<PAGE>   1
                                 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 JANUARY 2, 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: 000-221199

                               ACCELGRAPHICS, INC.
             (Exact name of registrant as specified in its charter)


                     DELAWARE                                77-0450627 
  (State or other jurisdiction of incorporation or        (I.R.S. Employer 
                  organization)                           Identification No.)

                                1873 BARBER LANE
                               MILPITAS, CA 95035
          (Address of principal executive offices, including zip code)

        Registrant's telephone number, including area code: 408-546-2100

        Securities registered pursuant to Section 12(b) of the Act: NONE

           Securities registered pursuant to Section 12(g) of the Act:

                    COMMON STOCK, PAR VALUE $0.001 PER SHARE


         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 than 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 registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  [  ]

         The aggregate market value of the voting stock held by non-affiliates
of the registrant was approximately $22,578,000 as of March 9, 1998, based upon
the closing sale price on the Nasdaq National Market reported for such date.
Shares of Common Stock held by each officer and director and by each person who
owns 5% of more of the outstanding Common Stock have been excluded in that such
persons may be deemed to be affiliates. This determination of affiliate status
is not necessarily a conclusive determination for other purposes.

         There were 8,446,537 shares of the registrant's Common Stock issued
and outstanding as of March 9, 1998.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Part III incorporates information by reference from the definitive
proxy statement for the Annual Meeting of Stockholders to be held on Thursday,
May 28, 1998.

<PAGE>   2

    The following information should be read in conjunction with the
Consolidated Financial Statements and the notes thereto. This annual report on
Form 10K, and in particular the Management's Discussion and Analysis of
Financial Condition and Results of Operations, contains forward- looking
statements regarding future events or the future performance of the Company that
involve certain risks and uncertainties including those discussed in "Risk
Factors" below. In this report, the words "anticipates", "believes", "expects",
"future" and similar expressions identify forward-looking statements. Actual
events or the actual future results of the Company may differ materially from
any forward-looking statements due to such risks and uncertainties. The Company
assumes no obligation to update these forward-looking statements to reflect
actual results or changes in factors or assumptions affecting such
forward-looking assumptions. Readers are cautioned not to place undue reliance
on these forward-looking statements, which reflect management's analysis only as
of the date hereof. The Company undertakes no obligation to publicly release the
results of any revision to these forward-looking statements, which may be made
to reflect events or circumstances after the date hereof or to reflect the
occurrence of unanticipated events.

                                     PART I

ITEM 1.   BUSINESS

    AccelGraphics, Inc., a Delaware corporation ("AccelGraphics" or "the
Company"), is a leading provider of high-performance, cost-effective,
3-dimensional ("3D") graphics subsystem products for the professional Windows
NT and Windows 95 markets. The Company pioneered the development of
professional 3D graphics subsystems for use with Microsoft's Windows NT
operating system ("NT"). A 3D graphics subsystem integrates graphics
acceleration chip(s), specialized hardware, firmware, software and memory.  The
Company's 3D graphics subsystems, when included in an Intel Pentium, Pentium
Pro, Pentium Pro II or Digital Alpha based computer, create a class of computer
system called a "Personal Workstation." Personal Workstations, which often sell
for less than $10,000, provide capabilities and performance comparable to more
expensive 3D graphics RISC/UNIX workstations. In January 1995, AccelGraphics
shipped what the Company believes was the first 3D graphics subsystem for NT
and currently offers three distinct 3D graphics subsystem product lines.

  The Company's products include a family of 3D graphics subsystems for
applications based on OpenGL and other 3D application programming interfaces
("APIs"), such as Autodesk's Heidi and Microsoft's DirectX. Through the
Company's extensive experience in 3D algorithms, the interaction of 3D
applications with OpenGL and overall 3D graphics system integration,
AccelGraphics delivers robust, well-integrated subsystem solutions to the
professional 3D graphics market.

  The Company sells its products through original equipment manufacturers
("OEMs") and a worldwide network of value added resellers ("VARs") and
distributors. Epson Direct, Gateway 2000, Inc. ("Gateway"), Hewlett-Packard
Company ("HP"), Hitachi, Ltd., NEC Corporation ("NEC"), Samsung Electronics
Co., Ltd. and Tri-Star Computer Corporation purchase the Company's
fully-integrated 3D graphics subsystems for use in high- performance Personal
Workstations. The Company also has technical relationships with Intel
Corporation ("Intel") and Microsoft Corporation ("Microsoft"), as well as with
key component suppliers including 3Dlabs, Inc. ("3Dlabs"), Evans & Sutherland
Computer Corporation ("Evans & Sutherland") and Mitsubishi Corporation
("Mitsubishi"). To enhance the performance of applications which use the
Company's 3D graphics subsystems, AccelGraphics has developed relationships,
some of which include joint engineering projects, with many leading Independent
Software Vendors ("ISVs") such as Autodesk, Inc. ("Autodesk") and Autodesk's
Kinetix Division ("Kinetix"), Computer Associates International, Inc.,
Electronic Data System Corporation's ("EDS") Unigraphics division, Matra
Datavision S.A., Microsoft Corporation's Softimage, Parametric Technology
Corporation ("PTC"), Ricoh Corporation, Structural Dynamics Research
Corporation ("SDRC") and Visible Decisions, Inc.

PRODUCTS

  The Company's product offerings include a range of professional 3D graphics
subsystems and accelerator software.  Today, a majority of the Company's
revenues are derived from the AccelSTAR II, AccelPRO MX and AccelECLIPSE
product lines.  The Company's products support the PCI and AGP buses, and major
professional 3D graphics APIs including OpenGL and Direct 3D.  The Company's
products support NT and in some cases Windows 95.  The Company's products have
been incorporated into systems that use Intel Pentium, Pentium Pro, Pentium Pro
II or Digital Alpha processors. In addition, the Company has developed
accelerator software and software utilities that improve the 3D graphics
capabilities of ISV applications, including Autodesk's AutoCAD and Mechanical
Desktop.

  The Company's principal product lines are summarized below. Estimated Street
Prices (United States) prices vary depending on system configuration.





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                                    HARDWARE

<TABLE>
<CAPTION>
                                                 Introduction                                      Estimated Street
                               Product Line          Date                  Description                   Price
                               ------------          ----                  -----------                   -----
                            <S>                <C>                <C>                               <C>
                            AccelECLIPSE II    November 1997      3D graphics subsystems with       $2,495 - $2,995
                                                                  advanced texture, overlay and
                                                                  anti-aliasing support

                            AccelPRO MX        May 1997           High-performance 3D graphics          $1,495
                                                                  subsystems with hardware
                                                                  texture support

                            AccelSTAR II       October 1997       Entry-level 2D/3D graphics             $279
                                                                  subsystems
</TABLE>



<TABLE>
<CAPTION>
                                                                    SOFTWARE

                                                 Introduction                                        Suggested End
                               Product Line          Date                  Description                User Price
                               ------------          ----                  -----------                ----------
                            <S>                <C>                <C>                                    <C>
                            AccelVIEW 3D       March 1996         Software add-on to Autodesk's          $199
                                                                  AutoCAD to deliver interactive
                                                                  3D graphics
</TABLE>


  AccelECLIPSE II- The AccelECLIPSE subsystem is available on either the PCI or
Accelerated Graphics Port ("AGP") bus and supports up to 1280 x 1024
resolution, integrated VGA, advanced tri-linear texture MIP mapping hardware,
overlays and anti-aliasing. The subsystem incorporates Mitsubishi's 3DPRO
chipset, which includes the REALimage architecture from Evans & Sutherland, 15
MB of 3DRAM, an advanced graphics memory chip architected by Mitsubishi, and up
to 16 MB of optional texture memory. The AccelECLIPSE subsystem targets
high-end visual simulation users, professional animators and CAD designers.

  AccelPRO MX - The AccelPRO MX subsystem supports OpenGL features such as
Gouraud shading, anti-aliasing, transparency and advanced features such as
hardware texture mapping. The product incorporates the GLINT MX and GLINT Delta
chips from 3Dlabs, up to 16 MB of combined VRAM and DRAM memory supporting up
to 1280 x 1024 resolution and on-board VGA and requires a PCI bus.  The
subsystem is targeted to customers who seek a full featured 3D graphics
subsystem solution for CAD design, animation and network management
applications.  The AccelPRO MX replaces the Company's AccelPRO TX product,
which the Company stopped manufacturing in the third quarter of 1997.

  AccelSTAR II- The AccelSTAR II is an entry level 2D/3D graphics subsystem
that provides competitive 2D capabilities along with leading OpenGL performance
and functionality including features such as Gouraud shading, texture mapping
and transparency. It includes an on-board VGA and triangle set up capabilities.
The 2D/3D graphics subsystem sells for a price comparable to a high-end 2D
graphics subsystems.  The AccelSTAR II incorporates the Permedia2 chip from
3Dlabs and up to 8 MB of total memory and is available on either the PCI or AGP
bus.

  AccelVIEW 3D - AccelVIEW 3D enables users of AutoCAD Release 13c4 on NT or
Windows 95 to perform dynamic interactive design and viewing on any database
that has been created with AutoCAD. With AccelVIEW 3D, users are able to
quickly render single parts or assemblies, as well as dynamically manipulate
and seamlessly interact with and edit wireframe, hidden-line and shaded models.
AccelVIEW 3D is tightly integrated with AutoCAD and operates as if it were a
standard part of the application. AccelVIEW 3D can work either with or without
an add-on 3D subsystem card.

The following is a glossary of product terms:

    Anti-Aliasing: a technique used to reduce the jagged or stair-step
    appearance of lines displayed on the screen.

    API (Application Program Interface): the language and message format used by
    a program to activate and interact with functions in another program or in
    the hardware.





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<PAGE>   4

    Bits of Color: related data that provides the information to identify the
    color in the display.

    Gouraud Shading: a display technique used to create a continuous transition
    of color across a surface as well as create a smoother overall appearance of
    an illuminated surface.

    Hidden-Line Removal: the portions of a wireframe object which are hidden
    from view when looking at an object.

    Overlay: multiple layers of images displayed on top of each other.

    Pixels: the smallest unit of a computer screen image; dots.

    Render: the act of displaying on the screen the solid 3D image calculated by
    the software application.

    Texture Mapping: the process of applying a pre-determined image to a surface
    (i.e. applying a picture of a brick building facade to a shape representing
    a wall).

    Tri-Linear MIP (Multi In Partem-Latin) Mapping: a rendering technique used
    to improve the appearance of a textured surface when viewed at a given
    distance combined with a technique for improving the appearance of a
    textured surface.

    Tri-Linear Texture: 3-dimensional images that are used to modify the color
    of fragments.

    VRML (Virtual Reality Model Language): a universal description language
    which allows navigation through 3-dimensional sites that are placed on the
    World Wide Web.

    Wireframe: an outline of a solid image.

    Z-Buffer: a memory storage area used to keep depth information for every
    pixel on the display.

TECHNOLOGY AND CORE COMPETENCIES

   AccelGraphics invests in several key technologies and believes the Company
possesses skills in the various disciplines and technology areas which are
necessary for developing professional 3D computing products. These competencies
include:

  OpenGL 3D Expertise. The Company enhances its products by combining its
proprietary high-performance 3D OpenGL software technology with the OpenGL
software provided by its suppliers of 3D graphic processors.  The Company has
invested thousands of engineering hours in its version of the OpenGL software
library, which currently contains four times more lines of code than the
original sample implementation made available by Silicon Graphics, Inc.
("SGI").  The Company optimizes the performance of its OpenGL software library
by eliminating much of the testing and branching required to process data and
instruction streams, while adding routines optimized for various application
profiles. This effort has resulted in what the Company believes is the fastest
and most stable version of OpenGL available for Windows NT.

  Software Systems Integration. The Company has invested in the development and
expansion of the "transport layer" of software that manages the direct
interfaces associated with various parts of the overall system.  Such parts of
the system include the virtual memory manager, the CPU and its timing, the PCI
bus implementation, the graphic board and chips, data buffer size
specifications and management, specific system configuration issues, NT
register settings and other device driver components. To ensure error-free
operation with maximum performance, the Company continually modifies and
optimizes its software to properly integrate with the various systems and
applications that utilize the Company's 3D graphics subsystems.

  3D Development Tools. The Company has developed tools to determine how
applications operate and how they utilize the 3D graphics pipeline.  Using
these proprietary development tools, AccelGraphics' engineers gain an
understanding of the structure and function of an application enabling them to
optimize the API, graphics libraries and hardware to efficiently process
commands from each application. The Company has developed specific features
for, and optimized the performance of, its software and its hardware with the
goal that key applications will perform better with its 3D graphics subsystems
than with competitive solutions.





                                       4
<PAGE>   5
  Hardware Design and Systems Engineering. The Company's three distinct 3D
graphics subsystem product lines have been designed and introduced in the past
two years.  An in-depth understanding of the importance of layout, trace lines,
memory interaction, chip characteristics, software implementation, BIOS
technologies and bus technology all contribute to building products and systems
that deliver reliable performance. By focusing on system level design, the
Company's 3D graphics subsystems integrate easily into Personal Workstations.

  2D and 3D Expertise. In addition to the Company's 3D expertise, the Company
has extensive experience and maintains active software development efforts in
2D graphics. The Company believes experience and competency in the smooth
implementation and interaction of 2D with 3D delivers a more robust solution to
a broader range of users.

STRATEGIC RELATIONSHIPS

    The NT workstation market is comprised of many vendors collaborating to
produce a complete solution for end users. The Company has developed close
strategic relationships with key companies in this market and participates in
industry consortiums from several market segments. AccelGraphics believes these
relationships provide access to the leading-edge information and technology
that the Company needs to remain at the forefront of this rapidly changing
market.

  The Company has technical relationships with Intel and Microsoft, as well as
with key component suppliers, including 3Dlabs, Mitsubishi, Cirrus Logic, Inc.
and Evans and Sutherland. These relationships include joint engineering
development and have often resulted in modifications to suppliers' product
features and performance through architectural review and early product
evaluation.

  The Company maintains relationships, some of which include joint engineering
projects, with many leading ISVs such as Alias|Wavefront, Autodesk and Kinetix,
Dassault Systemes S.A., EDS Unigraphics, Matra Datavision S.A., Microsoft's
Softimage, PTC, SDRC, Sense8 Corporation, SolidWorks Corporation and Visible
Decisions, Inc.  Examples of such joint engineering products include support of
OpenGL graphics extensions for PTC's Pro/ENGINEER, developing Windows NT
"overlay plane" support with engineers from Microsoft's Softimage group,
software development and engineering assistance with SDRC's migration from UNIX
to NT, and developing and then licensing 3D technology to power Autodesk's
Mechanical Desktop.  By providing resources and assisting its ISV partners in
their transition to NT, the Company has often gained a period of market
advantage for new NT applications. This advantage results from the Company's 3D
graphics subsystems often being the first subsystem certified by the ISV and
sometimes the only subsystem supported by the application for an exclusive
period of time.

  To develop advanced knowledge and influence the direction of new technologies
and products, the Company is actively involved in various technology
consortiums, industry standards organizations and special interest groups. The
Company's engineers are active in the OpenGL Architectural Review Board, the
VRML Consortium, the PCI Special Interest Group, the AGP Implementors Forum and
the Video Electronics Standards Association ("VESA").
  .
3D PROFESSIONAL MARKETS AND APPLICATIONS
  The Company focuses on the professional 3D graphics market and has engineered
3D solutions to support its ISV partners. In many cases, the Company's products
were the first NT-based products supported by these ISVs. The following table
illustrates various 3D market segments. Identified within each market segment
are selected ISVs, their 3D software applications and examples of customers
using the respective applications.



<TABLE>
<CAPTION>
  --------------------------------------------------------------------------------------------------------------------------------

                     ISV                                      APPLICATION                       ISV CUSTOMER EXAMPLES

  --------------------------------------------------------------------------------------------------------------------------------
  <S>                                                  <C>                                      <C>
  MECHANICAL COMPUTER AIDED DESIGN -- Design of products prior to manufacturing
  Autodesk                                              Mechanical Desktop                       Siemens, Wisne Design
  EDS                                                   Unigraphics II                           General Motors
  Matra Datavision S.A.                                 Prelude Design                           Renault
  PTC                                                   Pro/ENGINEER                             Caterpillar, John Deere
  SolidWorks Corporation                                SolidWorks 97                            Lockheed Martin, Alcoa
  SDRC                                                  I-DEAS Master Series                     Ford Motor
  --------------------------------------------------------------------------------------------------------------------------------
  ENGINEERING ANALYSIS -- Verification of structural, vibration and thermal integrity
  Altair Computing, Inc.                                HyperMesh                                Chrysler, Nissan Motor
  ANSYS, Inc.                                           ANSYS                                    General Electric, 3M
  Mechanical Dynamics Incorporated                      Adams                                    Caterpillar
</TABLE>





                                        5
<PAGE>   6

<TABLE>
<CAPTION>
  --------------------------------------------------------------------------------------------------------------------------------

                      ISV                                    APPLICATION                       ISV CUSTOMER EXAMPLES

  --------------------------------------------------------------------------------------------------------------------------------
  <S>                                                   <C>                               <C>
  ANIMATION AND MULTIMEDIA AUTHORING --  video games, commercials
  Kinetix                                               3D Studio MAX                      Mindscape, DreamWorks
  Microsoft                                             Softimage 3D                       Industrial Light & Magic, Sony
  NewTek, Inc.                                          LightWave 3D                       LucasArts Entertainment, Digital Domain
  --------------------------------------------------------------------------------------------------------------------------------
  ARCHITECTURE, ENGINEERING AND CONSTRUCTION -- Plant design, maintenance, and architectural design
  Bentley Systems, Inc.                                 MicroStation 95 and SE             Amoco, Dow Chemical Incorporated
  CADCENTRE, Ltd.                                       Plant Design Maintenance           Brown & Root, British Nuclear Fuels
  EA Systems Inc.                                       Plant Walk                         Mitsui Engineering
  --------------------------------------------------------------------------------------------------------------------------------
  VISUALIZATION -- Representation of complex data such as that from Medical, Geospatial, or Oil and Gas applications
  Advanced Visual Systems, Inc.                         AVS Express                        NASA, Sandia National Laboratories
  --------------------------------------------------------------------------------------------------------------------------------
  FINANCIAL VISUALIZATION -- Decision support for financial analysis
  Visible Decisions, Inc.                               Discovery                          Canadian Imperial Bank
  --------------------------------------------------------------------------------------------------------------------------------
  SIMULATION AND TRAINING SYSTEMS -- Flight training, driver education and corporate training
  Sense 8 Corporation                                   World Tool Kit                     Amoco, BMW
  --------------------------------------------------------------------------------------------------------------------------------
</TABLE>

CUSTOMERS, SALES AND MARKETING

  Sales. The Company's sales efforts consist of a combination of direct sales
to OEMs and a worldwide network of distributors and VARs.  The Company
maintains a wholly owned subsidiary, AccelGraphics Deutschland GmbH, to market
its products in Europe.  As of December 31, 1997, direct sales, marketing and
support staff totaled 22 people located in Northern California, Southern
California, New Jersey, Ohio and Wiesbaden, Germany. Asia Pacific sales are
directed by the Vice President of Asia Pacific Sales out of the Company's
Milpitas headquarters.  Revenues from HP and the Company's former customer,
Digital Equipment Corporation ("Digital"), accounted for 36% and 22%,
respectively, of revenues in 1997, and 23% and 28%, respectively, of revenues
in 1996. Since the second quarter of 1997, Digital has not purchased any of the
Company's products.  The Company does not expect that revenues from Digital, if
any, will comprise a significant portion of the Company's future revenue.
International sales revenues represented approximately 46% and 31% of revenues
in 1997 and 1996, respectively.

  OEMs. The Company and its distributors sell fully-integrated 3D graphics
subsystems to HP, Gateway, Hitachi Ltd., Acer America, Inc., NEC America, Aspen
Computer, Carrera Computer and Tri-Star Computer Corporation for use in
high-performance Personal Workstations. AccelGraphics works closely with its
OEM customers to ensure the complete testing of the Company's 3D graphics
subsystems within their Personal Workstations to achieve maximum system
performance and error-free integration.  Revenues from OEMs accounted for
approximately 68% and 57% of the Company's revenues in 1997 and 1996,
respectively.

  The Product Purchase Agreement with HP provides for HP to supply the Company
non-binding forecasts of HP's requirements for products, and the Company to
provide HP product warranty and product support, indemnification and certain
manufacturing rights in the event the Company is declared bankrupt or goes into
receivership or is unable to supply HP with specified quantities of products
due to a cause not associated with the negligence of either party.

  Distributors and VARs. The Company distributes its products in 32 countries
through a network of distributors and VARs. The Company sells its products in
the United States through large VARs such as JAR Associates and Rand
Technologies. Distributors include Ingram Micro, MicroSouth, Inc., Pioneer-
Standard Electronics, Inc. and Wyle Electronics in the United States,
Performance Graphics, Ltd., and Noesse Datentechnik in Europe and Memorex Telex
Japan, Ltd. in Asia Pacific.  Revenues from distributors and VARs accounted for
32% and 43% of the Company's revenues in 1997 and 1996, respectively.

  The Company grants certain of its distributors price protection and limited
rights of return with respect to products purchased by them.  The short product
life cycles of the Company's products and the difficulty in predicting future
sales increase the risk that new product introductions, price reductions by the
Company or its competitors, or other factors affecting the 3D graphics
subsystems market could result in significant product returns or price
protection claims.

  Marketing. The Company's marketing efforts consist primarily of advertising
in targeted trade publications, exhibiting at industry trade shows and joint
marketing activities with ISVs. The Company's collaborative marketing efforts
include mailings by the ISVs to their customers on the behalf of the Company
and inclusion of the Company's promotional literature with the ISVs software
distributions. The Company also participates in joint demonstrations and pilot
programs





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<PAGE>   7
and seeks to obtain reviews of its products in leading trade publications such
as Pro/E The Magazine, NT Studio and CADalyst.

  Customer Support. The Company utilizes the Sutherland Group ("SG") for
initial support within the United States for VARs, distributors and end users.
The Company maintains its own in-house pre- and post-sale support staff to
provide support for the rest of the world, OEM support and extended support for
the United States. In addition, the Company utilizes its Internet site as well
as e-mail exchange to support its customers. The Company generally provides a
three-year warranty for its products. In general, the Company's return policy
permits return within five days after receipt of products that do not meet
product specifications.

RESEARCH AND DEVELOPMENT

    Research and development expenses increased to $4.5 million in 1997 from
$2.7 million in 1996, representing approximately 13% and 14% of revenues,
respectively. The Company believes that continued investment in research and
development is critical to the Company's success.  The Company's research and
development organization consisted of 20 employees as of December 31, 1997.

  The Company's hardware development efforts are focused on the design and
testing of new products incorporating advanced components into high performance
accelerators that make efficient use of the PCI and AGP busses, system BIOS
architectures, and graphic libraries. The hardware development team combines 2D
and 3D graphic processors, RAMDACS, graphic memory chips and firmware into
integrated, efficient graphics accelerators.

  Software development efforts are focused on development of software and
firmware drivers to enhance the performance of applications and support for new
graphics accelerator chips that may be incorporated in future products. From
time to time, the Company also employs outside consultants to assist with the
development of specific projects.

  The Company dedicates certain engineering personnel to its ISV partners to
optimize their applications with the Company's accelerator products. The
dedicated engineering personnel may work directly on-site with the ISV
engineering development team on development of the next generation of ISV
products. The Company also works with suppliers of graphics chip sets to
specify the next generation of requirements and components for the Company's
new products. The Company coordinates with leading personal computer and NT
workstation hardware and operating system vendors to remain abreast of emerging
industry trends and opportunities.

  The markets for the Company's products are characterized by rapidly changing
technology, evolving industry standards, frequent new product introductions and
rapid product obsolescence. The Company's success will be substantially
dependent upon its ability to continue to develop and introduce competitive
products and technologies on a timely basis with features and functionality
that meet changing customer requirements. The Company's business would be
adversely affected if the Company were to incur delays in developing new
products or enhancements, or if such products or enhancements did not gain
widespread market acceptance. The Company's business would also be adversely
affected if it were to select new chipsets from among those chipsets offered by
its various semiconductor vendors, new chipsets that do not perform favorably
on a price-performance basis compared to competing products or if a vendor
experiences delays in the production of a chipset which the Company has
selected for one of its products. In addition, there can be no assurance that
products or technologies developed by others will not render the Company's
products or technologies noncompetitive or obsolete. The Company must
continually assess emerging technologies and standards, and evolving market
needs, and must continually decide which technologies and product directions to
pursue. If the Company were to focus its efforts on technologies, standards or
products that do not meet emerging end user needs and do not achieve market
acceptance, the Company could miss one or more product cycles. In such an
event, the Company's business, financial conditions and results of operations
would be adversely affected.

MANUFACTURING

  All manufacturing and testing is completed by contract manufacturers, located
in Singapore and Chicago, Illinois, on a turnkey basis.  This turnkey assembly
enables the Company to avoid the cost of owning and operating a manufacturing
facility while adding flexibility to the manufacturing process. The Company
does not have contractual commitments with these subcontractors and therefore
these subcontractors are not obligated to supply assemblies, products or
services to the Company for any specific time or at any specific price, except
as provided for by specific purchase orders. Although at present there is an
abundance of turnkey manufacturing in the world, there is no guarantee this
situation will continue. Some long lead time and sole-sourced items are
forecasted and purchased by the Company and are sold to the turnkey vendors
upon demand. Quality auditing and root cause failure analysis are performed by
the Company to maintain quality.





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<PAGE>   8
The Company generally negotiates prices with vendors on key components and
assigns such  pricing to its contract manufacturers, while receiving the
benefit of the subcontractors' volume purchase prices on the more standard
parts.

  The Company relies on subcontractors to manufacture, subassemble, test and
ship the Company's products. The Company relies on sole-source suppliers for
certain critical components, such as 3Dlabs for its graphics acceleration
chips, Mitsubishi for its graphics acceleration chips and 3DRAM/CDRAM chips,
Texas Instruments Incorporated for its RAMDAC chips, Cirrus Logic Inc. for its
VGA chips and Elec & Eltek Co., Ltd. for its printed circuit boards. In
addition, there is a limited availability of certain application specific
integrated circuit chipsets that provide VRAM and DRAM memory. The Company
procures its components and products through purchase orders and does not have
specific requirement agreements with any of its subcontractors or suppliers.
Each of the Company's subcontractors and suppliers can cease supplying the
services, products or components at any time with no penalty. In the event it
becomes necessary for the Company to replace a key subcontractor or supplier,
the Company could incur significant manufacturing set-up costs and delays while
new sources are located and alternate components are integrated into the design
of the Company's products. There can be no assurance that the Company will be
able to maintain its current subcontractor and supplier relationships or that
the Company will be able to find suitable replacement subcontractors and
suppliers, if necessary. Although the Company maintains ongoing efforts to
obtain required quantities of products, component shortages may exist from time
to time, and there can be no assurance that the Company's current
subcontractors and suppliers will continue to provide sufficient quantities of
suitable quality product components at acceptable prices. The Company's
emphasis on maintaining low inventory may accentuate the effects of any
shortages that may result from sole source products or subcontractors. The
inability of the Company to obtain product components at their historical cost
levels would directly affect the cost of the Company's products. Also, product
components may contain undetected errors or "bugs" when first supplied to the
Company that, despite testing by the Company, are discovered only after the
Company's product has been installed and used by customers. There can be no
assurance that errors will not be found in the Company's products due to errors
in the product components, or that any such errors will not impair the market
acceptance of these products or require significant product recalls. Problems
encountered by customers and product recalls could have a material adverse
effect on the Company's business, financial condition and results of
operations. In addition, the Company's ability to respond to greater than
anticipated market demand may be constrained by availability of services,
products or components.  The loss of subcontractors or suppliers or the failure
of subcontractors or suppliers to meet the Company's price, quality, quantity
and delivery requirements would have a material adverse effect on the Company's
business, financial condition and results of operations.

PROPRIETARY RIGHTS

  Although the Company has three patent applications filed in the United
States, these claims are not related to the Company's current product lines.
Instead, the Company relies exclusively on trade secret and copyright
protection for its proprietary technology. Despite the Company's precautions,
it may be possible for a third party to copy or otherwise obtain and use the
Company's technologies without authorization or to develop competing
technologies independently. Furthermore, the laws of certain countries in which
the Company does business, including countries in which the Company does a
significant amount of business, such as the United Kingdom and Germany, may not
protect the Company's software and intellectual property rights to the same
extent as the laws of the United States. There can be no assurance that the
Company's means of protecting its proprietary rights will be adequate or that
the Company's competitors will not independently develop similar technology. If
unauthorized copying or misuse of the Company's products were to occur to any
substantial degree, or if a competitor of the Company were to effectively
duplicate the Company's proprietary technology, the Company's business,
financial condition and results of operations would be materially adversely
affected. Furthermore, while the Company requires employees and consultants to
enter into confidentiality agreements, there can be no assurance that
proprietary information will not be disclosed, that others will not
independently develop substantially equivalent proprietary information and
techniques or otherwise gain access to the Company's trade secrets or disclose
such technology, or that the Company can meaningfully protect its trade
secrets. Certain technology used in the Company's products is licensed from
third parties, generally on a non-exclusive basis. The termination of any such
license, or the failure of any third party licensor to adequately maintain or
update its product, could result in delay in the Company's ability to ship its
products while it seeks to implement technology offered by alternative sources,
if any. Any required replacement licenses could prove to be either unavailable
or costly.

  While the Company has not received notices from third parties alleging
infringement claims that the Company believes would have a material adverse
effect on the Company's business, there can be no assurance that third parties
will not claim that the Company's current or future products or manufacturing
processes infringe the proprietary rights of others. Any such claim, with or
without merit, could result in costly litigation or might require the Company
to enter into royalty or licensing agreements. Such royalty or licensing
agreements, if required, may not be available on terms acceptable to the
Company, or





                                       8
<PAGE>   9
at all, which could have a material adverse effect upon the Company's business,
financial condition and results of operations.

COMPETITION

  The market for 3D graphic accelerators is extremely competitive and subject
to rapid change. The Company expects competition to increase in the future from
existing competitors and from new market entrants with products that may be
less costly than the Company's products or provide better performance or
additional features not currently provided by the Company. For example, SGI has
recently announced its intention to develop products which operate under the
Windows NT operating system; Intel has recently entered into an agreement with
Digital to purchase Digital's semiconductor manufacturing operations
cross-license certain patents; and Compaq and Digital are in the process of
combining into one company.  The Company competes with the following three
major groups: professional 3D graphics board companies (including Intergraph
Corporation and Dynamic Pictures, Inc.), RISC/UNIX workstation companies
(including Sun Microsystems, Inc. ("Sun") and SGI) and traditional volume PC
board suppliers (including ELSA GmbH, Diamond Multimedia Systems, Inc., Matrox
Electronic Systems Ltd. and STB Systems Inc.).  A variety of potential actions
by any of the Company's competitors could have a material adverse effect on the
Company's business, financial condition and results of operations. Such actions
may include reduction of product prices, increased promotion, announcement or
accelerated introduction of new or enhanced products, product giveaways,
product bundling or other competitive actions.

  Many of the companies that currently compete with the Company or that may
compete with the Company have longer operating histories and significantly
greater financial, technical, sales, marketing and other resources, as well as
greater name recognition and larger customer bases, than the Company. As a
result, these competitors may be able to respond more quickly and effectively
to new or emerging technologies and changes in customer requirements or to
devote greater resources to the development, promotion, sale and support of
their products than the Company. Consequently, the Company expects to continue
to experience increased competition, which could result in significant price
reductions, loss of market share and lack of acceptance of new products, any of
which could have a material adverse effect on the Company's business, financial
condition and results of operations. There can be no assurance that the Company
will be able to compete against current or future competitors successfully or
that competitive pressures faced by the Company will not have a material
adverse effect upon its business, financial condition and results of
operations.

EMPLOYEES

  As of December 31, 1997, the Company had 60 employees, including 22 in sales,
marketing and customer support, 22 in research and development and 16 in
finance, administration and operations.  The Company has entered into
employment agreements with certain of its officers, which provisions include
acceleration of vesting of stock options and termination benefits, in the event
of certain changes in control of the Company's ownership.  None of the
Company's employees are represented by a labor union.  The Company has not
experienced work stoppages and believes it has a good relationship with its
employees.  As competition for qualified personnel in the industry in which the
Company competes is intense, the Company believes that its future success will
depend in part on its continued ability to attract, hire and retain qualified
personnel.  See "Risk Factors - Dependence on Key Personnel; Need to Attract
and Retain Highly Skilled Personnel."


ITEM 2.  PROPERTIES.

  The Company's principal facilities occupy approximately 25,000 square feet in
Milpitas, California, pursuant to a lease which expires in May 1999.  In
addition, the Company subleases a sales and support facility in Wiesbaden,
Germany. The Company believes its current facilities are adequate to meet its
needs through the next 12 months.


ITEM 3.  LEGAL PROCEEDINGS.

  There are no material pending or threatened legal proceedings against the
Company. The Company from time to time is involved in routine legal matters
incident to its business.


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

  No matters were submitted to a vote of the security holders during the fourth
quarter of the fiscal year ended January 2, 1998.





                                       9
<PAGE>   10

                                    PART II

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

  The Company's Common Stock has been traded in the over-the counter market
under the Nasdaq symbol ACCL since the Company's initial public offering on
April 10, 1997.  Prior to the initial public offering, no public market existed
for the Common Stock.

  The prices per share reflected in the table represent the range of high and
low closing price in the Nasdaq National Market System for the time period or
quarter indicated.

<TABLE>
<CAPTION>
                                                                HIGH         LOW
                                                              ---------    --------
<S>                                                           <C>          <C>
Period from April 10, 1997 to June 30, 1997 *                 $   13.88    $   4.13
Third quarter ended September 30, 1997 *                      $    9.75    $   4.13
Fourth quarter ended December 31, 1997 *                      $    6.63    $   3.19
</TABLE>

*   The Company operates under a 52-53 week fiscal year with thirteen week
    quarters that end on the Friday closest to calendar quarter end. For
    convenience of presentation, price per share information has been shown as
    ending on the last date of the calendar quarter.

    Historically, the Company has not paid cash dividends on its Common Stock
and there is no plan to pay dividends in the future.

    The Company had approximately 1,800 stockholders of record as of March 9,
1998.


ITEM 6.  SELECTED FINANCIAL DATA.


<TABLE>
<CAPTION>
                                                                               YEAR ENDED DECEMBER 31,
                                                                          1997          1996           1995
                                                                        --------      --------      --------
                                                                      (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                                     <C>           <C>           <C>     
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
    Revenues ......................................................     $ 33,509      $ 18,671      $  3,911
    Cost of revenues ..............................................       23,171        12,077         2,501
                                                                        --------      --------      --------

    Gross profit ..................................................       10,338         6,594         1,410
                                                                        --------      --------      --------

    Operating expenses:
         Research and development .................................        4,493         2,663         2,618
         Sales and marketing ......................................        4,815         3,635         2,154
         General and administrative ...............................        1,909         1,131         1,039
                                                                        --------      --------      --------

           Total operating expenses ...............................       11,217         7,429         5,811
                                                                        --------      --------      --------

    Loss from operations ..........................................         (879)         (835)       (4,401)
    Interest expense ..............................................          (72)         (145)         (183)
    Interest and other income, net ................................          855            48           119
                                                                        --------      --------      --------

    Net loss ......................................................     $    (96)     $   (932)     $ (4,465)
                                                                        ========      ========      ========

    Basic and diluted net loss per share ..........................     $  (0.02)     $  (1.09)     $  (9.15)
                                                                        ========      ========      ========

    Shares used to compute basic and diluted net loss per share (1)        6,103           854           488
                                                                        ========      ========      ========
</TABLE>

(1) See Note 1 of Notes to Consolidated Financial Ssttements for an explanation
    of the determination of shares used in computing net loss per share.



                                       10
<PAGE>   11

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                             1997        1996
                                                           -------     -------
                                                              (IN THOUSANDS)
<S>                                                       <C>         <C>
CONSOLIDATED BALANCE SHEET DATA:
    Cash and cash equivalents ........................     $ 9,367     $ 2,979
    Short-term investments ...........................       6,526         -
    Working capital ..................................      21,876       5,030
    Total assets .....................................      28,309       8,439
    Long term obligations ............................         482       1,782
    Mandatorily redeemable convertible preferred stock         -         8,930
    Total stockholders' equity (deficit) .............      24,265      (5,170)
</TABLE>


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

OVERVIEW

         AccelGraphics, Inc. designs, develops and markets high-performance,
cost-effective, 3-dimensional ("3D") graphics subsystems, software accelerators
and application utility software products for the professional Windows NT and
Windows 95 markets. The Company commenced operations in late 1994.

         The Company's graphic subsystems include the AccelECLIPSE, AccelPRO,
and  AccelSTAR product lines, while the Company's application utility software
includes the AccelVIEW product.

         The Company's customers include OEMs, distributors and VARs.  Revenues
from product sales are generally recognized upon shipment, less an allowance
for estimated future returns and exchanges. The Company's gross margin has
varied with the mix of revenues by sales channel, as OEM revenues generally
yield lower gross margins, and because of competitive pricing pressures.

         The Company has increased its research and development, sales and
marketing and administrative capabilities since its inception and expects to
expand such capabilities in the future.  The anticipated increase in the
Company's operating expenses caused by this expansion could have a material
adverse effect on the Company's operating results if revenues and gross profit
do not increase at an equal or greater rate.  Also, the Company's expenses for
these and other activities are based in significant part on its expectations
regarding future revenues and are fixed to a large extent in the short term.
Accordingly, the Company may be unable to adjust spending in a timely manner to
compensate for any unexpected revenue shortfall, which would have a material
adverse effect on the Company's business, financial condition and results of
operations.

         The Company has a limited operating history upon which an evaluation
of the Company and its prospects can be based. The Company's prospects must be
considered in light of the risks, expenses and difficulties frequently
encountered by companies in the early stages of development, particularly
companies in new and rapidly evolving markets. To address these risks, the
Company must, among other things, respond to competitive developments, attract,
retain and motivate qualified persons, continue to upgrade its technologies and
commercialize its products. There can be no assurance that the Company will be
successful in addressing these and other risks.

         Although the Company has experienced significant annual revenue growth
since its inception, the Company does not believe that such growth rates are
sustainable.  In the third quarter of 1997, revenues declined by 58% from the
second quarter of 1997 and revenues for the fourth quarter of 1997 were 16%
lower than revenues in the fourth quarter of 1996; consequently, past or
current revenue growth rates may not be indicative of future revenue growth, if
any, or future operating results. The Company has incurred losses in each year
since its inception.  Although the Company has been profitable on a quarterly
basis, it has incurred losses during the last two quarters of 1997 and there
can be no assurance that the Company will regain profitability on a quarterly
basis or will achieve profitability on an annual basis.  The Company's limited
operating history makes the prediction of future operating results difficult,
if not impossible.





                                       11
<PAGE>   12
RESULTS OF OPERATIONS

         The following table sets forth selected items of the Company's
consolidated statement of operations as a percentage of revenues for the
periods indicated:

<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31,
                                                1997          1996          1995
                                                -----         -----         -----
<S>                                            <C>           <C>           <C>
Revenues ..............................         100.0%        100.0%        100.0%
Cost of revenues ......................          69.1          64.7          63.9
                                                -----         -----         -----
Gross profit ..........................          30.9          35.3          36.1
                                                -----         -----         -----

Operating expenses:
    Research and development ..........          13.4          14.3          66.9
    Sales and marketing ...............          14.4          19.5          55.1
    General and administrative ........           5.7           6.0          26.6
                                                -----         -----         -----
    Total operating expenses ..........          33.5          39.8         148.6
                                                -----         -----         -----

Loss from operations ..................           2.6)         (4.5)       (112.5)
Interest expense ......................          (0.2)         (0.8)         (4.7)
Interest and other income, net ........           2.5           0.3           3.0
                                                -----         -----         -----
Net loss ..............................          (0.3)%        (5.0)%      (114.2)%
                                                =====         =====         =====
</TABLE>


YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

Revenues
  Revenues increased by 79% to $33.5 million in 1997 from $18.7 million in 1996
and by 377% from $3.9 million in 1995.  The increases were primarily due to
increased sales of its AccelPRO and AccelPRO TX product lines in 1996 and 1997
and sales of its AccelECLIPSE and AccelSTAR products, which were introduced in
1997.

  Revenues from product sales are generally recognized upon product shipment,
less an allowance for estimated future returns and exchanges.  Provision for
the estimated costs of providing technical support services and future warranty
obligations for the Company's products are recorded as a cost of revenues upon
recognition of related revenues.

  Revenue from software licenses and royalty agreements ("License Revenues"),
which were 3% of the Company's revenues in 1997, are generally the result of
one-time or short-term agreements and generally do not extend beyond one year.
License Revenues generally yield high gross margins.  To the extent that the
Company is unable to sustain current levels of License Revenues, or if License
Revenues were to increase, this would have an accentuated impact on the
Company's gross margins.

  International revenues increased by 165% to $15.4 million in 1997 from $5.8
million in 1996 and by 582% from $850,000 in 1995, representing 45.8%, 31.0%,
and 21.7%, respectively, of revenues.  The increase in international revenues
is primarily a result of an increase in sales of the Company's products in
Europe and, to a lesser extent, in Asia Pacific. Revenues from the Company's
international customers are generally denominated in United States dollars.
Although the effects of currency fluctuations have been insignificant to date,
there can be no assurance that such fluctuations will not be significant in the
future. See "Risk Factors -- International Revenues."

  Revenues from HP and the Company's former customer, Digital, accounted for
36.4% and 22.4%, respectively, of revenues in 1997, and 22.8% and 27.9%,
respectively, of revenues in 1996.  Revenues from the Company's former
customer, NeTpower, Inc. ("NeTpower"), accounted for 16.6% of revenues in 1995.
Revenues from NeTpower have been insignificant subsequent to 1995.  The
inability to obtain major customer relationships, the loss of any major
customer, or the delay in or reduction of orders from such customers could have
a material adverse effect on the Company's business, financial condition and
results of operations. See "Risk Factors -- Reliance on Third Party
Distribution and Major OEMs."

Gross Profit
  Gross profit increased by 57% to $10.3 million in 1997 from $6.6 million in
1996 and by 368% from $1.4 million in 1995, representing 30.9%, 35.3% and
36.1%, respectively, of revenues in 1997, 1996 and 1995.  The absolute dollar
increase in gross profit resulted from increased revenues, while the decline in
gross margin is primarily due to an increased proportion of sales to OEMs,
which generally yield lower margins, competitive pricing pressures and
significantly lower





                                       12
<PAGE>   13

gross margins during 1997 on the Company's maturing AccelPRO TX product.  The
Company expects that gross margins may decrease over time as a result of
competitive pricing pressures and changes in sales channel and product mix.

  The Company's gross margin is affected by many factors, including the sales
channel mix, sales to OEMs which generally yield lower gross margins, the mix
of products sold, competitive pricing pressures, introductions of new products
and the availability, reliability and cost of components and products from the
Company's subcontractors and suppliers.  In addition, the Company orders
products in advance of planned shipments and, due to rapid technological
changes or other factors such as customers curtailing or changing timing or mix
of orders, there is a risk that the Company will forecast incorrectly and
produce excess or insufficient inventories of particular products.  The
Company's customers' ability to reschedule or cancel orders without significant
penalty could adversely affect the Company's operating results, as the Company
may be unable to adjust its purchases from its subcontractors and suppliers to
match such customers' changes and cancellations. See "Risk Factors --
Dependence on Subcontractors and Sole-Source Suppliers" and "-- Significant
Variability in Quarterly Results."

Operating Expenses
  Research and Development. Research and development expenses increased by 69%
to $4.5 million in 1997 from $2.7 million in 1996 and by 4% from $2.6 million
in 1995, representing 13.4%, 14.3% and 66.9%, respectively, of 1997, 1996 and
1995 revenues. Research and development expenses consist primarily of personnel
costs and other personnel-related expenses, including the services of outside
consultants. The increase in research and development expenses in 1997 was
primarily due to increased personnel and related costs to support new product
development activities.  In 1996, research and development expenses were
positively impacted by the receipt of a $190,000 non-recurring engineering fee
from a technical partner to facilitate the development of the Company's
AccelPRO product line. Research and development expenses during 1995 were
negatively impacted by a heavy reliance on consultants, who are generally more
expensive than employees. The Company anticipates that research and development
expenses will increase in absolute dollars as the Company continues to add
research and development personnel and support for new product development
activities.

  Sales and Marketing. Sales and marketing expenses increased by 32% to $4.8
million in 1997 from $3.6 million in 1996 and by 68.8% from $2.2 million in
1995, representing 14.4%, 19.5% and 55.1%, respectively, of 1997, 1996 and 1995
revenues. Sales and marketing expenses consist primarily of salaries,
commissions, marketing expenses and technical support for the sales
organization.  The absolute dollar increase in sales and marketing expenses was
due primarily to the expansion of the Company's sales efforts in the United
States, Europe and the Asia Pacific, as well as increased marketing and public
relations activities related to the Company's products.  The Company
anticipates that sales and marketing expenses will continue to increase in
absolute dollars as the Company expands its sales force and marketing
activities in both Europe and Asia Pacific as well as within the Americas.

  General and Administrative. General and administrative expenses increased by
69% to $1.9 million from $1.1 million in 1996 and by 8.9% from $1.0 million in
1995, representing 5.7%, 6.0% and 26.6%, respectively, of 1997, 1996 and 1995
revenues.  Increased general and administrative expenses were due primarily to
increased staffing and other costs incurred to support the Company's growth and
the added cost of being a public company. The Company anticipates that general
and administrative expenses may increase in absolute dollars to support the
Company's expansion.

Interest Expense
  Interest expense decreased to $72,000 in 1997 from $145,000 in 1996 and from
$183,000 in 1995.  This expense is primarily attributable to the Subordinated
Convertible Note Payable to Kubota (the "Kubota Note"), as well as capital
leases and the Company's term loan with a bank.  The decrease in 1997 was the
result of the repayment of the Kubota Note in April 1997 and in 1996 was
primarily related to the conversion to preferred stock, which was converted in
Common Stock at the initial public offering, of one half of the original
principal balance on the Kubota Note in June 1995.  The Company anticipates
that interest expense will increase as the Company continues to borrow under
the term loan.

Interest and other income, net
  Interest and other income, net increased to $855,000 in 1997 from $48,000 in
1996 and from $119,000 in 1995.  Interest and other income, net is primarily
comprised of interest income on the Company's cash, cash equivalents and
investments.  The increase in 1997 is attributable to increased levels of cash,
cash equivalents and investments, primarily due to proceeds from the Company's
initial public offering in April 1997.


  The Company recorded state minimum tax expense of $5,000 for 1997 and no
provision for income taxes in 1996 or 1995 as it incurred losses.  At December
31, 1997, the Company had approximately $1.8 million of federal net operating
loss carryforwards available to offset future taxable income. Future annual use
of these carryforwards may be limited as a result of ownership change
limitations.





                                       13
<PAGE>   14

  At December 31, 1997, the Company had approximately $2.2 million of deferred
tax assets, comprised primarily of reserves not currently deductible for tax
purposes and net operating loss and credit carryforwards. The Company believes
the available objective evidence creates sufficient uncertainty regarding the
realizability of such deferred tax assets; therefore, a full valuation
allowance has been recorded. The factors considered include the Company's
history of losses, the lack of carryback capacity to realize deferred tax
assets, the limitation on the annual utilization of net operating loss
carryforwards, the uncertainty of the development of the products and markets
in which the Company competes and the fact that the market in which the Company
competes is intensely competitive and characterized by rapidly changing
technology.  The Company believes that based on the currently available
evidence, it is more likely than not that the Company will not generate
sufficient taxable income to realize the Company's deferred tax assets.

LIQUIDITY AND CAPITAL RESOURCES

  In April 1997, the Company completed an initial public offering of 2,535,000
shares of the Company's Common Stock at $9.00 per share for net proceeds of
$20.3 million.  Prior to the initial public offering, the Company financed its
operations primarily through private sales of $7.3 million of Redeemable
Convertible Preferred Stock and Common Stock, the issuance of $3.3 million of
convertible debt and, to a lesser extent, credit lines.  Cash used in
operations was $3.6 million, $1.3 million and $4.6 million in 1997, 1996 and
1995, respectively.  Net cash used in operations for 1997 was primarily due to
increases in accounts receivable of $2.2 million and inventory of $2.1 million,
offset in part by an increase in accounts payable of $600,000.  Net cash used
in operations for 1996 was primarily due to the net loss of approximately
$930,000 and a $3.3 million increase in accounts receivable which was partially
offset by a decrease in inventories and increases in accounts payable, accrued
liabilities and customer deposits.  For 1995, net cash used in operations was
due primarily to the net loss of $4.5 million and increases in accounts
receivable and inventories associated with higher revenues, which were
partially offset by an increase in accounts payable and other liabilities.

  Net cash used in investing activities was $9.2 million in 1997, comprised
primarily of purchases of $8.5 million of investments and $700,000 of property
and equipment.  In each of 1996 and 1995, cash of approximately $250,000 was
used primarily for the purchase of property and equipment. The Company has no
significant capital spending or purchase commitments other than normal purchase
commitments and commitments under leases. Net cash provided by financing
activities was $19.2 million, $3.2 million and $4.1 million in 1997, 1996 and
1995, respectively, due primarily to proceeds from the issuance of Common and
Preferred Stock.

  The Company has not invested in derivative securities or any other financial
instrument that involves a high level of complexity or risk.  Management
expects that, in the future, cash in excess of current requirements will
continue to be invested in investment-grade, interest- bearing securities.

  At December 31, 1997, the Company had $15.9 million in cash, cash equivalents
and short-term investments as well as approximately $2 million of available for
sale long-term investments.  The Company has borrowing facilities of $4.0
million with a bank, of which $549,000 in loans and $1.1 million of standby
letters of credit to vendors are outstanding.  The borrowings bear interest at
rates between 8.75% and 9.0%, are secured by all of the Company's assets and
require that the Company maintain certain financial ratios and levels of
tangible net worth and profitability and also restrict the Company's ability to
pay cash dividends.  As a result of the loss incurred in the third quarter of
1997, the Company was in violation of certain debt covenants; however, the bank
waived such covenants.  The $3 million line of credit portion of the borrowing
facilities expires in December 1998.

  The Company believes that existing cash, cash equivalents and short-term
investments of $15.9 million and its available borrowing facilities will be
sufficient to finance its working capital and capital expenditure requirements
for at least the next 12 months. Thereafter, the Company may require additional
funds to support its working capital requirements or for other purposes and may
seek to raise such additional funds through bank borrowings and public or
private sales of its securities,  including equity and debt securities. The
Company's future capital requirements will depend on numerous factors,
including, without limitation, the success of marketing, sales and distribution
efforts, market acceptance of the Company's products, the progress of its
research and development programs, the costs involved in defending and
enforcing intellectual property rights, competition, competing technological
and market developments, and the effectiveness of product commercialization
activities and arrangements. There can be no assurance that additional funds,
if required, will be available to the Company on favorable terms or at all.





                                       14
<PAGE>   15

RISK FACTORS

   In addition to other information in this Form 10-K, the following are
important factors that should be considered carefully in evaluating the Company
and its business.

LIMITED HISTORY OF PROFITABILITY AND UNCERTAINTY OF FUTURE FINANCIAL RESULTS

  The Company has incurred a net operating loss in each year since commencing
operations in late 1994.  As a result, the Company had an accumulated deficit
as of December 31, 1997 of approximately $5.6 million. There can be no
assurance that the Company will ever achieve profitability on an annual basis
in the future or that it will regain profitability on a quarterly basis.  In
addition, the Company does not believe that its current annual revenue growth
rates are sustainable.  To date, the Company has earned substantially all of
its revenues from sales of its graphics subsystem product lines. The Company
has completed three years of operations and is subject to the risks inherent in
the operation of a new business, such as the difficulties and delays often
encountered in the development and production of new, complex technologies.
There can be no assurance that the Company will be able to adequately mitigate
these risks.

  The Company may expand its research and development, sales and marketing and
administrative capabilities. The anticipated increase in the Company's
operating expenses which may result from such an expansion could have a
material adverse effect on the Company's operating results if revenues do not
increase at an equal or greater rate. Also, the Company's expenses for these
and other activities are based in significant part on its expectations
regarding future revenues and are fixed to a large extent in the short term.
Accordingly, the Company may be unable to adjust spending in a timely manner to
compensate for any unexpected revenue shortfall, which would have a material
adverse effect on the Company's business, financial condition and results of
operations.

SIGNIFICANT VARIABILITY IN QUARTERLY RESULTS

  Although the Company generated profits in the first and second quarter of
1997, the Company incurred losses in the third and fourth quarters of 1997.
The Company's quarterly operating results are likely to continue to vary
significantly in the future. The Company's quarterly results are affected by a
wide variety of factors including the gain or loss of significant customers,
size and timing of individual orders, timely introduction and market acceptance
of new products offered by the Company and its competitors, availability,
reliability and cost of components, the Company's success in negotiating OEM
and other customer agreements, customer order deferrals in anticipation of new
products, technological changes in operating systems or applications,
variations in manufacturing quality or capacities, changes in the pricing
policies of the Company or its competitors, changes in demand for 3D graphics
functionality, changes in the mix of revenues from products having differing
gross margins, changes in sales channel mix, changes in average sales prices,
warranty expenses, fluctuations in the Company's expense levels, the Company's
success at expanding its direct sales force and indirect distribution channels,
risks related to international operations, extraordinary events such as
litigation or acquisitions and general industry and economic conditions, as
well as other factors.  Any of the above risks could have a material adverse
effect on the Company's business, financial condition and results of
operations.

  Quarterly revenues and operating results depend primarily on the volume,
timing and shipment of orders during the quarter, which are difficult to
forecast because customers generally place their orders on an as-needed basis
and, accordingly, the Company has historically operated with a relatively small
backlog. The Company's third party distribution channels provide the Company
with limited information regarding the quantity of the Company's products in
the sales channel. This reduces the Company's ability to predict fluctuations
in revenues resulting from a surplus or a shortage in its distribution channel
and could contribute to volatility in the Company's results of operations and
cash flows. A surplus of inventory in the distribution channel could
unexpectedly cause a reduction in product shipments and revenues.  Moreover, a
disproportionate percentage of the Company's revenues in any quarter may be
generated in the last month of a quarter. As a result, a shortfall in revenues
in any quarter as compared to expectations may not be identifiable until near
the end of the quarter. The Company may experience relatively weak demand in
third quarters due to historically weak summer sales in Europe.

  The Company's gross margins are impacted by the sales channel mix, mix of
products sold, increased competition and related decreases in unit average
selling prices, introduction of new products and manufacturing of existing
older products, availability, reliability and cost of components from the
Company's subcontractors and suppliers, and general economic conditions.
Currently, the Company is focusing on increasing its sales to OEMs, which have
historically yielded lower margins than other channels. Individual product
lines generally provide higher margins at the beginning of the life cycle and
lower margins as the product line matures. In addition, the Company's markets
are characterized by rapidly changing technology and declining average selling
prices. Accordingly, the Company's gross margins may decline from the levels





                                       15
<PAGE>   16

experienced to date, which would have an adverse effect on the Company's
business, financial condition and results of operations.

  A significant portion of the Company's operating expenses are relatively
fixed in the short term and planned expenditures are based on revenue
forecasts. As a result, if revenues are below levels needed to offset these
operating expenses, the Company's business, financial condition and results of
operations may be disproportionately affected because only a portion of the
Company's expenses vary with revenue. The Company generally must plan
production, order components and undertake its development, sales and marketing
activities several months in advance of shipping product and recognizing
revenues. Accordingly, any shortfall in revenues in a given quarter may impact
the Company's operating results and cash balances in a magnified way due to the
Company's inability to adjust expenses or inventory during the quarter to match
the level of revenues for the quarter. In addition, in the event the Company's
customers desire to purchase products in excess of forecasted amounts, the
Company may not have sufficient inventory or access to sufficient manufacturing
capacity to meet such demands. Although the Company has experienced growth in
revenues in recent quarters, there can be no assurance that the Company will
sustain such revenue growth or be profitable on an operating basis in any
future period. For the foregoing reasons, the Company believes that
period-to-period comparisons of its results are not necessarily meaningful and
should not be relied upon as indications of future performance. Further, when
the Company announced that its revenues and net income were below the
expectations of market analysts for the second quarter of 1997 and again in the
third quarter of 1997, the Company's stock price suffered significant declines.
Accordingly, it is likely that in some future quarter the Company's revenues or
operating results will be below the expectations of public market analysts and
investors. In such event, the price of the Common Stock could be materially
adversely affected.

RAPID TECHNOLOGICAL CHANGE

  The computer industry in general, and the markets for the Company's products
in particular, are characterized by ongoing technological developments,
evolving industry standards and rapid changes in customer requirements.
Customer preferences can change rapidly and new technology can quickly render
existing products obsolete. In order to keep pace with this rapidly changing
market environment, the Company must continually develop and incorporate into
its products technological advances and new features desired by customers at
competitive prices. There can be no assurance that the Company will be
successful in developing and marketing, on a timely basis or at all,
competitive products, product enhancements and new products that respond to
technological changes or changes in customer requirements and industry
standards, or that the Company's enhanced or new products will adequately
address the changing needs of the marketplace.

  Additionally, application programming interfaces ("APIs") have evolved and
changed over time. Although OpenGL has developed into a leading industry
standard API for professional 3D graphics development, it is likely that
industry standards will continue to evolve to meet rapidly changing customer
requirements.  There can be no assurance that the Company will be successful in
developing and marketing product enhancements or new products that respond to
these evolving standards.  In addition, Intel has introduced the Accelerated
Graphics Port (AGP) bus structure, an alternative to the existing PCI bus
structure, which is expected to be adopted through the first quarter of 1998.
Recently, Microsoft and SGI have announced the Fahrenheit project to create a
new suite of APIs.  Fahrenheit is expected to incorporate Microsoft's Direct3D
and DirectDraw APIs and SGI's OpenGL technology.  Fahrenheit is expected to
become available in the first half of 1999.  Failure by the Company to respond
effectively to changes in the 3D graphics market, to develop or acquire new
technology or to successfully conform to industry standards would have a
material adverse effect on the business, financial condition and results of
operations of the Company.

  Operating systems and independent software vendor ("ISV") applications are
updated from time to time. The Company must constantly monitor these changes
and upgrade its products to remain compatible with any upgrades in operating
systems and ISV applications. There can be no assurance that the Company will
be successful in developing new versions or enhancements to its products or
that the Company will not experience delays in the upgrade of its products. In
the event that there are delays in the completion of any upgrade to its
products, the Company's business, financial condition and results of operations
would be materially adversely affected. In addition, the Company strives to
achieve compatibility between the Company's products and 3D graphics
applications the Company believes are or will become popular and widely
adopted. The Company invests substantial resources in development efforts aimed
at achieving such compatibility. Any failure by the Company to anticipate or
respond adequately to changes in applications could result in a loss of
competitiveness and could adversely affect the Company's business, financial
condition and results of operations.





                                       16
<PAGE>   17
COMPETITION

  The market for 3D graphics accelerators is extremely competitive and subject
to rapid change. The Company expects competition to increase in the future from
existing competitors and from new market entrants with products that may be
less costly than the Company's products or provide better performance or
additional features not currently provided by the Company's products. The
Company competes with the following three major groups: professional 3D
graphics board companies (including Intergraph Corporation and Dynamic
Pictures, Inc.), RISC/UNIX workstation companies (including Sun and SGI) and
traditional volume personal computer ("PC") board suppliers (including ELSA
GmbH, Diamond Multimedia Systems, Inc., Matrox Electronic Systems Ltd. and STB
Systems, Inc.).  A variety of potential actions by any of the Company's
competitors could have a material adverse effect on the Company's business,
financial condition and results of operations. Such actions may include
reduction of product prices, increased promotion, announcement or accelerated
introduction of new or enhanced products, product giveaways, product bundling
or other competitive actions.

  Many of the companies that currently compete with the Company or that may
compete with the Company have longer operating histories and significantly
greater financial, technical, sales, marketing and other resources, as well as
greater name recognition and larger customer bases, than the Company. As a
result, these competitors may be able to respond more quickly and effectively
to new or emerging technologies and changes in customer requirements or to
devote greater resources to the development, promotion, sale and support of
their products than the Company.  Some of these companies also purchase their
components from the Company's suppliers. Consequently, the Company expects to
continue to experience increased competition, which could result in significant
price reductions, loss of market share and lack of acceptance of new products,
any of which could have a material adverse effect on the Company's business,
financial condition and results of operations. There can be no assurance that
the Company will be able to compete against current or future competitors
successfully or that competitive pressures faced by the Company will not have a
material adverse effect upon its business, financial condition and results of
operations.

LIMITED HISTORY OF PRODUCT DEVELOPMENT

  The Company's products are complex, are based on relatively new technology
and have a limited history of reliability. The Company generally provides a
three-year warranty for its products. In general, the Company's return policy
permits return within five days after receipt of products that do not meet
product specifications. Companies engaged in the development and production of
new, complex technologies and products often encounter difficulties in
performance and reliability and delays in product introduction and volume
shipments. Additionally, products as complex as those offered by the Company
may contain undetected errors or "bugs" when introduced that, despite testing
by the Company, are discovered only after a product has been installed and used
by customers. There can be no assurance that the Company will be successful in
resolving any problems with the Company's existing or future products. Failure
by the Company to resolve manufacturing or operational problems with any
existing product or any new product in a timely manner would have a material
adverse effect on the Company's business, financial condition and results of
operations.

  The success of the Company will likely depend on its ability to develop and
market new products that provide superior performance at competitive prices.
Any quality, reliability or performance problems with such products, regardless
of materiality, or any other actual or perceived problems with the Company's
products, could have a material adverse effect on market acceptance of such
products and the Company's reputation. There can be no assurance that such
problems or perceived problems will not arise or that, even in the absence of
such problems, the Company's products will receive market acceptance. A failure
of the Company's products to receive market acceptance for any reason would
have a material adverse effect on the Company's business, financial condition
and results of operations. In addition, the announcement by the Company of new
products and technologies could cause customers to defer purchases of the
Company's existing products, which would have a material adverse effect on the
Company's business, financial condition and results of operations.

SHORT PRODUCT LIFE CYCLES

  The market for the Company's products is characterized by frequent new
product introductions and rapid product obsolescence. The life cycles of the
Company's products are difficult to estimate. Generally, life cycles of
personal computer 3D graphics subsystems are relatively short, approximately
six to fifteen months. The Company must constantly monitor industry trends and
select new technologies and features for its products, as well as monitor the
timing of introduction of new products. Moreover, short product life cycles,
coupled with single-source supply of components used in the Company's products,
may prevent the Company from being able, in a timely manner, to reduce its
procurement commitments, production or inventory levels in response to
obsolescence, unexpected shortfalls in orders, revenues or declines in prices
or, conversely, to increase production in response to unexpected increases in
demand. Failure to respond





                                       17
<PAGE>   18
to the market adequately could have a material adverse effect on the Company's
business, financial condition and results of operations. The timing of the end
of a product's life cycle is difficult to predict and is typically
characterized by steep declines in unit sales, pricing and margins. As new
products are planned and introduced, the Company may not be able to control the
inventory levels of older products and phase out production, potentially
resulting in excess inventory and the expenses associated therewith. The
Company could experience unexpected reductions in revenues from older
generation products as customers anticipate new products. To the extent the
Company is unsuccessful in managing product transitions, its business,
financial condition and results of operations would be adversely affected.

RELIANCE ON THIRD PARTY DISTRIBUTION AND MAJOR OEMS

  The Company relies on OEMs, distributors and VARs for both domestic and
international revenues.  In particular, revenues from HP and its former
customer, Digital, accounted for 36.4% and 22.4%, respectively, of revenues in
1997, and 22.8% and 27.9%, respectively, of revenues in 1996.  The Company
believes that its future success depends upon its ability to broaden its
customer base and attract new significant customers. There can be no assurance
that a major customer will not reduce, delay or eliminate its purchases from
the Company, which could have a material adverse effect on the Company's
business, financial condition and results of operations.  For example, in the
third quarter of 1997, revenues from Digital declined to 4.2% of total revenues
from 20.8% of revenues in the second quarter of 1997 and from 44.7% in the
first quarter of 1997.  In connection with the OEM agreement with HP, HP has a
non-exclusive manufacturing license pursuant to which it is granted the right
to manufacture or have manufactured the Company's products in the event of the
Company's bankruptcy, receivership or failure to supply HP with specified
quantities of products due to a cause not associated with the negligence of
either party for the term of the agreement or until the Company is out of
bankruptcy or receivership.  In the event the Company were required to grant
such nonexclusive manufacturing rights to HP or any other OEM that subsequently
may obtain such rights, such grant could have the effect of decreasing the
value of the Company's ownership rights with respect to such products and/or
decrease the Company's revenues, either of which could have an adverse effect
on the Company's business, financial condition or results of operations.

  The Company's customer agreements are short term and automatically renew each
year and generally may be canceled for convenience upon written notice by
either party. Generally, there are no minimum purchase requirements for the
Company's OEMs, distributors and VARs.  Some of the Company's OEMs,
distributors and VARs offer competitive products manufactured internally or by
third parties. There can be no assurance that the Company's OEMs, distributors
and VARs will give a priority to the marketing of the Company's products as
compared to competing products or alternative solutions or that such OEMs,
distributors and VARs will continue to offer the Company's products.  Moreover,
there can be no assurance that the Company will continue to sell substantial
quantities of its products to these OEMs, distributors and VARs, or that upon
any termination of the Company's relationships with any of these OEMs, VARs or
distributors, the Company would be able to obtain suitable alternate
distribution channels, or that OEMs will not internally manufacture 3D graphics
subsystems rather than purchase them from the Company.  The inability to
attract new significant OEM customers or the loss of one or more of the
Company's OEMs, VARs or distributors could have a material adverse effect on
the Company's business, financial condition and results of operations.
Additionally, the Company's southern and northern European distributor
maintains a credit limit with the Company for the purchase of a certain amount
of the Company's products. In the event that the demand for the Company's
products exceeds this credit limit, the Company may be unable to supply this
distributor with additional quantities of products. Accordingly, the Company
may experience significant backlog and delays in the supply of additional
products to this distributor, which could have a material adverse effect on the
Company's business, financial condition and results of operations.

  Although the Company seeks information from end users who purchase the
Company's products from OEMs, distributors and VARs, the Company generally does
not sell directly to end users and cannot directly observe their experience
with the Company's products. The Company also does not have direct control over
the marketing and support efforts of its OEMs, distributors and VARs. This lack
of direct control may result in the inability of the Company to identify
potential opportunities with these customers and may cause a potential delay by
the Company in the recognition and correction of any problems with such OEM,
distributor or VARs sales or support organizations. Failure of the Company to
respond to customer preferences or experience with its products or the failure
of OEMs, distributors or VARs to market and support the Company's products
successfully, could have a material adverse effect on the Company's business,
financial condition and results of operations.

INTERNATIONAL REVENUES

  International revenues accounted for approximately 46%, 31% and 22% of the
Company's 1997, 1996 and 1995 revenues, respectively, and primarily consisted
of sales to the European and Asia Pacific operations of HP and Digital as well
as distributors based in the United Kingdom, Germany and Japan.  The Company
believes that products sold to its





                                       18
<PAGE>   19
European distributors are resold throughout Europe. The Company expects that
international revenues will continue to account for a significant portion of
its total revenues in future periods. International revenues are subject to
certain inherent risks, including unexpected changes in regulatory requirements
and tariffs, government controls, political instability, longer payment cycles,
difficulties in collecting accounts receivable, difficulties in staffing and
managing foreign operations and potentially adverse tax consequences. The
Company's inability to obtain foreign regulatory approvals on a timely basis
could have a material adverse effect on the Company's business, financial
condition and results of operations. Fluctuations in currency exchange rates
could cause the Company's products to become relatively more expensive to end
users in a particular country, leading to a reduction in sales in that country.
The impact of future exchange rate fluctuations cannot be predicted adequately.
To date, the Company has not found it appropriate to hedge the risks associated
with fluctuations in exchange rates, as substantially all of the Company's
foreign sales have been denominated in U.S. dollars. However, if future
transactions are denominated in foreign currencies, the Company may undertake
to hedge transactions. There can be no assurance that any hedging techniques
implemented by the Company would be successful or that the Company's results of
operations would not be materially adversely affected by exchange rate
fluctuations. In general, certain seasonal factors and patterns impact the
level of business activities at different times in different regions of the
world. For example, sales in Europe are adversely affected in the third quarter
of each year as many customers and end users reduce their business activities
during the summer months. These seasonal factors and currency fluctuation risks
could have a material adverse effect on the Company's business, financial
condition and results of operations. Further, because the Company operates in
different countries, the Company's management must address differences in
regulatory environments and cultures. Failure to address these differences
successfully could be disruptive to the Company's operations and could have a
material adverse effect on the Company's business, financial condition and
results of operations.

UNCERTAINTY REGARDING ASIAN MARKETS

  A significant number of the Company's customers and suppliers are in Asia.
Although the recent currency fluctuations and economic turmoil in the Asian
financial markets has, to date, not had a material impact on the Company's
revenues or operations, the financial instability in these regions may have an
adverse impact on the financial position of customers and suppliers in the
region which could impact the Company's future revenues and operations,
including the ability of customers to pay the Company or the Company's
customers, which could also impact the ability of such customers to pay the
Company. The Company generally requires sales to Asia to be transacted on a
prepaid wire transfer basis.  Should the current volatility in Asia continue,
the Company or the Company's customers may be unable to sell its products in
the region.  The inability to generate revenues in this region, or the
inability to collect amounts due, could have a material adverse impact on the
Company's business, financial condition and results of operations.

DIFFICULTIES IN MANAGING GROWTH

  The Company has experienced significant growth in its business over the past
three years which has placed demands on the Company's operational and financial
personnel and systems, outside manufacturing capacity, research and
development, technical support and other resources. The Company is expanding
its sales and marketing organizations, developing its distribution channels to
penetrate different and broader markets, funding additional research and
development and increasing its support organization to accommodate its growing
customer base.  With continued growth, the Company may find it necessary to
enhance existing and implement new financial and management information systems
and controls and train its personnel to effectively operate such systems. Any
delay in the implementation of or any disruptions in the transition to such new
and enhanced systems and controls and personnel training could adversely affect
the Company's ability to accurately forecast sales demand and adjust third
party manufacturing to such demand, adjust purchasing levels, accurately record
and control inventory levels and record and report financial and management
information on a timely and accurate basis. Inaccuracy in demand forecasts in
the environment in which the Company operates can quickly result in either
insufficient or excess inventory and disproportional overhead expenses. Certain
of the Company's officers have recently joined the Company and the Company
anticipates further increases in the number of employees. The Company plans to
expand the geographic scope of its customer base and operations. Failure to
manage these changes and to expand effectively any of these areas would have a
material adverse effect on the Company's business, financial condition and
results of operations.

DEPENDENCE ON SUBCONTRACTORS AND SOLE-SOURCE SUPPLIERS

  The Company relies on subcontractors to manufacture, subassemble, test and
ship the Company's products. The Company relies on sole-source suppliers for
certain critical components, such as 3Dlabs for its graphics acceleration
chips, Mitsubishi for its graphics acceleration chips and 3DRAM/CDRAM chips,
Texas Instruments Incorporated for its RAMDAC chips, Cirrus Logic Inc. for its
VGA chips and Elec & Eltek Co., Ltd. for its printed circuit boards. In
addition, there is a limited availability of certain application specific
integrated circuit chipsets that provide VRAM and DRAM 






                                       19

<PAGE>   20

memory. The Company procures its components and products through purchase orders
and does not have specific requirement agreements with any of its subcontractors
or suppliers. Each of the Company's subcontractors and suppliers can cease
supplying the services, products or components at any time with no penalty. In
the event it becomes necessary for the Company to replace a key subcontractor or
supplier, the Company could incur significant manufacturing set-up costs and
delays while new sources are located and alternate components are integrated
into the design of the Company's products. There can be no assurance that the
Company will be able to maintain its current subcontractor and supplier
relationships or that the Company will be able to find suitable replacement
subcontractors and suppliers, if necessary. Although the Company maintains
ongoing efforts to obtain required quantities of products, component shortages
may exist from time to time, and there can be no assurance that the Company's
current subcontractors and suppliers will continue to provide sufficient
quantities of suitable quality product components at acceptable prices. The
Company's emphasis on maintaining low inventory may accentuate the effects of
any shortages that may result from sole source products or subcontractors. The
inability of the Company to obtain product components at their historical cost
levels would directly affect the cost of the Company's products. Also, product
components may contain undetected errors or "bugs" when first supplied to the
Company that, despite testing by the Company, are discovered only after the
Company's product has been installed and used by customers. There can be no
assurance that errors will not be found in the Company's products due to errors
in the product components, or that any such errors will not impair the market
acceptance of these products or require significant product recalls. Problems
encountered by customers and product recalls could have a material adverse
effect on the Company's business, financial condition and results of operations.
In addition, the Company's ability to respond to greater than anticipated market
demand may be constrained by availability of services, products or components.
The loss of subcontractors or suppliers or the failure of subcontractors or
suppliers to meet the Company's price, quality, quantity and delivery
requirements would have a material adverse effect on the Company's business,
financial condition and results of operations.

DEPENDENCE ON KEY PERSONNEL; NEED TO ATTRACT AND RETAIN HIGHLY SKILLED
PERSONNEL

  The success of the Company depends to a large extent upon its ability to
continue to attract and retain highly skilled personnel. Competition for
employees in the high technology sector in general, and in the graphics
industry in particular, is intense, and there can be no assurance that the
Company will be able to attract and retain sufficient numbers of qualified
employees. The Company has recently experienced a significant expansion in the
overall level of its business and the scope of its operations, including
research and development, marketing, sales, technical support and
administration. It may become increasingly difficult to hire, train and
assimilate the new employees needed given the market conditions. If the Company
is unable to continue to attract and retain sufficient numbers of qualified
employees, it may be required to rely on more expensive consultants. The
Company has entered into employment agreements with certain of its key
personnel.  Such agreements provide, in the event of certain changes in
control, for the acceleration of vesting of stock options held by such
personnel.  In addition, if such employee is terminated within 18 months after
the change of control transaction, such employee is to receive certain
termination benefits.  Such agreements may have the effect of discouraging a
third party from acquiring the Company.  Additionally, the Company has not
required its key personnel to enter into noncompetition agreements with the
Company. The Company's inability to retain, attract and assimilate certain
members of the executive management team or key employees would have a material
adverse effect on the Company's business, financial condition and results of
operations.

DEPENDENCE ON ISV RELATIONSHIPS

  The Company's business strategy includes developing strategic relationships
with major ISVs that serve the 3D graphics market, including Alias|Wavefront,
Autodesk and Kinetix, Dassault Systemes S.A., EDS' Unigraphics division,
Microsoft's Softimage division, PTC, SDRC, Sense8 Corporation, SolidWorks
Corporation and Visible Decisions, Inc.  The Company has devoted substantial
engineering and management resources to developing relationships with its ISV
partners. If any of the Company's current or future ISV partners were to cease
supporting the Company's products, such action could have a material adverse
effect on the Company's business, financial condition and results of
operations. Further, there can be no assurance that the Company will be able to
successfully sustain its relationships or enter into new relationships with
major ISVs on terms acceptable to the Company or at all.

UNCERTAINTY REGARDING DEVELOPMENT OF 3D GRAPHICS MARKET

  The 3D graphics market on NT workstations has recently begun to develop and
is rapidly evolving. The Company's future financial performance will depend in
large part on the continued growth of this market and the demand for 3D
graphics for professional 3D applications. The failure of the 3D graphics
market to achieve anticipated growth levels or a substantial change in 3D
graphics customer preferences would have a material adverse effect on the
Company's business, financial condition and results of operations.
Additionally, demand for the Company's products is also dependent upon the





                                       20
<PAGE>   21

widespread development of 3D graphics applications by ISVs, the success of the
Company's customers in effectively developing a market for the Company's
products and the willingness of end users to pay for enhanced 3D capabilities
on NT workstations. The Company's products currently are designed for use on NT
and/or Windows 95 workstations. In the event that end users, and particularly
businesses, delay their adoption of or fail to adopt NT or Windows 95, the
market for the Company's products would be diminished and the Company's
business, financial condition and results of operations could be materially
adversely affected.

RISK OF MIGRATION TO THE MOTHERBOARD

  The Company's 3D graphics subsystems function with Personal Workstations to
provide additional 3D and 2D graphics performance and functionality. As
technology becomes more widely utilized, it may become economically feasible to
incorporate certain 3D graphics capabilities onto PC motherboards or into
microprocessors. The Company recognizes that migration could occur with respect
to the functionality provided by the Company's current products. The Company's
success is largely dependent on its ability to continue to develop products
which incorporate higher performance technologies and additional functionality
which system manufacturers have not yet fully incorporated into PC motherboards
or microprocessors. While the Company believes that a market will continue to
exist for add-in subsystems that provide additional performance and advanced
functionality and that offer flexibility in systems configuration, there can be
no assurance that the incorporation of certain 3D and 2D capabilities onto PC
motherboards or microprocessors will not adversely affect the market for the
Company's products and consequently, the Company's business, financial
condition and results of operations could be materially adversely affected.

NEW OPERATING SYSTEMS

  The PC industry has recently been characterized by significant operating
system changes, such as the introduction of Windows 95 in 1995 and Windows NT
4.0 in 1996, and the introduction of significant new operating systems
components, such as Microsoft's DirectX and ActiveX for Windows 95.  Microsoft
has also announced new versions of its operating systems, Windows 98 and
Windows NT 5.0, which are scheduled for release in 1998 and 1999.  New
operating systems and operating systems components may require that the Company
expend a significant amount of engineering resources to develop software that
is compatible with the new operating systems.  In addition, the Company may be
required to update its existing software for products sold prior to the release
of the new operating system to be compatible with the new operating systems in
order to maintain customer satisfaction.  This effort involves substantial
investment in software engineering, compatibility testing and customer
technical support investment with limited or no incremental revenue return
since these software driver updates are usually provided via electronic
distribution free to the Company's installed customer base. In addition, the
installation of this software may result in increased customer support calls,
thereby generating expenses that do not have offsetting revenue.  Moreover,
during the introductory period of a major new operating system release, the
effort required to support the Company's installed customer base will reduce
the research and development and customer technical support resources available
for new products.  Furthermore, new operating systems for which the Company
prospectively develops driver support may not be successful, or the drivers
themselves may not be successful or accepted by customers, and a reasonable
financial return on the corollary research and development investment may never
be achieved.

MARKET ANTICIPATION OF NEW PRODUCTS, NEW TECHNOLOGIES OR LOWER PRICES

  The environment in which the Company operates is characterized by rapid new
product and technology introductions and generally falling prices for existing
products.  The Company's customers may from time to time postpone purchases in
anticipation of such new product introductions or lower prices. If such
anticipated changes are viewed as significant by the market, such as the
introduction of a new operating system or microprocessor architecture, this may
have the effect of delaying customers' purchases of the Company's products
thereby negatively impacting the Company's operating results.  The substantial
publicity of among other products, Microsoft's Windows NT 5.0 upgrade to
Windows NT 4.0, which is expected to be publicly available in the first quarter
of 1999, Microsoft's Windows 98 upgrade to Windows 95, which is expected to be
publicly available in the third quarter of 1998, and Intel's release of newer
high performance CPUs and associated chipset supporting the AGP architectures
may cause a delay in customers' purchasing decisions and thereby result in
lower revenues and an adverse effect on the Company's operating results.

  The potential negative impact on the Company's operating results as a result
of customer decisions to postpone purchases in favor of new and "publicized"
technology can be further magnified if products or components based on such new
technology are not available in a timely manner or in sufficient supply to meet
the demand caused by the market's shift to the new technology from an older
technology.  For example, the Company's operating results could be adversely
affected if the Company makes poor selections of chip architectures or chip
suppliers to pursue its 3D graphics subsystems and, as a





                                       21
<PAGE>   22
result, may be unable to achieve market acceptance of new products or unable to
secure a sufficient supply of such components.

  Also, if the Company, one of its competitors or its chip vendors announces a
product that the market views as having more desirable features or pricing than
the Company's existing products, demand for the Company's existing products may
decline even though the new product is not yet available.  Similarly, if the
Company's customers anticipate that the Company may reduce its prices in the
near term, they may postpone their purchases until such price reductions are
effected, reducing the Company's near-term shipments and revenue.  In general,
market anticipation of new products, new technologies or lower prices, even
though potentially positive in the longer term, can negatively impact the
Company's operating results in the short term.

SOFTWARE DEFECTS

  The Company's software products, and its hardware products incorporating any
software, are extremely complex as a result of such factors as advanced
functionality, the diverse operating environments in which they may be
deployed, the need for interoperability and the multiple versions of such
products that must be supported for diverse operating platforms, languages and
standards. These products may contain undetected errors or failures when first
introduced or as new versions are released. The Company generally provides a
three-year warranty for its products. In general, the Company's return policy
permits return within five days after receipt of products that do not meet
product specifications. There can be no assurance that, despite testing by the
Company and by current and potential customers, errors will not be found in new
products after commencement of commercial shipments, resulting in loss of or
delay in market acceptance. Such loss or delay would likely have a material
adverse effect on the Company's business, financial condition and results of
operations. Additionally, new versions or upgrades to operating systems and ISV
applications may require upgrades to the Company's software products to
maintain compatibility with these new versions or upgrades. There can be no
assurance that the Company will be successful in developing new versions or
enhancements to its software or that the Company will not experience delays in
the upgrade of its software products. In the event the Company experiences
delays or is unable to maintain compatibility with operating systems and ISV
applications, the Company's business, financial condition and results of
operations would be materially adversely affected.

RISKS ASSOCIATED WITH INTELLECTUAL PROPERTY

  Although the Company has three patent applications filed in the United
States, these claims are not related to the Company's current product lines.
Instead, the Company relies exclusively on trade secret and copyright
protection for its proprietary technology. Despite the Company's precautions,
it may be possible for a third party to copy or otherwise obtain and use the
Company's technologies without authorization or to develop competing
technologies independently. Furthermore, the laws of certain countries in which
the Company does business, including countries in which the Company does a
significant amount of business, such as the United Kingdom and Germany, may not
protect the Company's software and intellectual property rights to the same
extent as the laws of the United States. There can be no assurance that the
Company's means of protecting its proprietary rights will be adequate or that
the Company's competitors will not independently develop similar technology. If
unauthorized copying or misuse of the Company's products were to occur to any
substantial degree, or if a competitor of the Company were to effectively
duplicate the Company's proprietary technology, the Company's business,
financial condition and results of operations would be materially adversely
affected. Furthermore, while the Company requires employees and consultants to
enter into confidentiality agreements, there can be no assurance that
proprietary information will not be disclosed, that others will not
independently develop substantially equivalent proprietary information and
techniques or otherwise gain access to the Company's trade secrets or disclose
such technology, or that the Company can meaningfully protect its trade
secrets. Certain technology used by the Company's products is licensed from
third parties, generally on a non-exclusive basis. The termination of any such
license, or the failure of any third party licensor to adequately maintain or
update its product, could result in delay in the Company's ability to ship its
products while it seeks to implement technology offered by alternative sources,
if any. Any required replacement licenses could prove to be either unavailable
or costly.

  Although the Company has not received notices from third parties alleging
infringement claims that the Company believes would have a material adverse
effect on the Company's business, there can be no assurance that third parties
will not claim that the Company's current or future products or manufacturing
processes infringe the proprietary rights of others. Any such claim, with or
without merit, could result in costly litigation or might require the Company
to enter into royalty or licensing agreements. Such royalty or licensing
agreements, if required, may not be available on terms acceptable to the
Company, or at all, which could have a material adverse effect upon the
Company's business, financial condition and results of operations.





                                       22
<PAGE>   23
YEAR 2000

  The "Year 2000" issue arises because most computer systems and programs were
designed to handle only a two-digit year, not a four-digit year.  These
computers may interpret "00" as the year 1900 and could either stop processing
date-related computations or could process them incorrectly.  The Company has
been informed by its information systems vendors that the Company's information
systems are able to process the Year 2000 accurately and accordingly does not
anticipate any Year 2000 issues from its own information systems, databases or
programs.  However, the Company could be adversely impacted by Year 2000 issues
faced by major distributors, suppliers, customers, vendors and financial
service organizations with which the Company interacts.  The Company is in the
process of developing a plan to determine the impact that third parties which
are not Year 2000 compliant may have on the operations of the Company.   There
can be no assurance that such plan will be able to address fully, or at all,
the impact of the Year 2000 issue on the Company, which could have a material
adverse effect upon the Company's business, financial condition and results of
operations.

FUTURE CAPITAL REQUIREMENTS

  The Company's future capital requirements will depend upon many factors,
including the development of new products, the success of the Company's
research and development efforts, the expansion of the Company's sales and
marketing efforts and the status of competitive products.  The Company believes
that existing cash, cash equivalents and investments and its available
borrowings and lines of credit will be sufficient to finance its working
capital and capital expenditure requirements for at least the next 12 months.
There can be no assurance, however, that the Company will not require
additional financing during such time. Further, there can be no assurance that
any additional financing will be available to the Company on acceptable terms,
if at all. If additional funds are raised by issuing equity securities, further
dilution to the existing stockholders could result. The inability to obtain
acceptable financing would have a material adverse effect on the Company's
business, financial condition and results of operations.

CONCENTRATION OF STOCK OWNERSHIP

  As of December 31, 1997, the Company's directors and officers and their
affiliates beneficially owned approximately 49% of the outstanding Common
Stock.  As a result, these stockholders will be able to exercise significant
influence over all matters requiring stockholder approval, including the
election of directors and approval of significant corporate transactions.  Such
concentration of ownership may have the effect of delaying or preventing a
change in control of the Company.

POSSIBLE VOLATILITY OF STOCK PRICE

  The price of the Company's Common Stock has experienced extreme price
fluctuations.  Factors such as quarterly variations in actual or anticipated
operating results, changes in earnings estimates by analysts, market conditions
in the industry, announcements by competitors, regulatory actions and general
economic conditions have had and may in the future have a significant effect on
the market price of the Common Stock.  Following fluctuations in the market
price of a corporation's securities, securities class action litigation has
often resulted.  There can be no assurance that such litigation will not occur
in the future with respect to the Company.  Such litigation could result in
substantial costs and a diversion of management's attention and resources,
which could have a material adverse effect on the Company's business, financial
condition and results of operations.

SHARES ELIGIBLE FOR FUTURE SALE

  As of December 31, 1997, the Company had 8,378,040 shares of Common Stock
outstanding.  As of December 31, 1997, the Company had 8,646,410 shares of
Common Stock eligible for sale in the public market (including approximately
268,370 shares issuable upon exercise of vested options).  Certain stockholders
holding 4,152,791 shares of Common Stock (assuming exercise of outstanding
warrants for 30,000 shares of Common Stock) are entitled to registration rights
with respect to their shares of Common Stock. If such stockholders, by
exercising their demand registration rights, cause a significant number of
securities to be registered and sold in the public market, such sales could
have an adverse effect on the market price of the Company's Common Stock.

BLANK CHECK PREFERRED STOCK; ANTI-TAKEOVER PROVISIONS

  The Company's Board of Directors has the authority to issue up to 2,000,000
shares of Preferred Stock and to determine the price, rights, preferences and
privileges of those shares without any further vote or action by the
stockholders. The rights of the holders of Common Stock will be subject to, and
may be adversely affected by, the rights of the holders of any





                                       23
<PAGE>   24
Preferred Stock that may be issued in the future. The issuance of Preferred
Stock may have the effect of delaying, deterring or preventing a change of
control of the Company without further action by the stockholders and may
adversely affect the voting and other rights of the holders of Common Stock.
The Company has no current plans to issue shares of Preferred Stock. The
Company's Certificate of Incorporation and Bylaws have eliminated cumulative
voting with respect to the election of directors, actions to be taken by
written consent of the Company's stockholders and certain procedures such as
advance notice procedures with regard to the nomination, other than by or at
the direction of the Board of Directors, of candidates for election as
directors. In addition, the Company's charter documents provide that the
Company's Board of Directors be divided into three classes, each of which
serves for a three-year term. The foregoing provisions could have the effect of
making it more difficult for a third party to effect a change in the control of
the Board of Directors. In addition, these provisions could have the effect of
making it more difficult for a third party to acquire, or of discouraging a
third party from attempting to acquire, or of making the Company less
attractive to a potential acquiror of a majority of the outstanding voting
stock of the Company, and may complicate or discourage a takeover of the
Company. The foregoing provisions may also result in the Company's stockholders
receiving less consideration for their shares than might otherwise be available
in the event of a takeover attempt of the Company.

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

  Not applicable.

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

<TABLE>
<CAPTION>
  Index to Consolidated Financial Statements                                                                   Page
  ------------------------------------------                                                                   ----
  <S>                                                                                                          <C>
  Report of Independent Accountants............................................................................  25
  Consolidated Balance Sheet as of December 31, 1997 and 1996..................................................  26
  Consolidated Statement of Operations for the three years in the period ended December 31, 1997 ..............  27
  Consolidated Statement of Stockholders' Equity (Deficit) for the three years in the period
      ended December 31, 1997 .................................................................................  28
  Consolidated Statement of Cash Flows for the three years in the period ended December 31, 1997 ..............  29
  Notes to Consolidated Financial Statements  .................................................................  30
</TABLE>

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







                                       24
<PAGE>   25

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
  of AccelGraphics, Inc.

  In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of operations, of stockholders' equity (deficit) and of
cash flows present fairly, in all material respects, the financial position of
AccelGraphics, Inc. and its subsidiaries at December 31, 1997 and 1996, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1997 in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits.  We conducted our audits of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the  amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.



PRICE WATERHOUSE LLP
San Jose, California
January 26, 1998










                                       25
<PAGE>   26
                              ACCELGRAPHICS, INC.
                           CONSOLIDATED BALANCE SHEET
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
                                                                                                   DECEMBER 31,
                                                                                                1997          1996
                                                                                              --------      --------
<S>                                                                                          <C>            <C>
                                                  ASSETS
Current assets:
   Cash and cash equivalents ............................................................     $  9,367      $  2,979
   Short-term investments ...............................................................        6,526          --
   Accounts receivable, net of allowances of $737 and $495 ..............................        6,545         4,392
   Inventories ..........................................................................        2,566           507
   Other current assets .................................................................          434            49
                                                                                              --------      --------
Total current assets ....................................................................       25,438         7,927
Property and equipment, net .............................................................          876           512
Long-term investments ...................................................................        1,995          --
                                                                                              --------      --------

                                                                                              $ 28,309      $  8,439
                                                                                              ========      ========

 LIABILITIES, MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED
  STOCK AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
   Current portion of long-term obligations .............................................     $    230      $     16
   Accounts payable .....................................................................        2,066         1,466
   Accrued liabilities ..................................................................        1,266         1,415
                                                                                              --------      --------

Total current liabilities ...............................................................        3,562         2,897
                                                                                              --------      --------

Capital lease obligation, net of current portion ........................................          105            34
                                                                                              --------      --------

Long term debt, net of current portion ..................................................          377          --
                                                                                              --------      --------

Subordinated convertible note payable to related party ..................................         --           1,748
                                                                                              --------      --------

Mandatorily redeemable convertible preferred stock ......................................         --           8,930
                                                                                              --------      --------

Commitments (Notes 4 and 8)

Stockholders' equity (deficit):
  Preferred Stock, $0.001 par value, 2,000 shares authorized; none issued and outstanding         --            --
  Common Stock, $0.001 par value, 50,000 shares authorized;
      8,378 and 1,253 shares issued and outstanding .....................................            8             1
  Additional paid-in capital ............................................................       30,037           785
  Notes receivable from stockholders ....................................................          (49)          (89)
  Deferred stock compensation ...........................................................         (160)         (396)
  Cumulative translation adjustment .....................................................           (9)           (5)
  Accumulated deficit ...................................................................       (5,562)       (5,466)
                                                                                              --------      --------

          Total stockholders' equity (deficit) ..........................................       24,265        (5,170)
                                                                                              --------      --------

                                                                                              $ 28,309      $  8,439
                                                                                              ========      ========
</TABLE>




   The accompanying notes are an integral part of these consolidated financial
                                  statements.





                                       26
<PAGE>   27
                              ACCELGRAPHICS, INC.

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


<TABLE>
<CAPTION>
                                                  YEAR ENDED DECEMBER 31,
                                           ------------------------------------
                                             1997          1996           1995
                                           --------      --------      --------
<S>                                        <C>           <C>           <C>    
Revenues .............................     $ 33,509      $ 18,671      $  3,911
Cost of revenues .....................       23,171        12,077         2,501
                                           --------      --------      --------

   Gross profit ......................       10,338         6,594         1,410
                                           --------      --------      --------

Operating expenses:
   Research and development ..........        4,493         2,663         2,618
   Sales and marketing ...............        4,815         3,635         2,154
   General and administrative ........        1,909         1,131         1,039
                                           --------      --------      --------

      Total operating expenses .......       11,217         7,429         5,811
                                           --------      --------      --------

Loss from operations .................         (879)         (835)       (4,401)
Interest expense .....................          (72)         (145)         (183)
Interest and other income, net .......          855            48           119
                                           --------      --------      --------

Net loss .............................     $    (96)     $   (932)     $ (4,465)
                                           ========      ========      ========

Net loss per share:
   Basic .............................     $  (0.02)     $  (1.09)     $  (9.15)
                                           ========      ========      ========
   Diluted ...........................     $  (0.02)     $  (1.09)     $  (9.15)
                                           ========      ========      ========

Shares used in per share calculations:
   Basic .............................        6,103           854           488
                                           ========      ========      ========
   Diluted ...........................        6,103           854           488
                                           ========      ========      ========
</TABLE>





  The accompanying notes are an integral part of these consolidated financial
                                  statements.





                                       27
<PAGE>   28

                              ACCELGRAPHICS, INC.

            CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                     NOTES                                           TOTAL
                                                                   RECEIVABLE   DEFERRED                             STOCK-
                                     COMMON STOCK      ADDITIONAL     FROM       STOCK    CUMULATIVE     ACCUM-     HOLDERS'
                                 --------------------   PAID-IN      STOCK-     COMPEN-  TRANSLATION    ULATED      EQUITY
                                  SHARES      AMOUNTS    CAPITAL     HOLDERS     SATION    ADJUSTMENT   DEFICIT     (DEFICIT)
                                 --------    --------   --------    --------    --------    --------    --------    --------
<S>                              <C>         <C>        <C>         <C>         <C>         <C>         <C>         <C>
Balance at December 31,1994 ..        910    $      1   $     60    $    (55)       $-          $-      $    (69)   $    (63)
Common Stock options exercised        202         -           31         (20)        -           -           -            11
Repurchase of Common Stock ...        (41)        -          (11)        -           -           -           -           (11)
Net loss .....................        -           -          -           -           -           -        (4,465)     (4,465)
                                 --------    --------   --------    --------    --------    --------    --------    --------

Balance at December 31, 1995 .      1,071           1         80         (75)        -           -        (4,534)     (4,528)
Common stock options exercised        129         -           23         (13)        -           -           -            10
Repayment of notes receivable
  from stockholders ..........        -           -          -             2         -           -           -             2
Interest on notes receivable .        -           -          -            (3)        -           -           -            (3)
Deferred compensation
  related to stock options ...        -           -          608         -          (608)        -           -           -
Stock issued in exchange for
  services ...................         53         -           74         -           -           -           -            74
Amortization of deferred
  compensation ...............        -           -          -           -           212         -           -           212
Translation adjustment .......        -           -          -           -           -            (5)        -            (5)
Net loss .....................        -           -          -           -           -           -          (932)       (932)
                                 --------    --------   --------    --------    --------    --------    --------    --------

Balance at December 31, 1996 .      1,253           1        785         (89)       (396)         (5)     (5,466)     (5,170)
Stock issued in initial
  public offering, net .......      2,535           3     20,330         -           -           -           -        20,333
Stock issued upon net
  exercise of warrants .......         22         -          -           -           -           -           -           -
Conversion of Preferred
  Stock to Common Stock ......      4,509           4      8,926         -           -           -           -         8,930
Common stock options exercised         59         -           40         -           -           -           -            40
Repayment of notes receivable
   from stockholder ..........        -           -          -            40         -           -           -            40
Amortization of deferred
  compensation and other .....        -           -          (44)        -           236         -           -           192
Translation adjustment .......        -           -          -           -           -            (4)        -            (4)
Net loss .....................        -           -          -           -           -           -           (96)        (96)
                                 --------    --------   --------    --------    --------    --------    --------    --------

Balance at December 31, 1997 .      8,378    $      8   $ 30,037    $    (49)   $   (160)   $     (9)   $ (5,562)   $ 24,265
                                 ========    ========   ========    ========    ========    ========    ========    ========
</TABLE>






  The accompanying notes are an integral part of these consolidated financial
                                  statements.










                                       28
<PAGE>   29
                               ACCELGRAPHICS, INC.
                      CONSOLIDATED STATEMENT OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                       YEAR ENDED DECEMBER 31,
                                                                                    1997        1996        1995
                                                                                  --------    --------    --------
<S>                                                                              <C>            <C>         <C>
Cash flows from operating activities:
Net loss ......................................................................   $    (96)   $   (932)    $(4,465)
  Adjustments to reconcile net loss to net cash used in operating activities:
     Depreciation and amortization ............................................        423         228         158
     Loss on disposal of property and equipment ...............................         28         -           -
     Stock compensation expense and other .....................................        192         283          98
     Changes in assets and liabilities:
       Accounts receivable ....................................................     (2,153)     (3,308)     (1,084)
       Inventories ............................................................     (2,059)        504        (130)
       Other assets ...........................................................       (385)         (1)         20
       Accounts payable .......................................................        600         964         340
       Accrued liabilities ....................................................       (149)        931         484
                                                                                  --------    --------    --------

Net cash used in operating activities .........................................     (3,599)     (1,331)     (4,579)
                                                                                  --------    --------    --------

Cash flows from investing activities:
  Acquisition of property and equipment .......................................       (661)       (251)       (245)
  Purchases of investments, net ...............................................     (8,521)        -           -
                                                                                  --------    --------    --------

       Net cash used in investing activities ..................................     (9,182)       (251)       (245)
                                                                                  --------    --------    --------

Cash flows from financing activities:
  Principal repayment of note payable/capital lease obligation ................     (2,289)         (4)       (470)
  Proceeds from issuance of notes payable .....................................      1,049         -           470
  Proceeds from repayment of notes receivable from stockholders ...............         40           2         -
  Net proceeds from issuance of Common Stock ..................................     20,373          10         -
  Proceeds from issuance of Preferred Stock ...................................        -         3,185       4,095
                                                                                  --------    --------    --------

       Net cash provided by financing activities ..............................     19,173       3,193       4,095
                                                                                  --------    --------    --------

Effect of exchange rate changes on cash .......................................         (4)         (5)        -
                                                                                  --------    --------    --------
Net increase (decrease) in cash and cash equivalents ..........................      6,388       1,606        (729)
Cash and cash equivalents at beginning of year ................................      2,979       1,373       2,102
                                                                                  --------    --------    --------

Cash and cash equivalents at end of year ......................................   $  9,367    $  2,979    $  1,373
                                                                                  ========    ========    ========

Supplemental cash flow disclosures:
  Interest paid ...............................................................   $    202    $    135    $     47
                                                                                  ========    ========    ========
  Income taxes paid ...........................................................   $    181    $      -    $      -
                                                                                  ========    ========    ========
Supplemental disclosure of noncash investing and financing activities:
  Property and equipment acquired under capital leases ........................   $    154    $     54    $      -
                                                                                  ========    ========    ========
  Conversion of note payable to Preferred Stock ...............................   $      -    $      -    $  1,650
                                                                                  ========    ========    ========
  Conversion of Mandatorily Redeemable Convertible
      Preferred Stock into Common Stock .......................................   $  8,930    $      -    $      -
                                                                                  ========    ========    ========
  Issuance (cancelation) of compensatory stock options ........................   $    (44)   $    608    $      -
                                                                                  ========    ========    ========
</TABLE>


  The accompanying notes are an integral part of these consolidated financial
                                  statements.





                                       29
<PAGE>   30

                              ACCELGRAPHICS, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 -- THE COMPANY AND A SUMMARY OF ITS SIGNIFICANT ACCOUNTING POLICIES:

 The Company

  AccelGraphics, Inc. (the "Company") designs, develops and markets
3-dimensional ("3D") graphics subsystems, software accelerators and application
utility software products for the professional Windows NT and Windows 95
markets.  The Company is incorporated in the State of Delaware and commenced
operations in late 1994.

  The Company completed its initial public offering of Common Stock in April
1997.  The offering consisted of 2,535,000 shares issued by the Company and
455,000 shares sold by existing stockholders and resulted in net proceeds to
the Company of approximately $20,300,000.  In conjunction with the offering,
all shares of mandatorily redeemable convertible preferred stock were
automatically converted into 4,509,000 shares of Common Stock.

 Basis of consolidation

  The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries.  All significant intercompany accounts and
transactions have been eliminated.

 Fiscal year end

  The Company operates under a 52-53 week fiscal year which ends on the Friday
closest to December 31.  Fiscal 1997 was a 53 week year, while fiscal 1996 and
1995 were 52 week years. For convenience of presentation, the accompanying
consolidated financial statements have been shown as ending on December 31 of
each year.

 Use of estimates

  The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

 Translation of foreign currencies

  The functional currency of the Company's wholly owned subsidiaries is the
local currency.  Accordingly, all assets and liabilities are translated into
United States dollars at current exchange rates as of the respective balance
sheet date. Revenue and expense items are translated using the average exchange
rates prevailing during the period.  Gains and losses resulting from
translation are accumulated as a component of stockholders' equity.  The
Company's sales are generally denominated in United States dollars.  Net gains
and losses resulting from foreign exchange transactions were not significant
during the periods presented.

 Revenue recognition

  Revenues from product sales are generally recognized upon product shipment,
less an allowance for estimated future returns and exchanges.  Provision for
the estimated costs of providing technical support services, and future
warranty obligations for the Company's products are recorded as a cost of
revenues upon recognition of related revenues.  Revenues from license and
royalty agreements is recognized when the revenue is earned and collectibility
is assured.

 Cash, cash equivalents and investments

  The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents.  At December
31, 1997 and 1996 approximately $9,331,000 and $2,408,000, respectively of
money market funds and commercial paper instruments, the fair value of which
approximate cost, are included in cash and cash equivalents.





                                       30
<PAGE>   31

                              ACCELGRAPHICS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


  Management determines the appropriate classification of its investments in
marketable debt securities at the time of purchase and re-evaluates such
designation as of each balance sheet date. The Company classifies all
securities as "available for sale" and carries them at fair value with any
unrealized gains or losses related to these securities reported as a separate
component of stockholders' equity.

 Inventories

  Inventories are stated at the lower of first-in, first-out cost or  market.

 Research and development costs

  Expenditures for research and development are charged to expense as incurred.
Software product development costs incurred from the time technological
feasibility has been reached until the product is generally available to
customers are capitalized and reported at the lower of cost or net realizable
value.  To date, no significant amounts have been expended subsequent to
reaching technological feasibility.  Non-recurring engineering fees are
reflected as a reduction of research and development expense in the period
earned.  During 1996, the Company recognized $190,000 of such fees.

 Property and equipment

  Property and equipment are recorded at cost. Depreciation is computed using
the straight-line method over the estimated useful lives of the assets which
range from two to five years. Capitalized lease assets and leasehold
improvements are amortized using the straight-line method over the shorter of
their estimated useful lives or the remaining lease term.

 Concentration of credit risk

  Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of cash, investments and trade accounts
receivable.  The Company places its cash and investments in money market
accounts, certificates of deposit, commercial paper and term notes.  Cash and
investments are maintained with high quality institutions and their composition
and maturities are regularly monitored by management.

  The Company's trade accounts receivable are derived from sales to original
equipment manufacturers, distributors and dealers located primarily in the U.S.
and Europe. The Company performs ongoing credit evaluations of its customers
and maintains an allowance for potential credit losses based upon the expected
collectibility of all accounts receivable.

  Revenues from Hewlett-Packard Company and Digital Equipment Corporation were
36.4% and 22.4%, respectively, of revenue in 1997. Revenues from
Hewlett-Packard Company and Digital Equipment Corporation were 22.8% and 27.9%,
respectively, of revenue in 1996.  Revenues from the Company's former customer,
NeTpower, Inc., comprised 16.6% of revenues in 1995.

  Revenues from export sales, primarily Europe, were approximately $15,360,000,
$5,810,000 and $850,000 during 1997, 1996, and 1995, respectively.

  Three customers accounted for 46.5%, 13.4% and 12.6% of the accounts
receivable balance at December 31, 1997.  In addition, a sub-contract
manufacturer for the Company accounted for 23.9% of accounts receivable at
December 31, 1997.

 Accounting for stock-based compensation

  The Company accounts for stock-based compensation in accordance with
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees." In January 1996, the Company adopted the disclosure requirements of
Statement of Financial Accounting Standards No. 123 ("FAS 123"), "Accounting
for Stock-Based Compensation" (see Note 7).

 Net loss per share

  Effective December 1997, the Company adopted Statement of Financial
Accounting Standards No. 128 ("FAS 128"), "Earnings per Share" and Staff
Accounting Bulletin No. 98; and consequently, all historical earnings per share
information has been restated.





                                       31
<PAGE>   32
                              ACCELGRAPHICS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



  Basic net loss per share is computed using the weighted-average number of
common shares outstanding during the periods.  In accordance with the
requirements of FAS 128, the Company has excluded 131,000, 317,000 and 502,000
shares of common stock, which are subject to repurchase at December 31, 1997,
1996 and 1995, respectively, from basic shares outstanding. For the years ended
December 31, 1997, 1996 and 1995, there were no outstanding dilutive common
equivalent shares.

 Recent pronouncements

  In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 130 ("FAS 130"), "Reporting
Comprehensive Income," which the Company is required to adopt for its 1998
annual financial statements. This statement will require the Company to report
in the financial statements, in addition to net income, comprehensive income
and its components including foreign currency items and unrealized gains and
losses on certain investments in debt and equity securities. Upon adoption of
FAS 130, the Company is also required to reclassify financial statements for
earlier periods provided for comparative purposes.

  In June 1997, the FASB issued Statement of Financial Accounting Standards No.
131 ("FAS 131"), "Disclosures about Segments of an Enterprise and Related
Information," which the Company is required adopt for its 1998 annual financial
statements. This statement establishes standards for reporting information
about operating segments in annual financial statements and requires 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. Under FAS 131,
operating segments are to be determined consistent with the way that management
organizes and evaluates financial information internally for making operating
decisions and assessing performance.


NOTE 2 -- RELATED-PARTY TRANSACTIONS:

  The Company had a subordinated convertible note payable to a related party
(see Note 5).  The note was repaid in April 1997.

  The Company has loans outstanding to certain employees totaling $49,000 at
December 31, 1997 for the purchase of Common Stock. These loans accrue interest
at a fixed rate of 7.32% per annum and are due on the earlier of November 9,
1998 or termination of employment with the Company. Upon termination of
employment, the Company has the option to repurchase the unvested shares by
canceling the related portion of the loan.

  At December 31, 1997, there were 51,000 shares of Common Stock which were
sold to certain employees and consultants as restricted stock for which
repurchase rights have not lapsed.  These shares may be repurchased at the
Company's option if the employee or consultant terminates services prior to
vesting, generally over four years.

  The Company purchased marketing services from a distributor which was also a
common stockholder until October 1997 for $12,000 and $108,000 in 1996 and
1995, respectively. No services were purchased in 1997.  These amounts have
been recorded in the consolidated statement of operations as sales and
marketing expense.  The Company recognized revenue from this distributor of
$990,000, $1,195,000 and $109,000 in 1997, 1996 and 1995, respectively.

  The Company's outside legal counsel are also stockholders. The Company
incurred legal expenses to this stockholder of $430,000, $121,000 and $89,000
during 1997, 1996, and 1995, respectively.

NOTE 3 -- BALANCE SHEET COMPONENTS (IN THOUSANDS):

<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                          1997             1996
                                                         ------           ------
<S>                                                      <C>              <C>
Cash and cash equivalents:
     Cash ....................................           $   36           $  571
     Commercial paper ........................            6,461              -
     Money market funds ......................            2,370            2,408
     Other ...................................              500              -
                                                         ------           ------

                                                         $9,367           $2,979
                                                         ======           ======
</TABLE>





                                       32
<PAGE>   33

                               ACCELGRAPHICS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)




<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                            1997            1996
                                                           ------           ----
<S>                                                       <C>              <C>
Short-term investments:
  Certificates of deposit ........................         $2,998           $  -
  Commercial paper ...............................          2,118             --
  Medium term notes ..............................          1,410             --
                                                           ------           ----

                                                           $6,526           $  -
                                                           ======           ====
</TABLE>

Realized and unrealized gains or losses on sales of available-for-sale
securities were immaterial for the years ended December 31, 1997, 1996 and 1995.
Short- term investments have maturities of less than one year and long-term
investments have maturities of up to 2 years.


<TABLE>
 <S>                                                       <C>          <C>
Inventories:
  Raw materials .........................................   $ 1,297     $   144
  Work-in-process .......................................       978          41
  Finished goods ........................................       291         322
                                                            -------     -------

                                                            $ 2,566     $   507
                                                            =======     =======

Property and equipment:
 Office furniture and equipment ........................    $ 1,584     $   871
 Leasehold improvements ................................         73          27
                                                            -------     -------
                                                              1,657         898
 Less: accumulated depreciation and amortization .......       (781)       (386)
                                                            -------     -------

                                                            $   876     $   512
                                                            =======     =======
</TABLE>

At December 31, 1997 and 1996, the Company had $208,000 and 54,000,
respectively, of capitalized lease equipment and related accumulated
amortization of $63,000 and $5,000, respectively.

<TABLE>
<S>                                                         <C>           <C>
Accrued liabilities:
 Accrued employee compensation .....................        $  410        $  616
 Warranty and customer support .....................           633           325
 Customer advances .................................          --             292
 Other accrued liabilities .........................           223           182
                                                            ------        ------

                                                            $1,266        $1,415
                                                            ======        ======
</TABLE>


NOTE 4 -- BORROWINGS:

  At December 31, 1997, the Company has borrowed $549,000 under a term loan
with a bank which provides for borrowings of up to $1,000,000 through May 1998.
Outstanding borrowings bear interest at the bank's prime rate plus 0.5% per
annum (9.0% at December 31, 1997) through May 1998; thereafter, principal and
interest are due in 24 equal payments.  The loan is secured by property and
equipment.

  The Company also has a revolving line of credit agreement with the bank,
which, through December 1998, provides for maximum borrowings in an amount up
to the lower of 80% of eligible accounts receivable or $3,000,000. Borrowings
under the line are secured by all of the Company's assets and bear interest at
the bank's prime rate plus 0.25% per annum (8.75% at December 31, 1997).  The
agreement requires that the Company maintain certain financial ratios and
levels of tangible net worth and profitability and also restricts the Company's
ability to pay cash dividends.  All borrowings are





                                       33
<PAGE>   34

                               ACCELGRAPHICS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



cross-collateralized.  At December 31, 1997, there were no borrowings and
$1,100,000 of standby letters of credit outstanding under the line of credit.
As a result of the loss incurred in September 1997, the Company was in
violation of certain debt covenants; however, the bank waived such covenants.


NOTE 5 -- SUBORDINATED CONVERTIBLE NOTE PAYABLE TO A RELATED PARTY:

  In December 1994, the Company issued a subordinated convertible note payable
in the amount of $3,300,000 to Kubota Corporation ("Kubota").  In 1995, Kubota
converted $1,650,000 of the note into 990,000 shares of the Company's Series A
Preferred Stock.  The outstanding balance of $1,650,000, together with accrued
interest of $98,000, was replaced with a new subordinated convertible note
payable of $1,748,000 which was repaid in April 1997.  Interest expense under
the note payable was $45,000, $144,000 and $178,000 during the years ended
December 31, 1997, 1996 and 1995, respectively.


NOTE 6 -- MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK:

  A summary of Preferred Stock activity is as follows (in thousands, except per
share amounts):

<TABLE>
<CAPTION>
                                                                                       SHARES   AMOUNT
                                                                                       ------   ------
<S>                                                                                   <C>       <C>   
Balance at December 31, 1994 ........................................................    --      $   -
  Issuance of Series A Preferred Stock (June 1995) at $1.67 per share for cash ......   1,707    2,845
  Issuance of Series A Preferred Stock (June 1995) at $1.67 per share upon conversion
    of note with Kubota Corporation .................................................     990    1,650
  Issuance of Series A Preferred Stock (July 1995) at $1.67 per share for cash ......     750    1,250
                                                                                       ------   ------

Balance at December 31, 1995 ........................................................   3,447    5,745
  Issuance of Series B Preferred Stock (March 1996) at $3.00 per share for cash .....   1,062    3,185
                                                                                       ------   ------

Balance at December 31, 1996 ........................................................   4,509    8,930
  Conversion of Preferred Stock into Common Stock ...................................  (4,509)  (8,930)
                                                                                       ------   ------
                                                                                            -   $    -
                                                                                       ======   ======

</TABLE>

NOTE 7 -- STOCK OPTION AND BENEFIT PLANS:

Stock Plan

  The 1995 Stock Plan (the "Plan") authorizes the Board of Directors to grant
incentive stock options, nonstatutory stock options and stock purchase rights
to employees and consultants.  Under the Plan, incentive stock options are
granted at a price not less than 100% of the fair market value of the Company's
Common Stock, as determined by the Company's Board of Directors, and at a price
not less than 110% of the fair market value for grants to employees who owned
more than 10% of the voting power of all classes of stock on the date of grant.
Nonqualified stock options may be granted at a price not less than 85% of the
fair market value of the Common Stock, as determined by the Board of Directors,
and at a price not less than 110% of the fair market value for grants to a
person who owned more than 10% of voting power of all classes of stock on the
date of grant.  Stock purchase rights may be granted at a price not less than
85% of the fair market value of the Common Stock and at a price of 100% of the
fair market value of the Common Stock for grants to a stockholder owning 10% or
more of the Company's outstanding stock. Stock purchase rights expire 30 days
after the date of grant.  Options generally become exercisable at a rate of not
less than 25% per year over a four year vesting period. At December 31, 1997,
options authorized under the Plan were 3,300,000 and options for approximately
1,810,000 shares were available for future grant.

Directors' Stock Option Plan

  The Company's 1997 Directors' Stock Option Plan (the "Directors' Plan") was
adopted by the Board of Directors in January 1997.  A total of 200,000 shares
of Common Stock has been reserved for issuance under the Directors' Plan.
During 1997, options to purchase 75,000 shares were granted under the
Directors' Plan.





                                       34
<PAGE>   35
                              ACCELGRAPHICS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



  A summary of activity under all the plans is as follows (in thousands except
per share amounts):

<TABLE>
<CAPTION>
                                                                           WEIGHTED-
                                                           RANGE OF          AVERAGE
                                                            PRICE         EXERCISE PRICE
                                          OPTION SHARES   PER SHARE          PER SHARE
                                          -------------   ---------          ---------
<S>                                         <C>          <C>                <C>
Outstanding at December 31, 1994 ......        --         $       -            $  -
 Granted ..............................         670       0.12-0.18            0.16
 Exercised ............................        (202)      0.12-0.18            0.13
 Canceled .............................         (11)      0.12-0.18            0.15
                                              -----


Outstanding at December 31,1995 .......         457       0.12-0.18            0.17
 Granted ..............................         723       0.18-6.90            1.74
 Exercised ............................        (129)      0.12-5.30            0.17
 Canceled .............................         (44)      0.12-0.18            0.15
                                              -----


Outstanding at December 31,1996 .......       1,007       0.12-6.90            1.30
 Granted ..............................         822       5.25-9.50            7.45
 Exercised ............................        (158)      0.12-5.30            0.34
 Canceled .............................        (624)      0.12-9.50            6.25
                                              -----


Outstanding at December 31,1997 .......       1,047       $0.12-$9.50      $   3.32
                                              =====
</TABLE>


  Options to purchase 268,000, 155,000, and 120,000 shares were exercisable at
December 31, 1997, 1996 and 1995, respectively.

  The weighted average fair value of options granted during 1997 and 1996 was
$3.18 and $2.20, respectively.  During 1996, the weighted average fair value of
options granted at exercise prices below the fair value of the underlying
Common Stock was $1.53.  All options granted during 1997 were granted at
exercise prices equal to the fair value of the underlying Common Stock.

  During 1996, the Company granted options for the purchase of approximately
776,000 shares of Common Stock to employees at exercise prices ranging from
$0.30 to $6.90 per share. Based in part on an independent valuation of the fair
value of the Company's Common Stock, management calculated deferred
compensation of approximately $608,000 related to options granted during 1996.
Such deferred compensation is being amortized over the vesting period relating
to these options, of which $192,000 and $212,000 has been recorded as expense
in 1997 and 1996, respectively.

  During 1996, the Company issued 53,000 shares to consultants for services
rendered. Such issuances were recorded at fair market value.

  The following table summarizes information about employee stock options
outstanding at December 31, 1997 (in thousands, except per share and life
amounts):


<TABLE>
<CAPTION>
                                                OPTIONS OUTSTANDING                    OPTIONS EXERCISABLE
                                -------------------------------------------------   -------------------------
                                                                                                      WEIGHTED
                                  WEIGHTED           AVERAGE           WEIGHTED                       AVERAGE
                                   NUMBER           REMAINING          AVERAGE        NUMBER          EXERCISE
RANGE OF EXERCISE PRICES        OUTSTANDING     CONTRACTUAL LIFE   EXERCISE PRICE   EXERCISABLE         PRICE
------------------------        -----------     ----------------   --------------   -----------         -----

<S>                               <C>                 <C>            <C>              <C>              <C>
$0.12 - $0.70 .........              591                8.10         $   0.26           224            $   0.24
$5.25 - $6.00 .........              247                9.66             5.56            33                5.64
$9.00 - $9.50 .........              209                9.27             9.31            11                9.50
                                   -----                                               ----   

                                   1,047                8.70         $   3.32           268            $   1.30
                                   =====                                               ====   
</TABLE>






                                       35
<PAGE>   36

                               ACCELGRAPHICS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)




 Fair Value Disclosures

  Had compensation expense for options granted in 1997, 1996 and 1995 been
determined based on the fair value at the grant dates, as prescribed in FAS
123, the Company's net loss and basic and diluted pro forma net loss per share
would have been as follows (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                                   YEAR ENDED DECEMBER 31,
                                                        1997                1996                 1995
                                                     ----------          ----------          ------------ 
   <S>                                               <C>                <C>                   <C>
    Net loss:
       As reported ......................            $      (96)         $     (932)         $     (4,465)
       Pro forma ........................                  (580)               (948)               (4,468)
    Basic and diluted net loss per share:
       As reported ......................            $    (0.02)         $    (1.09)         $      (9.15)
       Pro forma ........................                 (0.09)              (1.11)                (9.16)
</TABLE>

  The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model with the following weighted average
assumptions used for grants during the years ended December 31, 1997, 1996 and
1995, respectively: dividend yield of 0% for all three years, risk-free
interest rates of 6.2%, 6.5% and 6.4%, expected volatility of 70%, 0% and 0%,
and expected lives of 3.5 years for all years presented.

  Warrants

  In 1996, in connection with the negotiation of its line of credit facility,
the Company granted the bank warrants to purchase 30,000 shares of the
Company's Common Stock at an exercise price of $1.67 per share. The warrants
expire on October 10, 2000.  The warrants had a nominal value at date of grant.

  In December 1995, in connection with a development agreement with a strategic
partner, the Company granted the strategic partner warrants to purchase 26,250
shares of the Company's Common Stock at $3.00 per share. The warrants were
automatically converted into 17,500 shares of Common Stock upon the closing of
the Company's initial public offering. The warrants had a nominal value at date
of grant.

  In conjunction with a lease line of credit, in July 1996 the Company granted
the lessor warrants to purchase 7,000 shares of the Company's Series B
Preferred Stock at an exercise price of $3.00 per share. The warrants were
automatically converted into 4,667 shares of Common Stock upon the closing of
the Company's initial public offering.  The warrants had a nominal value at
date of grant.

 Employee Stock Purchase Plan

  In January 1997, the Board of Directors approved the 1997 Employee Stock
Purchase Plan (the "Purchase Plan") which provides for a total of 400,000
shares of Common Stock to be issued in a series of twelve month offering
periods, other than the first offering period, commencing on February 1, and
August 1, of each year.  The first offering period commenced on April 16, 1997.
The Purchase Plan permits eligible employees to purchase Common Stock through
payroll deductions, which may not exceed 10% of an employee's compensation, at
a price equal to the lower of 85% of the fair market value of the Company's
Common Stock at the beginning or end of the offering period.  No shares were
issued under the Purchase Plan during 1997.


NOTE 8 -- LEASES AND COMMITMENTS:

  The Company is obligated under a non-cancelable operating lease for office
space and a non-cancelable capital lease for equipment. The leases expire at
various times through 2000. The office lease agreement provides for scheduled
rent increases.  Rent expense is recognized ratably over the lease term. Rent
expense was $400,000, $156,000 and $129,000 for 1997, 1996 and 1995,
respectively.





                                       36
<PAGE>   37
                               ACCELGRAPHICS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)





  Future minimum lease commitments under these leases at December 31, 1997 are
as follows (in thousands):

<TABLE>
<CAPTION>
                                                                    OPERATING         CAPITAL
                                                                     LEASE             LEASE
                                                                     -----             -----
  Year ending December 31,
<S>                                                                 <C>                <C>
       1998..............................................            $ 394             $  69
       1999..............................................              131                69
       2000..............................................             --                  42
                                                                     -----             -----

           Total ........................................            $ 525               180
                                                                     =====

    Less amount representing interest ...................                                (17)
                                                                                       -----

    Present value of capital lease obligation ...........                                163
    Less current portion ................................                                (58)
                                                                                       -----

    Long term capital lease obligation ..................                              $ 105
                                                                                       =====
</TABLE>


NOTE 9 -- INCOME TAXES:

    The provision for income taxes of $5,000 in 1997 is minimum state taxes and
is included in interest income and other, net.  No provision for federal and
state income taxes was recorded in 1996 or 1995 as the Company incurred net
operating losses.

    Significant components of the Company's deferred tax assets are as follows
(in thousands):

<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                         1997                1996
                                                       -------             -------
<S>                                                    <C>                 <C>
    Net operating loss carryforwards ......            $   790             $ 1,365
    Tax credit carryforwards ..............                450                 200
    Nondeductible reserves and accruals ...                944                 630
                                                       -------             -------

    Total deferred tax assets .............              2,184               2,195
    Deferred tax asset valuation allowance              (2,184)             (2,195)
                                                       -------             -------

                                                       $     -             $     -
                                                       =======             =======
</TABLE>


  The Company has incurred losses since its inception through December 31,
1997. Management believes that based on the currently available evidence,
including the Company's history of annual losses, the lack of carryback
capacity to realize deferred tax assets, the annual limitation on the
utilization of net operating loss carryforwards, the uncertainty of the
development of the market in which the Company competes and the fact that the
market in which the Company competes is intensely competitive and characterized
by rapidly changing technology, it is more likely than not that the Company
will not generate sufficient taxable income to realize the deferred tax asset.
Accordingly, a full valuation allowance has been recorded.

  At December 31, 1997, the Company had federal and state net operating loss
carryforwards of approximately $1,800,000 and $1,600,000, respectively,
available to offset future taxable income.  Such carryforwards expire beginning
in 2010.  At December 31, 1997, the Company also has $250,000 and $200,000 of
federal and state research and development credit carryforwards, respectively.
Utilization of approximately $1,500,000 of the Company's net operating loss and
research and development credit carryforwards is subject to an annual
limitation due to ownership change limitations prescribed by the Internal
Revenue Code of 1986 and similar state provisions and may be further limited
should another ownership change occur. The annual limitation may result in the
expiration of the net operating loss and credit carryforwards before their
utilization.





                                       37
<PAGE>   38
                              ACCELGRAPHICS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)




NOTE 10 - BUSINESS SEGMENTS

  The Company operates in a single industry segment encompassing the
development, marketing and support of graphic accelerator subsystems.  The
Company markets its products to customers in the United States, Europe and
Asia-Pacific.  The Company's customer base consists primarily of large OEMs and
distributors in United States, Europe and Asia.

  Revenue information by geographic region is as follows (in thousands):

<TABLE>
<CAPTION>
                                              YEAR ENDED DECEMBER 31,
                                         1997          1996            1995
                                       -------        -------        -------
<S>                                    <C>            <C>            <C>
    United States .............        $18,149        $12,861        $ 3,061
    Europe ....................          8,820          4,810            600
    Asia-Pacific ..............          6,540          1,000            250
                                       -------        -------        -------

                                       $33,509        $18,671        $ 3,911
                                       =======        =======        =======
</TABLE>





















                                       38
<PAGE>   39


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

  None.


                                    PART III

  Certain information required by Part III is omitted from this report because
the Company will file a definitive proxy statement within 120 days after the
end of its fiscal year pursuant to Regulation 14A (the "Proxy Statement") for
its annual meeting of stockholders to be held Thursday, May 28, 1998, and the
information included in the Proxy Statement  is incorporated herein by
reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

  Incorporated by reference to the Company's Proxy Statement.

ITEM 11. EXECUTIVE COMPENSATION.

  Incorporated by reference to the Company's Proxy Statement.

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

  Incorporated by reference to the Company's Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

  Incorporated by reference to the Company's Proxy Statement.

                                     PART IV

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

  (a)    The following documents are filed as part of this report:

        (2)    Exhibits (numbered in accordance with Item 601 of Regulation S-K)


                                  EXHIBIT INDEX

<TABLE>
<CAPTION>
  NUMBER                                            DESCRIPTION
  ------                                            -----------
<S>           <C>
   3.5*       Amended and Restated Certificate of Incorporation of Registrant (Delaware)

   3.8*       Amended and Restated Bylaws of Registrant (Delaware)

   4.1*       Specimen Common Stock Certificate

   4.2*       Warrant to Purchase shares of Common Stock

   4.3*       Warrant to Purchase shares of Series A Preferred Stock

   4.4*       Warrant to Purchase shares of Series B Preferred Stock

   4.5*       Convertible Note Purchase Agreement dated December 22, 1994 between the Company and
              Kubota Corporation

   9.1*       Amended and Restated Voting Agreement dated March 7, 1996 between the Company and
              certain holders of the Company's securities

   10.1*      1995 Stock Plan, as amended and forms of stock purchase and stock option agreement

   10.2*      1997 Directors' Stock Option Plan and form of stock option agreement

   10.3*      1997 Employee Stock Purchase Plan and form of subscription agreement

   10.4*      AccelGraphics, Inc. 401(k) Savings & Retirement Plan

   10.6*      Form of Indemnification Agreement (Delaware)

   10.7*      Amended and Restated Registration Rights Agreement dated as of July 1, 1996, between
</TABLE>




                                                 39
<PAGE>   40


                                  EXHIBIT INDEX

<TABLE>
<CAPTION>
  NUMBER                                            DESCRIPTION
  ------                                            -----------
<S>           <C>

              Registrant and holders of its Preferred Stock and warrant holders

   10.8*      Lease Agreement dated December 16, 1994 between the Company and John Arrillaga,
              Trustee and Richard T. Perry, Trustee

   10.9*      Digital Equipment Corporation OEM Agreement dated February 21, 1996 between the
              Company and Digital Equipment Corporation

   10.10*     Product Purchase Agreement dated as of July 1, 1996 between the Company and
              Hewlett-Packard France

   10.11*     Turnkey Agreement dated as of February 5, 1996 between the Company and MAT
              Technologies Ltd.

   10.12*     Software License Agreements dated August 8, 1995, January 23, 1996 and July 5, 1996,
              respectively between the Company and 3D Labs Inc.

   10.13*     Open GL License Agreement dated June 30, 1992, as amended, between the Company and
              Kubota Pacific Computer

   10.14*     Silicon Valley Bank Loan Business Loan Agreement dated October 11, 1995, between the
              Company and Silicon Valley Bank

   10.15*     Sublease Agreement dated as of March 31, 1997 between Registrant and C-Cube
              Microsystems, Inc. and the related Sublease Agreement dated as of December 8, 1996
              between C-Cube Microsystems, Inc. and LSI Logic Corporation and the Lease dated as of
              August 25, 1995 between Oak Creek Delaware, Inc. and LSI Logic Corporation

   10.16      Key Employee Retention Agreement - Jeff Dunn 

   10.17      Form of Key Employee Retention Agreement  

   10.18      Software Licensing Agreement dated May 8, 1997 Between the Company and Evans &
              Sutherland Computer Corporation  

   21.1*      Subsidiaries of Registrant

   23.1       Consent of Price Waterhouse LLP, Independent Accountants 

   27.1       Financial Data Schedule 

   27.2       Financial Data Schedule quarters ended Sep, Jun and Mar 1997

   27.3       Financial Data Schedule for the year ended December 31, 1996 

</TABLE>

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

*        Incorporated by reference to identically numbered exhibits filed in
         response to Item 27 (a), "Exhibits," of Registrant's Registration
         Statement on Form SB-2, as amended (File No. 333-21343), which became
         effective on April 10, 1997.

   (b)   Financial statement schedules

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

   (c)   Reports on Form 8-K

         No reports on Form 8-K were filed during the quarter ended January 2,
         1998.








                                       40
<PAGE>   41

                                   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.

                                             ACCELGRAPHICS, INC.

                                             By: /s/ Nancy E. Bush
                                                 -----------------------------
                                                 Nancy E. Bush
                                                 Chief Financial Officer

Date:  March 30, 1998
                               POWER OF ATTORNEY
         KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Jeffrey W. Dunn and Nancy E. Bush,
jointly and severally, his or her attorneys-in-fact, each with the 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 his or her 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 dates indicated.
<TABLE>
<CAPTION>
    SIGNATURE                    TITLE                                                          DATE
    ---------                    -----                                                          ----
<S>                             <C>                                                            <C>
/s/ JEFFREY W. DUNN
-------------------------        CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE                       March 30, 1998
JEFFREY W. DUNN                  OFFICER (Principal Executive Officer)
                              
                              
/s/ NANCY E. BUSH                              
-------------------------        VICE PRESIDENT, CHIEF FINANCIAL OFFICER, AND                  March 30, 1998
NANCY E. BUSH                    DIRECTOR (Principal Financial and Accounting Officer)
                              
                              
 /s/ DAVID E. GOLD                             
-------------------------        Director                                                      March 30, 1998
DAVID E. GOLD               
                              
                              
/s/ JOS C. HENKENS
-------------------------        Director                                                      March 30, 1998
JOS C. HENKENS               


/s/ DAVID W. PIDWELL                              
-------------------------        Director                                                      March 30, 1998
DAVID W. PIDWELL              
                              
                              
 /s/ PETER L. WOLKEN                             
-------------------------        Director                                                      March 30, 1998
PETER L. WOLKEN              
</TABLE>                  





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