testing and (iv)
full compliance and/or the creation of contingency plans. The Company has
completed an inventory and assessment of its systems for Year 2000 readiness.
The assessment indicated that most of the Company's significant information
technology systems could be affected, particularly the general ledger, billing
and inventory systems. That assessment also indicated that software and hardware
(embedded chips) used in development, production and manufacturing systems also
are at risk. Based on a review of its product line, the Company believes that
its products do not require remediation to be Year 2000 compliant. Accordingly,
the Company believes that the Company's products will not expose the Company to
material Year 2000 related liabilities. The Company has also queried its
significant supplier and subcontractors that do not share information systems
with the Company ("external agents"). Although the Company is not aware of any
external agent with a Year 2000 issue that would materially affect the Company's
results of operations or financial condition, the failure of an external agent
to be Year 2000 compliant could have a material adverse effect on the Company's
results of operations or financial condition. The Company intends to
periodically review its external agents to monitor their progress toward
completion of their Year 2000 compliance.
 
     The Company has completed the remediation phase for its information
technology systems and expects to complete software reprogramming and
replacement in the first half of 1999. Once software is reprogram-
 
                                       17
<PAGE>   20
 
med or replaced for a system, the Company begins testing and implementation.
These phases run concurrently for different systems. To date, the Company has
completed approximately 50% of its testing. Completion of the testing phase for
all remediated systems is expected to occur by the first half of 1999, with all
remediated systems fully tested and implemented by the second quarter of 1999.
The Company's order entry system interfaces directly with significant third
party vendors. The Company is in the process of working with third party vendors
to ensure that the Company's systems that interface directly with third parties
are Year 2000 compliant by the third quarter of 1999.
 
     The Company will utilize both internal and external resources to reprogram,
or replace, test and implement its software and operating equipment for Year
2000 modifications. The Company believes that costs for remediation, testing and
implementation are not significant.
 
     The Company currently has no contingency plans in place in the event it
does not complete all phases of the Year 2000 program. The Company plans to
evaluate the status of completion by the first half of 1999 and determine
whether such a plan is necessary. The failure of either the Company's critical
systems or those of its material third parties to be Year 2000 complaint would
result in the interruption of its business, which could have material adverse
affect on the results of operations or financial condition of the Company.
 
FACTORS THAT MAY AFFECT OUR RESULTS
 
OUR OPERATING RESULTS MAY FLUCTUATE
 
     Our operating results have in the past varied significantly and are
expected to vary significantly in the future due to several factors, some of
which are beyond our control. Those factors include:
 
     - changes in our pricing policies or those of our competitors or suppliers;
 
     - competitive pressures on average selling prices;
 
     - the availability and cost of products from our suppliers;
 
     - changes in the mix of products sold by us or in the mix of distribution
       channels through which those products are sold;
 
     - the timing of new product introductions by us or our competitors;
 
     - market acceptance of new or enhanced versions of our products;
 
     - disruptions in our production or shipping processes;
 
     - the gain or loss of significant customers;
 
     - seasonal customer demand;
 
     - the operating results of USC, our manufacturing joint venture; and
 
     - general economic conditions, including economic conditions in Asia in
       particular, that could affect the timing of customer orders and capital
       spending and result in order cancellations or rescheduling.
 
     Some or all of those factors could adversely affect demand for our products
and, therefore, our operating results, in the future.
 
     In addition, 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 industry, is likely to continue and makes
future quarterly operating results less predictable.
 
WE MAY NOT RETURN TO PROFITABILITY
 
     We had a net loss of $113.2 million in 1998. Our net sales decreased 49%
from 1997 to 1998 and we experienced a negative gross margin in 1998. These
results occurred primarily because we did not offer competitive products in the
high end of the graphics and multimedia accelerator market. As a result, our
sales
 
                                       18
<PAGE>   21
 
consisted of sales of primarily older generation and lower price products that
were sold into markets that had significant price competition. We took a charge
for excess and obsolete inventory. Our manufacturing yields were lower than
expected which required us to take a charge for yield losses. We also took a
$4.0 million charge for underutilized prepaid production capacity. We may not be
able to return to profitability.
 
OUR PRODUCTS ARE SUBJECT TO SIGNIFICANT PRICING PRESSURES
 
     Prices for graphics accelerators tend to decline over time, and prices for
newly introduced products are under significant pricing pressures due in part to
aggressive pricing from some of our competitors. We have experienced and
anticipate that we will continue to experience increased pricing pressures on
average selling prices for our ViRGE, Trio and Savage families of accelerators.
 
WE HAVE ONLY RECENTLY STARTED TO OFFER A PRODUCT THAT SPANS ALL VOLUMES OF THE
COMMERCIAL AND CONSUMER PC MARKET
 
     The graphics accelerator market is transitioning from 2D acceleration to 3D
acceleration and products that compete in the high performance segment of that
market have higher gross margins than products in the mainstream PC or in the
sub-$1,000, or "segment zero," PC market. We commenced shipment of our Savage3D
product during the third quarter of 1998. This product was intended to address
the high performance 3D acceleration market. However, the Savage3D failed to
achieve significant market acceptance. We have recently introduced our Savage4,
which is designed to compete in multiple performance segments of the commercial
and consumer PC markets of the 3D acceleration market. We do not know whether
Savage4 will be able to compete successfully in that segment. If we are not able
to introduce and successfully market higher performance products, our gross
margin and profitability could be negatively affected.
 
WE MAY NOT ADEQUATELY FORECAST DEMAND FOR OUR PRODUCTS
 
     Because we are "fabless" and must order products and build inventory
substantially in advance of product shipments, and because the markets for the
our products are volatile and subject to rapid technological and price changes,
we might forecast product demand incorrectly and produce excessive or
insufficient inventories of particular products. In addition, our customers may
change delivery schedules or cancel orders without significant penalty. If we
produce excessive or insufficient inventories of particular products, our
operating results could be negatively affected, as they were in 1998.
 
WE FACE SUBSTANTIAL COMPETITION
 
     The market for our products is extremely competitive and is characterized
by declining selling prices over the life of a particular product and rapid
technological changes. Our principal competitors for graphics accelerators
include 3DFX Interactive, Inc., ATI Technologies, Inc., Intel Corporation,
Matrox Graphics Inc., NVIDIA Corporation, and Trident Microsystems, Inc. Our
principal competitors in the multimedia market include the companies just named
as well as a number of smaller companies that 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. Our product offerings may not address the demand for the next
generation of accelerators or be competitive. If we expand our product line to
add products with additional functionality, we will encounter substantial
competition from established semiconductor companies and may experience
competition from companies designing chips based on different technologies.
 
     Furthermore, the need of PC manufacturers to rapidly introduce a variety of
products aimed at different segments of the PC market may lead to the shift by
system OEMs to the purchase of graphics and multimedia add-in cards provided by
others. Some of our competitors supply both add-in cards and accelerator chips,
which may provide those competitors with an advantage over suppliers that offer
only accelerator chips. In addition, some of our potential competitors, such as
Intel, that supply add-in cards and/or motherboards may seek to use their
card/board business to leverage their graphics accelerator business. Some of our
current and
 
                                       19
<PAGE>   22
 
potential competitors have greater technical, manufacturing, financial and
marketing resources than we do. We believe that our ability to compete
successfully will depend upon a number of factors both within and outside of our
control, including:
 
     - product performance and quality;
 
     - product features;
 
     - product availability;
 
     - the prices that we charge;
 
     - the timing of new product introductions by us and our competitors;
 
     - the emergence of new graphics and PC standards;
 
     - the level of customer support we offer; and
 
     - industry and general economic trends.
 
     We may not have the financial resources, technical expertise or marketing,
distribution and support capabilities to compete successfully.
 
OUR SUCCESS DEPENDS UPON OUR ABILITY TO DEVELOP NEW PRODUCTS AND KEEP PACE WITH
RAPID TECHNOLOGICAL CHANGE
 
     The PC industry in general, and the market for our products in particular,
is characterized by rapidly changing technology, evolving industry standards and
frequent new product introductions. Products in our market typically have a life
cycle of 12 to 18 months, with regular reductions of unit average selling prices
over the life of a specific product. The successful development and
commercialization of new products required to replace or supplement existing
products involve many risks, including the identification of new product
opportunities, the successful and timely completion of the development process
and the selection of our products by leading systems suppliers and add-in card
and motherboard manufacturers for design into their products. There can be no
assurance that we will successfully identify new product opportunities and
develop and bring to market new products in a timely manner. Furthermore, there
can be no assurance that products or technologies developed by others will not
render our products or technologies noncompetitive, or that our products will be
selected for design into its customers' products.
 
     Our products are designed to improve the graphics and multimedia
performance of Pentium-based PCs and Microsoft Windows, Windows NT and IBM OS/2
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 has announced
plans to develop chips that integrate graphics and processor functions to serve
the lower cost PC market. A substantial portion of our 1998 sales were derived
from products addressing the lower cost PC market, and we anticipate that a
substantial portion of our 1999 sales will also be derived from products
addressing that market. We have not previously offered either single function or
integrated accelerator products that provide these functions, which have
traditionally been provided by separate single function chips or chipsets. We
have and will continue to expand the scope of our research and development
efforts to provide these functions, which will require the hiring of engineers
skilled in the respective areas and additional management and 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 there can be no assurance that any such technology will be
available for license or purchase on terms acceptable to us.
 
     Furthermore, there is a limited amount of space on PC motherboards, and
companies that offer solutions that provide the greatest amount of functionality
within this limited space may have a competitive advantage. While our strategy
is to develop new and enhanced graphics and multimedia accelerator products that
will be complementary to present and future versions of Intel and other
Pentium-based microprocessors and integrate
                                       20
<PAGE>   23
 
additional functionality, there can be no assurance that we will be able to
develop such new or enhanced products in a timely manner or correctly anticipate
the additional functionality that will be needed to compete effectively in this
market. Our initial product containing a number of additional functions,
Plato/PX, has been discontinued. There can be no assurance that, if developed,
our new or enhanced products that incorporate additional functions will achieve
market acceptance.
 
     We are continually developing new products, such as Savage4, to address
changing market needs. If new products are not brought to market in a timely
manner or do not address market needs or achieve market acceptance, then our
operating results could be negatively affected. Market acceptance of our
products depends upon a number of factors, some of which are significantly
beyond our control, such as the acceptance of other components, such as memory,
that our products are designed to work with.
 
WE MUST KEEP PACE WITH EVOLVING INDUSTRY STANDARDS
 
     Our products are designed to improve the graphics and multimedia
performance of Pentium-based PCs and Microsoft Windows, Windows NT and IBM OS/2
operating systems, the predominant standards in today's PC market. Any shift
away from such standards would require us to develop new products. We cannot be
certain that new technological developments or changes in standards will not
result in decreased demand for graphics and multimedia accelerators or for our
products that are not compatible with such changed standards.
 
     In 1996, for example, there was an absence of an industry standard 3D
graphics API. As a result, we developed and promoted our proprietary API.
Microsoft has since introduced its Direct3D API and Silicon Graphics has
introduced OpenGL, which have emerged as the standard APIs for 3D acceleration.
While our 3D accelerators currently support our proprietary API, Direct 3D API
and OpenGL, it is possible that another API will emerge as an industry standard
and that our accelerators will not support such a new standard, which would have
a materially negative effect on our business, financial condition and results of
operations.
 
     Furthermore, due to the widespread industry acceptance of Intel's
microprocessor architecture and interface architecture, including its AGP bus,
Intel exercises significant influence over the PC industry generally. From time
to time, Intel significantly modifies its existing technology, architecture and
standards. If we fail to develop products that are compatible with such
modifications, that failure would have a material adverse effect on our
business, financial condition and results of operations. Likewise, any delay in
the public release of information relating to any such modifications could have
a material adverse effect on us.
 
WE ARE A FABLESS SEMICONDUCTOR COMPANY AND DEPEND ON INDEPENDENT FOUNDRIES FOR
THE MANUFACTURE OF OUR PRODUCTS
 
     We currently rely on two independent foundries to manufacture all of our
products either in finished form or wafer form. We have a "take or pay" contract
with Taiwan Semiconductor Manufacturing Company ("TSMC") and a joint venture
foundry, United Semiconductor Corporation ("USC"). In 1995, we expanded and
formalized our relationship with TSMC to provide additional capacity over the
1996 to 2000 time frame. The foundry agreement with TSMC requires us to make
certain annual advance payments to purchase certain committed capacity amounts
to be applied against the following year's capacity or forfeit advance payments
against such amounts. In the fourth quarter, we wrote off approximately $4.0
million of the 1998 prepaid production capacity because we did not fully utilize
the capacity related to the advance payment. Our current note payable to TSMC is
$14.4 million. During 1998, we commenced negotiations with TSMC to modify and
amend the foundry agreement. Although the terms have not been finalized, we are
requesting TSMC to reduce its option capacity and extend the term of the
agreement. If we purchase excess inventories of particular products or choose to
forfeit advance payments, our operating results could be negatively affected.
 
     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
                                       21
<PAGE>   24
 
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. There can be no
assurance that we will 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, and 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 products in 1999. Disruption of operations at these foundries for
any reason, including work stoppages, fire, earthquakes or other natural
disasters, would cause delays in shipments of our products, and 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 our operating results.
 
WE ARE SUBJECT TO THE RISK OF OPERATING LOSSES FROM OUR JOINT VENTURE
 
     We currently own 15.75% of USC and maintain the right to purchase up to
31.25% of USC's output. If USC experiences operating losses, we will recognize
our proportionate share of those losses and may be required to contribute
additional capital. We believe that a number of manufacturers are expanding or
planning to expand their fabrication capacity over the next several years, which
could lead to over-capacity in the market and resulting decreases in costs of
finished wafers. If the wafers produced by USC cannot be produced at competitive
prices, USC could sustain operating losses. There can be no assurance that these
operating losses will not have a material adverse effect on our operating
results.
 
WE RELY ON THIRD PARTIES TO ASSEMBLE AND TEST OUR PRODUCTS
 
     Our products are assembled and tested by a variety of independent
subcontractors. Our reliance on independent assembly and testing houses to
provide these services involves a number of risks, including the absence of
adequate availability of certain packaging technologies, the absence of
guaranteed capacity and reduced control over delivery schedules, quality
assurance and costs.
 
COMMITMENTS WE HAVE MADE TO OBTAIN MANUFACTURING CAPACITY COULD EXPOSE US TO
SIGNIFICANT FINANCIAL RISKS AND GIVE RISE TO FUTURE CAPITAL NEEDS
 
     In order to obtain an adequate supply of wafers, especially wafers
manufactured using advanced process technologies, we have entered into and may
consider in the future various transactions, including:
 
     - the use of "take or pay" contracts that commit us to purchase specified
       quantities of wafers over extended periods;
 
     - equity investments in or advances or issuances of equity securities to
       wafer manufacturing companies in exchange for guaranteed production
       capacity; or
 
     - the formation of joint ventures to own and operate or construct foundries
       or to develop certain products.
 
     Any such transactions would involve financial risk to us and could require
us to commit substantial capital or provide technology licenses in return for
guaranteed production capacity.
 
     In particular, we have entered into a "take or pay" contract with TSMC and
have entered into the USC joint venture. The need to commit substantial capital
may require us to seek additional equity or debt financing. Although we
currently believe that the need for such additional capital will be minimal for
the next two years, if such capital is needed, the sale or issuance of
additional equity or convertible debt securities could result in additional
dilution to our stockholders. There can be no assurance that such additional
financing, if
 
                                       22
<PAGE>   25
 
required, will be available when needed or, if available, will be on terms
acceptable to us. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources" and
"Business -- Manufacturing and Design Methodology."
 
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. This concentration is reflected
in our accounts receivable where greater than 75% of the balance is represented
by three customers at December 31, 1998.
 
     Three customers, Synnex Technology, Inc. ("Synnex"), IBM Corporation and
Promate Electronic Co. ("Promate"), accounted for 39%, 14% and 13%,
respectively, of net sales in 1998. Three customers, Synnex, CNW International
Limited ("CNW"), and Compaq Computer Corporation, accounted for 20%, 13% and
12%, respectively, of net sales in 1997. Two customers, Diamond Multimedia
Systems, Inc. and Synnex, accounted for 16% and 15%, respectively, of net sales
in 1996. Synnex, Promate and CNW are distributors. We expect a significant
portion of our future sales to remain concentrated within a limited number of
strategic customers. There can be no assurance that we will be able to retain
our strategic customers or that these customers will not otherwise cancel or
reschedule orders, or in the event of canceled orders, that such orders will be
replaced by other sales.
 
OUR SALES MAY BE HURT BY SHORTAGES OF COMPONENTS AND PRODUCT DEFECTS
 
     PC graphics and multimedia subsystems include, in addition to our products,
a number of other components that are supplied by third-party manufacturers. Any
shortage of such components in the future could negatively impact our business
and operating results.
 
     Furthermore, it is possible that our products may be found to be defective
after we have already shipped significant volumes. If that were to occur, there
can be no assurance that we would be able to correct such defects successfully
or that such corrections would be acceptable to our customers. The occurrence of
such an event could have a materially negative effect on our business and
operating results.
 
WE DEPEND ON SALES THROUGH DISTRIBUTORS
 
     A substantial percentage of our products are distributed in the
distribution channel through add-in card manufacturers that in turn sell to
Value Added Resellers ("VARS"), System Integrators ("SI"), Original Equipment
Manufacturers ("OEM") and distributors. Accordingly, we are dependent upon these
add-in card manufacturers to assist in promoting market acceptance of our
products. The board manufacturers that purchase our products are generally not
committed to make future purchases of our products and therefore could
discontinue incorporating our products into their graphics boards in favor of a
competitor's product, or for any other reason.
 
     In addition, our distributors are given limited rights to return to us the
products purchased by them, and we provide our distributors with price
protection in the event that we reduce the price of our products.
 
NEARLY ALL OF OUR SALES ARE MADE ON THE BASIS OF PURCHASE ORDERS
 
     Nearly all of our sales are made on the basis of purchase orders rather
than long-term agreements. As a result, we may commit resources to the
production of products without having received advance purchase commitments from
customers. Any inability to sell products to which we have devoted significant
resources could have a material adverse effect on our business, financial
condition or operating results. In addition, cancellation or deferral of product
orders could result in us holding excess inventory, which could have a material
adverse effect on our profit margins and restrict our ability to fund our
operations.
 
WE MAY NOT BE ABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS AND PROPRIETARY
INFORMATION
 
     Our ability to compete is affected by our ability to protect our
intellectual property rights and proprietary information. We have filed several
United States and foreign patent applications and to date have a number of
                                       23
<PAGE>   26
 
issued United States patents. We rely primarily on our trade secrets and
technological know-how in the conduct of our business. The steps taken by us to
protect our intellectual property might not be adequate to prevent
misappropriation of our technology. Also, our competitors might independently
develop technologies that are substantially equivalent or superior to our
technology. The semiconductor and software industries are characterized by
frequent claims and related litigation regarding patent and other intellectual
property rights. We are party to various claims of this nature. Although the
ultimate outcome of these matters is not presently determinable, our management
presently believes that the resolution of all such pending matters will not have
a material adverse effect on our operating results. There can be no assurance
that third parties will not assert additional claims or initiate litigation
against us, our foundries or our customers with respect to existing or future
products. In addition, we may initiate claims or litigation against third
parties for infringement of our proprietary rights or to determine the scope and
validity of our proprietary rights or those of others.
 
     Litigation by or against us has in the past resulted in, and could in the
future result in, substantial expense to us and diversion of the efforts of our
technical and management personnel, whether or not litigation is determined in
favor of us. In the event of an adverse result in any such litigation, we could
be required to pay substantial damages, cease the manufacture, use, sale, offer
for sale and importation of infringing products, expend significant resources to
develop or obtain non-infringing technology, discontinue the use of certain
processes or obtain licenses to the technology which is the subject of the
litigation. There can be no assurance that we would be successful in such
development or acquisition or that any such licenses, if available, would be
available on commercially reasonable terms, and any such development or
acquisition could require expenditures by us of substantial time and other
resources. Any such litigation or unfavorable outcome of litigation could have a
material adverse effect on our operating results. For example, in October 1995,
Brooktree alleged that certain of our products infringed a Brooktree patent. The
resulting lawsuit resulted in substantial expense to us to defend the action and
diverted the efforts of our technical and management personnel. In a settlement
of that suit, we agreed to pay to Brooktree a license fee and royalties relating
to certain product revenues over a five-year period.
 
WE MUST ATTRACT, INTEGRATE, TRAIN AND RETAIN KEY PERSONNEL KNOWLEDGEABLE ABOUT
OUR BUSINESS
 
     Our future success depends in part on the continued service of certain key
engineering, sales, marketing and executive personnel, including highly skilled
semiconductor design personnel and software developers, and our ability to
identify and hire additional personnel. Competition for such personnel is
intense, particularly in the technology sectors and in the regions where our
facilities are located. We cannot be certain that we will be able to retain
existing personnel or attract, hire or retain additional qualified personnel.
The loss of services of any of our senior management team or other key employees
or our failure to attract, integrate, train and retain additional key employees
could harm our business.
 
WE HAVE RECENTLY UNDERGONE A MANAGEMENT TRANSITION
 
     In November 1998, we appointed Kenneth F. Potashner as President and Chief
Executive Officer. Our Board of Directors also increased the size of the board
by one, elected Mr. Potashner to fill the newly created vacancy and elected Mr.
Potashner Chairman of the Board. Terry N. Holdt, who returned from his
retirement in January 1998 to assume the role of interim President, Chief
Executive Officer and Chairman of the Board, remains as Vice Chairman of our
Board of Directors. There can be no assurance as to the effects of this
management transition on our business and operating results. The loss of key
personnel could have a material adverse effect on our business and operating
results. We do not maintain key man insurance on any of our employees.
 
                                       24
<PAGE>   27
 
WE HAVE SIGNIFICANT EXPOSURE TO INTERNATIONAL MARKETS
 
     Export sales accounted for 89%, 70% and 58% of our net sales in 1998, 1997
and 1996, respectively, and 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.
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 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.
 
     We have experienced an adverse impact associated with the economic downturn
in Asia which contributed to our decrease in net sales in 1998. In addition, our
international operations are subject to general geopolitical risks, such as
political and economic instability and changes in diplomatic and trade
relationships. Our foundries, TSMC and USC, are located in Taiwan. The People's
Republic of China and Taiwan at times experienced strained relations in 1995 and
1996, and a worsening of relations or the development of hostilities between the
two parties could have a material adverse effect on us. Finally, the laws of
certain foreign countries may not protect our intellectual property rights to
the same extent as do the laws of the United States.
 
WE HAVE A SIGNIFICANT LEVEL OF DEBT
 
     As a result of the sale by us of $103,500,000 aggregate principal amount of
Convertible Subordinated Notes in September 1996, our ratio of long-term debt to
total capitalization increased from approximately 9.5% at June 30, 1996 to
approximately 31.2% at December 31, 1996. At December 31, 1998, this ratio
increased to 38.8%. The increase in this ratio is the result of the decrease in
the Company's total capitalization as the result of its net loss for 1998. 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 increased
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. See
"Selected Consolidated Financial Data," and "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources."
 
OUR STOCK PRICE IS HIGHLY VOLATILE
 
     The market price of our common stock, like that of the common stock of many
other semiconductor companies, has been and is likely to be highly volatile.
This volatility may result from:
 
     - general market conditions and market conditions affecting technology and
       semiconductor stocks generally;
 
     - actual or anticipated fluctuations in our quarterly operating results;
 
                                       25
<PAGE>   28
 
     - announcements of design wins, technological innovations, acquisitions,
       investments or business alliances; 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. Such litigation could result in substantial costs and a diversion
of our management's attention and resources. Such litigation was brought against
the Company in 1994 and the Company is currently involved in another such
proceeding. See "Item 3. -- Legal 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. Discovery is currently proceeding. 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 United States Securities and Exchange
Commission ("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.
 
                                       26
<PAGE>   29
 
     Principal (Notional) Amounts Maturing in 1999 in U.S. Dollars:
 
<TABLE>
<CAPTION>
                                                              FAIR VALUE AT
                                                            DECEMBER 31, 1998
                                                  -------------------------------------
                                                  (IN THOUSANDS, EXCEPT INTEREST RATES)
<S>                                               <C>
At December 31, 1998:
Cash and equivalents............................                $ 31,022
Weighted average interest rate..................                    4.94%
Short term-investments..........................                $ 88,553
Weighted average interest rate..................                    5.67%
Total portfolio.................................                $119,575
Weighted average interest rate..................                    5.48%
</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, 1998 was approximately
$76.75 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, 1998 and 1997 was not material.
Since foreign currency exposure increases as intercompany receivables grow, the
Company is using foreign exchange forward contracts as a means for hedging these
balances. In general, these foreign exchange forward contracts mature in three
months. As of December 31, 1998, the Company held the following forward exchange
contracts which mature within three months:
 
<TABLE>
<CAPTION>
                                                          NOTIONAL    FAIR VALUE
                                                          --------    ----------
                                                              (IN THOUSANDS)
<S>                                                       <C>         <C>
Foreign Currency Forward Exchange Contracts:
1,500,000 Singapore Dollars.............................    $879         $25
</TABLE>
 
                                       27
<PAGE>   30
 
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...........    29
Report of Deloitte & Touche LLP, Independent Auditors.......    30
Consolidated Statements of Operations for the years ended
  December 31, 1998, 1997 and 1996..........................    31
Consolidated Balance Sheets as of December 31, 1998 and
  1997......................................................    32
Consolidated Statements of Stockholders' Equity for the
  years ended
  December 31, 1998, 1997 and 1996..........................    33
Consolidated Statements of Cash Flows for the years ended
  December 31, 1998, 1997 and 1996..........................    34
Notes to Consolidated Financial Statements..................    35
Selected Quarterly Consolidated Financial Data
  (Unaudited)...............................................    52
 
  INDEX TO FINANCIAL STATEMENTS OF UNITED SEMICONDUCTOR CORPORATION
 
Report of PricewaterhouseCoopers............................    54
United Semiconductor Corporation Balance Sheet as of
  December 31, 1998 and 1997................................    55
United Semiconductor Corporation Statement of Income for the
  Years Ended
  December 31, 1998 and 1997................................    57
United Semiconductor Corporation Statement of Changes in
  Stockholders' Equity for the Years Ended December 31, 1998
  and 1997..................................................    58
United Semiconductor Corporation Statement of Cash Flows for
  the Years Ended
  December 31, 1998 and 1997................................    59
United Semiconductor Corporation Notes to Financial
  Statements................................................    60
</TABLE>
 
                                       28
<PAGE>   31
 
               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, 1998, 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, 1998 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. The financial statements of United Semiconductor Corporation (a
corporation in which the Company has a 15.75% interest), have been audited by
other auditors whose report has been furnished to us; insofar as our opinion on
the consolidated financial statements relates to data included for United
Semiconductor Corporation, it is based solely on their report.
 
     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 and the report of other auditors provide a reasonable basis
for our opinion.
 
     In our opinion, based on our audit and the report of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of S3 Incorporated at
December 31, 1998, 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 21, 1999
 
                                       29
<PAGE>   32
 
             REPORT OF DELOITTE & TOUCHE LLP, INDEPENDENT AUDITORS
 
Board of Directors and Stockholders
S3 Incorporated:
 
     We have audited the accompanying consolidated balance sheet of S3
Incorporated and subsidiaries as of December 31, 1997, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the two years in the period ended December 31, 1997. Our audits also
included the financial statement schedule at Item 14(a)(2) for the years ended
December 31, 1997 and 1996. 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 audits. 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 of $104,465,000
in USC's net assets at December 31, 1997, and of $19,012,000 in that company's
net income (after investor's applicable taxes) for the year then ended are
included in the accompanying financial statements. The financial statements of
USC were audited by other auditors whose report was furnished to us, and our
opinion, insofar as it relates to the amounts included for such company, is
based solely on the report of such other auditors.
 
     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for our opinion.
 
     In our opinion, based on our audits and the report of the other auditors,
such consolidated financial statements present fairly, in all material respects,
the financial position of S3 Incorporated and subsidiaries at December 31, 1997,
and the results of their operations and their cash flows for each of the two
years in the period ended December 31, 1997 in conformity with generally
accepted accounting principles. Also, in our opinion, the financial statement
schedule for the years ended December 31, 1997 and 1996, 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
 
                                       30
<PAGE>   33
 
                                S3 INCORPORATED
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                                 YEAR ENDED DECEMBER 31,
                                                            ---------------------------------
                                                              1998         1997        1996
                                                            ---------    --------    --------
<S>                                                         <C>          <C>         <C>
Net sales.................................................  $ 224,639    $436,359    $439,243
Cost of sales.............................................    226,711     301,185     270,367
                                                            ---------    --------    --------
Gross margin (loss).......................................     (2,072)    135,174     168,876
Operating expenses:
  Research and development................................     78,566      78,612      63,382
  Selling, marketing and administrative...................     41,926      55,879      48,800
  Other operating expense.................................     41,335      17,180          --
                                                            ---------    --------    --------
          Total operating expenses........................    161,827     151,671     112,182
                                                            ---------    --------    --------
Income (loss) from operations.............................   (163,899)    (16,497)     56,694
  Gain on sale of joint venture...........................     26,561          --          --
  Interest income.........................................      7,253       5,295       4,328
  Interest expense........................................     (6,235)     (6,477)     (1,971)
  Other income (expense)..................................     (6,309)       (952)       (128)
                                                            ---------    --------    --------
Income (loss) before income taxes and equity in income of
  manufacturing joint venture.............................   (142,629)    (18,631)     58,923
Provision (benefit) for income taxes......................    (11,956)     (8,497)     19,792
                                                            ---------    --------    --------
Income (loss) before equity in income of manufacturing
  joint venture...........................................   (130,673)    (10,134)     39,131
Equity in income from manufacturing joint venture.........     17,469      19,012       2,457
                                                            ---------    --------    --------
Net income (loss).........................................  $(113,204)   $  8,878    $ 41,588
                                                            =========    ========    ========
Per share amounts:
  Basic...................................................  $   (2.22)   $   0.18    $   0.88
  Diluted.................................................  $   (2.22)   $   0.17    $   0.81
Shares used in computing per share amounts:
  Basic...................................................     51,078      49,519      47,460
  Diluted.................................................     51,078      51,740      52,451
</TABLE>
 
          See accompanying notes to consolidated financial statements.
                                       31
<PAGE>   34
 
                                S3 INCORPORATED
 
                          CONSOLIDATED BALANCE SHEETS
                (IN THOUSANDS, EXCEPT SHARES AND PER SHARE DATA)
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              --------------------
                                                                1998        1997
                                                              --------    --------
<S>                                                           <C>         <C>
Current assets:
  Cash and equivalents......................................  $ 31,022    $ 90,484
  Short-term investments....................................    88,553      27,186
  Accounts receivable (net of allowances of $6,525 in 1998
     and $5,664 in 1997)....................................    23,864      60,713
  Inventories...............................................    11,383      71,882
  Production capacity rights................................    15,709      19,200
  Prepaid taxes.............................................    20,203       8,367
  Prepaid expenses and other................................     6,444      23,605
                                                              --------    --------
          Total current assets..............................   197,178     301,437
Property and equipment -- net...............................    22,392      46,628
Production capacity rights..................................        --       4,800
Investment in joint venture.................................    88,056     104,465
Other assets................................................    18,175      35,524
                                                              --------    --------
          Total.............................................  $325,801    $492,854
                                                              ========    ========
 
                       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable..........................................  $ 16,315    $ 42,819
  Notes payable.............................................    14,400      25,246
  Accrued compensation and benefits.........................     6,491       8,888
  Accrued liabilities.......................................     5,823       3,570
  Deferred revenue..........................................     1,905      10,921
                                                              --------    --------
          Total current liabilities.........................    44,934      91,444
Notes payable...............................................        --       4,800
Other liabilities...........................................    13,837      22,270
Convertible subordinated notes..............................   103,500     103,500
Commitments and contingencies (Notes 7 and 11)
Stockholders' equity:
  Preferred stock, $.0001 par value; 5,000,000 shares
     authorized; none outstanding...........................        --          --
  Common stock, $.0001 par value; 70,000,000 shares
     authorized; 51,716,171,and 50,549,279, shares
     outstanding in 1998 and 1997 respectively..............         5           5
  Additional paid-in capital................................   191,642     187,271
  Accumulated other comprehensive loss......................   (14,755)    (16,278)
  Retained earnings (accumulated deficit)...................   (13,362)     99,842
                                                              --------    --------
          Total stockholders' equity........................   163,530     270,840
                                                              --------    --------
          Total.............................................  $325,801    $492,854
                                                              ========    ========
</TABLE>
 
          See accompanying notes to consolidated financial statements.
                                       32
<PAGE>   35
 
                                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,
  1995.......................  46,797,327     $5      $156,469      $     14       $  49,376     $ 205,864
  Comprehensive Income
     Net income..............          --     --            --            --          41,588        41,588
     Other comprehensive
       loss, net of tax:
       Change in unrealized
       loss on investments...          --     --            --           (68)             --           (68)
                                                                                                 ---------
     Other comprehensive
       loss..................                                                                          (68)
                                                                                                 ---------
  Comprehensive income.......                                                                       41,520
  Exercise of stock
     options.................   1,204,235     --         4,550            --              --         4,550
  Employee stock purchase
     plan....................     231,161     --         2,467            --              --         2,467
  Tax benefit of stock option
     transactions............          --     --         4,725            --              --         4,725
  Stock compensation plan....      99,071     --         1,195            --              --         1,195
                               ----------     --      --------      --------       ---------     ---------
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
                               ==========     ==      ========      ========       =========     =========
</TABLE>
 
          See accompanying notes to consolidated financial statements.
                                       33
<PAGE>   36
 
                                S3 INCORPORATED
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                           ----------------------------------
                                                             1998         1997        1996
                                                           ---------    --------    ---------
<S>                                                        <C>          <C>         <C>
OPERATING ACTIVITIES
  Net income (loss)......................................  $(113,204)   $  8,878    $  41,588
  Adjustments to reconcile net income to net cash
     provided by (used for) operating activities:
     Deferred income taxes...............................     15,453       5,432      (10,469)
     Depreciation........................................     18,844      15,504       10,713
     Amortization........................................      8,347       2,987           --
     Write-off of prepaid production capacity............      4,000          --           --
     Utilization of production capacity rights...........      4,291      (2,400)      (7,200)
     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..................      8,000          --           --
     Gain on sale of shares of joint venture.............    (26,561)         --           --
     Stock compensation..................................         --       2,064        1,195
     Equity in income from joint venture.................    (17,469)    (30,962)      (3,999)
     Changes in assets and liabilities:
       Accounts receivable...............................     36,849      15,407        8,090
       Inventories.......................................     60,499     (18,416)     (10,173)
       Prepaid expenses and other........................      1,158     (25,451)      (6,975)
       Accounts payable..................................    (26,573)     (8,341)     (10,921)
       Accrued compensation and benefits.................     (2,397)     (1,574)        (802)
       Accrued liabilities...............................      1,515       3,362        5,237
       Deferred revenue..................................     (9,015)     (1,192)      12,079
       Income taxes payable..............................    (11,576)     (3,536)       5,810
                                                           ---------    --------    ---------
  Net cash provided by (used for) operating activities...     (9,305)    (18,844)      34,173
                                                           ---------    --------    ---------
INVESTING ACTIVITIES
  Property and equipment purchases, net..................     (5,916)    (30,299)     (23,403)
  Purchases of short-term investments....................   (125,406)    (16,404)     (74,798)
  Maturities of short-term investments...................     66,691      55,705       36,592
  Investment in real estate partnership..................         --          --       (2,100)
  Sale of joint venture..................................     68,025          --           --
  Equity investment in technology company................         --      (5,000)          --
  Investment in joint venture............................         --          --      (53,006)
  Purchase of technology.................................    (40,000)         --           --
  Other assets...........................................     (2,276)    (10,412)      (3,778)
                                                           ---------    --------    ---------
  Net cash used for investing activities.................    (38,882)     (6,410)    (120,493)
                                                           ---------    --------    ---------
FINANCING ACTIVITIES
  Sale of common stock, net..............................      4,371      11,976        7,017
  Sale of convertible subordinated notes.................         --          --      103,500
  Debt issuance costs....................................         --          --       (3,370)
  Net borrowings (repayments) of notes payable...........    (10,000)     10,000       (2,000)
  Net borrowings (repayments) on equipment financing.....     (5,646)       (854)       6,500
                                                           ---------    --------    ---------
  Net cash provided by (used for) financing activities...    (11,275)     21,122      111,647
                                                           ---------    --------    ---------
  Net increase (decrease) in cash and equivalents........    (59,462)     (4,132)      25,327
CASH AND EQUIVALENTS AT BEGINNING OF PERIOD..............     90,484      94,616       69,289
                                                           ---------    --------    ---------
CASH AND EQUIVALENTS AT END OF PERIOD....................  $  31,022    $ 90,484    $  94,616
                                                           =========    ========    =========
SUPPLEMENTAL CASH FLOW INFORMATION
  Interest paid..........................................  $   6,235    $  6,665    $     231
  Income taxes paid (refunded), net......................  $ (15,900)   $ 10,119    $  20,483
</TABLE>
 
          See accompanying notes to consolidated financial statements.
                                       34
<PAGE>   37
 
                                S3 INCORPORATED
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
 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.
The Company's products are used in, and its business is dependent on, the
personal computer industry with sales primarily in the U.S., Asia and Europe
(see Note 10). 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
Incorporated 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 and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Significant estimates include allowances for doubtful accounts
and customer returns, deferred tax assets, the useful lives of fixed assets and
intangible assets, inventory reserves 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 designation of the contracts as hedges of
firm foreign currency commitments. Gains and losses on forward
 
                                       35
<PAGE>   38
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
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, 1998, the Company had one foreign exchange
forward contract outstanding. The Company purchased a forward contract allowing
them to acquire approximately 1,500,000 Singapore Dollars for approximately
$879,000. The contract expires March 31, 1999.
 
  Inventories
 
     Inventories consist of 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,
                                                           ------------------
                                                            1998       1997
                                                           -------    -------
                                                             (IN THOUSANDS)
<S>                                                        <C>        <C>
Work in process..........................................  $ 6,340    $28,392
Finished goods...........................................    5,043     43,490
                                                           -------    -------
          Total..........................................  $11,383    $71,882
                                                           =======    =======
</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 years for
machinery and equipment and five 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,
                                                           ------------------
                                                            1998       1997
                                                           -------    -------
                                                             (IN THOUSANDS)
<S>                                                        <C>        <C>
Machinery and equipment..................................  $37,718    $71,340
Furniture and fixtures...................................    3,622      5,460
Leasehold improvements...................................    4,347      3,688
                                                           -------    -------
          Total..........................................   45,687     80,488
Accumulated depreciation and amortization................  (23,295)   (33,860)
                                                           -------    -------
Property and equipment, net..............................  $22,392    $46,628
                                                           =======    =======
</TABLE>
 
  Long-Lived Assets
 
     In accordance with Statement of Financial Accounting Standards No. 121
("SFAS 121"), "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of," 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'
 
                                       36
<PAGE>   39
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
carrying amounts. The impairment loss is measured by comparing the fair value of
the asset to its carrying amount. The Company annually evaluates the
recoverability of its long-lived assets based on the estimated future
undiscounted cash flows. See Note 12 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 which 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 is derived from sales to manufacturers in the
computer industry. Three customers accounted for greater than 75% of the
Company's accounts receivable balance at December 31, 1998. 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 pursuant to SFAS No. 109, "Accounting for Income Taxes."
 
  Stock-Based Compensation
 
     The Company accounts for stock-based awards to employees using the
intrinsic value method in accordance with Accounting Principles Board No. 25
("APB 25"), "Accounting for Stock Issued to Employees." The Company adopted the
disclosure requirements of SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), which require the disclosure of pro forma net income
and earnings per share as if the Company adopted the fair value-based method in
measuring compensation expense as of the beginning of fiscal 1995.
 
                                       37
<PAGE>   40
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
  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 consistent standard for the recognition and
measurement of derivatives and hedging activities. The statement is effective
for fiscal years commencing after June 15, 1999. The Company does not believe
that SFAS 133 will have a material impact on earnings or the financial condition
of the Company.
 
  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. FINANCIAL INSTRUMENTS
 
     The following is a summary of available-for-sale securities:
 
<TABLE>
<CAPTION>
                                                                       UNREALIZED   UNREALIZED
                                                AMORTIZED    MARKET     HOLDING      HOLDING
                                                  COST       VALUE       GAINS        LOSSES
                                                ---------   --------   ----------   ----------
                                                               (IN THOUSANDS)
<S>                                             <C>         <C>        <C>          <C>
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      $ (2413)
                                                ========    ========     ======      =======
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)
                                                ========    ========     ======      =======
DECEMBER 31, 1997:
Corporate Debt Securities.....................  $ 21,931    $ 21,954     $   42      $   (19)
Mortgage-Backed Securities....................     3,197       3,197         --           --
Debt securities of states of the United States
  and political subdivisions of the states....     2,038       2,035         --           (3)
                                                --------    --------     ------      -------
          Total short-term investments........    27,166      27,186         42          (22)
                                                --------    --------     ------      -------
Corporate Equity Securities...................     5,000       8,646      3,646           --
                                                --------    --------     ------      -------
          Total short-term and long-term
            investments.......................  $ 32,166    $ 35,832     $3,688      $   (22)
                                                ========    ========     ======      =======
</TABLE>
 
                                       38
<PAGE>   41
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
  Fair Value Disclosures
 
     The carrying values and fair values of the Company's financial instruments
are as follows:
 
<TABLE>
<CAPTION>
                                                DECEMBER 31, 1998        DECEMBER 31, 1997
                                              ----------------------   ----------------------
                                              CARRYING    ESTIMATED    CARRYING    ESTIMATED
                                               AMOUNT     FAIR VALUE    AMOUNT     FAIR VALUE
                                              ---------   ----------   ---------   ----------
                                                              (IN THOUSANDS)
<S>                                           <C>         <C>          <C>         <C>
Cash and cash equivalents...................  $  31,022    $31,022     $  90,484    $90,484
Short-term investments......................     88,553     88,553        27,186     27,186
Convertible subordinated notes..............   (103,500)   (76,750)     (103,500)   (68,880)
Foreign currency forward exchange
  contracts.................................         --         25            --         --
</TABLE>
 
 3. 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 the Science
Based Industrial Park in Hsin Chu City, Taiwan, Republic of China. The Company
invested $36.4 million in 1995 and $53.0 in 1996 for its 23.75% equity interest.
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. As a result of the January 1998
sale to UMC, S3's percentage ownership in USC decreased to 15.75%. The facility
commenced production utilizing advanced submicron semiconductor manufacturing
processes in 1996. The Company has the right to purchase up to 31.25% of the
output from the foundry.
 
     The Company accounts for its investment in USC using the equity method of
accounting. The Company records its share of the earnings or losses of the
investment in its income statement. The Company believes that the equity method
of accounting is appropriate due to the significant influence it has in the
financial and operating decisions of USC.
 
     Summarized financial information below uses the respective year-end
exchange rate for the financial position and an average exchange rate for the
respective year for results of operations. Summarized financial information of
USC at December 31, 1998, 1997 and 1996 is as follows (in thousands):
 
<TABLE>
<CAPTION>
                                            YEAR ENDED DECEMBER 31,
                                 ----------------------------------------------
                                     1998             1997             1996
                                 -------------    -------------    ------------
<S>                              <C>              <C>              <C>
RESULTS OF OPERATIONS
Net sales......................  U.S. $352,827    U.S. $328,966    U.S. $60,656
Gross profit...................        152,566          151,037          16,941
Net income.....................        112,151          136,969             577
</TABLE>
 
                                       39
<PAGE>   42
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
<TABLE>
<CAPTION>
                                                         DECEMBER 31,
                                                ------------------------------
                                                    1998             1997
                                                -------------    -------------
<S>                                             <C>              <C>
FINANCIAL POSITION
Current Assets................................  U.S. $398,284    U.S. $349,419
Non-current Assets............................        526,175          370,394
Current Liabilities...........................        151,418          127,873
Non-current Liabilities.......................        219,697          159,644
Stockholders' Equity..........................        553,344          432,296
</TABLE>
 
  Interest in Partnership
 
     In 1995, the Company entered into a limited partnership arrangement with a
developer to obtain a ground lease and develop and operate the Company's current
Santa Clara facilities. The Company's investment of $2.1 million represents a
50% interest in Mission Real Estate L.P. (the partnership), in which the Company
is a limited partner. Permanent nonrecourse financing has been obtained. The
Company is not a guarantor on the permanent financing.
 
 4. 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 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, 1998 was approximately $76.75 million.
 
 5. LINE OF CREDIT AND NOTES PAYABLE
 
     As of December 31, 1997, the Company had $10.0 million outstanding under a
$75.0 million unsecured revolving line of credit that expired September 26,
1998. Borrowings were charged interest at the bank's prime rate. The Company was
not in compliance with one financial covenant at December 31, 1997. Subsequent
to year-end, the lender waived non-compliance with the violated debt covenant
for the period ended December 31, 1997. During 1998, the Company repaid all
amounts outstanding and terminated this unsecured revolving line of credit.
 
     The Company had two separate secured equipment lines of credit totaling
$10.0 million at December 31, 1997. Borrowings were charged interest at the
prime rate. The Company had $5.6 million outstanding under these secured
equipment lines at December 31, 1997. During 1998, the Company repaid all
amounts outstanding and terminated these two secured equipment lines of credit.
 
     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 agreement. The notes bear interest at 10% per annum commencing
on the individual notes' maturity dates if such notes are not paid. The Company
made no payments in 1998, and paid $9.6 million in 1997 and
 
                                       40
<PAGE>   43
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
$7.2 million in 1996. At December 31, 1998, the remaining advance payments (and
corresponding promissory notes) totaled $14.4 million which the Company is
obligated to pay in 1999. During 1998, the Company commenced negotiations with
TSMC to modify and amend its capacity agreement. Although the terms have not
been finalized, the Company is requesting TSMC to reduce its option capacity and
extend the term of the agreement.
 
 6. 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, 1998, 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 Rights may be redeemed at $0.01 per Right pursuant to
the plan by the Board of Directors. The Rights expire May 14, 2007.
 
  Employee Stock Purchase Plan
 
     Under the Company's 1993 Employee Stock Purchase Plan (the "Purchase Plan")
2,800,000 shares of common stock are reserved for issuance pursuant thereto. The
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
offering period. At December 31, 1998, 1,618,169 shares have been issued under
the Purchase Plan and 1,181,831 shares have been reserved for further issuance.
 
  Stock Plan
 
     Under the Company's stock option plan (the "Option Plan") at December 31,
1998, 26,253,692 shares of common stock have been authorized 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. At December
31, 1998, 16,562,258 shares of common stock are reserved for issuance under the
Option Plan and 1,547,576 shares were available for future grant.
 
                                       41
<PAGE>   44
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
     A summary of stock option activity is as follows:
 
<TABLE>
<CAPTION>
                                                  NUMBER OF     WEIGHTED AVERAGE
                                                    SHARES      PRICE PER SHARE
                                                  ----------    ----------------
<S>                                               <C>           <C>
BALANCE, JANUARY 1, 1996........................   6,984,939         $ 8.37
Options granted.................................   6,538,362          12.09
Options exercised...............................  (1,204,235)          3.83
Options cancelled...............................  (3,398,967)         15.28
                                                  ----------
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
                                                  ==========
</TABLE>
 
     Options to purchase 4,400,697, 2,284,502 and 2,267,969 shares were
exercisable at December 31, 1998, 1997 and 1996, respectively, with a weighted
average exercise price of $5.89, $7.16 and $4.29, respectively. Options to
purchase 4,500,000 shares granted in October 1998 to Kenneth F. Potashner were
granted outside of the plan.
 
     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 on 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.
 
     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 vests upon the earlier of
(i) six months from the date Mr. Potashner was hired by the Company, (ii) a
change in control of the Company, (iii) the termination of Mr. Potashner's
employment without cause or (iv) the termination of Mr. Potashner's employment
following the occurrence of among other things, a diminution in Mr. Potashner's
duties or a reduction in Mr. Potashner's compensation, each of which is deemed a
"constructive termination" and treated similarly to a termination without cause.
The second option for 3,000,000 shares vests over a four year period in
accordance with the following schedule: 750,000 shares shall 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.
 
                                       42
<PAGE>   45
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
  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 and on June 30,
1996. No shares were issued under this plan during 1998. The Company accrued the
related compensation cost ratably over the 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 of SFAS 123. The
fair value method of the Company's stock-based awards to employees was estimated
using the Black-Scholes option pricing 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, 1998:
 
<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 - $ 4.88    7,125,131       7.89        $3.51        717,886     $3.43
  4.91 -   8.63    7,103,676       8.36         5.40      3,119,888      5.37
 10.00 -  14.50      738,187       7.52        11.45        509,021     11.30
 16.13 -  20.19       75,723       7.66        17.20         53,902     17.37
                  ----------                              ---------
$ 0.12 - $20.19   15,042,717       8.09        $4.86      4,400,697     $5.89
                  ==========                              =========
</TABLE>
 
     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
                                   --------------------------------    --------------------------------
                                     1998        1997        1996        1998        1997        1996
                                   --------    --------    --------    --------    --------    --------
<S>                                <C>         <C>         <C>         <C>         <C>         <C>
                                        0.5
Expected life from vest date       yrs.....    0.5 yrs.    0.5 yrs.    0.0 yrs.    0.0 yrs.    0.0 yrs.
Volatility.......................        84%         69%         60%         84%         65%         60%
Risk-free interest rate..........       4.9%        5.9%        6.1%        5.0%        5.5%        6.1%
</TABLE>
 
     The weighted-average estimated fair value of stock options granted during
1998, 1997 and 1996 was $2.21, $3.53 and $4.97 per share, respectively. The
weighted-average estimated fair value of shares granted under the Purchase Plan
during 1998, 1997 and 1996 was $3.46, $5.17 and $6.97 per share, respectively.
 
                                       43
<PAGE>   46
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
     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,
                                              ----------------------------------------
                                                  1998           1997          1996
                                              ------------    ----------    ----------
                                              (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                           <C>             <C>           <C>
Pro forma net income (loss).................   $(127,967)      $(7,575)      $28,504
Pro forma per share amounts:
  Basic.....................................   $   (2.51)      $ (0.15)      $  0.60
  Diluted...................................   $   (2.51)      $ (0.15)      $  0.56
</TABLE>
 
     Because SFAS 123 is applicable only to awards granted subsequent to
December 31, 1994, its pro forma effect will not be fully reflected until
approximately 1999.
 
  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. The warrant expires in December
2000.
 
 7. LEASES AND COMMITMENTS
 
  Operating Leases
 
     The Company leases administrative facilities under operating leases that
expire in 2008. 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.
 
     Future minimum annual payments under operating leases are as follows:
 
<TABLE>
<CAPTION>
                                        OPERATING LEASES
                                        ----------------
                                         (IN THOUSANDS)
<S>                                     <C>
1999..................................      $ 8,571
2000..................................        6,756
2001..................................        5,186
2002..................................        4,426
2003..................................        4,426
Thereafter............................       22,129
                                            -------
          Total minimum lease
            payments..................      $51,494
                                            =======
</TABLE>
 
     The total of minimal rentals to be received in the future under
non-cancelable subleases is $45.1 million as of December 31, 1998.
 
                                       44
<PAGE>   47
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
     Rent expense for 1998, 1997 and 1996, was $8.9 million, $7.1 million and
$3.5 million, respectively. Sublease income for 1998, 1997 and 1996 was $2.6
million, $1.5 million and $0, respectively. Net rent expense for 1998, 1997 and
1996 was $6.3 million, $5.6 million and $3.5 million, respectively.
 
 8. INCOME TAXES
 
     The provision for income taxes consists of:
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                               ------------------------------
                                                 1998       1997       1996
                                               --------    -------    -------
                                                       (IN THOUSANDS)
<S>                                            <C>         <C>        <C>
CURRENT TAX EXPENSE:
  Federal....................................  $(20,802)   $(6,102)   $27,838
  State......................................        --      4,123      3,966
                                               --------    -------    -------
                                                (20,802)    (1,979)    31,804
                                               --------    -------    -------
DEFERRED TAX EXPENSE:
  Federal....................................     4,995     (3,248)   (10,722)
  State......................................     3,851     (3,270)    (1,290)
                                               --------    -------    -------
                                                  8,846     (6,518)   (12,012)
                                               --------    -------    -------
          Total..............................  $(11,956)   $ 8,497    $19,792
                                               ========    =======    =======
</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
$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.
 
     The difference between the provision for taxes on income and the amount
computed by applying the federal statutory income tax rate to income before
taxes is explained below:
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                               ------------------------------
                                                 1998       1997       1996
                                               --------    -------    -------
                                                       (IN THOUSANDS)
<S>                                            <C>         <C>        <C>
Tax computed at 35%..........................  $(49,920)   $(6,521)   $20,623
State income taxes, net of federal effect....        --        554      1,739
Tax credits..................................    (2,800)    (2,200)    (3,396)
Valuation allowance for tax losses and
  credits....................................    40,729         --         --
Other........................................        35       (330)       826
                                               --------    -------    -------
Provision for income taxes...................  $(11,956)   $(8,497)   $19,792
                                               ========    =======    =======
Effective tax rate...........................       8.4%      45.6%      33.6%
                                               ========    =======    =======
</TABLE>
 
                                       45
<PAGE>   48
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
     Significant components of the Company's deferred income tax asset are as
follows:
 
<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                          -------------------
                                                           1998        1997
                                                          -------    --------
                                                            (IN THOUSANDS)
<S>                                                       <C>        <C>
Deferred tax assets:
  Reserves not currently deductible.....................  $10,682    $  5,138
  Deferred revenue......................................       --       4,214
  Compensation expense not currently deductible.........    4,185       3,762
  Depreciation/Amortization.............................   16,851       4,021
  Credits and net operating loss carryforwards..........   16,653       5,307
                                                          -------    --------
          Total deferred tax assets.....................   48,371      22,442
  Valuation allowance for deferred tax assets...........  (40,729)         --
                                                          -------    --------
          Net deferred tax assets.......................    7,642      22,442
                                                          -------    --------
Deferred tax liabilities:
  Earnings from foreign joint venture...................   (7,642)    (13,573)
  Other.................................................       --         (23)
                                                          -------    --------
          Total deferred tax liabilities................   (7,642)    (13,596)
                                                          -------    --------
          Net deferred tax asset........................  $    --    $  8,846
                                                          =======    ========
</TABLE>
 
     The Company has net operating loss carryforwards for federal and state tax
purposes of approximately $16.0 million and $25.0 million, respectively,
expiring in 2002 through 2018. The Company has tax credit carry-forwards for
federal and state purposes of approximately $6.4 million and $5.0 million,
respectively, most of which will expire between 2005 and 2018.
 
 9. 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. The cash bonus under this plan was $0,
$0, and $2.0 million in 1998, 1997 and 1996, respectively.
 
     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 6). 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.
 
                                       46
<PAGE>   49
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
     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). Contributions
may be made by the Company at the discretion of the Board of Directors. No
contributions by the Company have been made to the plan since its inception.
 
10. EXPORT SALES AND SIGNIFICANT CUSTOMERS
 
     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 89%, 70% and 58% of net sales
in 1998, 1997 and 1996, respectively. Approximately 29%, 28% and 37% of export
sales in 1998, 1997 and 1996, respectively, were to affiliates of United States
customers. 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. In 1996, 16% and 45% of export sales were shipped
to Hong Kong and Taiwan, respectively. 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. Two customers accounted for 16%
and 15% respectively, of net sales in 1996.
 
     In June 1997, SFAS No. 131, "Disclosure about Segments of an Enterprise and
Related Information" was issued and adopted by the Company in 1998. SFAS 131
establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements and requires
that those enterprises report selected information about operating segments in
interim financial reports issued to stockholders. It also establishes standards
for related disclosures about products and services, geographic areas and major
customers. The Company operates and tracks its results in one segment. The
Company's chief operating decision maker believes that management decisions
regarding products, geographic areas and customers can be made with Company wide
data at the current time. Accordingly, there are no additional disclosure
requirements involved with the Company's adoption of SFAS 131.
 
11. CONTINGENCIES
 
     The semiconductor industry is 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 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 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
                                       47
<PAGE>   50
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
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.
 
12. OTHER OPERATING EXPENSES
 
     Other operating expense is as follows:
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                                -----------------------------
                                                 1998       1997       1996
                                                -------    -------    -------
                                                       (IN THOUSANDS)
<S>                                             <C>        <C>        <C>
Write-off of acquired technologies............  $ 8,000    $    --    $    --
Impairment of long-lived assets...............   27,226     17,180         --
Restructuring.................................    6,109         --         --
                                                -------    -------    -------
          Total...............................  $41,335    $17,180    $    --
                                                =======    =======    =======
</TABLE>
 
     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 until the fourth quarter of 1998.
 
     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 and 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
 
                                       48
<PAGE>   51
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
Company reduced its headcount and consolidated facilities. The following
analysis sets forth the significant components of the restructuring reserve at
December 31, 1998:
 
<TABLE>
<CAPTION>
                                SEVERANCE AND    FACILITY    FURNITURE AND
                                  BENEFITS       CLOSURE       EQUIPMENT       TOTAL
                                -------------    --------    -------------    -------
<S>                             <C>              <C>         <C>              <C>
Restructuring charge..........     $1,024        $ 2,474        $ 2,611       $ 6,109
Cash charge...................       (804)            --             --          (804)
Non-cash charge...............         --         (2,474)        (2,611)       (5,085)
                                   ------        -------        -------       -------
Reserve balance December 31,
  1998........................     $  220        $    --        $    --       $   220
                                   ======        =======        =======       =======
</TABLE>
 
     Severance and related benefits represented the reduction of approximately
70 employees, of which 69 have been paid and separated from the Company as of
December 31, 1998. All severance packages will be 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 or
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's plan to vacate one of two leased buildings at the
Company's headquarters facility, and include leasehold improvements, furniture,
fixtures and network costs. The Company plans to complete its move by the end of
the second quarter of 1999.
 
     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.
 
13. EARNINGS PER SHARE
 
     When computing diluted earnings per share, the Company includes only
potential common shares that are dilutive. Exercise of approximately 15,042,000
options in 1998 and the conversion of approximately 5,385,000 convertible
securities in 1998 and 1997 is not assumed because the result would have been
anti-dilutive.
 
                                       49
<PAGE>   52
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
     The following table sets forth the computation of basic and diluted
earnings per share:
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                               ------------------------------
                                                 1998        1997      1996
                                               ---------    ------    -------
                                                       (IN THOUSANDS,
                                                 EXCEPT PER SHARE AMOUNTS)
<S>                                            <C>          <C>       <C>
NUMERATOR
  Net Income (Loss)
     Basic...................................  $(113,204)   $8,878    $41,588
     Interest expense on subordinated debt...         --        --      1,071
                                               ---------    ------    -------
     Diluted.................................  $(113,204)   $8,878    $42,659
                                               =========    ======    =======
DENOMINATOR
  Denominator for basic earnings per share...     51,078    49,519     47,460
  Common stock equivalents...................         --     2,221      3,469
  Subordinated debt..........................         --         0      1,522
                                               ---------    ------    -------
  Denominator for diluted earnings per
     share...................................     51,078    51,740     52,451
                                               =========    ======    =======
Basic earnings per share.....................  $   (2.22)   $ 0.18    $  0.88
Diluted earnings per share...................  $   (2.22)   $ 0.17    $  0.81
</TABLE>
 
14. COMPREHENSIVE INCOME
 
     As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income" ("SFAS 130"). SFAS 130 establishes new rules for the
reporting and display of comprehensive income and its components; however, the
adoption of the Statement had no impact on the Company's net income (loss) or
stockholders' equity. SFAS 130 requires unrealized gains or losses on the
Company's available-for-sale securities and foreign currency translation
adjustments, which prior to adoption were reported separately in stockholders'
equity, to be included in other comprehensive income. Prior year financial
statements have been reclassified to conform to the requirements of SFAS 130.
 
     The following are the components of accumulated other comprehensive loss,
net of tax:
 
<TABLE>
<CAPTION>
                                                         DECEMBER 31,
                                                 ----------------------------
                                                   1998        1997      1996
                                                 --------    --------    ----
                                                        (IN THOUSANDS)
<S>                                              <C>         <C>         <C>
Unrealized gain (loss) on investments..........  $ (2,329)   $  3,666    $(54)
Foreign currency translation adjustments.......   (12,426)    (19,944)     --
                                                 --------    --------    ----
  Accumulated other comprehensive loss.........  $(14,755)   $(16,278)   $(54)
                                                 ========    ========    ====
</TABLE>
 
     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 and the immaterial components of other
comprehensive income in 1996, tax amounts were nominal.
 
                                       50
<PAGE>   53
                                S3 INCORPORATED
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                                  ---------------------------
                                                   1998        1997      1996
                                                  -------    --------    ----
                                                        (IN THOUSANDS)
<S>                                               <C>        <C>         <C>
Unrealized gain (loss) on investments
  Unrealized gain (loss) on available-for-sale
     securities.................................  $(5,967)   $  3,715    $(92)
  Less: reclassification adjustment for (gain)
     loss realized in net income................      (28)          5      24
                                                  -------    --------    ----
Net unrealized gain (loss) on investments.......   (5,995)      3,720     (68)
Foreign currency translation adjustments........    7,518     (19,944)     --
                                                  -------    --------    ----
Other comprehensive income (loss)...............  $ 1,523    $(16,224)   $(68)
                                                  =======    ========    ====
</TABLE>
 
                                       51
<PAGE>   54
 
         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, 1998
Net sales.......................................  $ 41,547    $ 47,286    $ 53,299    $ 82,507
Gross margin (loss).............................   (16,322)     (7,920)      6,492      15,678
Income (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
YEAR ENDED DECEMBER 31, 1997
Net sales.......................................  $101,911    $119,604    $ 84,589    $130,255
Gross margin....................................    26,443      33,413      24,883      50,435
Income (loss) from operations(2)................   (25,305)       (407)     (9,648)     18,863
Net income (loss)...............................  $ (8,122)   $  4,384    $ (1,766)   $ 14,382
Per share amounts:
  Basic.........................................  $  (0.16)   $   0.09    $  (0.04)   $   0.30
  Diluted(4)....................................  $  (0.16)   $   0.08    $  (0.04)   $   0.27
Shares used in computing per share amounts:
  Basic.........................................    50,440      49,764      49,201      48,672
  Diluted(4)....................................    50,440      52,380      49,201      57,503
Stock prices:(5)
High............................................  $  13.19    $  17.44    $  13.13    $  18.88
Low.............................................  $   4.81    $  10.56    $   9.19    $  12.44
</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, 1998. 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 period presented.
 
(2) 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. Income
    (loss) from operations for 1997 includes a charge for impairment of
    long-lived assets of $17.2 million in the fourth quarter of 1997.
 
(3) Net income (loss) includes gain on sale of joint venture of $26.6 million in
    the first quarter of 1998.
 
(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 the second and fourth quarters of 1997 and all quarters of
    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, 1998, there were approximately 665 stockholders of record
of the Company's common stock and approximately 35,000 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.
 
                                       52
<PAGE>   55
 
                        UNITED SEMICONDUCTOR CORPORATION
 
                              FINANCIAL STATEMENTS
 
                           DECEMBER 31, 1998 AND 1997
 
                                       53
<PAGE>   56
 
January 22, 1999
(99)B.L36P4065
 
To the Board of Directors of United Semiconductor Corporation
 
     We have examined the accompanying balance sheets of United Semiconductor
Corporation as of December 31, 1998 and 1997, and the related statements of
income, of changes in stockholders' equity and of cash flows for the years then
ended. Our examinations were made in accordance with the "Rules Governing the
Certification of Financial Statements by Certified Public Accountants" and
generally accepted auditing standards and accordingly included such tests of the
accounting records and such other auditing procedures as we considered necessary
in the circumstances.
 
     In our opinion, the financial statements examined by us present fairly the
financial position of United Semiconductor Corporation as of December 31, 1998
and 1997, and the results of its operations and its cash flows for the years
then ended, in conformity with generally accepted accounting principles
consistently applied.
 
PricewaterhouseCoopers
Hsinchu, Taiwan R.O.C.
 
                                       54
<PAGE>   57
 
                        UNITED SEMICONDUCTOR CORPORATION
 
                                 BALANCE SHEET
                                  DECEMBER 31,
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                                 1998           1997
                                                              -----------    -----------
<S>                                                           <C>            <C>
CURRENT ASSETS
  Cash and cash equivalents (Note 4(1)).....................  $ 7,516,907    $ 5,469,227
  Marketable securities (Note 4(2)).........................    3,138,393      3,190,746
  Notes receivable
     -- third parties.......................................          189             --
     -- related parties (Note 5)............................        8,352            781
  Accounts receivable
     -- third parties (Note 4(3))...........................      778,399        937,320
     -- related parties (Note 5)............................      436,937        939,664
  Other receivables.........................................      165,146         88,905
  Inventories (Note 4(4))...................................      665,344        511,486
  Prepaid expenses..........................................        7,803         17,669
  Other current assets (Note 4(12)).........................       93,353        230,381
                                                              -----------    -----------
                                                               12,810,823     11,386,179
                                                              -----------    -----------
LONG-TERM INVESTMENTS (NOTES 4(5))
  Long-term investment......................................      105,759             --
  Prepaid long-term investment..............................      250,400             --
                                                              -----------    -----------
                                                                  356,159             --
                                                              -----------    -----------
PROPERTY, PLANT AND EQUIPMENT (NOTES 4(6) AND 6)
  Cost
  Machinery and equipment...................................   18,591,271     10,169,495
  Transportation equipment..................................        3,206          3,206
  Furniture and fixtures....................................      217,742        130,771
  Leasehold improvements....................................       10,966         10,966
  Other equipment...........................................       40,974         14,270
                                                              -----------    -----------
                                                               18,864,159     10,328,708
  Accumulated depreciation..................................   (4,452,290)    (1,944,961)
  Construction in progress and prepayments..................      967,065      2,460,306
                                                              -----------    -----------
                                                               15,378,934     10,844,053
                                                              -----------    -----------
INTANGIBLE ASSET
  Other intangible assets...................................      813,455      1,037,500
                                                              -----------    -----------
OTHER ASSETS
  Deposit-out...............................................        1,475         30,979
  Deferred expense..........................................      134,044         54,027
  Deferred income tax assets (Note 4 (12))..................      238,121        103,102
  Other assets..............................................        2,231             --
                                                              -----------    -----------
                                                                  375,871        188,108
                                                              -----------    -----------
          TOTAL ASSETS......................................  $29,735,242    $23,455,840
                                                              ===========    ===========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
                                       55
<PAGE>   58
 
                        UNITED SEMICONDUCTOR CORPORATION
 
                                 BALANCE SHEET
                                  DECEMBER 31,
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
                      LIABILITIES AND STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                                                                 1998           1997
                                                              -----------    -----------
<S>                                                           <C>            <C>
CURRENT LIABILITIES
  Short-term loans (Note 4(7))..............................  $   781,944    $ 1,911,632
  Notes payable (Note 5)....................................           --        125,209
  Accounts payable
     -- third parties.......................................      461,646        513,371
     -- related parties (Note 5)............................       23,634         21,485
  Accrued expenses (Note 5).................................      811,301        578,013
  Other payables............................................    1,213,782        359,172
  Current portion of long-term loans (Note 4(8))............    1,571,458        656,744
Other current liabilities...................................        6,607          1,268
                                                              -----------    -----------
                                                                4,870,372      4,166,894
                                                              -----------    -----------
LONG-TERM LIABILITIES
  Long-term loans (Note 4(8))...............................    7,041,589      5,190,525
                                                              -----------    -----------
OTHER LIABILITIES
  Accrued pension liabilities...............................       24,958         11,619
                                                              -----------    -----------
          Total Liabilities.................................   11,936,919      9,369,038
                                                              -----------    -----------
STOCKHOLDERS' EQUITY
  Common stock (Note 4(10)).................................   13,367,809     10,000,000
  Capital reserve generated from the gain on disposal of
     fixed assets...........................................           40             40
  Retained earnings (Note 4(11))
     -- Legal reserve.......................................      408,676             --
     -- Unappropriated earnings.............................    4,022,045      4,086,762
  Cumulative translation adjustment.........................         (247)            --
                                                              -----------    -----------
          Total stockholders' equity........................   17,798,323     14,086,802
                                                              -----------    -----------
COMMITMENTS AND CONTINGENT LIABILITIES (NOTE 7)
          TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY........  $29,735,242    $23,455,840
                                                              ===========    ===========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
                                       56
<PAGE>   59
 
                        UNITED SEMICONDUCTOR CORPORATION
 
                              STATEMENT OF INCOME
                        FOR THE YEARS ENDED DECEMBER 31,
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS
                        EXCEPT EARNINGS PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                 1998           1997
                                                              -----------    -----------
<S>                                                           <C>            <C>
Operating Revenues
  Sales revenues............................................  $12,614,679    $10,003,022
  Sales returns.............................................     (186,848)       (21,216)
  Sales allowance...........................................     (634,954)      (302,184)
                                                              -----------    -----------
  Net sales.................................................   11,792,877      9,679,622
  Other operating revenues..................................      183,553         81,542
                                                              -----------    -----------
  Net operating revenues....................................   11,976,430      9,761,164
                                                              -----------    -----------
Operating Cost
  Cost of goods sold........................................   (6,748,200)    (5,278,405)
  Other operating cost......................................     (129,181)       (38,604)
                                                              -----------    -----------
                                                               (6,877,381)    (5,317,009)
                                                              -----------    -----------
Gross Profit................................................    5,099,049      4,444,155
                                                              -----------    -----------
Operating Expenses
  Selling expenses..........................................     (218,789)       (88,841)
  Administrative expenses...................................     (214,364)      (265,943)
  Research and development expenses.........................     (701,179)      (443,866)
                                                              -----------    -----------
                                                               (1,134,332)      (798,650)
                                                              -----------    -----------
Operating Income............................................    3,964,717      3,645,505
                                                              -----------    -----------
Non-operating Income
  Interest income...........................................      368,695        264,153
  Dividends revenue.........................................       28,010         21,420
  Gain on disposal of investment............................       41,516         16,956
  Foreign exchange gain.....................................           --        397,616
  Gain on reverse of allowance on inventory loss............       59,540             --
  Other income..............................................        5,370          6,853
                                                              -----------    -----------
                                                                  503,131        706,998
                                                              -----------    -----------
Non-operating Expenses
  Interest expense..........................................     (464,199)      (354,973)
  Foreign exchange loss.....................................      (71,071)            --
  Provision for loss on obsolescence of inventories.........           --        (50,562)
  Financial expense.........................................      (10,919)          (391)
  Other loss................................................     (103,307)          (419)
                                                              -----------    -----------
                                                                 (649,496)      (406,345)
                                                              -----------    -----------
Income before income tax....................................    3,818,352      3,946,158
Income tax (expense) benefit (Note 4(12))...................      (69,803)        84,057
                                                              -----------    -----------
Net income..................................................  $ 3,748,549    $ 4,030,215
                                                              ===========    ===========
Earnings per share (Note 4(13))
  Net income................................................  $      2.80    $      3.01
                                                              ===========    ===========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
                                       57
<PAGE>   60
 
                        UNITED SEMICONDUCTOR CORPORATION
 
                  STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
                        FOR THE YEARS ENDED DECEMBER 31,
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
<TABLE>
<CAPTION>
                                                            RETAINED EARNINGS       CUMULATIVE TRANSLATION
                                                        -------------------------      ADJUSTMENT FROM           TOTAL
                                              CAPITAL    LEGAL     UNAPPROPRIATED         LONG-TERM          STOCKHOLDERS'
                               COMMON STOCK   RESERVE   RESERVE       EARNINGS           INVESTMENTS            EQUITY
                               ------------   -------   --------   --------------   ----------------------   -------------
<S>                            <C>            <C>       <C>        <C>              <C>                      <C>
Balance at January 1, 1997...  $10,000,000      $--     $     --    $    56,587             $  --             $10,056,587
Net income for 1997..........           --       --           --      4,030,215                --               4,030,215
Transfer of the gain on
  disposal of fixed assets to
  capital reserve............           --       40           --            (40)               --                      --
                               -----------      ---     --------    -----------             -----             -----------
Balance at December 31,
  1997.......................   10,000,000       40           --      4,086,762                --              14,086,802
Appropriation of 1997
  earnings:
  Appropriation for legal
     reserve.................           --       --      408,676       (408,676)               --                      --
  Capitalization of
     employees' bonus........      367,809       --           --       (367,809)               --                      --
  Directors' and supervisors'
     renumeration............           --       --           --        (36,781)               --                 (36,781)
  Stock dividends............    3,000,000       --           --     (3,000,000)               --                      --
Net income for 1998..........           --       --           --      3,748,549                --               3,748,549
Cumulative translation
  adjustment.................           --       --           --             --              (247)                   (247)
                               -----------      ---     --------    -----------             -----             -----------
Balance at December 31,
  1998.......................  $13,367,809      $40     $408,676    $ 4,022,045             $(247)            $17,798,323
                               ===========      ===     ========    ===========             =====             ===========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
                                       58
<PAGE>   61
 
                        UNITED SEMICONDUCTOR CORPORATION
 
                            STATEMENT OF CASH FLOWS
                        FOR THE YEARS ENDED DECEMBER 31,
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
<TABLE>
<CAPTION>
                                                                 1998           1997
                                                              -----------    -----------
<S>                                                           <C>            <C>
OPERATING ACTIVITIES:
  Net income................................................  $ 3,748,549    $ 4,030,215
  Adjustments to reconcile net income to net cash provided
     by (used in) operating activities
  Depreciation..............................................    2,510,951      1,591,371
  Amortization..............................................      363,314        320,071
(Reverse of) Provision for loss on obsolescence of
  inventories...............................................      (47,943)        38,403
  (Loss) gain on disposal of fixed assets...................           15            (40)
  Fixed assets transferred to expenses......................        4,759         26,516
  Changes in asset and liability accounts:
  Accounts and notes receivable.............................      653,888     (1,026,445)
  Other receivables.........................................      (76,241)       (24,017)
  Inventories...............................................     (105,915)       (64,203)
  Prepaid expenses..........................................        9,866         (5,673)
  Other current assets......................................      137,028       (208,429)
  Deferred income tax assets................................     (135,019)       116,684
  Other assets..............................................       (2,231)            --
  Accounts and notes payable................................     (174,785)       213,748
  Accrued expenses and other payable........................      233,288        283,571
  Other current liabilities.................................         (908)         5,911
  Accrued pension liabilities...............................       13,339         11,619
                                                              -----------    -----------
  Net cash provided by operating activities.................    7,131,955      5,309,302
                                                              -----------    -----------
INVESTING ACTIVITIES:
  Acquisition of fixed assets...............................   (6,280,177)    (4,644,743)
  Proceeds from disposal of fixed assets....................           --          9,180
  Decrease (increase) in marketable securities..............       52,353     (2,987,926)
  Increase in long-term investment..........................     (356,406)            --
  Increase in deferred expense and intangible assets........     (128,858)       (25,882)
  Decrease (increase) in deposits-out.......................       29,504           (915)
                                                              -----------    -----------
  Net cash used in investing activities.....................   (6,683,584)    (7,650,286)
                                                              -----------    -----------
FINANCING ACTIVITIES:
  Decrease (increase) in short-term loans...................   (1,129,688)     1,750,112
  Proceeds from long-term loans.............................    2,765,778      1,517,771
  Appropriation of directors' and supervisors'
     renumeration...........................................      (36,781)            --
                                                              -----------    -----------
  Net cash provided by financing activities.................    1,599,309      3,267,883
                                                              -----------    -----------
  Net increase in cash and cash equivalents.................    2,047,680        926,899
  Cash and cash equivalents at the beginning of year........    5,469,227      4,542,328
                                                              -----------    -----------
  Cash and cash equivalents at the end of year..............  $ 7,516,907    $ 5,469,227
                                                              ===========    ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
  Cash paid for interest (excluding interest capitalized)...  $   444,233    $   345,781
                                                              ===========    ===========
  Cash paid for income tax..................................  $     1,744    $    51,501
                                                              ===========    ===========
INVESTING ACTIVITIES PARTIALLY PAID BY CASH
  Acquisition of fixed assets...............................  $ 7,154,510    $ 3,445,946
  Add: payable at the beginning of year.....................      352,925      1,551,722
  Less: payable at the end of year..........................   (1,213,782)      (352,925)
     Fixed assets exchange..................................      (13,476)            --
                                                              -----------    -----------
  Cash paid.................................................  $ 6,280,177    $ 4,644,743
                                                              ===========    ===========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
                                       59
<PAGE>   62
 
                        UNITED SEMICONDUCTOR CORPORATION
 
                         NOTES TO FINANCIAL STATEMENTS
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
 1. HISTORY AND ORGANIZATION
 
     United Semiconductor Corporation was incorporated as a company limited by
shares on October 6, 1995 and commenced its operations in June, 1996. As of
December 31, 1998, the paid-in capital is $13,367,809. The Company's major
business activities are as follows:
 
          a. Semiconductor and semiconductor device foundry;
 
          b. Providing the mask tooling, package, burn-in, and testing services
     for the above-mentioned products; and
 
          c. Research and development for the technology of wafer fabrication.
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  Translation of foreign currency transactions
 
     The accounts of the Company are maintained in New Taiwan dollars.
Transactions denominated in foreign currencies are translated into New Taiwan
dollars at the rates of exchange prevailing on the transaction dates.
Receivables, other monetary assets and liabilities denominated in foreign
currencies are translated into New Taiwan dollars at the rates of exchange
prevailing at the balance sheet date. Exchange gains or losses are included in
the current year's results.
 
  Cash equivalents
 
     Cash equivalents are short-term, highly liquid investments, which are
readily convertible to known amounts of cash and with maturity dates that do not
present significant risk of changes in value because of changes in interest
rates.
 
  Marketable securities
 
     Marketable securities are recorded at cost when acquired. The carrying
amount of the marketable securities portfolio is stated at the lower of its
aggregate cost or market value at the balance sheet date. The market value for
listed equity securities or close-ended funds are determined by the average
closing prices occurred during the last month of the fiscal year. The market
value for open-ended funds are determined by their equity per unit at balance
sheet date.
 
  Inventories
 
     Inventories, except raw materials stated at actual, are stated at standard
cost which is adjusted to actual cost based on weighted average method at month
end. Inventories are valued at the lower of cost or market value at the year
end. An allowance for loss on obsolescence and decline in market value is
provided when necessary.
 
  Long-term investments
 
          A. If the investee company is listed and the Company owns less than
     20% of the outstanding shares and has no significant influence on
     operational decisions of the listed company, such investment is accounted
     for by the lower of cost or market value method. The unrealized loss
     resulting from the decline in market value of such investment is deducted
     from stockholders' equity. The Company's investment in a company which is
     not listed is accounted for under the cost method.
 
                                       60
<PAGE>   63
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
          B. Investment income or loss from investments in both listed and
     unlisted companies is accounted for under equity method provided that the
     Company owns over 20% of the outstanding shares or has significant
     influence on operational decisions of the listed and unlisted companies.
 
          C. For long-term investments in which the Company owns more than 50%
     of the subsidiary, consolidated financial statements are prepared, if the
     total assets and the operating income of the subsidiary are less than 10%
     of the respective nonconsolidated total assets and income of the Company,
     the subsidiary's financial statements are not consolidated and instead are
     accounted for using the equity method. Irrespective of the above test, when
     the total combined assets or operating income of all such nonconsolidated
     subsidiaries constitute more than 30% of the Company's nonconsolidated
     total assets or income, then each individual subsidiary with total assets
     or operating income greater than 3% of the Company's respective
     nonconsolidated total assets and income is included in the consolidation.
 
          D. In evaluation of overseas long-term investment, the cumulative
     translation adjustment derived from the investee's foreign currency
     financial statements is treated as adjusted item of the Company's
     stockholders' equity account.
 
  Property, plant and equipment
 
          A. Property, plant and equipment are stated at cost. Interest incurred
     on loans used to finance the construction of property and plant is
     capitalized and depreciated accordingly.
 
          B. Depreciation is provided on the straight-line method using the
     assets' economic service lives. When the economic service lives are
     completed, fixed assets which are still in use are depreciated based on the
     residual value. The service lives of the fixed assets are five to ten
     years.
 
          C. Maintenance and repairs are charged to expenses as incurred.
     Significant renewals and improvements are treated as capital expenditures
     and are depreciated accordingly.
 
  Intangible assets
 
          A. Technology knowhow was provided by a major shareholder as part of
     paid-in capital. The asset is amortized over five years on the
     straight-line method starting from the date of operation.
 
          B. Royalties are stated at cost and amortized on a straight-line basis
     over the contract period.
 
  Deferred charges
 
     Deferred charges are stated at cost and amortized on a straight-line basis
over the following years: software -- 3 years; organization cost -- 5 years.
 
  Retirement plan
 
          A.  The Company has a non-contributory and funded defined benefit
     retirement plan covering all its regular employees.
 
          B. The net pension cost is computed based on an actuarial valuation in
     accordance with the provision of FASB No. 18 of the R.O.C., which requires
     consideration of cost components such as service cost, interest cost,
     expected return on plan assets and amortization of net obligation at
     transition.
 
                                       61
<PAGE>   64
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
  Income tax
 
     Income tax is provided based on accounting income after adjusting for
permanent differences. The provision for income tax includes deferred tax
resulting from items reported in different periods for tax and financial
reporting purposes and from investment tax credits. A valuation allowance is
provided for deferred tax asset to the extent that it is more likely than not
that the tax benefits will not be realized. Deferred tax assets or liabilities
are further classified into current or noncurrent items and are presented in the
financial statements as net balance. Over or under provision of prior years'
income tax liabilities are included in the current year's income tax expense.
 
 3. EFFECT OF CHANGE IN ACCOUNTING PRINCIPLES
 
     None.
 
 4. CONTENTS OF SIGNIFICANT ACCOUNTS
 
     (1) CASH AND CASH EQUIVALENTS
 
<TABLE>
<CAPTION>
                                                            DECEMBER 31
                                                      ------------------------
                                                         1998          1997
                                                      ----------    ----------
<S>                                                   <C>           <C>
Cash:
Cash on hand........................................  $    2,355    $    1,817
Demand accounts.....................................     387,694        58,655
Checking accounts...................................     169,402        16,607
Time deposits.......................................   6,054,016     5,342,348
                                                      ----------    ----------
                                                       6,613,467     5,419,427
Cash equivalents:
Bonds with repurchase agreement.....................     903,440        49,800
                                                      ----------    ----------
                                                      $7,516,907    $5,469,227
                                                      ==========    ==========
</TABLE>
 
     (2) MARKETABLE SECURITIES
 
<TABLE>
<CAPTION>
                                                            DECEMBER 31
                                                      ------------------------
                                                         1998          1997
                                                      ----------    ----------
<S>                                                   <C>           <C>
Mutual funds........................................  $  199,040    $  251,393
Listed equity securities stocks.....................   2,939,353     2,939,353
                                                      ----------    ----------
                                                      $3,138,393    $3,190,746
                                                      ==========    ==========
</TABLE>
 
     (3) ACCOUNTS RECEIVABLE -- NET
 
<TABLE>
<CAPTION>
                                                            DECEMBER 31
                                                       ----------------------
                                                         1998          1997
                                                       --------      --------
<S>                                                    <C>           <C>
Accounts receivable -- third parties.................  $863,417      $959,159
Less: Allowance for doubtful accounts................   (20,982)      (21,839)
Less: Allowance for sales returns and discounts......   (64,036)           --
                                                       --------      --------
                                                       $778,399      $937,320
                                                       ========      ========
</TABLE>
 
                                       62
<PAGE>   65
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
     (4) INVENTORIES
 
<TABLE>
<CAPTION>
                                                             DECEMBER 31
                                                         --------------------
                                                           1998        1997
                                                         --------    --------
<S>                                                      <C>         <C>
Raw materials, supplies and spare parts................  $ 88,653    $226,426
Work in process........................................   445,414     315,274
Finished goods.........................................   171,737      58,189
                                                         --------    --------
                                                          705,804     599,889
Less: Allowance for loss on obsolescence...............   (40,460)    (88,403)
                                                         --------    --------
                                                         $665,344    $511,486
                                                         ========    ========
</TABLE>
 
     (5) LONG-TERM INVESTMENT
 
<TABLE>
<CAPTION>
                                                                    DECEMBER 31
                                                 --------------------------------------------------
                                                           1998                       1997
                                                 ------------------------    ----------------------
                                                              PERCENTAGE                PERCENTAGE
               INVESTEE COMPANY                   AMOUNT     OF OWNERSHIP    AMOUNT    OF OWNERSHIP
               ----------------                  --------    ------------    ------    ------------
<S>                                              <C>         <C>             <C>       <C>
Investment accounted for under equity method:
  UMC-USA......................................  $106,006         20%          $--         --
  Cumulative translation adjustment............      (247)                     --
                                                 --------                      --
  Subtotal.....................................   105,759                      --
                                                 --------                      --
Prepaid long-term investment:
  Industrial Bank of Taiwan....................   250,000                      --
  SBIP Administration Recycle Co...............       400                      --
                                                 --------                      --
     Subtotal..................................   250,400                      --
                                                 --------                      --
          Grand total..........................  $356,159                      $--
                                                 ========                      ==
</TABLE>
 
                                       63
<PAGE>   66
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
     (6) PROPERTY, PLANT AND EQUIPMENT
 
<TABLE>
<CAPTION>
                                                     ACCUMULATED
                                         COST        DEPRECIATION    BOOK VALUE
                                      -----------    ------------    -----------
<S>                                   <C>            <C>             <C>
DECEMBER 31, 1998
Machinery and equipment.............  $18,591,271    $(4,387,198)    $14,204,073
Transportation equipment............        3,206         (1,122)          2,084
Furniture and fixtures..............      217,742        (53,978)        163,764
Leasehold improvements..............       10,966         (4,142)          6,824
Other equipment.....................       40,974         (5,850)         35,124
Construction in progress and
  prepayments.......................      967,065             --         967,065
                                      -----------    -----------     -----------
                                      $19,831,224     (4,452,290)     15,378,934
                                      ===========    ===========     ===========
DECEMBER 31, 1997
Machinery and equipment.............  $10,169,495    $(1,915,540)    $ 8,253,955
Transportation equipment............        3,206           (587)          2,619
Furniture and fixtures..............      130,771        (24,341)        106,430
Leasehold improvements..............       10,966         (2,315)          8,651
Other equipment.....................       14,270         (2,178)         12,092
Construction in progress and
  prepayments.......................    2,460,306             --       2,460,306
                                      -----------    -----------     -----------
                                      $12,789,014    $(1,944,961)    $10,844,053
                                      ===========    ===========     ===========
</TABLE>
 
     Interest expense amounting to $118,745 and $24,321 were capitalized in 1998
and 1997, respectively.
 
     (7) SHORT-TERM LOANS
 
<TABLE>
<CAPTION>
                                                          DECEMBER 31
                                                 ------------------------------
                                                     1998             1997
                                                 -------------    -------------
<S>                                              <C>              <C>
Unsecured loans................................       $781,944       $1,911,632
                                                 =============    =============
Annual interest rates..........................   0.73% - 8.22%    1.25% - 7.66%
                                                 =============    =============
</TABLE>
 
     (8) LONG-TERM LOANS
 
<TABLE>
<CAPTION>
                                                          DECEMBER 31
                                                 ------------------------------
                                                     1998             1997
                                                 -------------    -------------
<S>                                              <C>              <C>
Long-term loans................................    $ 8,613,047       $5,847,269
Less: Current portion..........................     (1,571,458)        (656,744)
                                                 -------------    -------------
                                                   $ 7,041,589       $5,190,525
                                                 =============    =============
Annual interest rates..........................   1.25% - 7.60%    1.31% - 7.20%
                                                 =============    =============
</TABLE>
 
     (9) RETIREMENT PLAN
 
     A.  All of the regular employees of the Company are covered by the pension
plan. Under the plan, the Company contributes an amount equal to 2% of total
wages on a monthly basis to the pension fund deposited in the Central Trust of
China. Pension benefits are generally based on service years (two points per
year for service years 15 years and below and one point per year for service
years over 15 years). Each employee is limited up to 45 points. During 1998 and
1997, the Company recognized pension cost amounting to $22,262
 
                                       64
<PAGE>   67
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
and $17,793, respectively. The balances of the Company's employees' retirement
fund in Central Trust of China was $18,068 and $9,270 at December 31, 1998 and
1997, respectively.
 
     B.  Based on actuarial assumptions for the years of 1998 and 1997, both the
discount rate and expected rate of return on plan asset are 6.25% and 6.5%,
respectively and the rates of compensation increase are both 8%. The
unrecognized net obligation at transition is amortized equally over 15 years.
The funded status of pension plan is listed as follows:
 
<TABLE>
<CAPTION>
                                                             DECEMBER 31
                                                         --------------------
                                                           1998        1997
                                                         --------    --------
<S>                                                      <C>         <C>
Vested benefit obligation..............................  $     --    $     --
Non-vested benefit obligation..........................   (11,417)     (4,947)
                                                         --------    --------
Accumulated benefit obligation.........................   (11,417)     (4,947)
Effect on projected salary increase....................   (57,082)    (25,388)
                                                         --------    --------
Projected benefit obligation...........................   (68,499)    (30,335)
Market-related value of plan assets....................    18,068       8,638
                                                         --------    --------
Projected benefit obligation exceeds plan asset........   (50,431)    (21,697)
Unrecognized net obligation at transition..............       260         281
Unrecognized pension gain or loss......................    26,647      11,360
                                                         --------    --------
Accrued pension liability..............................  $(23,524)   $(10,056)
                                                         ========    ========
</TABLE>
 
     (10) COMMON STOCK
 
     A. As of December 31, 1998, the Company's authorized capital was
$23,000,000, representing 2,300,000 thousand shares, with par value of NT$10.
The total issued and outstanding capital at December 31, 1998 and 1997 were
$13,367,809 and $10,000,000, respectively.
 
     B. Based on the resolution of the shareholders' meeting on May 26, 1998,
the Company issued new shares of 336,781 thousand shares from the capitalization
of retained earnings of $3,000,000 and employees' bonus of $367,809. The Company
has completed the amendment procedures for registration.
 
     (11) RETAINED EARNINGS
 
     A. According to the Company's Articles of Incorporation, current year's
earnings, if any, shall be distributed in the following order:
 
          (1) paying all taxes and dues;
 
          (2) covering prior years' operating losses, if any;
 
          (3) setting aside 10% of the remaining amount, after deducting (1) and
     (2), as legal reserve;
 
          (4) allocating not over 10% of par value of common stocks as interest
     of capital to common stockholders;
 
          (5) allocating 1% of the remaining amount, after deducting (1), (2),
     (3) and (4) above from the current year's earnings, as directors' and
     supervisors' remuneration;
 
          (6) allocating not below 10% of the remaining amount, after deducting
     (1), (2), (3) and (4) above from the current year's earnings, as employees'
     bonus; and
 
                                       65
<PAGE>   68
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
          (7) distributing the remaining amount in accordance with the
     resolution of the board of directors and stockholders.
 
     (12) INCOME TAX
 
     A.  Income tax receivable at December 31, 1998 and 1997 was derived as
follows:
 
<TABLE>
<CAPTION>
                                                           1998        1997
                                                         --------    --------
<S>                                                      <C>         <C>
Income tax expense (benefit)...........................  $ 69,803    $(84,057)
Net effect of the change in deferred income tax assets
  and liabilities......................................   (54,187)     89,634
Adjustment of prior year's income tax expense..........    (3,101)         --
Withholding income tax.................................   (34,994)    (51,259)
Tax on interest which is subject to separate
  withholding income tax...............................    (1,744)       (242)
                                                         --------    --------
Income tax receivable (shown in other current
  assets)..............................................  $(24,223)   $(45,924)
                                                         ========    ========
</TABLE>
 
     B.  Deferred income tax assets and liabilities as of December 31, 1998 and
1997 were as follows:
 
<TABLE>
<CAPTION>
                                                            DECEMBER 31
                                                      ------------------------
                                                         1998          1997
                                                      ----------    ----------
<S>                                                   <C>           <C>
Deferred income tax assets -- current...............  $   43,335    $  228,270
Deferred income tax liabilities -- current..........      (4,271)           --
                                                      ----------    ----------
                                                          39,064       228,270
                                                      ----------    ----------
Deferred income tax assets -- noncurrent............   1,526,536     1,262,960
Deferred income tax liabilities -- noncurrent.......    (470,012)     (611,435)
Valuation allowance for deferred income tax
  assets -- noncurrent..............................    (818,403)     (548,423)
                                                      ----------    ----------
                                                         238,121       103,102
                                                      ----------    ----------
                                                      $  277,185    $  331,372
                                                      ==========    ==========
</TABLE>
 
                                       66
<PAGE>   69
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
     C.  Components of deferred income tax assets and liabilities as of December
31, 1998 and 1997 were as follows:
 
<TABLE>
<CAPTION>
                              DECEMBER 31, 1998            DECEMBER 31, 1997
                          -------------------------    -------------------------
                            AMOUNT       TAX EFFECT      AMOUNT       TAX EFFECT
                          -----------    ----------    -----------    ----------
<S>                       <C>            <C>           <C>            <C>
Current items:
Temporary differences
Unrealized foreign
  exchange gain.........  $   195,322    $   39,064    $ 1,141,350    $  228,270
                          -----------    ----------    -----------    ----------
Non-current items:
Temporary differences
Depreciation............   (2,350,062)     (470,012)    (3,057,175)     (611,435)
Amortization of
  technology knowhow,
  etc...................      135,180        27,036        956,290       191,258
Investment tax
  credits...............           --     1,499,500             --     1,071,702
Valuation allowance for
  deferred income tax
  assets................           --      (818,403)            --      (548,423)
                          -----------    ----------    -----------    ----------
                          $(2,214,882)      238,121    $(2,100,885)      103,102
                          ===========    ----------    ===========    ----------
                                         $  277,185                   $  331,372
                                         ==========                   ==========
</TABLE>
 
     D.  The Company's income tax return for 1996 has been assessed and approved
by the Tax Authority.
 
     E.  Pursuant to the "Statute For The Establishment and Administration of
Science-Based Industrial Park", the Company was granted several periods of tax
holidays with respect to income derived from approved investments. The tax
holidays will be expired on December, 2001.
 
     F.  As of December 31, 1998, the unused investment tax credits amounting to
$1,499,500 resulting from the acquisition of equipment and expenditures on
research and development will expire on December 31, 2002.
 
     G.  As of December 31, 1998, the Company's deductible credit account
balance for shareholders' income tax is $36,733. The ending balance of
unappropriated earnings amounting to $4,022,045, of which $3,748,549 came from
the year of 1998 and $273,496 came from and before the years of 1997. The
estimated ratio of deductible tax credit for the appropriation of 1998's
earnings is 0.33%.
 
     (13) EARNINGS PER SHARE
 
<TABLE>
<CAPTION>
                                                         1998          1997
                                                      ----------    ----------
<S>                                                   <C>           <C>
Net income..........................................  $3,748,549    $4,030,215
                                                      ==========    ==========
Weighted average outstanding common stock (Expressed
  in thousand shares)...............................   1,336,781     1,000,000
                                                      ==========    ==========
Retroactively adjusted weighted average outstanding
  common stock (Expressed in thousand shares).......   1,336,781     1,336,781
                                                      ==========    ==========
Earnings per share (Expressed in New Taiwan
  dollars)..........................................  $     2.80    $     4.03
                                                      ==========    ==========
Retroactively adjusted weighted average earnings per
  share.............................................  $     2.80    $     3.01
                                                      ==========    ==========
</TABLE>
 
                                       67
<PAGE>   70
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
 5. RELATED PARTY TRANSACTION
 
     (1) NAMES AND RELATIONSHIPS OF RELATED PARTIES
 
<TABLE>
<CAPTION>
    NAME OF THE RELATED PARTIES          THE RELATIONSHIP WITH THE COMPANY
    ---------------------------          ---------------------------------
<S>                                     <C>
United Microelectronics Co., Ltd.
  (UMC)                                 The major investor of the Company
United Integrated Circuits
  Corporation                           Common board chairman
United Silicon Incorporated             Common board chairman
Utek Semiconductor Inc.                 Common board chairman
AMIC Technology, Incorporated           The affiliate of UMC
Faraday Technology Corporation          Common major investor
NOVATEK Microelectronics Corp.          Common major investor
Integrated Technology Express           Common major investor
MediaTek Incorporation                  Common major investor
Industrial Bank of Taiwan               The Company is the promoter
Chiao Tung Bank                         The Company's chairman is a board
                                        member of the Bank
S3 Inc.                                 A director of the Company
S3 International Ltd.                   100% investee of S3 Inc.
ALLIANCE Semiconductor Corp.
  (Alliance)                            A director of the Company
UMC-USA                                 The investee of the Company
</TABLE>
 
     (2) SIGNIFICANT RELATED PARTY TRANSACTIONS
 
          a. Sales
 
<TABLE>
<CAPTION>
                                         1998                          1997
                              --------------------------    --------------------------
                                             PERCENTAGE                    PERCENTAGE
                                AMOUNT      OF NET SALES      AMOUNT      OF NET SALES
                              ----------    ------------    ----------    ------------
<S>                           <C>           <C>             <C>           <C>
United Microelectronics Co.,
  Ltd.......................  $1,562,443         13%        $2,503,897         26%
United Integrated Circuit
  Co., Ltd..................     229,583          2%           302,866          3%
S3 International Ltd........   1,456,778         12%                --         --
  Alliance..................     271,453          2%                --         --
Others......................     108,098          1%           425,071          4%
                              ----------         --         ----------         --
                              $3,628,355         30%        $3,231,834         33%
                              ==========         ==         ==========         ==
</TABLE>
 
     The above sales are dealt with in the ordinary course of business similar
to those with other companies. The actual collection period is approximately two
months.
 
                                       68
<PAGE>   71
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
          b. Purchases
 
<TABLE>
<CAPTION>
                                            1998                     1997
                                   ----------------------    ---------------------
                                               PERCENTAGE               PERCENTAGE
                                                 OF NET                   OF NET
                                    AMOUNT     PURCHASES     AMOUNT     PURCHASES
                                   --------    ----------    -------    ----------
<S>                                <C>         <C>           <C>        <C>
United Microelectronics Co.,
  Ltd............................  $ 69,942        3%        $15,912         2%
United Silicon Incorporated......    17,115        1%             --        --
United Integrated Circuit Co.,
  Ltd............................    19,060        1%             --        --
                                   --------        --        -------        --
                                   $106,117        5%        $ 15912         2%
                                   ========        ==        =======        ==
</TABLE>
 
     The above purchases are dealt with in the ordinary course of business
similar to those with other companies and are payable after two months from the
date of transaction entries.
 
          c. Notes receivable
 
<TABLE>
<CAPTION>
                                              1998                    1997
                                      --------------------    --------------------
                                                PERCENTAGE              PERCENTAGE
                                                 OF NOTES                OF NOTES
                                      AMOUNT    RECEIVABLE    AMOUNT    RECEIVABLE
                                      ------    ----------    ------    ----------
<S>                                   <C>       <C>           <C>       <C>
United Microelectronics Co., Ltd....  $   --        --         $781        100%
AMIC Technology Incorporated........   6,736        79%          --         --
Faraday Technology Corporation......     812        10%          --         --
Integrated Technology Express.......     804         9%          --         --
                                      ------        --         ----        ---
                                      $8,352        98%        $781        100%
                                      ======        ==         ====        ===
</TABLE>
 
          d. Accounts receivable
 
<TABLE>
<CAPTION>
                                          1998                       1997
                                 -----------------------    -----------------------
                                             PERCENTAGE                 PERCENTAGE
                                             OF ACCOUNTS                OF ACCOUNTS
                                  AMOUNT     RECEIVABLE      AMOUNT     RECEIVABLE
                                 --------    -----------    --------    -----------
<S>                              <C>         <C>            <C>         <C>
United Microelectronics
  Co., Ltd. ...................  $303,987        22%        $218,633        11%
United Integrated Circuits Co.,
  Ltd..........................        --        --          317,533        17%
S3 International Ltd...........   140,624        10%         263,252        14%
Others.........................    79,157         6%         148,453         8%
                                 --------        --         --------        --
                                  523,768        38%         947,871        50%
Less: Allowance for doubtful
  accounts.....................    (4,541)       --           (8,207)       --
Less: Allowance for sales
  returns and discounts........   (82,290)       (6)%             --        --
                                 --------        --         --------        --
                                 $436,937        32%        $939,664        50%
                                 ========        ==         ========        ==
</TABLE>
 
          e. Notes payable
 
<TABLE>
<CAPTION>
                                             1998                    1997
                                     --------------------    ---------------------
                                               PERCENTAGE               PERCENTAGE
                                                OF NOTES                 OF NOTES
                                     AMOUNT     PAYABLE      AMOUNT      PAYABLE
                                     ------    ----------    -------    ----------
<S>                                  <C>       <C>           <C>        <C>
United Microelectronics Co., Ltd...    $--        --         $25,992        21%
                                       ==          ==        =======        ==
</TABLE>
 
                                       69
<PAGE>   72
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
          f. Accounts payable
 
<TABLE>
<CAPTION>
                                            1998                      1997
                                   ----------------------    ----------------------
                                              PERCENTAGE                PERCENTAGE
                                              OF ACCOUNTS               OF ACCOUNTS
                                   AMOUNT       PAYABLE      AMOUNT       PAYABLE
                                   -------    -----------    -------    -----------
<S>                                <C>        <C>            <C>        <C>
United Microelectronics Co.,
  Ltd............................  $20,776         4%        $ 9,428         2%
United Integrated Circuit Co.,
  Ltd............................    1,281        --          12,057         2%
United Silicon Incorporated......    1,577         1%             --        --
                                   -------        --         -------        --
                                   $23,634         5%        $21,485         4%
                                   =======        ==         =======        ==
</TABLE>
 
          g. Accrued expenses
 
<TABLE>
<CAPTION>
                                            1998                     1997
                                   ----------------------    ---------------------
                                               PERCENTAGE               PERCENTAGE
                                               OF ACCRUED               OF ACCRUED
                                    AMOUNT      EXPENSES     AMOUNT      EXPENSES
                                   --------    ----------    -------    ----------
<S>                                <C>         <C>           <C>        <C>
United Microelectronics Co.,
  Ltd............................  $190,761        24%        77,387       $13%
Others...........................       197        --             --        --
                                   --------        --        -------       ---
                                   $190,958        24%       $77,387        13%
                                   ========        ==        =======       ===
</TABLE>
 
          h.Property transaction
 
          1998: None.
 
               1997: The Company sold one set of machinery and equipment to
               United Integrated Circuit Co., Ltd. for $9,180. The gain on the
               transaction was $40.
 
          i. Financing transaction -- Long-term loan
 
<TABLE>
<CAPTION>
                         THE HIGHEST BALANCE
                       ------------------------
                           TIME         AMOUNT    ENDING BALANCE    INTEREST RATE    INTEREST EXPENSE PAID
                       -------------   --------   --------------   ---------------   ---------------------
<S>                    <C>             <C>        <C>              <C>               <C>
1998
Chiao-Tung Bank......  February 1998   $720,144      $576,112      6.575% - 6.975%          $44,824
                                       ========      ========                               =======
1997
Chiao-Tung Bank......  December 1997   $720,144      $720,144               6.575%          $40,409
                                       ========      ========                               =======
</TABLE>
 
          j. Other transactions
 
<TABLE>
<CAPTION>
        RELATED PARTIES                         ITEM                  1998       1997
        ---------------             -----------------------------   --------   --------
<S>                                 <C>                             <C>        <C>
United Microelectronics Co.,
  Ltd. .........................    Rental                          $201,211   $199,329
United Microelectronics Co.,
  Ltd. .........................    Fab service charge                87,696     64,954
United Microelectronics Co.,
  Ltd. .........................    Research & design expense        168,420     76,992
United Microelectronics Co.,
  Ltd. .........................    Technology developing expense    145,911         --
United Microelectronics Co.,
  Ltd. .........................    Management allocation fee         69,915         --
                                                                    --------   --------
                                                                     673,153    341,275
UMC-USA.........................    Commission                       137,272         --
                                                                    --------   --------
                                                                    $810,425   $341,275
                                                                    ========   ========
</TABLE>
 
                                       70
<PAGE>   73
                        UNITED SEMICONDUCTOR CORPORATION
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                           DECEMBER 31, 1998 AND 1997
                   (EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)
 
 6. ASSETS PLEDGED AS COLLATERAL
 
<TABLE>
<CAPTION>
                                       DECEMBER 31
                                -------------------------
                                   1998           1997          SUBJECT OF COLLATERAL
                                -----------    ----------       ---------------------
<S>                             <C>            <C>           <C>
Machinery and equipment.......  $12,575,024    $6,272,029    Long-term loan
Deferred assets-software......       53,690            --    Long-term loan
Time deposits.................        2,231         2,111    Guaranty for Customs Duties
                                -----------    ----------
                                $12,630,945    $6,274,140
                                ===========    ==========
</TABLE>
 
 7. COMMITMENTS AND CONTINGENT LIABILITIES
 
     a.  The Company's unused letters of credit for import machinery were
approximately USD25,510 thousand dollars, JPY3,516,992 thousand dollars, and
DEM120 thousand dollars at December 31, 1998.
 
     b.  The Company has signed several contracts for the purchase of equipment
amounting to USD1,204,098 thousand dollars, JPY91,153,936 thousand dollars, and
DEM703 thousand dollars. As of December 31, 1998, the amount of unrecorded
outstanding obligations under these contracts are USD1,101,281 thousand dollars,
JPY77,117,921 thousand dollars, and DEM120 thousand dollars.
 
     c.  On September 24, 1997, the Department of Commerce (DOC) of the United
States of America (USA) made a preliminary determination that Static Random
Access Memory (SRAM) manufactured in Taiwan are being sold at less than fair
market value, i.e. dumped prices. In March, 1998, the DOC issued its final
determination, setting the duty rate at 41.75% for "all others" not named as
direct participants in the investigation (such as customers who used the Company
to fabricate SRAM). Management believes that this final ruling of the case will
not have a material adverse effect on the Company's financial position because
the volume of SRAM products exported by the Company to the USA is not
significant.
 
     d.  On December 7, 1998, the International Trade Commission (ITC) of the
USA issued a statement to the DOC that there was a reasonable indication that
the U.S. industry is suffering a material injury as a result of Dynamic Random
Access Memory (DRAM), which are manufactured in Taiwan and being sold at less
than fair market value in the USA. Based on the precedent set in the SRAM
investigation described above, the Company expects that foundry customers who
were not participants in the investigation will also be subject to the "all
other" rate with respect to DRAM. Management believes that the final outcome of
the investigation will not have a material adverse effect to the Company's
financial position because the Company's volume of export sales of DRAM to the
USA is not significant.
 
     e.  A number of third parties hold patents in the area of semiconductor
processing, and some have notified the Company demanding that the Company obtain
a license for various semiconductor fabrication techniques and circuit designs.
The third parties involved include Texas Instruments, EMI, Intel, Chou H. Li,
NEC, and Sanyo. Management has indicated a willingness to obtain licenses
wherever required and necessary to continue its business.
 
 8. COMPARATIVE FIGURES RECLASSIFICATION
 
     Certain accounts in the 1997 financial statements have been reclassified to
conform with the presentation adopted for the 1998 financial statements.
 
                                       71
<PAGE>   74
 
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 ended December 31, 1997 and 1998, 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 1999 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.
 
                                       72
<PAGE>   75
 
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 and the Index to Financial Statements of United
        Semiconductor Corporation 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, 1998, 1997 and 1996 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>
Report of Ernst & Young LLP, Independent Auditors...........     29
Report of Deloitte & Touche LLP, Independent Auditors.......     30
Schedule II -- Valuation and Qualifying Accounts............     76
</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           Certificate of Amendment of Restated Certificate of
                      Incorporation.
     3(ii)     (10)   Amended and Restated Bylaws.
</TABLE>
 
                                       73
<PAGE>   76
 
<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER    NOTES                     DESCRIPTION OF DOCUMENT
    -------   -----                     -----------------------
    <S>       <C>     <C>
     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 the 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*             1989 Stock Plan of S3 Incorporated (Amended and Restated as
                      of December 14, 1998) (the "1989 Plan").
    10.2*             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        (1)   Form of Indemnification Agreement between the Registrant and
                      its directors.
    10.6        (7)   Lease between Mission Real Estate, L.P. and Registrant dated
                      November 29, 1995.
    10.7        (3)   Office Lease dated May 13, 1993, between the Registrant and
                      San Tomas No. 2 Limited Partnership.
    10.8        (3)   First Amendment of Office Lease dated September 9, 1993,
                      between the Registrant and San Tomas No. 2 Limited
                      Partnership.
    10.9        (5)   Foundry Venture Agreement among Registrant, Alliance
                      Semiconductor Corporation and United Microelectronics
                      Corporation dated as of July 8, 1995.
    10.10       (4)   Office Lease dated March 30, 1994, between the Registrant
                      and San Tomas No. 1 Limited Partnership.
    10.11       (4)   Second Amendment of Office Lease dated March 30, 1994,
                      between the Registrant and San Tomas No. 2 Limited
                      Partnership.
    10.12*     (11)   Employment Agreement between Registrant and Terry N. Holdt
                      dated December 18, 1997.
    10.13*            Employment Agreement between Registrant and Kenneth F.
                      Potashner, dated October 30, 1998
    10.14*            Employment Agreement between Registrant and Ronald T. Yara,
                      dated November 20, 1998
    10.15*            Involuntary Termination Agreement between Registrant and
                      Paul G. Franklin, dated September 22, 1998
    10.16*            Involuntary Termination Agreement between Registrant and
                      Walter D. Amaral, dated September 30, 1998
    10.17*            Involuntary Termination Agreement between Registrant and
                      Daniel A. Karr, dated October 29, 1998
    12.1              Statement of Computation of Ratio of Earnings to Fixed
                      Charges
    16.1       (12)   Letter of Deloitte and Touche LLP regarding change in
                      certifying public accountant
    21.1              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).
    23.3              Consent of PricewaterhouseCoopers LLP (Hsinchu, Taiwan).
    24.1              Power of Attorney (see page 77 of this Form 10-K).
    27.1              Financial Data Schedule.
</TABLE>
 
---------------
  *  Indicates management contract or compensatory plan or arrangement.
 
 (1) Incorporated by reference from 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.
 
                                       74
<PAGE>   77
 
 (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 Exhibit 16 to the Registrant's Current Report
     on Form 8-K filed April 7, 1998.
 
  (b) Reports on Form 8-K:
 
     The following reports on Form 8-K were filed by the Company during the
three months ended December 31, 1998: On November 6, 1998, the Company filed a
Current Report on Form 8-K with the Securities and Exchange Commission that
disclosed, among other things: (i) the appointment of Kenneth F. Potashner as
the Company's President and Chief Executive Officer, (ii) the increase in the
size of the Company's Board of Directors from five directors to six directors,
(iii) the election of Mr. Potashner as Chairman of the Board and (iv) the terms
of Mr. Potashner's employment agreement.
 
                                       75
<PAGE>   78
 
                                                                     SCHEDULE II
                       VALUATION AND QUALIFYING ACCOUNTS
 
                  YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                        REVERSALS
                                              BALANCE AT   CHARGED TO   TO COSTS                   BALANCE AT
                                              BEGINNING    COSTS AND       AND                       END OF
                DESCRIPTION                   OF PERIOD     EXPENSES    EXPENSES    (DEDUCTIONS)     PERIOD
                -----------                   ----------   ----------   ---------   ------------   ----------
<S>                                           <C>          <C>          <C>         <C>            <C>
Allowance for doubtful accounts:
  1998......................................    $1,507       $  600       $  --       $   189        $2,296
  1997......................................     1,438        1,200          --        (1,131)        1,507
  1996......................................       645        1,522          --          (729)        1,438
Sales returns and allowances:
  1998......................................    $4,157       $1,453       $(631)      $  (750)       $4,229
  1997......................................     1,210        4,680          --        (1,733)        4,157
  1996......................................       969          241          --            --         1,210
</TABLE>
 
                                       76
<PAGE>   79
 
                                   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 31, 1999.
 
                                          S3 INCORPORATED
                                          (Registrant)
 
                                          By:   /s/ KENNETH F. POTASHNER
                                            ------------------------------------
                                                    Kenneth F. Potashner
                                                         President
                                                  Chief Executive Officer
                                                   Chairman of the Board
 
March 31, 1999
 
                               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 Ronald T. Yara, 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, Chief Executive      March 31, 1999
---------------------------------------------------    Officer Chairman of the Board
               Kenneth F. Potashner
 
                 /s/ ROBERT P. LEE                               Director               March 31, 1999
---------------------------------------------------
                   Robert P. Lee
 
               /s/ WALTER D. AMARAL                    Senior Vice President & Chief    March 31, 1999
---------------------------------------------------    Financial Officer (Principal
                 Walter D. Amaral                    Financial and Accounting Officer)
 
               /s/ JOHN C. COLLIGAN                              Director               March 31, 1999
---------------------------------------------------
                 John C. Colligan
 
                /s/ TERRY N. HOLDT                      Vice Chairman of the Board      March 31, 1999
---------------------------------------------------
                  Terry N. Holdt
 
              /s/ CARMELO J. SANTORO                             Director               March 31, 1999
---------------------------------------------------
                Carmelo J. Santoro
 
                /s/ RONALD T. YARA                               Director               March 31, 1999
---------------------------------------------------
                  Ronald T. Yara
</TABLE>
 
                                       77
<PAGE>   80
 
                                 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           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 the 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*            1989 Stock Plan of S3 Incorporated (Amended and Restated as
                 of December 14, 1998 (the "1989 Plan").
10.2*            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      (1)    Form of Indemnification Agreement between the Registrant and
                 its directors.
10.6      (7)    Lease between Mission Real Estate, L.P. and Registrant dated
                 November 29, 1995.
10.7      (3)    Office Lease dated May 13, 1993, between the Registrant and
                 San Tomas No. 2 Limited Partnership.
10.8      (3)    First Amendment of Office Lease dated September 9, 1993,
                 between the Registrant and San Tomas No. 2 Limited
                 Partnership.
10.9      (5)    Foundry Venture Agreement among Registrant, Alliance
                 Semiconductor Corporation and United Microelectronics
                 Corporation dated as of July 8, 1995.
10.10     (4)    Office Lease dated March 30, 1994, between the Registrant
                 and San Tomas No. 1 Limited Partnership.
10.11     (4)    Second Amendment of Office Lease dated March 30, 1994,
                 between the Registrant and San Tomas No. 2 Limited
                 Partnership.
10.12*   (11)    Employment Agreement between Registrant and Terry N. Holdt
                 dated December 18, 1997.
10.13*           Employment Agreement between Registrant and Kenneth F.
                 Potashner, dated October 30, 1998
10.14*           Employment Agreement between Registrant and Ronald T. Yara,
                 dated November 20, 1998
10.15*           Involuntary Termination Agreement between Registrant and
                 Paul G. Franklin, dated September 22, 1998
10.16*           Involuntary Termination Agreement between Registrant and
                 Walter D. Amaral, dated September 30, 1998
10.17*           Involuntary Termination Agreement between Registrant and
                 Daniel A. Karr, dated October 29, 1998
12.1             Statement of Computation of Ratio of Earnings to Fixed
                 Charges
</TABLE>
<PAGE>   81
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER   NOTES                     DESCRIPTION OF DOCUMENT
-------  -----                     -----------------------
<S>      <C>     <C>
16.1     (12)    Letter of Deloitte and Touche LLP regarding change in
                 certifying public accountant
21.1             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).
23.3             Consent of PricewaterhouseCoopers LLP (Hsinchu, Taiwan).
24.1             Power of Attorney (see page 77 of this Form 10-K).
27.1             Financial Data Schedule.
</TABLE>
 
---------------
  *  Indicates management contract or compensatory plan or arrangement.
 
 (1) Incorporated by reference from 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 Exhibit 16 to the Registrant's Current Report
     on Form 8-K filed April 7, 1998.