<PAGE>
 
                    U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, DC  20549

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

                                  FORM 10-KSB

(Mark One)

     [X]  Annual report under Section 13 of 15(d) of the Securities Exchange Act
          of 1934
          

            For the Fiscal Year Ended September 30, 1998

     [_]  Transition report under Section 13 or 15(d) of the Securities Exchange
          Act of 1934
          
          For the transitional period from _______ to ________

Commission File No. 0-029024


                                 BENTHOS, INC.
--------------------------------------------------------------------------------
                (Name of Small Business Issuer in Its Charter)


   Massachusetts                                                04-2381876
--------------------------------------------------------------------------------
(State or Other Jurisdiction of                              (I.R.S. Employer
Incorporation or Organization)                               Identification No.)


49 Edgerton Drive, Falmouth, Massachusetts                         02556
--------------------------------------------------------------------------------
(Address of Principal Executive Offices)                         (Zip Code)


                                 508-563-1000
--------------------------------------------------------------------------------
               (Issuer's Telephone Number, Including Area Code)


     Securities registered under Section 12(b) of the Act:


                              Name of Each Exchange on
Title of Each Class           Which Registered

            None

     Securities registered under Section 12(g) of the Act:

                        Common Stock, $.0667 par value
<PAGE>
 
Check whether the issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months
(or for such shorter period that the issuer was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.

Yes  [X]       No  [_]
--------       -------


Check if there is no disclosure of delinquent filers in response to item 405 of
Regulation S-B contained in this form, and no disclosure will 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-KSB or any
amendment to this Form 10-KSB [ ]

The registrant had total operating revenues of $14,038,000 for its most recent
fiscal year ended September 30, 1998.

The aggregate market value of the voting stock held by non-affiliates of the
registrant as of December 4, 1998, based on the closing price for the stock on
such date as reported on the Nasdaq SmallCap Market of $6.375 per share was
$7,242,972.  Shares of Common Stock held by each officer and director and by
each person who owns 5% or 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.

                   APPLICABLE ONLY TO CORPORATE REGISTRANTS

     State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date:

           1,352,335 Shares of Common Stock, as of December 4, 1998

                      DOCUMENTS INCORPORATED BY REFERENCE

                               See Exhibit Index


Transitional Small Business Issuer Format (check one):

Yes  [_]       No  [X]
--------       -------

                                       2
<PAGE>
 
     This report contains forward-looking statements which involve certain risks
and uncertainties. See Item 6, "Management's Discussion and Analysis--Forward-
Looking Information" herein. Actual results and events may differ from those
discussed in the forward-looking statements.

     Except as otherwise noted herein, all information in this report has been
adjusted to reflect the three for two stock split, effected in the form of a
stock dividend paid by the Company to stockholders of record as of November 18,
1997.

                                    PART I

ITEM 1.  DESCRIPTION OF BUSINESS

     Benthos, Inc. (the "Company") was founded in 1962 to act as a supplier of
oceanographic products.  It was incorporated as a Massachusetts corporation in
1965.  Over the last 36 years, the Company has developed and acquired new
technology and products. Currently, the Company consists of two distinct
divisions: the Undersea Systems Division and the Container Inspection Systems
Division.

     Historically, the Company has focused its efforts on the Undersea Systems
marketplace with particular emphasis placed on the military and government
markets.  Early in the 1990's, funding for these markets declined and the
Company's sales to these markets suffered a corresponding reduction.  As a
result, the Company shifted its priorities to business development efforts in
commercial markets.  These markets include the geophysical industry, where the
Company's hydrophone products are used to discover oil and gas deposits
offshore, as well as the scientific research, nuclear inspection and
environmental markets.  Also as a result of these efforts, added resources were
applied to the Company's Container Inspection Systems Division.  A series of new
products were introduced and these products gained rapid acceptance into major
market segments such as the beer and beverage markets. The Company plans to
continue its emphasis on these markets into the future independent of any
recovery in the levels of government funding for the military market.

     The Company's wholly-owned subsidiary, Benthos International, Inc. acts as
a foreign sales corporation (FSC) for the Company's foreign sales. It has no
substantial assets, liabilities or income.

Undersea Systems Division

     The Company's Undersea Systems Division designs, develops, manufactures and
sells products and services used in oceanographic and undersea environments.
The markets for these products include the oceanographic research community
(research institutions, universities, government agencies and similar
organizations). Certain products are also sold to the oil industry (for offshore
oil and gas exploration) and the nuclear power industry.  The product range
includes acoustic transponders used for location 

                                       3
<PAGE>
 
marking and navigation, acoustic release devices used for recovering
instrumentation packages from the depths of the ocean, imaging systems
(including video, 35mm and digital still cameras), hydrophones used for
geophysical exploration and sound detection, remotely operated vehicles for
inspection and light work tasks and glass flotation products used to house
instruments and to provide buoyancy. The Company's undersea products are
generally marketed under the trade name "Benthos."

Container Inspection Systems Division

     The Company's  Container Inspection Systems Division designs, develops,
manufactures and sells systems used to inspect the integrity of containers in
the food, pharmaceutical and beverage industries.  The customers for these
systems include manufacturers of food, beverages and pharmaceuticals packaged in
bottles, cans, glass jars, plastic containers and assorted vacuum packages with
metal and plastic caps.  These systems are marketed under the trade name
"TapTone."  TapTone systems integrate various sensor technologies with digital
signal processing techniques in order to inspect containers for leakage, seal
integrity, low or high pressure, and similar packaging defects.   TapTone
systems may be used on-line as continuous inspection systems that operate at
production speeds or as off-line inspection systems to periodically validate
package integrity.

1.   Principal Products

Undersea Systems

     The Company's undersea products are divided into five distinct product
groups as follows:

     a.   Acoustics

     The Acoustics product group includes transponders, acoustic releases and
companion deck control systems.  Transponders are used to transmit and receive
acoustic signals underwater for the purposes of determining location,
navigation, or sending and receiving data.  These products are used for
scientific research, salvage and ship positioning operations.  Both expendable
and recoverable products are manufactured.  The transponder line includes low
cost versions that transmit a limited signal selection in response to a command
received, as well as more sophisticated versions that can be programmed to
transmit a wide variety of functions in response to received commands.
Transponders are monitored by and communicate with companion deck units which
are typically located on board a ship.

     Acoustic releases are sound-operated devices that will anchor underwater
products in place and will release those products, allowing them to float to the
surface, in response to an acoustic command signal transmitted from the surface.
The acoustic release product line includes both deep water (up to 12,000
meters), heavy 

                                       4
<PAGE>
 
duty, releases as well as recently introduced shallow water (up to 600 meters),
light duty, low cost releases. Releases may be operated with companion deck
control units.

     b.   Hydrophones

     Hydrophones are underwater sensors designed to produce an output signal in
response to an acoustic pressure signal.  They can be thought of as underwater
microphones.  The Company's hydrophone products are typically used in the
offshore oil and gas exploration industry, where they listen to acoustic sound
waves generated by the reflections of an acoustic signal as it bounces off of
the various geological layers beneath the ocean floor.  These data are used to
generate information about the geological structure beneath the ocean as a means
of locating promising oil and gas exploration sites.  The Company's hydrophone
product line is  also used in military applications to listen for and detect
submarines and other vessels under and on the surface of the ocean.  Hydrophones
may also be sold to research institutions for various applications such as
listening to marine animals.

     The Company's hydrophone product line includes sophisticated versions that
offer high sensitivity and can operate at great depth without significant
variation in response, as well as low cost hydrophones for the seismic research
industry that are produced in high production volumes.  The Company's hydrophone
products may be used with companion amplifiers that convert the electrical
signals to usable formats and they may be integrated into arrays, which are
groupings of hydrophones assembled together in long tubes for the purpose of
added acoustic sensitivity and for listening to acoustic signals over a long
distance.

     c.   Imaging

     The imaging products group consists of a line of cameras that are packaged
in enclosures that allow them to operate at varying depths underwater.  The
Company's capabilities include still cameras (typically 35 mm), video cameras,
and recently introduced digital still cameras that can capture an image
comprised of digital data for transmission to the surface and subsequent
processing by software.  The Company also sells companion underwater camera
flashes.

     The Company's imaging products are used in research to photograph
underwater wildlife and geological formations.  Imaging products are also used
in the commercial market to photograph underwater structures, such as oil rigs
and shipwrecks, for the purposes of inspection. Imaging products are also
employed in military applications to remotely inspect underwater objects such as
mines.

     d.   Remotely Operated Vehicles (ROVs)

     ROVs are unmanned underwater vehicles that are controlled from the surface
by a skilled operator.  The Company's ROV product line 

                                       5
<PAGE>
 
includes a number of specialized designs that are aimed at specific markets.
These markets include the research sector, where ROVs may be used as a camera
delivery system for visual documentation and inspection. ROVs are also sold to
the nuclear power industry, where they are used to perform inspections and light
work tasks in radioactive cooling water pools, and to the military sector, where
they may be used for remote inspection and to retrieve or deliver objects. The
Company's ROV products are also used for sewer and pipeline inspection. ROV
systems are occasionally used by the entertainment industry.

     e.   Glass Flotation

     The Company manufactures a line of glass spheres that are used to provide
buoyancy to underwater products and systems and may be used to house underwater
instruments and electronics,  such as transponders.  Glass spheres are offered
in three sizes depending on the individual requirements of buoyancy and/or
housing size. The Company also customizes its glass spheres for individual
customer requirements by providing various penetrations, machined surfaces and
electrical connectors.  The Company pressure tests all of its glass sphere
products in order to insure successful operation at desired depths.  Glass
spheres are normally provided with companion plastic "hard hats" that allow for
protection of the glass from breakage and for safe transport.

Container Inspection Systems

     The Company's container inspection systems are used to inspect bottles,
cans and similar packages for a variety of defects.  The TapTone product line
includes the following:

     a.   TapTone II Pressure/Vacuum Discriminator

     TapTone II uses acoustic technology to test for acceptable levels of
pressure or vacuum in containers that have metal closures and/or are metallic
themselves (such as beverage cans,  glass bottles with metal crowns, and
conventional steel cans).  These data are used to determine if the tested
package meets preset quality acceptance criteria.  TapTone II is used for a
variety of food processing and beverage applications and its principal market is
the brewing and beverage industry.  The TapTone II system is an on-line, high
speed inspection system designed to test 100% of produced products and to reject
containers that are determined to be defective.  A typical TapTone II system
consists of a sensor assembly, an electronic control and display unit, and a
rejector for removing defective containers from the production line. TapTone II
is also available in a case configuration which incorporates multiple sensors
for testing products that have been packaged in sealed cases.

     b.   Tracker

     The Tracker system uses a proximity sensor to measure the deflection of the
metal lid on a container.  These data are used to 

                                       6
<PAGE>
 
determine if the container meets preset quality acceptance criteria based upon
lid deflection and its correlation with the pressure or vacuum inside the
container. Tracker systems are normally used on beverage cans and conventional
steel cans. Tracker systems are on-line, high speed inspection systems designed
to test 100% of produced product, rejecting containers that are determined to be
defective. A typical Tracker system consists of a sensor assembly, an electronic
control and display unit, and a rejector for removing defective containers from
the production line. Tracker systems are also available in a case configuration
that incorporates multiple proximity sensors for testing products that have been
packaged in sealed cases.

     c.   Turbo Tracker

     The Turbo Tracker uses digital signal processing to enhance the accuracy
and performance of the Tracker system,  allowing the system to test a wider
variety of containers.  The Turbo Tracker system is also available in a case
configuration.

     d.   Laser Tracker

     The Laser Tracker system is similar to the Tracker system except that it
uses a laser beam to measure closure deflection on a container with a non-
metallic lid or closure.  These data are correlated with pressure inside the
container and are used to determine container quality based upon preset
criteria.

     e.   Squeezer System

     The Squeezer system mechanically deforms a resilient container with a
preset force.  These data are used to determine if the container is leaking
based upon preset criteria.  Squeezer systems are typically used on squeezable
packages, such as plastic bottles, jugs, and pouches.

     f.   RayTrak

     RayTrak is an X-ray based container inspection system used to determine if
containers are filled to the correct level.  The inspection system illuminates
the container with an X-ray beam as it passes through the RayTrak.  A detector
measures the X-ray radiation that passes through the container and correlates
that signal to the level of material in the container.  The system can be
configured to detect underfills, overfills, or both.  Containers such as steel
cans, aluminum beverage cans, bottles and jars are used with RayTrak.

2.   Distribution and Marketing Methods

     The Undersea Systems Division and the Container Inspection Systems Division
market their products through an international network of independent sales
representatives and distributors.  Sales representatives and distributors are
located in North America, South America, Europe, the Far East, Africa and
Australia. 

                                       7
<PAGE>
 
Domestic and international customers may also order the Company's products
directly from its headquarters in Massachusetts. Both divisions of the Company
participate in a number of trade shows and exhibitions around the world. The
Company also maintains an internal staff of trained sales and marketing
personnel with experience and expertise in the markets served by the Company.

3.   New Products

     During fiscal year 1998, the Company introduced TapTone-PC which is a
software package designed for supplemental data collection and analysis from
installed TapTone machines.  A new rejection system designed for cases and heavy
packages was also introduced.  The Company also continued its practice of
providing upgrades and improvements to its standard line of TapTone Inspection
Systems.  The Company also introduced the MANTA-ROV system, designed for deep
water inspection tasks for the offshore oil and gas industry.  Also introduced
was a low cost deck set designed to communicate with the 875 Series of shallow
water acoustic release systems.

4.   Competition

     Undersea Systems Division

     The Company competes with a variety of larger and smaller companies in each
of its product sectors. The Company's policy is to compete based upon technical
superiority and quality.  In some product categories, such as glass flotation,
the Company believes that it has a majority share of the market. In the
hydrophone and ROV product groups, the Company has a minority market share and
competes with larger companies, such as Teledyne, that have significantly more
resources than the Company.  In the acoustics and imaging product groups, the
Company competes with a variety of domestic and foreign competitors that are
generally of the same approximate size as the Company.

     Container Inspection Systems Division

     The Container Inspection Systems Division competes with a number of
domestic and international competitors.  At least two of these companies are
larger than the Company and offer a broader range of products.  All of these
competitors offer some products that compete with certain models offered by the
Company.  One German competitor recently introduced a product designed to
compete with the Company's leak detection products used for glass bottles with
metal caps.

     The Company's policy is to compete by offering technically advanced,
innovative products.  The Company also has a policy of pursuing patent
protection for its products when possible.  The Company also competes by
providing customers with well trained field service and application engineering
support.

                                       8
<PAGE>
 
5.   Sources and Availability of Raw Materials

     The products of both divisions generally utilize mechanical and electrical
components that are readily available from a wide variety of domestic and
foreign vendors.  In certain cases, the Company produces components internally,
utilizing its labor force and machine shop capability.  Some components are
specially designed for specific products and are purchased from a single vendor.
A ceramic component that is used in the seismic hydrophone product is purchased
from a single vendor, Motorola, Inc., although the Company believes that there
are other vendors that possess the capability to provide a replacement
component.  The Company's glass flotation products are also purchased from a
single vendor, Holophane Corp., although similar products could be obtained from
other vendors.  The Company has not experienced any problems with the supply of
its raw materials and it believes that its sources of supply are adequate for
its present and future requirements.

6.   Dependence on Major Customers

     Although the Company has a number of major customers, during fiscal 1998,
only one customer, Syntron, Inc., represented more than 10% of the Company's
total revenue.

7.   Patents, Trademarks and Other Agreements

     The Company possesses several patents pertaining to the design and
manufacture of its products. Several names utilized by the Company are also
trademarked.  It is the Company's policy to seek patent protection on products
and designs that it considers important to its future.  However, the Company
believes that quality and technical superiority, rather than patent protection,
are the most important criteria for its future success.  The Company does not
license any of its patents or designs to others at this time.  The Company is
currently a licensee under a non-exclusive license pertaining to the design of
its seismic hydrophone product from The Penn State Research Foundation.  The
Company is also a licensee under an exclusive agreement with Syntron, Inc. for a
patent pertaining to the design of the Company's Geopoint hydrophone product.

8.   Government Approvals and Contracts

     There are no government approvals required for any of the products
currently manufactured by the Company.  Certain products of the Undersea Systems
Division cannot be sold to certain countries under U.S. export controls.  The
Company does not anticipate that these export restrictions will be removed in
the near future.

     During fiscal 1998, less than 5% of the sales of the Undersea Systems
Division were derived from military procurement contracts, primarily 
contracts with the U.S. Navy. 

                                       9
<PAGE>
 
9.   Effect of Government Regulations

     The Company is not aware of any government regulations or pending
legislation that would affect the future sales of its products.

10.  Research and Development

     The Company maintains an internal staff of engineers and external
consultants with experience and expertise in the technologies it utilizes.  The
majority of research and development programs are internally funded. Research
and development expenditures were $665,000, $1,307,000 and $1,239,000 for the
fiscal years ended September 30, 1996, 1997 and 1998, respectively. In addition,
the Company has an ongoing technical consulting agreement with William D.
McElroy, an expert in undersea acoustics.

11.  Environmental Protection Regulations

     The Company believes that its compliance with current federal, state, and
local environmental regulations will not have a material adverse effect on its
capital expenditures, earnings, or competitive position.
 
12.  Employees

     As of September 30, 1998, the Company employed 92 full-time individuals, 14
of whom were engaged in research and development, 54 in manufacturing and 24 in
sales, marketing and administrative positions.  Of the 92 full-time employees,
24 are employed on a temporary basis.  None of the Company's employees is
covered by a collective bargaining agreement.  The Company believes that it
maintains good relations with its employees.

ITEM 2.  DESCRIPTION OF PROPERTY

     The Company owns its corporate offices in North Falmouth, Massachusetts,
which consist of 35,000 square feet of office and light industrial manufacturing
space in two single-story, industrial buildings on a 34 acre rural setting.  The
Undersea Systems Division and the Container Inspection Systems Division are
housed in separate facilities, each with its own dedicated engineering,
manufacturing, testing and sales administration staff. All facilities have been
recently modernized and are in good condition.

                                       10
<PAGE>
 
ITEM 3.  LEGAL PROCEEDINGS

     Not Applicable.

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

     No matters were submitted during the fourth quarter of the fiscal year
covered by this report to a vote of security holders, whether through the
solicitation of proxies or otherwise.

                                    PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     The Company's Common Stock is traded over-the-counter and is listed on the
Nasdaq SmallCap Market under the symbol BTHS. Prior to January 31, 1997, the
Company's Common Stock was traded on the OTC Bulletin Board.

     The following table sets forth the high and low bid information for the
Company's Common Stock for the periods shown. Said quotations reflect inter-
dealer prices, without retail mark-up, mark-down, or commission, and may not
represent actual transactions.  The stock prices set forth below are adjusted to
reflect the three for two stock split, effected in the form of a stock dividend
paid to stockholders of record as of November 18, 1997.
<TABLE>
<CAPTION>
 
Quarter Ended               High    Low
<S>                        <C>     <C>
 
     December 31, 1996     $13.99  $ 9.82
     March 31, 1997         13.99   10.08
     June 30, 1997          12.32    9.49
     September 30, 1997     17.99   11.83
     December 31, 1997      19.33   14.67
     March 31, 1998         15.50   12.25
     June 30, 1998          13.50    9.25
     September 30, 1998      9.50    4.50
</TABLE>

     As of December 4, 1998, there were approximately 280 holders of record of
the Company's Common Stock.

     The Company has never declared dividends on its Common Stock and does not
anticipate paying dividends in the foreseeable future.

     The Company did not issue any equity securities during the fiscal year
ended September 30, 1998 that were not registered under the Securities Act of
1933, other than the issuance of 3,824 shares of Common Stock to the Benthos,
Inc. Employee Stock Ownership Plan.

                                       11
<PAGE>
 
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS

     Overview

     The Company was founded in 1962 to act as a supplier of oceanographic
products.  Over the last 36 years, the Company has developed and acquired new
technology and products.  Currently, the Company consists of two distinct
divisions: the Undersea Systems Division and the Container Inspection Systems
Division.  The Container Inspection Systems Division was formed in 1971 using
aspects of acoustic technology (originally developed for oceanographic products)
and applied to the testing of cans, bottles and other containers for the purpose
of finding leaks and other package defects.

Results of Operations

     The following table presents, for the periods indicated, certain
consolidated statements of income data. The Company has reclassified certain
prior year information to conform with the current year's presentation.

<TABLE>
<CAPTION>
                                       Year Ended
                                     September 30,
                              ----------------------------
                                1998      1997      1996
                              --------  --------  --------
                                     (In Thousands)
<S>                           <C>       <C>       <C>
 
Net sales                     $14,038   $16,414   $11,143
 
Cost of sales                   7,529     7,639     5,392
                              -------   -------   -------
 
Gross profit                    6,509     8,775     5,751
Selling, general and
  administrative expenses       4,374     4,903     3,153
Research and development
  expenses                      1,239     1,307       665
                              -------   -------   -------
 
Income from operations            896     2,565     1,933
Interest income                   165        42        10
Interest expense                  (41)      (82)     (106)
                              -------   -------   -------
Income before provision
  for income taxes              1,020     2,525     1,837
 
Provision for income taxes        305       967       666
                              -------   -------   -------
 
Net income                    $   715   $ 1,558   $ 1,171
                              =======   =======   =======
</TABLE>

    The following table presents, for the periods indicated, the percentage
relationship of consolidated statements of income items to net sales.

                                       12
<PAGE>
 
<TABLE>
<CAPTION>
                                       Year Ended
                                      September 30,
                               ---------------------------
                                1998       1997       1996
                               ------     ------     ------
<S>                            <C>       <C>        <C>
 
Net sales                      100.0%     100.0%     100.0%
 
Cost of sales                   53.6       46.5       48.4
                               -----      -----      -----
 
Gross profit                    46.4       53.5       51.6
Selling, general and
  administrative expenses       31.2       29.9       28.2
Research and development
  expenses                       8.8        8.0        6.0
                               -----      -----      -----
 
Income from operations           6.4       15.6       17.4
Interest income                  1.2        0.3        0.1
Interest expense                (0.3)      (0.5)      (1.0)
                               -----      -----      -----
Income before provision for
  income taxes                   7.3       15.4       16.5
Provision for income taxes       2.2        5.9        6.0
                               -----      -----      -----
 
Net income                       5.1%       9.5%      10.5%
                               =====      =====      =====
 
</TABLE>
Years Ended September 30, 1998 and 1997

Sales.  Total sales decreased 14.5% to $14,038,000 for fiscal year 1998 as
compared to $16,414,000 for fiscal year 1997.  Sales by the Undersea Systems
Division decreased by 3.1% to $9,290,000 for fiscal year 1998 as compared to
$9,591,000 for fiscal year 1997. This decrease resulted primarily from decreased
sales of the Company's acoustic and glass flotation product lines and was
somewhat offset by increases in sales of the Company's imaging, hydrophone (used
for offshore oil exploration), and remotely operated vehicle (ROV) product
lines.  Sales by the Container Inspection Systems Division decreased by 30.4% to
$4,748,000 for fiscal year 1998 as compared to $6,823,000 for fiscal year 1997.
This decrease was attributable to fewer large project orders and the effects of
the Asian financial crisis, which caused some Asian customers to delay orders.

Gross Profit.  Gross profit decreased by 25.8% to $6,509,000 for fiscal year
1998 as compared to $8,775,000 for fiscal year 1997. As a percentage of sales,
gross profit was 46.4% for fiscal year 1998 as compared to 53.5% for fiscal year
1997, as a result of decreased sales of the Company's Container Inspection
Systems Division (which has higher profit margins) and start-up expenses
incurred in fiscal year 1998 related to the Company's Undersea Systems
Division's new Geopoint acoustic hydrophone product line.

Selling, General and Administrative Expenses.  Selling, general and
administrative expenses decreased 10.8% to $4,374,000 for fiscal 

                                       13
<PAGE>
 
year 1998 as compared to $4,903,000 for fiscal year 1997. The decrease in these
expenses was a result of lower commission and selling expenses relating to the
decreased sales volume, reductions in overall Company expenses coinciding with
this reduced sales volume and a nonrecurrence of the expenses related to the
registration and listing of the Company's securities which occurred in fiscal
year 1997. As a percentage of sales, selling, general and administrative
expenses increased to 31.2% for fiscal year 1998 as compared to 29.9% for fiscal
year 1997.

Research and Development Expenses.  Research and development expenses decreased
5.2% to $1,239,000 for fiscal year 1998 as compared to $1,307,000 for fiscal
year 1997.  As a percentage of sales, research and development expenses were
8.8% for fiscal year 1998 as compared to 8.0% for fiscal year 1997.  The
increase in percentage of sales is a result of investments in new product
development and reduced sales volume and is consistent with the Company's
current operational plans.

Interest Income.  Interest income increased to $165,000 for fiscal year 1998 as
compared to $42,000 for fiscal year 1997.  This increase resulted from higher
invested cash balances.

Interest Expense.   Interest expense decreased 50% to $41,000 for fiscal year
1998 as compared to $82,000 for fiscal year 1997.  The decrease was a result of
no borrowing on the credit line in fiscal year 1998 and the elimination of the
Company's short and long term debt in 1998.

Provision for Income Taxes.  The provision for income taxes decreased to
$305,000 for fiscal year 1998 as compared to $967,000 for fiscal year 1997.  The
effective tax rate used for fiscal year 1998 was 29.9% as compared to an
effective tax rate of 38.3% used in fiscal year 1997.  The rate used in fiscal
year 1998 is lower than the statutory rate due to the benefit from the Company's
foreign sales corporation and other state tax credits which benefited the
Company in fiscal year 1998.

Years Ended September 30, 1997 and 1996

Sales.  Total sales increased 47.3% to $16,414,000 for fiscal year 1997 as
compared to $11,143,000 for fiscal year 1996.  Sales by the Undersea Systems
Division increased by 80.6% to $9,591,000 for fiscal year 1997 as compared to
$5,312,000 for fiscal year 1996. The increase in Undersea Systems Division sales
was the result of the increased shipments of hydrophones used for offshore oil
exploration as well as an overall increase in the sales of the Company's
acoustic, imaging, and glass flotation product lines. Sales by the Container
Inspection Systems Division increased by 17.0% to $6,823,000 for fiscal year
1997 as compared to $5,831,000 

                                       14
<PAGE>
 
for fiscal year 1996. This increase was attributable to improved sales to the
worldwide brewing industry as well as continued penetration of the food and
beverage segments.

Gross Profit.  Gross profit increased by 52.6% to $8,775,000 for fiscal year
1997 as compared to $5,751,000 for fiscal year 1996. As a percentage of sales,
gross profit was 53.5% for fiscal year 1997 as compared to 51.6% for fiscal year
1996, principally as a result of changes in product mix.

Selling, General and Administrative Expenses.  Selling, general and
administrative expenses increased by 55.5% to $4,903,000 for fiscal year 1997 as
compared to $3,153,000 for fiscal year 1996.  The increase in total expenses was
a result of higher selling and commission expenses coinciding with the increased
volume, additional staff necessary to support the Company's growth, expenses
relating to the registration  and listing of the Company's securities on the
Nasdaq SmallCap Market, and various other legal and investor relations
activities in fiscal year 1997.  As a percentage of sales, selling, general and
administrative expenses increased to 29.9% for fiscal year 1997 as compared to
28.2% for fiscal year 1996.

Research and Development Expenses.  Research and development expenses increased
96.5% to $1,307,000 for fiscal year 1997 as compared to $665,000 for fiscal year
1996.  As a percentage of sales, research and development expenses increased to
8.0% for fiscal year 1997 from 6.0% for fiscal year 1996.  The increase in the
percentage of sales and dollars expended is due to investments in new product
development and is consistent with the Company's current operational plans.

Interest Income.  Interest income increased to $42,000 for fiscal year 1997 as
compared to $10,000 for fiscal year 1996.  This increase resulted from higher
invested cash balances.

Interest Expense.  Interest expense decreased to $82,000 for fiscal year 1997 as
compared to $106,000 for fiscal year 1996.  The decreased level of interest
expense was a result of decreased borrowing under the credit line.

Provision for Income Taxes.  The provision for income taxes increased to
$967,000 for fiscal 1997 as compared to $666,000 for fiscal 1996.  The effective
tax rate used for fiscal year 1997 was 38.3% as compared to an effective tax
rate of 36.2% used in fiscal 1996.  The rate used in fiscal year 1997 is lower
than the statutory rate due to the benefit from the Company's foreign sales
corporation and other state tax credits which benefited the Company in fiscal
year 1997.

                                       15
<PAGE>
 
Liquidity and Capital Resources

     The Company's principal capital requirement is to provide working capital
to support growth.

     As of September 30, 1998, the Company had cash and cash equivalents of
$2,509,000 as compared to a balance of $2,663,000 on September 30, 1997.
Operating income for the fiscal year ended September 30, 1998 was $896,000 as
compared to $2,565,000 for the fiscal year ended September 30, 1997.  Accounts
receivable decreased by $561,000 as a result of decreased sales volume.
Inventories increased by $730,000 to support a growing backlog of orders for the
Company's Geopoint and other hydrophone products and other planned early fiscal
year 1999 shipments.  Deferred tax assets increased by $135,000 as the result of
an increase in refundable income taxes.  Accounts payable increased by $676,000
as purchasing activities increased to support necessary inventory levels.
Accrued expenses decreased by $411,000 as reduced operating earnings resulted in
lower profit sharing payments.  Net cash provided by operating activities
decreased to $1,095,000 for fiscal year 1998 as compared to $2,324,000 for
fiscal year 1997.

     In the fiscal year ended September 30, 1998, the Company used $595,000 for
investing activities.  Of this total, $215,000 was used to purchase property,
plant, and equipment, $313,000 represents the long term portion of an account
receivable and the balance was expended on miscellaneous matters.

     Cash used in financing activities for the fiscal year ended September 30,
1998 was $654,000.  Included in this were payments on long-term debt of
$825,000, $101,000 from the exercise of stock options, and $70,000 from the sale
of treasury stock to the ESOP.

     The Company has an unsecured line of credit for $2,000,000. As of September
30, 1998, the Company had no outstanding advances against the line of credit.

     The Company believes that existing cash balances, current line of credit
arrangement and cash anticipated to be generated from operations will be
sufficient to finance the Company's operations for the next twelve months.  A
portion of the Company's cash may be used to acquire or invest in complementary
businesses or products or to obtain the right to use complementary technologies.
From time to time, in the ordinary course of business, the Company evaluates
potential acquisitions of such businesses, products or technologies.  The
Company engages in discussions and negotiations with respect to potential
acquisitions from time to time but has no current agreements or commitments at
the present time.

                                       16
<PAGE>
 
Prospects for the Future

     The Company will continue to focus resources on growth opportunities in the
markets that it serves.  These activities will include research and development,
distribution channels development, and geographical market development.  In
addition, the Company will increase its efforts at identifying and pursuing
strategically compatible product and/or company acquisitions.

Undersea Systems Division

     The Undersea Systems Division has made significant progress in penetrating
the market for geophysical oil and gas exploration.  It is expected that this
division will continue to focus its resources on further business development in
this market.  The Company believes that a number of its present products, as
well as those under development, are well-positioned to take advantage of
developing trends in the offshore oil and gas markets.  These trends include an
increased effort to search for oil and gas deposits in deeper waters as well as
efforts to perform more accurate geophysical surveys in areas that were
previously surveyed using older, less accurate technology.

     The Company will also continue to maintain its presence and focus on its
traditional markets, including military, oceanographic research and nuclear
inspection.  Some of these markets are affected by the level of U.S. Government
expenditures which have declined sharply in recent years.  However, the Company
believes that some future recovery is likely and that several promising
opportunities presently exist within these markets.

     The Company is not aware of any trends or changes in market characteristics
for the markets served by its Undersea Systems Division that would adversely
affect either sales or gross profits.

Container Inspection Systems Division

     The Container Inspection Systems Division serves the brewing, beverage,
food processing and pharmaceutical markets.  An active competitive environment,
concerns about product liability, an increased focus on improving quality, and
efforts at cost reduction are characteristic trends within these industries.
These trends are favorable for the Company's products and the Company expects
these trends to continue in the future.

     The Company will continue to focus its efforts on its development of the
domestic and international beer market.  In addition, the Company plans to
diversify its product range by developing and/or acquiring compatible inspection
products that expand the Company's inspection abilities.

     The Container Inspection Systems Division competes with a number of
domestic and international companies.  It is possible that increased competitive
pressures will be experienced in the future, affecting both sales and gross
profits.  The Company is not aware of any technological trends that would
adversely affect the 

                                       17
<PAGE>
 
sales of its products within the industry segments served by its Container
Inspection Systems Division.

Profit Margins

Overall

     Overall profit margins on the Company's products are influenced by the
relative mix of sales between the Undersea Systems Division and the Container
Inspection Systems Division. For fiscal year ended September 30, 1998, sales of
the Undersea Systems Division increased to 66% of total Company sales as
compared to 58% for the prior fiscal year, while sales of the Container
Inspection Systems Division decreased to 34% of total Company sales as compared
to 42% for the prior fiscal year.  The decrease in sales from fiscal year 1997
to fiscal year 1998 was 3.1% for the Undersea Systems Division and 30.4% for the
Container Inspection Systems Division.  This resulted in an overall gross profit
for the Company of 46.4% for the fiscal year ended September 30, 1998 as
compared to 53.5% for the fiscal year ended September 30, 1997.

Undersea Systems Division

     Profit margins on Undersea Systems Division products range from
approximately 30% for certain imaging systems products to more than 50% for
certain glass flotation products.  Hydrophone products have gross profit margins
ranging between approximately 25% to 40%. The Company expects that the overall
sales mix of its undersea products will shift slightly in the future due to
increased sales of hydrophone products to the offshore oil and gas market.  The
Company does not expect this sales mix to adversely affect overall profit
margins.  It is possible that increased competition will result in lower
realized selling prices for certain products, especially hydrophones, resulting
in reductions in product profit margins.  The Company is not aware of other
trends or competitive pressures that would adversely affect either product mix
or gross profit margin within its glass flotation, imaging, ROV and acoustic
product lines.

Container Inspection Systems Division

     Profit margins on Container Inspection Systems Division products range
between approximately 45% and 65%.  The Company expects that the sales mix of
different products will not significantly change and will not adversely affect
overall divisional gross margins in the future.  It is possible that increased
competition will result in an overall reduction of selling prices and associated
profit margins.  The Company is not aware of any technological trends or
marketplace trends which would adversely affect gross margins on these product
lines.

                                       18
<PAGE>
 
Forward-Looking Information

     This statements made in this report and in oral statements which may be
made by representatives of the Company relating to plans, strategies, economic
performance and trends and other statements that are not descriptions of
historical facts may be forward-looking statements within the meaning of the
Private Securities Litigation Reform Act, Section 27A of the Securities Act of
1933 and Section 21E of the Securities Exchange Act of 1934. Such information
includes information relating to the Company which is based upon the beliefs of
the Company's management as well as assumptions made by and information
currently available to the Company's management.  When used in this report,
words such as "anticipate," "believe," "estimate," "expect," "intend," and
similar expressions, as they relate to the Company's management, identify
forward-looking statements.  Such statements reflect the current views of
management with respect to future events and are subject to certain inherent
risks, uncertainties and assumptions relating to the operations and results of
operations of the Company, the timing of large project orders, competitive
factors, shifts in customer demand, government spending, economic cycles,
availability of financing as well as the factors described in this report.
Should one or more of these risks or uncertainties materialize, or should
underlying assumptions prove incorrect, actual results or outcomes may vary
materially from those described herein as anticipated, believed, estimated,
expected or intended.

Year 2000 Issues

     During 1998, the Company has been actively engaged in addressing Year 2000 
("Y2K") issues, which result from the use of two-digit, rather than four-digit, 
year dates in software, a practice which could cause date-sensitive systems to 
malfunction or fail because they may not recognize or process date information 
correctly.

     State of Readiness: To manage its Y2K program, the Company has divided its 
efforts into four program areas:

         * Information Technology (computer hardware and software)
         * Physical Plant (manufacturing equipment and facilities)
         * Products (including product development)
         * Extended Enterprise (suppliers and customers)

                                       19
<PAGE>

     For each of these program areas, the Company is using a four-step approach:

         * Ownership (creating awareness, assigning tasks)
         * Inventory (listing items to be assessed for Y2K readiness)
         * Assessment (prioritizing the inventoried items, assessing their Y2K 
           readiness, planning corrective actions, developing initial 
           contingency plans)
         * Corrective Action Deployment (implementing corrective actions, 
           verifying implementation, finalizing and executing contingency plans)

     As of September 30, 1998, the Ownership and Inventory steps were 
essentially complete for all program areas. The Company expects to complete the 
Assessment and Corrective Action Deployment steps by June 1999.

     Costs to Address Y2K Issues: The Company began incurring expenses in 1997 
to resolve this issue. All expenditures will be expensed as incurred and are not
expected to have a significant impact on the Company's ongoing results of 
operations.

     Risks of Y2K Issues and Contingency Plans: The Company is in the process of
assessing the Year 2000 issues relating to its physical plant, products and 
suppliers. The Company intends to develop a contingency planning process to 
mitigate worst-case business disruptions such as delays in product delivery, 
which could potentially result from events such as supply chain disruptions. The
Company expects its contingency plans to be complete by June 1999.

ITEM 7.  FINANCIAL STATEMENTS

     The information required by this item is incorporated by reference to the
Financial Statements set forth on pages F-1 through F-16 hereof.

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

     Not Applicable.

                                       20
<PAGE>
 
                                    PART III

     The information required by Part III of this report is incorporated by
reference from the registrant's definitive proxy statement for its 1999 annual
meeting of stockholders to be filed with the Commission in accordance with Rule
14a-101, Schedule 14A, on or before January 28, 1999.

ITEM 13.  EXHIBITS AND REPORTS ON FORM 8-K

     (a)  The financial statements set forth in the Index to Consolidated
          Financial Statements contained on page F-1 hereof are filed herewith
          as a part of this report.

     (b)  The exhibits set forth in the Exhibit Index on the page immediately
          preceding the exhibits are filed herewith as a part of this report.

     (c)  No reports on Form 8-K were filed by the registrant during the last
          quarter of the fiscal year covered by this report.

                                       21
<PAGE>
 
                                  SIGNATURES

     In accordance with Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

                                     BENTHOS, INC.


                                     By: JOHN L. COUGHLIN
                                         ----------------------
                                            John L. Coughlin,
                                                President

Date: December 16, 1998

     In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities and on
the dates indicated.



JOHN L. COUGHLIN           President, Chief Executive       December 16, 1998
-------------------------    Officer and Director    
John L. Coughlin           



FRANCIS E. DUNNE, JR.      Treasurer and Chief              December 16, 1998
-------------------------    Financial Officer                      
Francis E. Dunne, Jr.        (principal financial    
                              and accounting officer)
                                                   


STEPHEN D. FANTONE         Chairman of the Board of         December 18, 1998
-------------------------    Directors             
Stephen D. Fantone                                                           



SAMUEL O. RAYMOND          Director                         December 16, 1998
-------------------------                                           
Samuel O. Raymond



A. THEODORE MOLLEGEN, JR.  Director                         December 21, 1998
-------------------------                                           
A. Theodore Mollegen, Jr.



THURMAN F. NAYLOR          Director                         December 16, 1998
-------------------------                                           
Thurman F. Naylor



GARY K. WILLIS             Director                         December 17, 1998
-------------------------                                           
Gary K. Willis

                                      22
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY
                                        
                       CONSOLIDATED FINANCIAL STATEMENTS
                       AS OF SEPTEMBER 30, 1998 AND 1997
                         TOGETHER WITH AUDITORS' REPORT
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY
                                        
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
<S>                                                                        <C>
                                                                
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS                                    F-1
                                                                
CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 1998 AND 1997               F-2
                                                                
CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED           
SEPTEMBER 30, 1998, 1997 AND 1996                                           F-3
                                                                
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' INVESTMENT FOR THE     
YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996                               F-4
                                                                
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS             
ENDED SEPTEMBER 30, 1998, 1997 AND 1996                                     F-5
                                                                
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                  F-6

</TABLE>
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To Benthos, Inc.:

We have audited the accompanying consolidated balance sheets of Benthos, Inc. (a
Massachusetts corporation) and subsidiary as of September 30, 1998 and 1997, and
the related consolidated statements of income, stockholders' investment and cash
flows for each of the three years in the period ended September 30, 1998.  These
financial statements are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Benthos, Inc. and subsidiary as
of September 30, 1998 and 1997, and the results of their operations and their
cash flows for each of the three years in the period ended September 30, 1998,
in conformity with generally accepted accounting principles.



Boston, Massachusetts
October 26, 1998

                                      F-1
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY
                                        
                          CONSOLIDATED BALANCE SHEETS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)


<TABLE>
<CAPTION>
                                    ASSETS
                                                                                                 SEPTEMBER 30,
                                                                                           1998               1997
<S>                                                                                       <C>                <C>
CURRENT ASSETS:
 Cash and cash equivalents                                                                  $ 2,509            $ 2,663
 Accounts receivable, less reserves of approximately $175 and $162 at
  September 30, 1998 and 1997, respectively                                                   1,609              2,170 
 Inventories                                                                                  2,793              2,063
 Prepaid expenses and other current assets                                                      630                469
 Deferred tax asset                                                                             651                516
                                                                                            -------            -------
     Total current assets                                                                     8,192              7,881
                                                                                            -------            -------
PROPERTY, PLANT AND EQUIPMENT, AT COST:
 Land                                                                                           127                127
 Buildings and improvements                                                                   1,878              1,845
 Equipment and fixtures                                                                       2,921              2,643
 Demonstration equipment                                                                      1,352              1,448
                                                                                            -------            -------
                                                                                              6,278              6,063

 Less--Accumulated depreciation                                                               4,418              4,102
                                                                                            -------            -------
                                                                                              1,860              1,961
                                                                                            -------            -------
OTHER ASSETS                                                                                    580                234
                                                                                            -------            -------
                                                                                            $10,632            $10,076
                                                                                            =======            =======
                   LIABILITIES AND STOCKHOLDERS' INVESTMENT

CURRENT LIABILITIES:
 Current maturities of long-term debt                                                       $     -            $    34
 Accounts payable                                                                               990                314
 Accrued expenses                                                                               962              1,373
 Customer deposits                                                                              237                141
                                                                                            -------            -------
     Total current liabilities                                                                2,189              1,862
                                                                                            -------            -------
LONG-TERM DEBT, NET OF CURRENT MATURITIES                                                         -                791
                                                                                            -------            -------
COMMITMENTS (Note 10)                                                                                      
                                                                                                           
STOCKHOLDERS' INVESTMENT:                                                                                  
 Common stock, $.0667 par value                                                                            
  Authorized--7,500,000 shares                                                                             
  Issued--1,634,865 and 1,586,115 shares at September 30, 1998 and 1997,
   respectively                                                                                 109                106
 Capital in excess of par value                                                               1,502              1,270
 Retained earnings                                                                            7,609              6,894
 Treasury stock, at cost                                                                       (777)              (847)
                                                                                            -------            -------
     Total stockholders' investment                                                           8,443              7,423
                                                                                            -------            -------
                                                                                            $10,632            $10,076
                                                                                            =======            =======
</TABLE>

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

                                      F-2
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY
                                        
                       CONSOLIDATED STATEMENTS OF INCOME

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)


<TABLE>
<CAPTION>
                                                                                       YEARS ENDED SEPTEMBER 30,
                                                                             1998                 1997                 1996
 
<S>                                                              <C>                  <C>                  <C>
NET SALES                                                                $   14,038           $   16,414           $   11,143
 
COST OF SALES                                                                 7,529                7,639                5,392
                                                                         ----------           ----------           ----------
 
     Gross profit                                                             6,509                8,775                5,751
 
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES                                  4,374                4,903                3,153
 
RESEARCH AND DEVELOPMENT EXPENSES                                             1,239                1,307                  665
                                                                         ----------           ----------           ----------
 
     Income from operations                                                     896                2,565                1,933
 
INTEREST INCOME                                                                 165                   42                   10
 
INTEREST EXPENSE                                                                (41)                 (82)                (106)
                                                                         ----------           ----------           ----------
 
     Income before provision for income taxes                                 1,020                2,525                1,837
 
PROVISION FOR INCOME TAXES                                                      305                  967                  666
                                                                         ----------           ----------           ----------
 
     Net income                                                          $      715           $    1,558           $    1,171
                                                                         ==========           ==========           ==========
 
BASIC EARNINGS PER SHARE (Note 8)                                              $.54                $1.27                 $.98
                                                                         ==========           ==========           ==========
 
DILUTED EARNINGS PER SHARE (Note 8)                                            $.52                $1.14                 $.90
                                                                         ==========           ==========           ==========
 
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING                             1,314,323            1,225,722            1,190,529
                                                                         ==========           ==========           ==========
 
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING, ASSUMING
 DILUTION                                                                 1,387,130            1,370,375            1,306,922
                                                                         ==========           ==========           ========== 
</TABLE>

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

                                      F-3
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

              CONSOLIDATED STATEMENTS OF STOCKHOLDERS' INVESTMENT

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)



<TABLE>
<CAPTION>
                                       COMMON STOCK         CAPITAL IN      RETAINED     TREASURY STOCK, AT COST          TOTAL
                                     NUMBER     $.0667    EXCESS OF PAR     EARNINGS       NUMBER                      STOCKHOLDERS'
                                   OF SHARES  PAR VALUE       VALUE                       OF SHARES      AMOUNT        INVESTMENT
<S>                              <C>          <C>        <C>                <C>           <C>           <C>        <C>
BALANCE, SEPTEMBER 30, 1995        1,472,678      $ 98         $  604       $4,165        282,639        $(813)           $4,054
 Sale of treasury stock                    -         -              -            -         (2,244)           7                 7
 Purchase of treasury stock                -         -              -            -         19,943          (92)              (92)
 Exercise of stock options,                                                                                       
   including tax benefit              37,500         3            170            -              -            -               173
 Net income                                -         -              -        1,171              -            -             1,171
                                   ---------      ----         ------       ------        -------        -----            ------
BALANCE, SEPTEMBER 30, 1996        1,510,178       101            774        5,336        300,338         (898)            5,313
 Sale of treasury stock                    -         -              -            -         (5,390)          51                51
 Exercise of stock options,                                                                                       
   including tax benefit              75,937         5            496            -              -            -               501
 Net income                                -         -              -        1,558              -            -             1,558
                                   ---------      ----         ------       ------        -------        -----            ------
BALANCE, SEPTEMBER 30, 1997        1,586,115       106          1,270        6,894        294,948         (847)            7,423
 Sale of treasury stock                    -         -              -            -         (3,823)          70                70
 Exercise of stock options,                                                                                       
   including tax benefit              48,750         3            232            -              -            -               235
 Net income                                -         -              -          715              -            -               715
                                   ---------      ----         ------       ------        -------        -----            ------
BALANCE, SEPTEMBER 30, 1998        1,634,865      $109         $1,502       $7,609        291,125        $(777)           $8,443
                                   =========      ====         ======       ======        =======        =====            ======
</TABLE>

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

                                      F-4
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

                                 (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                                         YEARS ENDED SEPTEMBER 30,
                                                                             1998                1997                1996
<S>                                                                       <C>                 <C>                 <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net income                                                                 $  715              $1,558              $1,171
 Adjustments to reconcile net income to net cash provided by
  operating activities--
  Depreciation and amortization                                                350                 621                 456
  Deferred income taxes                                                       (135)                (59)               (198)
  Changes in assets and liabilities--
   Accounts receivable                                                         561                (651)               (523)
   Inventories                                                                (730)              1,489                (659)
   Prepaid expenses                                                            (27)                (74)                 99
   Accounts payable and accrued expenses                                       265                (426)              1,356
   Customer deposits                                                            96                (134)                (54)
                                                                            ------              ------              ------
       Net cash provided by operating activities                             1,095               2,324               1,648
                                                                            ------              ------              ------
CASH FLOWS FROM INVESTING ACTIVITIES:
 Purchase of property, plant and equipment                                    (215)               (504)               (528)
 Increase in other assets                                                     (380)               (106)                (39)
                                                                            ------              ------              ------
       Net cash used in investing activities                                  (595)               (610)               (567)
                                                                            ------              ------              ------
CASH FLOWS FROM FINANCING ACTIVITIES:
 Purchase of treasury stock                                                      -                   -                 (92)
 Sale of treasury stock                                                         70                  51                   7
 Exercise of stock options                                                     101                 176                  69
 Decrease in demand note payable                                                 -                   -                (275)
 Payments on long-term debt, net                                              (825)                (29)                (56)
                                                                            ------              ------              ------
       Net cash (used in) provided by financing activities                    (654)                198                (347)
                                                                            ------              ------              ------
 
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                          (154)              1,912                 734
 
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR                                 2,663                 751                  17
                                                                            ------              ------              ------

CASH AND CASH EQUIVALENTS, END OF YEAR                                      $2,509              $2,663              $  751
                                                                            ======              ======              ======
 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
 Interest paid during the year                                              $   41              $   82              $  105
                                                                            ======              ======              ======
 Income taxes paid during the year, net of refunds                          $  (38)             $1,624              $  235
                                                                            ======              ======              ======
 
SUPPLEMENTAL DISCLOSURE OF NONCASH ACTIVITIES:
 Tax benefit for exercise of stock options                                  $  134              $  325              $  104
                                                                            ======              ======              ======
</TABLE>

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

                                      F-5
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)



(1)  Operations and Significant Accounting Policies

     Benthos, Inc. (the Company) designs, manufactures, sells and services
     oceanographic and robotic equipment for underwater exploration, research
     and defense, as well as electronic inspection equipment for the automated
     assessment of the seal integrity of consumer food, beverage, pharmaceutical
     and chemical containers. The Company's customers are located throughout the
     world.

     The accompanying consolidated financial statements reflect the application
     of certain significant accounting policies as described below and elsewhere
     in the accompanying notes to the consolidated financial statements.

     (a)  Principles of Consolidation

          The consolidated financial statements include the accounts of the
          Company and its wholly owned subsidiary, Benthos International, Inc.,
          a foreign sales corporation. All material intercompany transactions
          and balances have been eliminated in consolidation.

     (b)  Management 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.

     (c)  Cash and Cash Equivalents

          The Company considers all highly liquid securities with original
          maturities of three months or less to be cash equivalents.

     (d)  Inventories

          Inventories are stated at the lower of cost (first-in, first-out) or
          market. Work-in-process and finished goods inventories include
          materials, labor and overhead. Inventories consist of the following at
          September 30, 1998 and 1997:

<TABLE>
<CAPTION>
                                          1998             1997
<S>                                      <C>              <C>
           Raw materials                 $   81           $   90
           Work-in-process                2,702            1,928
           Finished goods                    10               45
                                         ------           ------
                                         $2,793           $2,063
                                         ======           ======
</TABLE>

                                      F-6
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


     (e)  Depreciation and Amortization

          The Company provides for depreciation and amortization using the
          straight-line method by charges to operations in amounts estimated to
          allocate the cost of the assets over their estimated useful lives, as
          follows:

<TABLE>
<CAPTION>
                                             ESTIMATED
             ASSET CLASSIFICATION           USEFUL LIFE
<S>                                       <C>
           Buildings and improvements       15-33 years
           Equipment and fixtures               5 years
           Demonstration equipment              3 years
</TABLE>

     (f)  Intangible Assets

          The Company assesses the realizability of intangible assets in
          accordance with Statement of Financial Accounting Standards (SFAS) No.
          121, Accounting for the Impairment of Long-Lived Assets and for Long-
          Lived Assets To Be Disposed Of. Under SFAS No. 121, the Company is
          required to assess the valuation of its long-lived assets, including
          intangible assets, based on the estimated cash flows to be generated
          by such assets. Based on its most recent analysis, the Company
          believes that no material impairment of intangible assets exists as of
          September 30, 1998. Intangible assets are included in other assets on
          the consolidated balance sheets and are amortized on a straight-line
          basis, based on their estimated lives.

     (g)  Revenue Recognition and Warranty Costs

          The Company recognizes revenue upon shipment and provides for
          estimated warranty costs at that time. Amounts received from customers
          for future delivery are shown as customer deposits in the accompanying
          consolidated balance sheets.

     (h)  Concentration of Credit Risk

          SFAS No. 105, Disclosure of Information about Financial Instruments
          with Off-Balance-Sheet Risk and Financial Instruments with
          Concentration of Credit Risk, requires disclosure of any significant
          off-balance-sheet and credit risk concentrations. The Company has no
          significant off-balance-sheet concentration of credit risk such as
          foreign exchange contracts, options contracts or other foreign hedging
          arrangements. Financial instruments, which potentially subject the
          Company to concentrations of credit risk, are principally cash, cash
          equivalents and accounts receivable. The Company places its cash and
          cash equivalents in rated financial institutions. In 1998 and 1997,
          one customer accounted for 22% and 16% of net sales, respectively. In
          1996, no

                                      F-7
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)



          single customer accounted for more than 10% of net sales. As of
          September 30, 1998 and 1997, one customer accounted for approximately
          30% and 12% of accounts receivable, respectively. In 1996, two
          customers accounted for 30% and 14%, respectively, of accounts
          receivable. The Company has not experienced significant losses related
          to receivables from individual customers or groups of customers in any
          specific industry or geographic area. Due to these factors, no
          additional credit risk beyond amounts provided for collection losses
          is believed by management to be probable in the Company's accounts
          receivable.

     (i)  Reclassifications

          The Company has reclassified certain prior year information to conform
          with the current year's presentation.

     (j)  Financial Instruments

          The estimated fair value of the Company's financial instruments, which
          include cash and cash equivalents, accounts receivable and debt,
          approximate their carrying value.

     (k)  New Accounting Standards

          In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive
          Income. SFAS No. 130 requires disclosure of all components of
          comprehensive income on an annual and interim basis. Comprehensive
          income is defined as the change in equity of a business enterprise
          during a period from transactions and other events and circumstances
          from nonowner sources. SFAS No. 130 is effective for fiscal years
          beginning after December 15, 1997.

          In July 1997, the FASB issued SFAS No. 131, Disclosures About Segments
          of an Enterprise and Related Information. SFAS No. 131 requires
          certain financial and supplementary information to be disclosed on an
          annual and interim basis for each reportable segment of an enterprise.
          SFAS No. 131 is effective for fiscal years beginning after December
          15, 1997. Unless impracticable, companies would be required to restate
          prior information upon adoption.

          The Company believes that the adoption of these new accounting
          standards will not have a material impact on the Company's financial
          statements.

                                      F-8
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


(2)  ACCRUED EXPENSES

     Accrued expenses consist of the following at September 30, 1998 and 1997:

<TABLE>
<CAPTION>
                                              1998            1997
<S>                                         <C>             <C>
         Accrued commissions                 $ 144          $  215
         Accrued vacation                      108             100
         Accrued profit sharing                 82             274
         Accrued bonus                         132             282
         Accrued warranty                      244             146
         Other accrued expenses                252             356
                                             -----          ------
                                             $ 962          $1,373
                                             =====          ======
</TABLE>

(3)  LONG-TERM DEBT

     Long-term debt in 1998 consisted of a mortgage note payable to a bank in
     monthly payments of principal and interest of $9 through June 2004, with
     the balance due in July 2004, interest at 9.25%. The note was secured by
     land and building and the Company was required to maintain certain
     covenants, including debt service coverage, as defined. The mortgage was
     paid in full during 1998 without penalty.

(4)  DEMAND NOTE PAYABLE

     As of September 30, 1998, the Company has a $2,000 unsecured line of credit
     with a bank expiring on January 31, 1999. There were no amounts outstanding
     under this line of credit at September 30, 1998. Borrowings under this
     agreement are payable on demand and bear interest at the Wall Street
     Journal's prime rate (8.25% at September 30, 1998). The Company is required
     to maintain certain covenants, including debt service coverage. The Company
     was in compliance with all covenants at September 30, 1998.

(5)  INCOME TAXES

     The Company accounts for income taxes under the liability method in
     accordance with SFAS No. 109, Accounting for Income Taxes. Under the
     liability method specified by SFAS No. 109, a deferred tax asset or
     liability is determined based on the difference between the financial
     statement and tax bases of assets and liabilities, as measured by the
     enacted tax rates.

                                      F-9
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


     The components of the provision for income taxes for each of the three
     years in the period ended September 30, 1998 were as follows:

<TABLE>
<CAPTION>
                                      1998             1997             1996
<S>                                   <C>              <C>              <C>
    Federal--
      Current                         $ 372            $ 785            $ 697
      Deferred                         (138)             (45)            (150)
                                      -----            -----            -----
                                        234              740              547
                                      -----            -----            -----
    State--
      Current                            68              241              167
      Deferred                            3              (14)             (48)
                                      -----            -----            -----
                                         71              227              119
                                      -----            -----            -----
                                      $ 305            $ 967            $ 666
                                      =====            =====            =====
</TABLE>
                                        
     The Company's effective tax rate differed from the statutory rate for the
     reasons set forth below:

<TABLE>
<CAPTION>
                                                           1998           1997           1996
 
<S>                                                <C>            <C>            <C>
      Federal statutory rate                               34.0%          34.0%          34.0%
      State income taxes, net of federal tax 
      benefit                                               3.5            6.2            5.2 
      Tax benefit of foreign sales corporation             (5.0)          (2.4)          (3.5)
      Tax credits                                          (3.6)             -              -
      Other                                                 1.0             .5             .5
                                                           ----          -----           ----
 
      Effective tax rate                                   29.9%          38.3%          36.2%
                                                           ====          =====           ====
</TABLE>

     The components of the net deferred tax asset recognized in the accompanying
     consolidated balance sheets are as follows:

<TABLE>
<CAPTION>
                                                                           1998             1997
<S>                                                                       <C>              <C>
Deferred tax assets are primarily the result of            
  temporary differences, including nondeductible reserves            
  and accruals                                                            $ 697            $ 562 
Valuation allowance                                                         (46)             (46)
                                                                          -----            -----
      Net deferred tax asset                                              $ 651            $ 516
                                                                          =====            =====
</TABLE>
                                        
     Under SFAS No. 109, the Company recognizes a deferred tax asset for the
     future benefit of its temporary differences if it concludes that it is more
     likely than not that the deferred tax asset will be realized. The Company
     has recorded a valuation allowance of $46 for certain temporary
     differences, about which the Company believes there is uncertainty
     regarding realizability.

                                      F-10
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


(6)  STOCK SPLIT

     On October 22, 1997, the Company's Board of Directors approved a three for
     two stock split, effected in the form of a dividend to shareholders of
     record as of November 18, 1997. The accompanying consolidated financial
     statements and related notes for all periods presented have been
     retroactively adjusted to reflect the stock split.

(7)  EMPLOYEE BENEFIT PLANS

     (a)  Stock Option Plans

          The Company has granted to certain directors nonqualified stock
          options to purchase shares of the Company's common stock at a price
          not less than the fair market value of the shares at the date of
          grant. The options are exercisable ratably over a three-year period,
          commencing one year from the date of grant, and expire not more than
          ten years from the date of grant. At September 30, 1998, 161,250
          shares of common stock were reserved for issuance upon exercise of the
          nonqualified stock options. At September 30, 1998, 120,000 shares were
          available for future grant.

          The Company's 1990 Stock Option Plan (the 1990 Plan) authorizes
          300,000 shares of the Company's common stock for issuance. The 1990
          Plan is administered by the Board of Directors and provides for the
          granting of incentive stock options and nonqualified stock options.
          The options are exercisable ratably over a four-year period,
          commencing one year from the date of grant, and expire not more than
          10 years from the date of grant. The purchase price applicable to
          incentive stock options granted may not be less than the fair market
          value of the shares at the date of grant. At September 30, 1998,
          85,500 shares were available for future grant.

                                      F-11
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


         Stock option activity is summarized as follows:

<TABLE>
<CAPTION>
                                               1990 PLAN                  DIRECTOR OPTIONS
                                                       WEIGHTED                       WEIGHTED
                                       NUMBER OF       AVERAGE        NUMBER OF       AVERAGE
                                        SHARES       OPTION PRICE      SHARES       OPTION PRICE
<S>                                   <C>           <C>              <C>           <C>
Outstanding, September 30, 1995         105,000          $ 1.98        82,500           $ 1.83
  Granted                                89,250            4.33             -                -
  Terminated                            (22,500)           2.04             -                -
  Exercised                                   -               -       (37,500)            1.83
                                        -------          ------       -------           ------
                                                       
Outstanding, September 30, 1996         171,750            3.19        45,000             1.83
  Granted                                29,250           11.36        11,250            11.50
  Terminated                             (7,500)           2.04             -                -
  Exercised                             (75,937)           2.33             -                -
                                        -------          ------       -------           ------
                                                       
Outstanding, September 30, 1997         117,563            5.86        56,250             3.77
  Granted                                31,500           17.54        30,000            13.81
  Terminated                            (10,500)          17.54             -                -
  Exercised                              (3,750)           2.04       (45,000)            1.83
                                        -------          ------       -------           ------
                                                       
Outstanding, September 30, 1998         134,813          $ 7.79        41,250           $13.18
                                        =======          ======       =======           ======
                                                       
Exercisable, September 30, 1998          47,254          $ 5.05         3,750           $11.50
                                        =======          ======       =======           ======
</TABLE>
                                        
The range of exercise prices for options outstanding and options exercisable at
September 30, 1998 for the 1990 Plan is as follows:

<TABLE>
<CAPTION>
                                       OPTIONS OUTSTANDING             OPTIONS EXERCISABLE
                                   ---------------------------     -----------------------------
                                     WEIGHTED                                     
                                     AVERAGE         WEIGHTED                     
 RANGE OF                           REMAINING        AVERAGE                         WEIGHTED  
 EXERCISE            OPTIONS       CONTRACTUAL      EXERCISE         OPTIONS         AVERAGE   
  PRICES           OUTSTANDING         LIFE           PRICE        EXERCISABLE    EXERCISE PRICE
<S>                <C>            <C>              <C>             <C>            <C>
$ 2.04-2.04            7,500            5.4           $ 2.04           7,500          $ 2.04
$ 4.33-4.33           77,063            7.5             4.33          32,439            4.33
$10.16-12.79          29,250            8.4            11.36           7,315           11.36
$17.54-17.54          21,000            9.1            17.54               -               -
                     -------            ---           ------          ------          ------
                     134,813            6.6           $ 7.79          47,254          $ 5.05
</TABLE>

                                      F-12
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


The range of exercise prices for options outstanding and options exercisable at
September 30, 1998 for director stock options is as follows:

<TABLE>
<CAPTION>
                                   OPTIONS OUTSTANDING             OPTIONS EXERCISABLE
                               --------------------------     --------------------------------
                                 WEIGHTED                                                   
                                 AVERAGE         WEIGHTED                                   
 RANGE OF                       REMAINING        AVERAGE                         WEIGHTED 
 EXERCISE        OPTIONS       CONTRACTUAL      EXERCISE        OPTIONS          AVERAGE 
  PRICES       OUTSTANDING         LIFE           PRICE       EXERCISABLE     EXERCISE PRICE
<S>           <C>             <C>             <C>             <C>             <C>
$11.50-14.25     41,250            7.8           $13.18           3,750          $11.50
</TABLE>

In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based
Compensation. SFAS No. 123 requires the measurement of the fair value of stock
options or warrants to be included in the statement of operations or disclosed
in the notes to financial statements. The Company has determined that it will
continue to account for stock-based compensation for employees under Accounting
Principles Board Opinion No. 25 and elect the disclosure-only alternative under
SFAS No. 123 for stock-based compensation awarded in 1998 and 1997 using the
Black-Scholes option pricing model prescribed by SFAS No. 123. The underlying
assumptions used are as follows:

<TABLE>
<CAPTION>
                                                                SEPTEMBER 30,
                                                             1998         1997
<S>                                                    <C>          <C>
Risk-free interest rate                                      4.38%        6.20%
Expected dividend yield                                         -            -
Expected life (years)                                           7            7
Expected volatility                                            65%          40%
Weighted average remaining contractual life of 
 options outstanding (years)                                  7.8          6.2
</TABLE>

The weighted average fair value of options granted during the years ended
September 30, 1998 and 1997 under these plans is $15.72 and $5.90, respectively.

                                      F-13
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


          Had compensation cost for the Company's stock option plans been
          determined consistent with SFAS No. 123, pro forma net income and net
          income per share would have been the following:

<TABLE>
<CAPTION>
                                                                             SEPTEMBER 30,
                                                                         1998            1997
<S>                                                                   <C>             <C>
           Net income--
           As reported                                                  $ 715          $1,558
           Pro forma                                                      445           1,463
 
           Basic earnings per share--
           As reported                                                  $ .54          $ 1.27
           Pro forma                                                      .34            1.19
 
           Diluted earnings per share--
           As reported                                                  $ .52          $ 1.14
           Pro forma                                                      .32            1.07
</TABLE>

          Because the method prescribed by SFAS No. 123 has not been applied to
          options granted prior to September 30, 1995, the resulting pro forma
          compensation cost may not be representative of that to be expected in
          future years.

     (b)  Employee Stock Ownership Plan

          The Company has an Employee Stock Ownership Plan (ESOP) for
          substantially all employees. Contributions to the ESOP are made at the
          discretion of the Board of Directors (the Board), provided that the
          total amount contributed for any ESOP year does not exceed the maximum
          amount allowable by the Internal Revenue Code. Amounts allocated to a
          participant's account vest ratably over five years based on years of
          completed service, as defined. The accompanying consolidated
          statements of income for the years ended September 30, 1998, 1997 and
          1996 include provisions for contributions to the ESOP of approximately
          $41, $71, and $51, respectively.

     (c)  401(k) Retirement Plan

          The Company maintains a 401(k) retirement plan covering all eligible
          employees, as defined. Contributions to the plan are made at the
          discretion of the Board in an amount determined by the Board. These
          contributions vest to a participant's account ratably over five years
          based on years of completed service, as defined. Additionally, each
          participant may elect to contribute up to 20% of his or her
          compensation for the plan year, but not more than $10,000 (for
          calendar 1998), to the plan. The accompanying consolidated statements
          of income for the years ended September 30, 1998, 1997 and 1996
          include provisions for contributions to the plan of approximately $41,
          $210, and $153, respectively.

                                      F-14
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


     (d)  Supplemental Executive Retirement Plan

          The Company has a Supplemental Executive Retirement Plan (SERP) for
          the benefit of certain management and highly compensated executive
          employees. Under the SERP, participants may elect to defer a portion
          of their compensation paid by the Company for supplemental retirement
          benefits. The Company also established the Supplemental Executive
          Retirement Trust (the Trust Fund) and shall regularly transfer to the
          Trust Fund amounts equal to the elective deferrals made by
          participants under the SERP. No such elective deferrals have been made
          by participants as of September 30, 1998.

(8)  EARNINGS PER SHARE

     Basic earnings per share were computed by dividing net income by the
     weighted average number of common shares outstanding during the period.
     Diluted earnings per share were computed by dividing net income by diluted
     weighted average number of common and common equivalent shares outstanding
     during the period. The weighted average number of common equivalent shares
     outstanding has been determined in accordance with the treasury-stock
     method. Common stock equivalents consist of common stock issuable upon the
     exercise of outstanding options.

     A reconciliation of basic and diluted shares outstanding is as follows:

<TABLE>
<CAPTION>
                                                       1998            1997            1996
<S>                                                <C>             <C>             <C>
        Weighted average common shares            
          outstanding                               1,314,323       1,225,722       1,190,529 
 
        Effect of dilutive securities                  72,807         144,653         116,393
                                                    ---------       ---------       ---------
        Weighted average common shares              
          outstanding, assuming dilution            1,387,130       1,370,375       1,306,922
                                                    =========       =========       ========= 
</TABLE> 
                                        
     As of September 30, 1998, 91,500 options were outstanding but not included
     in the diluted weighted average common share calculation as the effect
     would have been antidilutive. As of September 30, 1997 and 1996, there were
     no antidilutive shares.

(9)  EXPORT SALES INFORMATION

     Export sales, primarily to Europe and Asia, were approximately $6,384,
     $6,976, and $6,082 in 1998, 1997 and 1996, respectively.

                                      F-15
<PAGE>
 
                          BENTHOS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                  (Continued)


(10) EMPLOYMENT AND NONCOMPETITION AGREEMENT

     The Company has an employment and noncompetition agreement, as amended,
     with a director/stockholder. In connection with the employment agreement,
     the Company has agreed to provide a $1,500 split-dollar life insurance
     policy on the director/stockholder. At the director/stockholder's request,
     the Company may be obligated to repurchase from the director/stockholder
     the number of shares that are contributed to or purchased by the Company's
     ESOP each year. The Company also has the right of first refusal on any
     future sales of common stock by the director/stockholder at fair market
     value. In addition, a change in the control of the Company, as defined,
     will result in certain payments to the director/stockholder, as outlined
     under the employment agreement.

     Compensation expense of approximately $85, $93, and $119 related to this
     agreement is included in the accompanying 1998, 1997 and 1996 consolidated
     statements of income, respectively.

(11) INDUSTRY SEGMENT INFORMATION

     The Company operates in two industry segments--undersea systems and
     container inspection systems. Information with respect to industry segments
     are set forth as follows:

<TABLE>
<CAPTION>
                                                                  YEARS ENDED SEPTEMBER 30,
                                                            1998            1997            1996
<S>                                                      <C>             <C>             <C>
      Sales to unaffiliated customers--
        Undersea systems                                  $ 9,290         $ 9,591         $ 5,312
        Container inspection systems                        4,748           6,823           5,831
                                                          -------         -------         -------
       Total                                              $14,038         $16,414         $11,143
                                                          =======         =======         =======
      Income from operations--
        Undersea systems                                  $   761         $ 1,355         $    88
        Container inspection systems                          135           1,210           1,845
                                                          -------         -------         -------
      Total                                               $   896         $ 2,565         $ 1,933
                                                          =======         =======         =======
      Identifiable assets--
        Undersea systems                                  $ 4,843         $ 3,555         $ 4,216
        Container inspection systems                        2,074           2,639           2,723
        Corporate assets                                    3,715           3,882           1,675
                                                          -------         -------         -------
      Total                                               $10,632         $10,076         $ 8,614
                                                          =======         =======         =======
</TABLE>

(12) RELATED PARTY

     The Company had research and development services performed by an entity
     controlled by the Company's Chairman of the Board. The Company expensed
     approximately $21 and $314 for these services in fiscal 1998 and 1997,
     respectively.

                                      F-16
<PAGE>
 

             REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE



To Benthos, Inc.:

We have audited, in accordance with generally accepted auditing standards, the
consolidated financial statements of Benthos, Inc. and subsidiary included in
this Form 10-KSB and have issued our report thereon dated October 26, 1998.  Our
audit was made for the purpose of forming an opinion on the basic consolidated
financial statements taken as a whole.  The  schedule listed in Item 14(a) is
the responsibility of the Company's management and is presented for purposes of
complying with the Securities and Exchange Commission's rules and is not part of
the basic consolidated financial statements.  This schedule has been subjected
to the auditing procedures applied in the audit of the basic consolidated
financial statements and, in our opinion, fairly states, in all material
respects, the financial data required to be set forth therein, in relation to
the basic consolidated financial statements taken as a whole.



                                                        ARTHUR ANDERSEN LLP



Boston, Massachusetts
October 26, 1998

<PAGE>
                                  SCHEDULE II
 
                          BENTHOS, INC. AND SUBSIDIARY

                       VALUATION AND QUALIFYING ACCOUNTS
                          ACCOUNTS RECEIVABLE, RESERVE

<TABLE>
<CAPTION>
                                     BALANCE,                                                BALANCE,
                                    BEGINNING      CHARGED TO COSTS                           END OF
                                    OF PERIOD        AND EXPENSES        DEDUCTIONS           PERIOD
                                    
                                    
For the Year Ended September 30,    
<S>                                 <C>            <C>                   <C>                 <C>
  1996                                 $ 71               $56              $  -                $127
  1997                                  127                56                21                 162
  1998                                  162                13                 -                 175
</TABLE>


<PAGE>
 
                                 BENTHOS, INC.

                                 EXHIBIT INDEX
 
          Exhibit
 
           3.1      Restated Articles of Organization (1)

           3.2      Articles of Amendment dated April 28, 1997 (2)

           3.3      Articles of Amendment dated April 20, 1998 (5)

           3.4      By-Laws (1)

           3.5      By-Law Amendments adopted January 23, 1998 (4)

           4.1      Common Stock Certificate (1)

          10.1      Employment Contract with Samuel O. Raymond (1)

          10.2      Amendment to Employment Contract with Samuel O. Raymond (2)

          10.3      Employment Contract with John L. Coughlin (1)

          10.4      Employee Stock Ownership Plan (1)

          10.5      First Amendment to Employee Stock Ownership Plan (2)

          10.6      401(k) Retirement Plan (1)

          10.7      First Amendment to 401(k) Retirement Plan (2)

          10.8      Second Amendment to 401(k) Retirement Plan (2)

          10.9      Third Amendment to 401(k) Retirement Plan (3)

          10.10     Supplemental Executive Retirement Plan (1)

          10.11     1990 Stock Option Plan (1)

          10.12     Stock Option Plan for Non-Employee Directors (1)

          10.13     1998 Non-Employee Directors' Stock Option Plan (4)

          10.14     License Agreement between the Company and The Penn State
                    Research Foundation dated December 13, 1993 (1)

          10.15     Technical Consultancy Agreement between the Company and
                    William D. McElroy dated July 12, 1994 (1)

          10.16     Technical Consultancy Agreement between the Company and
                    William D. McElroy dated October 1, 1996 (3)
<PAGE>
 
          Exhibit

          10.17     General Release and Settlement Agreement between the Company
                    and Lawrence W. Gray dated February 8, 1996 (1)

          10.18     Line of Credit Loan Agreement between the Company and Cape
                    Cod Bank and Trust Company dated September 24, 1990, as
                    amended (1)

          10.19     Commercial Mortgage Loan Extension and Modification
                    Agreement between the Company and Cape Cod Bank and Trust
                    Company, dated July 6, 1994 (1)

          10.20     License Agreement between the Company and Optikos
                    Corporation dated July 29, 1997 (3)

          21        Subsidiaries of the Registrant (1)

          23        Consent of Arthur Andersen LLP

          27        Financial Data Schedule

          27.1      Restated Financial Data Schedule (1997)

          27.2      Restated Financial Data Schedule (1996)


          (1) Previously filed as an exhibit to Registrant's Registration
     Statement on Form 10-SB filed with the Commission on December 17, 1996
     (File No. O-29024) and incorporated herein by this reference.

          (2) Previously filed as an exhibit to Registrant's Quarterly Report on
     Form 10-QSB for the quarterly period ended March 30, 1997 (File No. 
     O-29024) and incorporated herein by this reference.

          (3) Previously filed as an exhibit to Registrant's Quarterly Report on
     Form 10-QSB for the quarterly period ended June 29, 1997 (File No. O-29024)
     and incorporated herein by this reference.

          (4) Previously filed as an exhibit to the Registrant's Quarterly
     Report on Form 10-QSB for the quarterly period ended December 31, 1997
     (File No. O-29024) and incorporated herein by this reference.

          (5) Previously filed as an exhibit to the Registrant's Quarterly
     Report on Form 10-QSB for the quarterly period ended March 31, 1998 (File
     No. 0-29024) and incorporated herein by this reference.