SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                   FORM 10-KSB
(Mark One)

     |X|  ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
          OF 1934

                  For the fiscal year ended: December 31, 1997

     |_|  TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
          ACT OF 1934

         For the transition period _____________from to _______________

                         Commission File Number: 0-13092

                              SpectraSCIENCE, Inc.
                 (Name of small business issuer in its charter)


             Minnesota                                    41-1448837
      (State of incorporation)                         (I.R.S. Employer
                                                      Identification No.)


  3650 Annapolis Lane, Suite 101,
      Minneapolis, Minnesota                              55447-5434
       (Address of principal                              (Zip Code)
        executive offices)

                    Issuer's telephone number: (612) 509-9999

         Securities registered under Section 12(b) of the Exchange Act:
                                      None

         Securities registered under Section 12(g) of the Exchange Act:
                          Common Stock, $.25 Par Value
                                (Title of Class)


                                   ----------

Check  whether the issuer (1) filed all reports  required to be filed by Section
13 or 15(d) of the  Exchange  Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports),  and (2) has been
subject to such filing requirements for the past 90 days. YES |X| NO |_|

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. |_|

Issuer's revenues for its fiscal year ended December 31, 1997 were:  $0

As of March 26,  1998,  the  number of  outstanding  shares of the  Registrant's
Common Stock,  par value $.25 per share,  was  4,624,338.  The aggregate  market
value  of  the  voting  stock  held  by  non-affiliates  of the  registrant  was
approximately  $28,902,113  based on the last reported closing price of $6.25 on
March 26, 1998.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions  of the  definitive  Proxy  Statement  for its 1998  Annual  Meeting of
Shareholders to be filed with the Securities and Exchange Commission on or prior
to April 20,  1998,  are  incorporated  herein  by  reference  in Part  III,  as
specified.

Transitional Small Business Disclosure Format (Check one): Yes |_| No |X|


<PAGE>



                              SpectraSCIENCE, Inc.

                                   FORM 10-KSB

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

                                Table of Contents

                                                                           Page
                                                                           ----

PART I                                                                       3

Item 1.   DESCRIPTION OF BUSINESS                                            3

Item 2.   DESCRIPTION OF PROPERTY.                                          10

Item 3.   LEGAL PROCEEDINGS.                                                10

Item 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.              10


PART II                                                                     10

Item 5.   MARKET FOR COMMON EQUITY AND
          RELATED SHAREHOLDER MATTERS.                                      10

Item 6.   MANAGEMENT'S DISCUSSION AND ANALYSIS
          OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.                 12

Item 7.   FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA                        15

Item 8.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
          ON ACCOUNTING AND FINANCIAL DISCLOSURE.                           15


PART III                                                                    16

Item 9.   DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND
          CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a)
          OF THE EXCHANGE ACT.                                              16

Item 10.  EXECUTIVE COMPENSATION.                                           16

Item 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
          AND MANAGEMENT.                                                   16

Item 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.                   16

Item 13.  EXHIBITS, FINANCIAL STATEMENTS, AND REPORTS ON FORM 8-K.          16

SIGNATURES                                                                  19



                                     Page 2
<PAGE>

                              SpectraSCIENCE, Inc.

                                   FORM 10-KSB

                   For the fiscal year ended December 31, 1997

--------------------------------------------------------------------------------
This Annual Report on Form 10-KSB contains  "forward-looking  statements" within
the meaning of the Private  Securities  Litigation  Reform Act of 1995. Words or
phrases such as "may," "expects," "will continue," "is anticipated," "management
believes," "estimate," "projects," "hope" or expressions of a similar nature are
intended to identify  forward-looking  statements within the meaning of the Act.
The  Company  wishes  to  caution   readers  not  to  place  undue  reliance  on
forward-looking  statements.  Please  refer  to  Exhibit  99  of  the  Company's
Quarterly Report on Form 10-QSB for the quarter ended June 30, 1996, for certain
important cautionary factors, risks and uncertainties related to forward-looking
statements.
--------------------------------------------------------------------------------

                                     PART I

Item 1.  DESCRIPTION OF BUSINESS

(a)  Business Development

General

     SpectraSCIENCE,   Inc.  (the   "Company"  or   "SpectraSCIENCE")   develops
innovative,  minimally-invasive  medical  delivery  systems  to  facilitate  the
diagnosis and treatment of a broad range of human diseases by utilizing advanced
spectroscopy, fiber optics, computer hardware and software.

     The Company was incorporated in the state of Minnesota on May 4, 1983 as GV
Medical,  Inc. The Company changed its name to  SpectraSCIENCE,  Inc. on October
16, 1992 and the name change was approved by the Company's  shareholders  on May
13, 1993.

     The  Company's  common  stock,  par value $.25 per share,  is traded on the
NASDAQ Small-Cap Market under the symbol SPSI.

     The Company's  corporate  offices are located at 3650 Annapolis Lane, Suite
101,  Minneapolis,  Minnesota  55447-5434.  The  Company's  telephone  number is
612/509-9999,  its fax  number  is  612/509-9805,  and  its  e-mail  address  is
spsi@spectrascience.com.  The Company also has a web-site  which can be accessed
at http://www.spectrascience.com.

(b)  Business of the Company

     From 1983 until 1992, the Company pursued the development,  manufacture and
sale of laser-enhanced  angioplasty  catheter systems for the treatment of heart
and blood vessel disease by focusing on its LASTAC(R) system,  and subsequently,
the Laser Angiosurgery  System, in conjunction with the Massachusetts  Institute
of Technology and the Cleveland Clinic  Foundation.  Since 1992, the Company has
re-focused   its   development   efforts  on   diagnostic   products   utilizing
spectroscopic  techniques and changed its name to SpectraSCIENCE,  Inc. in 1992.
Two products based on  spectroscopic  techniques and technology  currently under
development   are  the   Optical   Biopsy(TM)   System  and  the   Spectroscopic
Guidewire(TM) System, which are described below.


Products and Markets

Optical Biopsy(TM) System

     The Optical  Biopsy(TM) System ("OBS") is composed of three  components:  a
spectro-photometric  console ("OBS Console"),  a biopsy forceps incorporating an
optical probe ("Optical  Biopsy  Forceps" or "Forceps") and  proprietary  tissue
recognition  algorithm software  ("Software").  The Forceps can be disposable or
reusable.  The reusable  Forceps  incorporates a disposable  optical probe.  The
Company  has  obtained  510(k)  clearance  from the United  States Food and Drug
Administration ("FDA") for the disposable Biopsy Forceps on December 2, 1996 and
the reusable  Biopsy Forceps on December 2, 1997 (see  Governmental  Regulations
below).


                                     Page 3
<PAGE>

     The OBS is currently targeted for use in the detection and  differentiation
of  cancerous,  pre-cancerous  and  healthy  tissues.  The  Company  intends  to
initially  focus  on  the  detection  and   differentiation  of  cancer  in  the
gastrointestinal tract using minimally-invasive endoscopic techniques.

     There  are  approximately  165,000  new  cases of  gastrointestinal  cancer
detected  annually,  of which an  estimated  131,200 are cancer of the colon and
rectum.  Colorectal  cancer is one of the most frequent cancer  diagnoses in the
United  States  and it is the  number two  contributor  to cancer  deaths in the
United States,  with an estimated  54,900 deaths per year (1997  estimate).  The
largest  cause of cancer  deaths in the United  States is lung  cancer,  with an
estimated 160,400 deaths in 1997.

     The current method of detection of colorectal  cancer is through  biopsies,
which  entails the  insertion of an endoscope  with a biopsy  forceps to harvest
tissue samples for analysis in the pathology laboratory.  The waiting period for
obtaining  biopsy  results  can be as long as two weeks.  The OBS,  on the other
hand,  could offer  immediate  feedback to the physician,  thereby  reducing the
number and cost of biopsies,  eliminating  waiting time and  preventing the need
for an additional  endoscopy.  In the United States,  it is estimated that about
7.5  million  colon  endoscopies  and three  million  in upper  gastrointestinal
endoscopies are currently performed each year. These procedures are growing at a
rate of approximately  15-20% per year. Outside of the United States, the number
of colon  endoscopies  currently  performed is estimated to be about 14 million,
and is also growing at a rate of approximately 15-20% per year.

     The Company  believes that once  commercialized,  the OBS could be expanded
into other medical applications, including the detection of cancer in the lungs,
urinary tract, bladder, prostate, cervix and other minimally-invasive endoscopic
and laparascopic  applications.  These medical  applications  could  potentially
represent large market opportunities for the Company.  However,  there can be no
assurance  that  the OBS will be  commercialized  or that  the  Company  will be
successful in adapting the OBS for other medical specialties.

Spectroscopic Guidewire(TM) System

     Like  the OBS,  the  Spectroscopic  Guidewire(TM)  System  ("SGS")  is also
composed of three components:  the spectrophotometric console ("SGS Console"), a
disposable  optical core spectroscopic  guidewire  ("Guidewire") and proprietary
tissue recognition algorithm software ("Software"). The SGS Console is virtually
identical to the OBS Console.  The Guidewire  functions both  mechanically  as a
conventional coronary guidewire and optically in the transmission and collection
of light energy when connected to the SGS Console.

     The SGS is  targeted  for the  detection  of  intra-coronary  thrombus  and
differentiation  of  atherosclerotic   plaque,   hospitals  with  cardiovascular
programs, both in the United States and overseas, are the primary market for the
SGS. Currently there are different methods to treat blockages of the arteries of
the  heart,  including  surgery,  drugs and  angioplasty.  There  are  different
modalities  of  angioplasty,   including  balloon  angioplasty  or  percutaneous
transluminal coronary angioplasty ("PTCA"),  laser angioplasty,  and atherectomy
using shaving or drilling devices.

     The market size for all PTCA procedures  worldwide is estimated to be about
1.1  million  procedures,  or $1.5  billion.  Slightly  more  than half of these
procedures  are  performed at about 1,000 centers in the United  States,  200 of
which perform about 65% of the total procedures in the United States. The number
of PTCA  procedures is growing rapidly with the  introduction of  intra-coronary
stents   that  have  been  found  to  reduce  the  rate  of   restenosis   (i.e.
re-establishment of blockage) in PTCA procedures.

     Due to the current competitive  environment and cost containment  measures,
reimbursement for angioplasty  procedures are capped.  In addition,  in the last
two years, stents have  revolutionized the entire angioplasty  procedure once it
was shown that the use of a stent improves the restenosis  rate. As such,  other
modalities  and  new  procedures,   including   atherectomy  and  intra-vascular
ultra-sound,  have rapidly  decreased in  popularity.  This trend has  obviously
affected the Company's strategy of positioning the SGS as a diagnostic  modality
to assist in PTCA procedures.

Distribution, Marketing and Customers

     The Company is  currently  engaged in ongoing  discussions  with  potential
strategic  partners with strong market niches which are dominant  players in the
United states and/or internationally in the field of gastrointestinal  medicine.
The Company believes that such strategic partners will be able to leverage their


                                     Page 4
<PAGE>


dominance in their respective niches with the Company's products, especially the
Optical  Biopsy(TM) System. The Company is also evaluating options to market and
distribute the Optical Biopsy System directly to managed-care organizations. The
Company  intends to build a small  in-house  marketing and business  development
department  to  assist  in  the  commercialization  of  the  Company's  products
worldwide  and  to  provide  clinical  education  to  physicians,   nurses,  and
laboratory technicians.

     While the Company signed a three-year exclusive international  distribution
agreement with SCIMED Life Systems, Inc. ("SCIMED"),  a wholly-owned  subsidiary
of Boston  Scientific  Corporation  (Natick,  Massachusetts)  in August  1994 to
distribute the SGS for  cardiovascular  applications in  international  markets,
sales  through  SCIMED were very modest at the  beginning of the  agreement  and
failed to meet expectations. The SCIMED agreement expired in 1997.

     On August 14, 1995, the Company received the European Community Certificate
of Conformity,  which allows the Company to put the Conformite  Europeane ("CE")
mark  on  the  Console,   indicating   that  it  was  in  compliance   with  the
electromagnetic  compatibility (EMC) standard EN 60601-1-2(1993).  However,  the
products  will have to be  re-certified  with the CE mark under the new  Medical
Device Directive of the European Union (see Government  Regulations  below).  In
order to receive a CE mark of the entire system,  ISO 9001 Certification must be
accomplished.  Under the new Medical Device Directive, products must be approved
with the CE mark before it can be  distributed  or sold in the  countries of the
European Union.

Competition

Spectroscopy

     While the use of  spectroscopy  for  scientific  research  is  common,  the
Company believes it is one of the pioneers in utilizing  spectroscopy for cancer
detection.  Several prominent  universities and medical  institutions have basic
research projects  involving  "in-vivo"  spectroscopic  diagnostics.  There is a
growing  interest in the  application  of  spectroscopic  diagnostics  for other
medical specialties, though few products have been commercialized.

     Xillix  Technologies  (Richmond,   British  Columbia,   Canada),   obtained
marketing clearance from the United States Food and Drug Administration  ("FDA")
for its LIFE-Lung fluorescence system that utilizes light-based spectroscopy for
the detection and localization of lung cancer.  Xillix is currently developing a
system for  detection of  gastrointestinal  cancers of the  esophagus,  stomach,
intestines  and  colon.  However,  its  system is large  and cost  approximately
$200,000  per system.  Xillix has a strategic  alliance  with  Olympus  (Japan).
Olympus  supplies  endoscopic  equipment to  endoscopists  throughout the world,
having an estimated 70% of the market. The second largest  endoscopic  equipment
supplier to endoscopists is Pentax (Japan) with about 25% of the market.

     Mediscience  Technology  (Cherry Hill,  New Jersey) is evaluating a product
called CD Scan which uses  scanning  fluorescence  technology  for  noninvasive,
early cancer detection. The device optically scans the surface of suspect tissue
with a fiberoptic probe. The resulting fluorescence spectrum is then compared to
a similar scan of healthy tissue. Currently,  Mediscience is focused on clinical
studies on oral leukopakia,  a precancerous condition of the mouth, and possibly
on precancerous gastrointestinal conditions.

     Lifespex  (Kirkland,  Washington) is a development  stage company utilizing
spectroscopic diagnostic techniques for the identification of cancerous tissues.

     Medispectra  (Cambridge,  Massachusetts)  is evaluating  an optical  biopsy
system  to detect a  variety  of  potentially  cancerous  conditions,  including
cervical  abnormalities,  precancerous bladder lesions, and suspicious polyps in
the colon.

Biopsy Forceps

     For standard (non-light transmitting) biopsy forceps, the market is divided
into disposable and reusable segments.  In the disposable segment,  representing
30% of the market,  the leader is Microvasive  (a division of Boston  Scientific
Corporation,  Natick,  Massachusetts)  which  has  70%  of the  market  segment,
followed by CR Bard (Murray Hill,  New Jersey) and  Wilson-Cook  (Winston-Salem,
North Carolina).  In the re-usable segment,  representing 75% of the market, the
leader is Olympus,  followed by Wilson-Cook  and CR


                                     Page 5
<PAGE>


Bard. Until recently,  the market was moving towards reusables but now is moving
back towards  disposables  again because of the fear of  transmission of HIV and
Hepatitis C virus and the lowering of disposable costs.








                                     Page 6
<PAGE>


Cardiovascular Applications

     In cardiovascular applications, the Company has no direct competitors using
spectroscopy for the detection and diagnosis of  atherosclerotic  plaque.  While
there are no similar  products,  the  competing  technologies  presently  in the
cardiovascular  market  are  intra-vascular   ultrasound  imaging  ("IVUS")  and
angioscopy. Companies currently marketing products utilizing IVUS technology are
Cardiovascular  Imaging  Systems/CVIS  (Sunnyvale,  California),  a wholly-owned
subsidiary of Boston Scientific Corporation, Endosonics (Pleasanton, California)
and Hewlett-Packard (Milpitas,  California).  Companies marketing products based
on  angioscopy  technology  are  Baxter-Edwards  (Irvine,  California),  Olympus
(Japan) and A.D. Krauth (Germany).

     Many of these competitors are better capitalized and have greater access to
financial, technical and other resources than the Company.

Manufacturing and Sources of Supply

     Currently, the basic assembly of the OBS Console is completed in-house. The
SGS Console was  assembled by an outside  contractor.  The Software is developed
in-house in conjunction with outside consultants.  The Guidewire and Forceps are
produced by other contract manufacturers that are experienced and specialized in
the manufacture of medical guidewires or forceps. The Company then assembles the
components, many of which are available "off-the-shelf",  inspects and tests the
completed systems at the Company's facilities.

     There  are  risks  involved  in  having  sole  sources  of  supply  for the
manufacturing  of the  Guidewire  and Forceps.  While the  performance  of these
manufacturers  has  been  satisfactory   to-date,  with  the  exception  of  one
manufacturer of Guidewires in the past, there can be no assurance that they will
continue to perform up to the Company's standards,  meet government  regulations
and handle labor unrest, if any. Any shortfalls in the ability of these contract
manufacturers  to meet  standards  and  regulations  could  severely  impact the
Company's ability to test and sell its products.

     The Company  purchases  many  components  from various  suppliers  that are
either   standard   components  or  are  built  to  the  Company's   proprietary
specifications. In addition, the Company contracts with third parties to perform
certain manufacturing processes.  Most of the purchased components and processes
are  available  from more than one  vendor.  The  process  of  qualification  of
additional  or  replacement  vendors  for  certain  components  or services is a
time-consuming  process,  especially  in the heavily  regulated  medical  device
industry,  and any supply  interruption  would have a material adverse effect on
the Company's business, financial condition and results of operations.

Patents

     The Company was issued a patent by the United  States  Patent and Trademark
Office on  February  11,  1997  entitled  "System  for  Diagnosing  Tissue  with
Guidewire" (Patent No. 5,601,087). The Company was also issued a European Patent
entitled  "Apparatus  for  Diagnostic  Imaging"  (European  Patent No.  0669820)
covering  eleven  countries on April 16,  1997.  The Company was informed by the
United States Patent and Trademark Office on November 25, 1997 that claims under
its patent  application  entitled  "Optical  Biopsy  Forceps"  (Application  No.
08/644,080) are allowed.  This patent is expected to be issued sometime in 1998.
The Company was issued two new  patents in the United  States in 1995,  entitled
"Guidewire Catheter and Apparatus for Diagnostic Imaging" (Patent No. 5,383,467)
and "Method of Diagnosing Tissue with Guidewire" (Patent No.  5,439,000).  These
patents augment the Company's current intellectual property portfolio.

     The Company  expects to file  additional  patent  applications in 1998. Two
additional  patents were filed in March 1998. As of March, 1998, there were five
patents pending in the United States, and two patents pending in various foreign
countries.  There can be no  assurance  whether any  additional  patents will be
filed or issued,  or if issued,  that such  patents  will afford the Company any
competitive advantage.

     In  addition  to the above,  the Company  also has an  exclusive  licensing
agreement  with  Massachusetts  Institute of Technology  for  thirty-one  issued
patents and pending  applications,  relative to the use of spectroscopy  for the
diagnosis of atherosclerotic  cardiovascular  disease.  This licensing agreement
runs  for the  life of the  patents  and  includes  technology  developed  under
National Institute of Health funding.


                                     Page 7
<PAGE>


     The Company also has a licensing arrangement with the Massachusetts General
Hospital's  Wellman  Laboratories of Photomedicine  ("Wellman Lab"). Any patents
that result from the Wellman Lab's research on cancer detection will be licensed
exclusively to the Company.

     The Company  believes  its  patents,  in  addition to the patents  that the
Company has  licensed,  will continue to strengthen  its  intellectual  property
position while assisting the Company's present and future research,  development
and marketing efforts.

Industry Economics

     In the United  States,  the market for the Company's  products is primarily
medical  institutions.  The health care  services such  institutions  provide to
their  patients  are  paid by  various  third-party  payers,  such as  Medicare,
Medicaid,  other government  programs and private insurance plans.  Medicare and
Medicaid determine whether a particular  procedure should be covered.  Hospitals
are  reimbursed  for medical  procedures at a fixed rate  according to Diagnosis
Related Groups ("DRGs") established by the Health Care Financing  Administration
("HCFA"), a federal government body. The fixed rate of reimbursement is based on
the procedure  performed and is typically unrelated to the specific devices used
in that  procedure.  If a  procedure  is not  covered by a DRG,  payers may deny
reimbursement. In addition, payers may deny reimbursement if they determine that
the device used in a treatment  was  unnecessary,  inappropriate,  experimental,
used for a non-approved indication, or not cost-effective.

     Currently,  there are no established DRGs covering spectroscopic diagnostic
procedures for either cancer detection or cardiovascular applications.  As such,
reimbursement  for procedures  using the Company's  products is not available at
this point.  However,  DRG  reimbursement  for  endoscopic  procedures,  such as
flexible  sigmoidoscopy,  colonoscopy and polypectomy,  are already established,
including fees for biopsies.  Since the OBS should provide  clinical utility and
reduces  cost and time,  the  Company  anticipates  that once FDA  clearance  is
obtained,  reimbursement  for procedures  utilizing the OBS would  eventually be
available.  However,  there can be no  certainty  that  this will  happen in the
future or within a time-frame that would benefit the Company.

     Although  reimbursement  for PTCA  procedures  is covered  under a DRG, the
amount of reimbursement is fixed.  Therefore,  the profit relating to the entire
PTCA procedure would be reduced to the extent the physician performs  additional
procedures  such as  spectroscopic  diagnostics.  Nevertheless,  the  additional
information  provided  by the SGS may help  physicians  select  the  appropriate
treatment method,  potentially reducing the number of therapeutic catheters used
during  a  PTCA  procedure   which  would  produce  a  more  effective   result.
Accordingly,  physicians  must determine  that the clinical  benefits of the SGS
justify the additional cost.

     Governmental  prospective   reimbursement  programs,  which  provide  fixed
reimbursement  based  on DRGs,  provide  economic  incentives  for  health  care
institutions  to reduce  operating costs by being more efficient and productive.
For every  illness to be treated or procedure to be  performed,  only an average
rate will be reimbursed. Therefore, the more cases that can be treated below the
designated rate with less major surgery and shorter  hospital stays,  the higher
the level of profitability.

     Capital costs for medical  equipment  purchased by hospitals are reimbursed
separately from DRG payments.  Therefore,  the market for the Company's products
could be adversely  affected by changes in governmental and private  third-party
payers' policies or by federal legislation that reduces reimbursements under the
capital cost pass through systems for capital equipment.

     The  funding for  Medicare  and  Medicaid is also  subject to limits set by
Congress.  In 1997  Congress  approved  an  increase  in funding to HCFA of $2.2
billion over five years for preventive  colorectal  cancer  screening tests. The
Company  believes  such funding  could lead to greater  awareness of the disease
among the general populace,  larger budgets for screening,  higher reimbursement
levels and  potentially the  establishment  of new  reimbursement  codes for new
technologies like the Optical Biopsy(TM) System.

     This does not mean that cost is not an issue in the healthcare  market.  On
the contrary, cost reduction, cost containment, managed care, capitation pricing
(i.e. fixed price per procedure,  rather than the number of disposable  products
or hospital  supplies used),  and  consignment  sales are becoming more and more
common,  not only in the United States but also in many  European  countries and
Japan.  Limits on third-party


                                     Page 8
<PAGE>


reimbursements   leading  to  cuts  in  reimbursements  for  new  procedures  or
experimental  procedures is becoming a reality. This would affect the ability of
smaller companies with new technologies,  like  SpectraSCIENCE,  to compete with
larger  established  firms.  The emphasis on cost containment and cost reduction
has led to an  increase  in  participants  in  managed  care  environments  when
companies  seek to reduce  their  cost of  providing  health  care  benefits  to
employees.

     With the strong emphasis on cost  containment,  many vendors have merged or
acquired  other  suppliers in order to achieve  economies of scale and to be the
dominant  vendors  for a range  of  products  which  would  lend  themselves  to
"bundling" of products or product lines together and be price competitive.

     The FDA continues to place a heavy emphasis on economic utility in addition
to being a watchdog for clinical utility and safety of products,  in considering
approvals of medical devices.  Companies will need to prove economic  advantages
up-front, which places a greater burden on companies,  especially if they are in
the start-up or development stages. This could potentially lead to less advances
in innovative technologies.  Also, it is very unlikely for HCFA to approve a new
technology unless it receives prior clearance from the FDA.

     Internationally,   similar   trends   of   cost   containment   and   lower
reimbursements  are also becoming very apparent.  In addition,  the countries of
the European Union have established other protectionist  barriers such as import
tariffs,  duties and taxes,  and  additional  regulations  such as requiring ISO
certification  and CE marking before products can be sold in the European Union.
Such regulations and requirements  could impact the Company's ability to compete
and enter those foreign markets.

Government Regulations

     The  Company's  development,  manufacturing  and marketing  activities  are
subject to regulation by numerous governmental  authorities in the United States
and other countries, particularly regarding product safety and effectiveness.

     In the United States,  medical  devices are subject to review and clearance
by the Food and Drug Administration ("FDA"). The Food, Drug and Cosmetic Act, as
amended,  the Public  Health  Service Act, the Safe Medical  Devices Act of 1990
(the "SMDA") and other federal statutes and regulations, govern or influence the
testing,  manufacture,  safety,  labeling,  storage, record keeping,  clearance,
advertising and promotion of such products.

     FDA  clearance  to  distribute  a new device can be  obtained in one of two
ways.  If a new device is  "substantially  equivalent"  to an  existing  legally
marketed  device,  the new device can be commercially  introduced after filing a
510(k) pre-market  notification with the FDA and the subsequent  issuance by the
FDA of an order permitting commercial distribution.  Changes to existing devices
that do not significantly  affect safety or effectiveness may be made without an
additional 510(k) notification.

     A second, more comprehensive  approval process applies to a new device that
is not  substantially  equivalent to an existing  product.  First, the applicant
must conduct  non-significant  risk clinical  trials in compliance  with testing
protocols   approved  by  the   Institutional   Review  Board  ("IRB")  for  the
participating research institution. The IRB is an internal board in each medical
institution  that  oversees  and  approves  all  clinical  studies.   Second,  a
pre-market  approval  ("PMA")  application  must be  submitted  to the FDA  that
describes the results of the clinical trials, the device and its components, the
methods, facilities and controls used for its manufacture, proposed labeling and
the  demonstration  that  the  product  is  safe  and  effective.  Finally,  the
manufacturing  site  for  the  product  subject  to the  PMA  must  pass  an FDA
pre-approval inspection.

     In  1997,the  FDA  approved  a  significant  number of PMA  medical  device
applications  within 180 days of submission  filing date.  However,  there is no
assurance if or when a PMA application would be approved. Furthermore, there can
be no assurance that FDA clearance for these products,  any future products,  or
any modification of an existing product will be granted, or the process will not
be unduly lengthy.

     In connection with either a 510(k)  notification or a PMA, clinical testing
of a "significant  risk" device  requires the  submission of an  investigational
device  exemption  ("IDE")  application  to the FDA. An IDE  application  is not
required for a  "non-significant  risk" ("NSR") device.  The Optical  Biopsy(TM)
System  ("OBS") is considered  an NSR device.  While an IDE  application  is not
required in this case, the FDA, in its discretion, may still require the Company
to submit an IDE application. In such an event, the Company may


                                     Page 9
<PAGE>


be required to repeat all or part of the  clinical  testing  conducted  prior to
obtaining an IDE, which may delay approval of the OBS.

     As  a  medical  device  manufacturer,   the  Company  and/or  its  contract
manufacturers  are  required  to  register  with the FDA and submit to  periodic
inspections for compliance with the FDA's Good Manufacturing  Practices ("GMP"),
Quality Systems  regulations and various FDA  requirements  for labeling.  These
regulations  require the Company to  manufacture  its  products and maintain its
documents  for  manufacturing,  testing and control  activities  in a prescribed
manner.  Failure to comply with these  requirements  could adversely  affect the
results  of  operations,  as  well  as  the  Company's  business  and  financial
condition.

     The Company  believes  that it complies in all material  respects with such
applicable regulations.  However, failure to comply could subject the Company to
fines and other enforcement actions.

     The Company is also subject to other federal,  state and local  regulations
regarding  environmental  protection and hazardous substance controls.  To-date,
the costs or effects of compliance with federal,  state and local  environmental
laws are routine and customary for a developing medical device company.

Clinical Studies

     The Company is conducting ongoing  multi-center  clinical studies using the
Optical  BiopsyTM  System for  detection of  colorectal  cancer at three medical
centers:  the Mayo Clinic in Rochester,  Minnesota,  the  Massachusetts  General
Hospital  in Boston,  Massachusetts,  the  Hennepin  County  Medical  Center and
Minnesota  Gastroenterology  PA,  both of  which  are  located  in  Minneapolis,
Minnesota.  As of January 20,  1998,  clinical  data on a  sufficient  number of
patients has been obtained to support a PMA  application to the FDA. The Company
expects to file a PMA application with the FDA in fiscal 1998.

     In addition, a multi-center  clinical trial for the detection of esophageal
cancer has also  commenced  at the Mayo Clinic and the Hennepin  County  Medical
Center.

     Internationally,  the  European  Union (the "EU") has adopted a new Medical
Device Directive, which will be implemented beginning July 1998 in all countries
of the  European  Union.  In order to sell a medical  device in the EU beginning
July 1998, companies must have ISO certification, and all products must have the
CE mark.  In order to receive a CE mark for sales in Europe,  the  Company  must
receive  ISO 9001  certification  first.  The  Company  will be seeking ISO 9001
certification and CE marks for the Optical  Biopsy(TM)  System.  There can be no
assurance that the Company will receive ISO  certification or CE mark for any of
its products or product components,  or if obtained,  they will be obtained in a
timely manner.

Product Research and Development

     During the years ended  December 31,  1997,  1996 and 1995,  the  Company's
research and development  expenditures  were  $1,095,281,  $998,137 and $660,504
respectively.  The  Company's  research  and  development  efforts  are  focused
primarily on the Company's Optical BiopsyTM System and, to a lesser degree,  the
Spectroscopic Guidewire(TM) System.

     The Company  obtained 510(k) clearance from the United States Food and Drug
Administration ("FDA") for the disposable Biopsy Forceps on December 2, 1996 and
the  Reusable  Biopsy  Forceps  on  December  2,  1997.   Current  research  and
development efforts are focused on (a) gathering  additional data to continually
improve the accuracy of the tissue recognition  algorithm software in regards to
colorectal cancer, (b) expanding clinical studies in esophageal cancer,  (c)cost
reduction  engineering and integration into existing endoscopy systems currently
utilized in endoscopy  suites in hospitals.  There can be no assurance  that the
Company will be successful  in its efforts or that  clinical  studies will yield
favorable results for the Company.

     In 1995, the Company signed a two-year  research and development  agreement
with  Wellman  Lab, to commence  clinical  feasibility  research  studies on the
detection and  differentiation of cancerous,  pre-cancerous and healthy tissues.
This agreement  called for the payment of  approximately  $50,000 per quarter to
Wellman Lab. The agreement expired in March 1997.

     Additional  plans to conduct  research into other medical  specialties  may
take place in a cooperative effort with strategic partners,  or when the Company
achieves profitability.


                                    Page 10
<PAGE>


Employees

     The Company hired a Director of Product  Development in June,  1997.  There
were nine full-time employees at December 31,1996, and 11 full-time employees at
December 31,  1997.  As of March 30,  1998,  there were 11 full-time  employees,
eight of whom were  engaged  in  product  engineering  design  and  development,
manufacturing, and regulatory affairs.

     The Company also relies heavily on external  consultants in the regulatory,
software  development  and  design  engineering  areas.  The  Company  has  been
successful in attracting and retaining qualified technical personnel.  There can
be no assurance,  however,  that the Company will be able to continue to attract
or retain the skilled  employees  it requires  for  profitable  operations.  The
Company is not subject to any collective  bargaining agreement and believes that
its employee relations are generally satisfactory.

Item 2. DESCRIPTION OF PROPERTY.

     The  Company  moved  its  offices  to a  leased  facility  located  at 3650
Annapolis  Lane,  Suite 101,  Minneapolis,  Minnesota  55447-5434 on November 1,
1996.  This  facility  consists of  approximately  5,530  square feet of office,
laboratory,  quality testing,  and warehouse space. The five-year lease provides
for monthly  rental  payments of $4,434 for the first 36 months,  and $4,561 for
the next 24 months.  The current  rent  including a pro rata share of  operating
expenses  and real estate  taxes is  approximately  $6,115 per month.  The lease
expires at the end of October  2001.  The Company  maintains  levels of standard
property and casualty  insurance coverage on its property that management of the
Company deems appropriate.


Item 3. LEGAL PROCEEDINGS.

     There are no material  ongoing or pending legal  proceedings  which involve
the Company.


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

     There were no matters submitted to a vote of the security holders since the
1997 annual meeting.


                                     PART II

Item 5. MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.

(a)  Market Information

     The Common  Stock of  SpectraSCIENCE  has  traded on the  NASDAQ  Small-Cap
Market since May 15, 1996,  under the symbol "SPSI".  The Common Stock traded on
the  National   Association  of  Security  Dealers  Automated  Quotation  System
("NASDAQ")  from November 13, 1984 under the symbol "GVMI".  In September  1992,
the stock  symbol  was  changed  from  "GVMI" to  "SPSC".  The stock  symbol was
subsequently  changed  to  "SPSI"  in  June  1994  when  it  was  listed  on the
over-the-counter ("OTC") market.

     The following  table sets forth,  for the periods  indicated,  high and low
closing prices as reported by NASDAQ and OTC Bulletin Board and also prices that
the Company  obtained from third party sources,  such as MetroData  Services and
the Wall Street Journal. To the best of its knowledge, the Company believes that
the information obtained from these sources is accurate.

                                    1997                        1996
   STOCK PRICES (1)       ------------------------    -----------------------
   (in $ per share)         High         Low            High         Low
   Quarter Ended            Close        Close          Close        Close
   ---------------------  ------------------------    -----------------------

   March 31                 5.125        3.625          9.125        6.75
   June 30                  4.5          2.4375        10.625        6.375
   September 30             4.75         3.625          7.75         4.25
   December 31              9.125        4.5625         6.00         4.375
   ---------------------  ------------------------    -----------------------



                                    Page 11
<PAGE>

     (1)  The prices of the Company's stock reflect  inter-dealer  prices and do
          not necessarily reflect the prices of actual transactions. The closing
          prices reflect prices without retail mark-up,  mark-down or commission
          and may not represent actual transactions.

     On March 26, 1998,  the closing price quoted for the Common Stock was $6.25
per share.

(b) Holders

     On March 26,  1998,  there were 989  registered  shareholders  of record of
4,624,338 shares of the Common Stock, excluding shareholders that are registered
in   "street-names."   The  Company   estimates  that  there  were  a  total  of
approximately 5,000 beneficial shareholders.

(c) Dividends

     Since its  incorporation,  the Company has not paid any  dividends,  and no
dividend payments are contemplated in the foreseeable  future.  The Company will
retain any earnings it may generate to provide for the  operation  and expansion
of its business.

(d)  Other Securities

     The Company did not raise any  additional  funds in 1997 through any public
or private  offerings.  A total of $95,514  was  raised in fiscal  1997  through
exercise of stock  options  for 10,069  shares of Common  Stock and  exercise of
warrants for 16,111 shares of Common Stock.

Bridge Loans

     On  September  30, 1994,  the Company  raised a total of $300,000 in bridge
loans.  Lenders  were given  five-year  warrants to purchase  100,000  shares of
Common Stock  exercisable  at $3.00 per share.  In the first  fiscal  quarter of
1995,  the Company  raised  $225,000 in  additional  bridge  loans with the same
terms.  This group of lenders was given  five-year  warrants to purchase  74,998
shares of Common Stock  exercisable at $3.00 per share.  All of the bridge loans
were converted to preferred stock in the private  placement which closed on June
29, 1995. The total number of warrants issued to lenders were 174,998,  which if
exercised would raise an additional $524,994 for the Company.

Private Placements of Preferred Stock

     Two  private  placements  of  convertible  preferred  stock  with  attached
warrants were completed in 1995.  Neither the shares of preferred  stock nor the
warrants are intended for trading on any official exchanges.

     The first private  placement,  which closed on June 29, 1995,  involved the
placement with qualified investors of 674,998 shares of Series A Preferred Stock
("Preferred A"), par value $1.00, at $3.00 per share. A net amount of $1,965,000
was raised. Of this amount,  $525,000 was from the conversion of bridge loans on
March 31, 1995.  Preferred A shares are  non-voting,  do not yield  dividends or
interest, and are convertible to an equivalent number of shares of Common Stock,
after March 31, 1996,  but generally one year from the date of receipt of funds.
Each  Preferred A share was issued with a  three-year  warrant to buy  one-third
share of Common  Stock at a price of $5.00 per  share.  Warrants  to  purchase a
total of 225,000 shares of Common Stock were issued to investors in this private
placement,  which if  exercised  would raise an  additional  $1,125,000  for the
Company.  Warrants for 33,333 shares of Common Stock at $5.00 were  exercised in
the third quarter of 1996, raising $166,665 for the Company.

     The second private placement,  which closed on December 28, 1995,  involved
the placement with  qualified  investors of 792,500 shares of Series B Preferred
Stock  ("Preferred  B"),  par value $1.00,  at $5.00 per share.  A net amount of
$3,526,625  was  raised.  Preferred  B  shares  are  non-voting,  do  not  yield
dividends,  unless the  holders of Common  Stock  fail to  authorize  sufficient
additional shares of Common Stock for the conversion of the Preferred B, and are
convertible  to an  equivalent  number of  shares  of  Common  Stock on or after
December 28, 1996.  Each Preferred B share was issued with a three-year  warrant
to buy one-third  share of Common Stock at a price of $9.50 per share.  Warrants
to purchase a total of 264,175  shares of Common  Stock were issued to investors
in this  private  placement,  which  if  exercised  would  raise  an  additional
$2,509,663 for the Company.

                                    Page 12
<PAGE>

     In addition,  the selling  agents for  Preferred A and Preferred B received
warrants  to  purchase  a total of  132,335  shares of Common  Stock,  at prices
ranging from $3.00 to $9.50,  and having terms ranging from three to five years.
If all the warrants issued to the selling agents were exercised,  it would raise
another $740,556 for the Company.

     The total amount raised by the Company was therefore $5,491,625,  including
the conversion of $525,000 bridge loans.

     As of February 28, 1997, all of the issued and outstanding 1,467,498 shares
of Preferred A and Preferred B have been  converted to an  equivalent  number of
shares of issued and outstanding  Common Stock and warrants for 33,333 shares of
Common  Stock were  exercised.  As such,  as of February  28, 1997 there were no
preferred shares  outstanding and there were warrants to purchase 763,175 shares
of Common Stock outstanding.

     The table below summarizes the history of the funds raised since 1994:

<TABLE>
                                 Preferred      Issue      Net Amount                           Exercise       Term/
                   Date            Shares       Price        Raised           Warrants            Price        Years
                   ----            ------       -----        ------           --------            -----        -----
<S>                <C>             <C>          <C>         <C>               <C>                <C>            <C>
Bridge Loans (1)   9/30/94                                  $   525,000       194,998(5)         $3.00          5
                   3/31/95                                                      6,667(6)         $5.00          3
Preferred          3/31/95           674,998    $3.00       $ 1,440,000       225,000(7)         $5.00          3
A (2,4)            6/29/95
Preferred          12/28/95          792,500    $5.00       $ 3,526,625       264,175            $9.50          3
B (3,4)                                                                        79,250            $5.00          5
                                                                               26,418            $9.50          5
                                   ---------                -----------       -------
  TOTAL                            1,467,498                $ 5,491,625       796,508(8)
                                   ---------                -----------       -------
</TABLE>

1.   Bridge Loans were later  converted to Preferred A.  Warrants for a total of
     26,667 were issued to the selling agent.

2.   Series  A  convertible   preferred   stock,  par  value  $1.00  per  share,
     non-voting,  non-dividend  and non-interest  yielding.  The total amount of
     $1,440,000 excludes the $525,000 raised through the bridge loans which were
     later converted to Preferred A.

3.   Series  B  convertible  preferred  stock,  par  value  $1.00,   non-voting,
     non-dividend  and  non-interest  yielding.  Warrants for a total of 105,668
     shares were issued to the selling agent.

4.   All  preferred  stock was converted to common stock by the first quarter of
     fiscal 1997.

5.   10,000 of these were exercised in the fourth quarter of fiscal 1997.

6.   3,333 of these were exercised in the fourth quarter of fiscal 1997.

7.   33,333 of these were  exercised  in the third  quarter  of fiscal  1996 and
     2,778 of these were exercised in the fourth quarter of fiscal 1997.

8.   As of February  27,  1998,  the total  number of shares  under  warrants is
     747,064,  which if completely  exercised,  will raise a total of $4,672,993
     for the  Company.  There is no assurance  that any of the warrants  will be
     exercised.

     In March 1998 (as of March 26, 1998), warrants for 111,112 shares of Common
Stock were  exercised at an exercise  price of $5.00,  raising  $555,560 for the
Company.  On February 2, 1998,  stock  options for 6,667  shares of Common Stock
were exercised at an exercise price of $3.00,  raising  $20,001 for the Company.
From January 1 through  March 26,  1998,  the total  amount  raised  through the
exercise of warrants and options was $575,561.

Stock Options

     As of March 26, 1998, there were 1,254,144 stock options outstanding, 90.7%
of which were held by employees.


                                    Page 13
<PAGE>

Item 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
        FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

     The  following  discussion  and  analysis  provides  information  that  the
Company's  management believes is relevant to an assessment and understanding of
the Company's  results of operations and financial  condition.  This  discussion
should be read in conjunction with the financial  statements and footnotes which
follow.











                                    Page 14
<PAGE>


Plan of Operation

     The  Company's  cash  position on December  31,  1997 was  $1,638,171.  The
Company intends to raise additional  funds from various  sources,  including but
not limited to,  strategic  partners  and private  placements.  The Company also
believes additional funds will be available from the exercise of warrants issued
to  investors  in previous  private  placements.  The  Company  believes it will
require an  additional  $3 million to $5 million in order to implement  the plan
described below.

     The Company  intends to utilize the additional  funds to continue  pursuing
the development of the Company's  products through (1) the expansion of clinical
studies and clinical  trials;  (2) working with  managed care  organizations  on
outcome based studies; and (3) expansion of the gastrointestinal applications of
the Company's products.

     In  addition,  the Company also  intends to utilize  additional  funding to
continue  the   development   of  a  market  for  the  Company's   products  and
strengthening  the  Company's  ability to compete in the industry  through:  (1)
entering  into  strategic  alliances  for  marketing  and  distribution  of  the
Company's  products in market niches in the United  States and  internationally;
(2)  establishing  manufacturing  processes or  relationships  for the Company's
products;   (3)   establishing  a  marketing  and  education   organization  for
monitoring, training and education of the Company's customers; (4) obtaining ISO
9001  certification  for the OBS; and (5) continuing to strengthen the Company's
intellectual property position with additional patents and licensing.

     If the Company is able to raise  additional  funds, the Company believes it
will be able to implement the above  planning goals without the need to purchase
or lease any  additional  plant space or  significant  pieces of equipment.  The
Company also believes it will be able to operate under the above  described plan
without having to increase the number of employees  significantly  during fiscal
1998.

     In the event the  Company  is unable to raise all or any of the  additional
funds it believes it  requires,  the Company will likely be forced to adjust the
plan and potentially be required to move at a slower than  anticipated  pace and
possibly pursue other courses of action.  While the Company  believes it will be
able to raise the necessary funds for on-going  operations and implementation of
its plan,  there can be no  assurance  that the Company  will be  successful  in
raising all or any of the funds it requires, or that the funds will be raised on
a timely basis.

Year 2000 issue

     In regards to the Year 2000 issue,  the Company has  analyzed  its internal
systems for the  potential  impact of Year 2000  compliance.  Although  computer
software  and  hardware  are used in  various  operations  within  the  Company,
including financial reporting, certain manufacturing and assembly functions, and
also in the OBS and SGS,  the Company  does not believe that the Year 2000 issue
will have a material impact on the Company.


Results of Operations

Years ended December 31, 1997 and 1996

Revenue

     The Company  recorded no revenue for the years ended  December 31, 1997 and
1996.  While the  Company has  received  510(k)  clearance  from the FDA for the
disposable  Biopsy  Forceps and the  reusable  Biopsy  Forceps,  the Company has
decided to  commercialize  the Forceps  only as part of the  Optical  Biopsy(TM)
System. As such, the Company does not expect to generate any significant revenue
until FDA clearance has been obtained for the entire Optical Biopsy(TM) System.

Research and Development

     Research  and  development  expenses  for the year ended  December 31, 1997
totaled  $1,095,281  compared to $998,137 for the year ended  December 31, 1996.
This  represented  an increase of $97,144 or 9.7% and was  primarily  due to (a)
increased  expenses  related to the human  multi-center  clinical  trials on the
Optical Biopsy(TM)  System, (b) two additional  personnel hired in the middle of
the year for product


                                    Page 15
<PAGE>

development  and  documentation,   (c)  increased  legal  fees  associated  with
intellectual  property protection and (d) filing and increased  consulting costs
for system development, data analysis and regulatory filing..

Selling, General & Administrative Expenses

     Selling,  general and  administrative  ("SGA")  expenses for the year ended
December 31, 1997 totaled  $679,809  compared  with  $723,825 for the year ended
December 31, 1996. This  represented a decrease of $44,016 or 6%. This reduction
in SGA expenses is primarily due to elimination of an office  administrator  and
many other  cost  reduction  measures.  The  reduction  in  expenses  was offset
partially by increase in expenses in investor  relations  related costs.  In the
third quarter of 1997,  the Company hired a consultant  who assisted the Company
in investor  relations  with  brokers and analysts in major cities in the United
States,  in order  to  provide  better  and  wider  dissemination  of  knowledge
regarding the Company and its technology.

Interest and Other Income

     Interest and other income was $131,299 for the year ended December 31, 1997
compared to $176,043 for the year ended  December 31, 1996.  This  represented a
decrease  of $44,744  or 25.4% and was due to the lower  average  cash  balances
during 1997 compared  with 1996.  The lower average cash balance in 1997 was the
result of the lack of revenue.

Net Losses

     As a result  of the  above  factors,  the  Company  reported  a net loss of
$1,643,791  for the year ended  December 31, 1997 compared to $1,545,919 for the
year ended December 31, 1996.  This  represented an increase of $97,872 or 6.3%,
primarily due to increased research and development costs and lower interest and
other  income.  The net loss per  share  was  $.37 for the year  ended  December
31,1997  compared to a net loss per share of $.47 in for the year ended December
31, 1996, as a result of a higher weighted  average shares  outstanding in 1997.
The  higher  number of  average  shares  outstanding  was  primarily  due to the
conversion of all the outstanding  preferred stock into an equivalent  number of
shares of common stock.


Years ended December 31, 1996 and 1995

Revenue

     Gross  revenue  for the year ended  December  31,  1996 was $0  compared to
$134,652 for the year ended December 31, 1995.  Revenue was  unfavorable for the
year ended 1996 primarily due to the more intense competitive factors facing the
healthcare  environment,  and in particular,  the  cardiovascular  business.  As
discussed  previously,  the  rapid  acceptance  of stents  in the  treatment  of
cardiovascular  diseases,  limited  reimbursements  for such procedures plus the
emphasis on cost  reduction  have put intense  pressures on other  modalities of
diagnosis and treatments.

     In  addition,   expectations  of  international  sales  through  SCIMED,  a
wholly-owned subsidiary of Boston Scientific  Corporation,  did not materialize.
The  Company  believes  that  this was  primarily  due to the fact  that  Boston
Scientific  Corporation,  was in an acquisition mode in the last two years which
required a lot of management time and resulted in many management changes.  This
adversely affected the Company's sales.

Research and Development

     Research  and  development  expenses  for the year ended  December 31, 1996
totaled $998,137 compared to $660,504 for the year ended December 31, 1995. This
represented  an  increase  of  $337,633  or 51.1% and was  primarily  due to the
following  factors:  (a) increased  expenses related to engineering  development
costs,  specialty  equipment  purchased  for the  development  of the  Company's
products, and higher depreciation expenses associated with other equipment;  (b)
expenses  related to ongoing  research and  development  agreement  with Wellman
Laboratories of Photomedicine which amounted to approximately  $200,000 per year
including travel expenses;  (c) increased expenses associated with the hiring of
the Vice  President of  Development  and the Director of Regulatory  Affairs and
Quality Assurance,  plus associated  recruitment  expenses;  (d) increased legal
fees associated with intellectual property protection and filing; and (e) higher
allocated costs associated with the research and development department, such as
space  allocations,


                                    Page 16
<PAGE>


phone usage and similar  expenses,  which were  previously  accounted for in the
selling, general and administrative expenses.

Selling, General & Administrative Expenses

     Selling,  general and  administrative  ("SGA")  expenses for the year ended
December 31, 1996 totaled  $723,825,  compared  with $711,753 for the year ended
December 31, 1995. This represented an increase of $12,072 or 1.7%. Increases in
SGA expenses  included:  (a) additional  expenses  associated with the filing of
additional registration statements and NASDAQ application in 1996; (b) insurance
expense;  (c) expenses related to the moving of the Corporate  offices;  and (d)
the full impact of hiring of the Chief Financial  Officer who joined the Company
on August 30, 1995.  The  increases  were offset by  decreases in the  following
expenses:(a)  travel  expenses;  (b)  shareholder  expenses;  (c) human resource
consulting  expenses;  and (d)  the  elimination  of the  Purchasing/Maintenance
manager position in September 1996.

Interest and Other Income

     Interest and other income was $176,043 for the year ended December 31, 1996
compared to $16,608 for the year ended  December 31, 1995.  This  represented an
increase of $159,435 and was the result of increased interest income from higher
average cash balances  during 1996 compared with 1995.  The higher  average cash
balance in 1996 was the result of the two private placements in 1995.

Net Losses

     As a result  of the  above  factors,  the  Company  reported  a net loss of
$1,545,919  for the year ended  December 31, 1996 compared to $1,345,910 for the
year ended  December 31,  1995.  This  represented  an increase in net losses of
$200,009 or 14.9%. Even though the net loss was higher in 1996, the net loss per
share was  similar  in both 1996 and 1995 at $.47 due to higher  average  shares
outstanding in 1996.

Liquidity and Sources of Capital

     On December 31,  1997,  the working  capital of the Company was  $1,454,649
compared to $2,950,452 on December 31, 1996 and $4,231,371 on December 31, 1995.
The  decrease in working  capital from 1996 to 1997 was the result of the use of
cash to fund  normal  on-going  operations  of the  Company.  The large  working
capital  position in 1995 was the result of the private  placements  in 1995 and
the conversion of bridge loans outstanding.

     Net cash used in operating  activities  was  $1,492,331 in 1997 compared to
$1,379,498 in 1996 and  $1,399,518  in 1995.  The increase from 1996 to 1997 was
primarily due to the higher net loss which resulted from the higher research and
development costs.

     Net cash provided by financing  activities  was $95,514 in 1997 compared to
$314,290 in 1996 and  $5,571,625  in 1995.  The net cash  provided by  financing
activities  in 1997 and 1996 was  primarily  due to the exercise of warrants and
stock options. The increase in 1995 was provided primarily by private placements
and the exercise of stock options. The 1995 amount only included $225,000 of the
$525,000  bridge loans  converted  to Preferred A, since  $300,000 of the bridge
loans were provided in 1994.

     Cash and cash  equivalents  as of December  31 of the years 1997,  1996 and
1995 were $1,638,173, $3,047,182 and $4,123,326, respectively. In March 1998 (as
of March 26, 1998),  warrants for 111,112  shares of Common Stock were exercised
at an exercise price of $5.00,  raising $555,560 for the Company. On February 2,
1998,  stock  options  for 6,667  shares of Common  Stock were  exercised  at an
exercise price of $3.00, raising $20,001 for the Company. From January 1 through
March 26,  1998,  the total amount  raised  through the exercise of warrants and
options was $575,561.

     The Company estimates that this amount of cash and cash equivalents will be
sufficient to last until  approximately  the fourth  quarter of fiscal 1998. The
Company  anticipates  that cash  usage  will  increase  in the first and  second
quarters of fiscal 1998,  primarily due to acceleration of clinical  studies and
related expenses and higher inventory.


                                    Page 17
<PAGE>


Item 7. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

     Reference  is made to the  Report of  Independent  Auditors  and  Financial
Statements  included in the Index to  Financial  Statements  at Page F-1 of this
Annual Report on Form 10-KSB.


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

     None.





















                                    Page 18
<PAGE>




                                    PART III

Item 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND
        CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a)
        OF THE EXCHANGE ACT.

     The  information  required by this item is incorporated by reference to the
information set forth under the similarly titled caption  contained in the Proxy
Statement to be used by the Company in connection  with its 1998 Annual  Meeting
of Shareholders,  to be filed with the Securities and Exchange  Commission on or
prior to April 20, 1998.


Item 10. EXECUTIVE COMPENSATION.

     The  information  required by this item is incorporated by reference to the
information set forth under the similarly titled caption  contained in the Proxy
Statement to be used by the Company in connection  with its 1998 Annual  Meeting
of Shareholders, which will be filed with the Securities and Exchange Commission
on or prior to April 20, 1998.


Item 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
         OWNERS AND MANAGEMENT.

     The  information  required by this item is incorporated by reference to the
information set forth under the similarly titled caption  contained in the Proxy
Statement to be used by the Company in connection  with its 1998 Annual  Meeting
of Shareholders, which will be filed with the Securities and Exchange Commission
on or prior to April 20, 1998.


Item 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     The  information  required by this item is incorporated by reference to the
information set forth under the similarly titled caption  contained in the Proxy
Statement to be used by the Company in connection  with its 1998 Annual  Meeting
of Shareholders, which will be filed with the Securities and Exchange Commission
on or prior to April 20, 1998.


Item 13. EXHIBITS, FINANCIAL STATEMENTS, AND REPORTS ON FORM 8-K.

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

     (1)  Financial Statements.

          Audited  financial  statements  for  each  of the  three  years  ended
     December 31, 1997, 1996 and 1995 are filed as part of this Form 10-KSB. See
     Index to financial Statements on Page F - 1.

     (2)  Reports on Form 8-K.

          The  Company  filed a  report  on Form  8-K on  December  17,  1997 in
     conjunction with its press release on December 5, 1997,  announcing that it
     received  510(k)  pre-market  notification  clearance  from the FDA for its
     fiberoptic reusable Biopsy Forceps.




                                    Page 19
<PAGE>



     (3)  Exhibits required by Item 601 of Regulation S-B:

     Exhibit
     Number    Description
     ------    -----------

      3.1      Articles of Incorporation, as amended. (Incorporated by reference
               to the Company's  Annual Report on Form 10-KSB,  Exhibit 3.1, for
               the year ended December 31, 1996.)

      3.2      Bylaws,  as amended.  (Incorporated by reference to the Company's
               Annual  Report on Form  10-KSB,  Exhibit  3.2, for the year ended
               December 31, 1995.)

     10.3      Incentive  Stock  Option Plan adopted by the  Company's  Board of
               Directors and shareholders on August 1, 1983, as amended March 5,
               1987,  and  May  5,  1987.  (Incorporated  by  reference  to  the
               Company's Registration Statement on Form S-8, Commission File No.
               2-93693-C,  as filed on March 28, 1986, effective April 17, 1986,
               as amended on June 2, 1987 and March 21, 1988.)

     10.4      Incentive  Stock  Option  Plan,  as  amended,  as  adopted by the
               Company's  Board of Directors and  shareholders on March 10, 1988
               (Incorporated by reference to the Company's Annual Report on Form
               10-K for the year ended December 31, 1988.)

     10.5      1988  Stock  Option  Plan  adopted  by  the  Company's  Board  of
               Directors  on March 10,  1988 and  shareholders  on May 5,  1988.
               (Incorporated   by  reference  to  the   Company's   Registration
               Statement on Form S-8, Commission File No. 33-22052,  as filed on
               May 25, 1988, effective June 14, 1988.)

     10.6      1990  Restricted  Stock Plan  adopted by the  Company's  Board of
               Directors  on March 15, 1990 and  shareholders  on May 17,  1990.
               (Incorporated   by  reference  to  the   Company's   Registration
               Statement on Form S-8, Commission File No. 33-36385,  as filed on
               August 15, 1990, effective August 15, 1990.)

     10.7      1991 Stock Plan  adopted by the  Company's  Board of Directors on
               July 11, 1991 and shareholders on January 30, 1992. (Incorporated
               by reference to the Company's Annual Report on Form 10-K, Exhibit
               10.12, for the year ended December 31, 1991.)

     10.8      Amendment  to 1991 Stock Plan adopted by the  Company's  Board of
               Directors on July 11, 1991 and  shareholders on January 30, 1992.
               (Incorporated by reference to the Company's Form 8-K Report filed
               with the Securities and Exchange  Commission on or about February
               3, 1992.)

     10.9      Amendment   to  1991   Stock  Plan   adopted  by  the   Company's
               shareholders on June 28, 1995.  (Incorporated by reference to the
               Company's Registration Statement on Form S-8, Commission File No.
               033-63047, as filed on September 28, 1995.)

     10.10     Amendment  to 1991 Stock Plan adopted by the  Company's  Board of
               Directors on October 4, 1995.  (Incorporated  by reference to the
               Company's  definitive Proxy Statement for its 1996 Annual Meeting
               of Shareholders.)

     10.11     Amendment   to  1991   Stock  Plan   adopted  by  the   Company's
               shareholders on March 28, 1996. (Incorporated by reference to the
               Company's Registration Statement on Form S-8, Commission File No.
               333-.4393, as filed on May 23, 1996.)

     10.12     Amendment  to 1991 Stock Plan as it pertains  to Section  5(k) of
               the Plan regarding  Directors  options,  adopted by the Company's
               Board of Directors on October 9, 1996. (Incorporated by reference
               to the Company's Annual Report on Form 10-KSB, Exhibit 10.10, for
               the year ended December 31, 1996.)

     10.13     Amendment  to 1991 Stock Plan as it  pertains to Section 3 of the
               Plan,  adopted by the  Company's  Board of  Directors on March 9,
               1998, filed herein.

     10.14     Self-Insurance  Trust Agreement between the Company and Richfield
               Bank and Trust Co., as trustee dated March 5, 1987. (Incorporated
               by reference to the Company's  Annual Report on Form 10-K for the
               year ended December 31, 1986.).

     10.15     Form of  Indemnification  Agreement that the Company has provided
               to all officers and directors.  (Incorporated by reference to the
               Company's  Annual Report on Form 10-K for the year ended December
               31, 1986.)


                                    Page 20
<PAGE>


     10.16     Yurek Employment  Agreement dated February 3, 1992 by and between
               the Company and Mr. Daryl F. Yurek. (Incorporated by reference to
               the  Company's  Form 8-K  report  filed with the  Securities  and
               Exchange Commission on or about February 17, 1992.)

     10.17     Employment  Agreement and Severance Agreement between the Company
               and Brian T. McMahon dated September 30, 1992.  (Incorporated  by
               reference to the Company's Annual Report on Form 10-KSB,  Exhibit
               10.23, for the year ended December 31, 1993.)

     10.18     Severance  (Change in Control)  Agreement between the Company and
               Brian T.  McMahon  dated  November  26,  1996.  (Incorporated  by
               reference to the Company's Annual Report on Form 10-KSB,  Exhibit
               10.15, for the year ended December 31, 1996.)

     10.19     Severance  (Change in Control)  Agreement between the Company and
               Ching-Meng  Chew  dated  November  26,  1996.   (Incorporated  by
               reference to the Company's Annual Report on Form 10-KSB,  Exhibit
               10.16, for the year ended December 31, 1996.)

     10.20     Severance  (Change in Control)  Agreement between the Company and
               Chester E. Sievert, Jr. dated May 21, 1997, filed herein.

     10.21     Five-Year  Lease  Agreement  between  the  Company  and St.  Paul
               Properties,   Inc.  dated  October  10,  1996   (Incorporated  by
               reference to the Company's Annual Report on Form 10-KSB,  Exhibit
               10.17, for the year ended December 31, 1996.)

     10.22     Distribution  Agreement between SCIMED Life Systems, Inc. and the
               Company  dated  August 19,  1994.  (Incorporated  by reference to
               Annual Report on Form 10-KSB,  Exhibit 10.29,  for the year ended
               December 31, 1994).

     10.23     Clinical   Research   Agreement   between  The  General  Hospital
               Corporation,  doing business as Massachusetts  General  Hospital,
               and the Company dated June 1, 1995. (Incorporated by reference to
               the Company's  Annual Report on Form 10-KSB,  Exhibit 10.15,  for
               the year ended December 31, 1995.)

     10.24     Cautionary  Statement  Identifying  Important  Factors that Could
               Cause the Company's Actual Results to Differ from Those Projected
               in Forward-Looking Statements.  (Incorporated by reference to the
               Company's  Quarterly  Report on Form 10-QSB,  Exhibit 99, for the
               quarter ended June 30, 1996.)

     10.25     Bridge Loan Agreement, including form of Promissory Note and form
               of Warrant by and  between the  Company  and  Qualified  Lenders,
               dated  September  30,  1994.  (Incorporated  by  reference to the
               Company's  Annual Report on Form 10-KSB,  Exhibit 10.28,  for the
               year ended December 31, 1994.)

     10.26     Form of Promissory  Note that was issued in conjunction  with the
               Bridge Loan  Agreement  by and between the Company and  Qualified
               Lenders, dated September 30, 1994.  (Incorporated by reference to
               the Company's Annual Report on Form 10-KSB,  Exhibit 10.28,  page
               45, for the year ended December 31, 1994.)

     10.27     Form of Promissory  Note that was issued in conjunction  with the
               Bridge Loan  Agreement  by and between the Company and  Qualified
               Lenders, dated September 30, 1994.  (Incorporated by reference to
               the Company's Annual Report on Form 10-KSB,  Exhibit 10.28,  page
               45, for the year ended December 31, 1994.)

     10.28     Form of Warrant.  (Incorporated  by  reference  to the  Company's
               Annual Report on Form 10-KSB,  Exhibit 10.28,  for the year ended
               December 31, 1994.)

     10.29     List  of  Lenders  in the  Bridge  Loans,  and  Investors  in the
               Company's  Preferred  Stock .  (Incorporated  by reference to the
               Company's Form S-3  Registration  Statement  under The Securities
               Act of 1933 as filed with the Securities and Exchange  Commission
               and  declared  effective  on June 7,  1996,  Commission  File No.
               333-1149.)

     10.30     Form of Subscription  Agreement that was used in conjunction with
               the  private   placements  of  the  Company's   Preferred  Stock.
               (Incorporated by reference to the Company's Annual Report on Form
               10-KSB, Exhibit 10.20, for the year ended December 31, 1995.)

     23.1      Consent of Independent Auditors, filed herein.

     27        Financial Data Schedule, filed herein.


                                    Page 21
<PAGE>


                                   SIGNATURES

     Pursuant to the  requirements  of  Sections 13 and 15(d) of the  Securities
Exchange Act of 1934, as amended,  the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.

                                            SpectraSCIENCE, Inc.
                                                (Registrant)


Date:     March 30, 1998               By: /s/ Brian T. McMahon
                                           ---------------------
                                               Brian T. McMahon
                                      Chairman and Chief Executive Officer


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


/s/ Brian T. McMahon            Chairman, Chief Executive         March 30, 1998
---------------------------        Officer and Director
    Brian T. McMahon               (Principal Executive Officer)


/s/ Chester E. Sievert, Jr.     President and Chief Operating     March 30, 1998
---------------------------       Officer
    Chester E. Sievert, Jr.



/s/ Ching-Meng Chew             Vice President Finance and        March 30, 1998
---------------------------       Administration, Chief Financial
    Ching-Meng Chew               Officer, Treasurer, Secretary
                                  (Principal Financial and Accounting
                                  Officer)



/s/ Henry M. Holterman          Director                          March 30, 1998
---------------------------
    Henry Holterman



/s/ Nathaniel S. Thayer         Director                          March 30, 1998
---------------------------
    Nathaniel S. Thayer










                                    Page 22
<PAGE>


                              SpectraSCIENCE, Inc.


                          Audited Financial Statements


                     Years ended December 31, 1997 and 1996




                                    Contents

Report of Independent Auditors.............................................. F-1

Audited Financial Statements

Balance Sheets.............................................................. F-2
Statements of Operations.................................................... F-3
Statement of Changes in Stockholders' Equity................................ F-4
Statements of Cash Flows.................................................... F-5
Notes to Financial Statements............................................... F-6


<PAGE>

                         Report of Independent Auditors


Board of Directors
SpectraScience, Inc.

We have audited the accompanying  balance sheets of  SpectraScience,  Inc. as of
December 31, 1997 and 1996, and the related statements of operations, changes in
stockholders'  equity and cash  flows for each of the three  years in the period
ended December 31, 1997. 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  SpectraScience,  Inc. at
December 31, 1997 and 1996, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1997, in conformity
with generally accepted accounting principles.


                                                   Ernst & Young LLP


February 13, 1998, except for Note 8,
as to which date is March 26, 1998




                                    Page F-1
<PAGE>

                              SpectraSCIENCE, Inc.

                                 Balance Sheets

                                                            December 31
                                                       1997            1996
                                                   ----------------------------
Assets
Current assets:
   Cash and cash equivalents                       $  1,638,173    $  3,047,182
   Inventory                                            180,474         192,151
   Other current assets                                  98,419         103,736
                                                   ----------------------------
Total current assets                                  1,917,066       3,343,069

Fixed assets:
   Office furniture and equipment                       249,935         239,915
   Machinery and equipment                              560,201         558,029
                                                   ----------------------------
                                                        810,136         797,944
   Less accumulated depreciation                       (655,090)       (590,424)
                                                   ----------------------------
                                                        155,046         207,520
                                                   ----------------------------
Total assets                                       $  2,072,112    $  3,550,589
                                                   ============================

Liabilities and stockholders' equity
  Current liabilities:
   Accounts payable                                $    140,809    $    107,866
   Accrued compensation and taxes                       100,690          97,735
   Accrued expenses                                      61,019          37,216
   Accrued clinical research fees                       159,899         149,800
                                                   ----------------------------
Total current liabilities                               462,417         392,617

Commitments

Stockholders' equity:
   Convertible preferred stock, Series A,
     par value $1.00 per share:
        Authorized shares--5,000,000
        Issued and outstanding
        shares--66,667 in 1996                               --          66,667
   Convertible preferred stock, Series B,
     par value $1.00 per share:
        Authorized shares--1,000,000
        Issued and outstanding
        shares--792,500 in 1996                              --         792,500
   Common stock, $.25 par value:
     Authorized shares--10,000,000
     Issued and outstanding
       shares--4,506,559 in 1997
       and 3,621,212 in 1996                          1,126,640         905,303
Additional paid-in capital                           44,620,283      43,886,939
Accumulated deficit                                 (44,137,228)    (42,493,437)
                                                   ----------------------------
Total stockholders' equity                            1,609,695       3,157,972
                                                   ----------------------------
Total liabilities and stockholders' equity         $  2,072,112    $  3,550,589
                                                   ============================

See accompanying notes.


                                    Page F-2
<PAGE>


                              SpectraSCIENCE, Inc.

                            Statements of Operations


                                                Year ended December 31
                                          1997           1996           1995
                                      -----------------------------------------
Net revenues
Product revenues                      $        --    $        --    $   134,652
Cost of products sold                          --             --        124,913
                                      -----------------------------------------
                                               --             --          9,739

Expenses
Research and development                1,095,281        998,137        660,504
Selling, general and administrative       679,809        723,825        711,753
Interest and other income                (131,299)      (176,043)       (16,608)
                                      -----------------------------------------
Total expenses                          1,643,791      1,545,919      1,355,649
                                      -----------------------------------------

Net loss                              $(1,643,791)   $(1,545,919)   $(1,345,910)
                                      =========================================

Net loss per share                    $      (.37)   $      (.47)   $      (.47)
Weighted average common
  shares outstanding
                                        4,467,233      3,276,193      2,857,738


See accompanying notes.



                                    Page F-3
<PAGE>

<TABLE>
                              SpectraSCIENCE, Inc.

                  Statement of Changes in Stockholders' Equity


<CAPTION>
                                                Series A Convertible Series B Convertible
                                Common Stock      Preferred Stock       Preferred Stock        Additional
                           ----------------------------------------------------------------     Paid-In     Accumulated
                             Shares     Amount    Shares     Amount    Shares       Amount      Capital       Deficit         Total
                           ---------------------------------------------------------------------------------------------------------
<S>                        <C>       <C>         <C>      <C>        <C>          <C>       <C>           <C>           <C>
Balance December 31, 1994  2,785,348 $  696,337       --  $      --               $     --  $ 38,765,897  $(39,601,608) $  (139,374)
 Exercise of stock options   148,000     37,000       --         --        --           --       343,000            --      380,000
 Issuance of non-interest
   bearing notes                  --         --       --         --        --           --         3,260            --        3,260
 Issuance of Series A
   convertible preferred
   stock upon debt
   conversion                     --         --  174,998    174,998        --           --       350,002            --      525,000
 Proceeds from issuance
   of Series A convertible
   preferred stock, net of
   expenses of $60,000            --         --  500,000    500,000        --           --       940,000            --    1,440,000
 Proceeds from issuance
   of Series B convertible
   preferred stock, net of
   expenses of $435,875           --         --       --         --   792,500      792,500     2,734,125            --    3,526,625
 Net loss                         --         --       --         --        --           --            --    (1,345,910)  (1,345,910)
                           ---------------------------------------------------------------------------------------------------------
Balance December 31, 1995  2,933,348    733,337  674,998    674,998   792,500      792,500    43,136,284   (40,947,518)   4,389,601
 Conversion of Series A
   preferred stock into
   common shares             608,331    152,083 (608,331)  (608,331)       --           --       456,248            --           --
 Exercise of Series A
   preferred stock
   detachable warrants
   into common shares
                              33,333      8,333       --         --        --           --       158,332            --      166,665
 Exercise of stock options    46,200     11,550       --         --        --           --       136,075            --      147,625
 Net loss                         --         --       --         --        --           --            --    (1,545,919)  (1,545,919)
                           ---------------------------------------------------------------------------------------------------------
Balance December 31, 1996  3,621,212    905,303   66,667     66,667   792,500      792,500    43,886,939   (42,493,437)   3,157,972
 Conversion of Series A
   preferred stock into
   common shares              66,667     16,667  (66,667)   (66,667)       --           --        50,000            --           --
 Conversion of Series B
   preferred stock into
   common shares             792,500    198,125       --         --  (792,500)    (792,500)      594,375            --           --
 Exercise of Series A
   preferred stock
   detachable warrants
   into common stock          16,111      4,028       --         --        --           --        56,527            --       60,555
 Exercise of stock options    10,069      2,517       --         --        --           --        32,442            --       34,959
 Net loss                         --         --       --         --        --           --            --    (1,643,791)  (1,643,791)
                           ---------------------------------------------------------------------------------------------------------
Balance December 31, 1997  4,506,559 $1,126,640       --  $      --        --     $     --  $ 44,620,283  $(44,137,228) $ 1,609,695
                           =========================================================================================================
</TABLE>


See accompanying notes.



                                    Page F-4
<PAGE>


<TABLE>
                              SpectraSCIENCE, Inc.

                            Statements of Cash Flows


<CAPTION>
                                                                                             Year ended December 31
                                                                                1997                  1996                  1995
                                                                            --------------------------------------------------------
<S>                                                                         <C>                   <C>                   <C>
Operating activities
Net loss                                                                    $(1,643,791)          $(1,545,919)          $(1,345,910)
Adjustments to reconcile net loss to net cash used
   in operating activities:
     Depreciation                                                                64,666                72,418                52,302
     Non-cash interest expense                                                       --                    --                 3,260
     Gain on sale of fixed assets                                                    --                  (387)                   --
     Changes in operating assets and liabilities:
       Accounts receivable                                                           --               100,641               (99,860)
       Inventory                                                                 11,677              (120,665)               18,597
       Other current assets                                                       5,317               (23,539)               35,492
       Accounts payable and accrued expenses                                     69,800               137,953               (63,399)
                                                                            --------------------------------------------------------
 Net cash used in operating activities                                       (1,492,331)           (1,379,498)           (1,399,518)

Investing activities
Purchases of fixed assets                                                       (12,192)              (13,418)             (107,379)
Proceeds from sale of fixed assets                                                   --                 2,482                   300
                                                                            --------------------------------------------------------
Net cash used in investing activities                                           (12,192)              (10,936)             (107,079)

Financing activities
Proceeds from issuance of notes payable                                              --                    --               225,000
Proceeds from issuance of common stock                                           95,514               314,290               380,000
Proceeds from issuance of preferred stock                                            --                    --             4,966,625
                                                                            --------------------------------------------------------
Net cash provided by financing activities                                        95,514               314,290             5,571,625
                                                                            --------------------------------------------------------

Net (decrease) increase in cash and cash equivalents                         (1,409,009)           (1,076,144)            4,065,028
Cash and cash equivalents at beginning of year                                3,047,182             4,123,326                58,298
                                                                            --------------------------------------------------------
Cash and cash equivalents at end of year                                    $ 1,638,173           $ 3,047,182           $ 4,123,326
                                                                            ========================================================

Supplemental schedule of noncash transactions
Notes payable converted into preferred stock                                $        --           $        --           $   525,000
Series A preferred stock converted into common stock                             66,667               608,331                    --
Series B preferred stock converted into common stock                            792,500                    --                    --
Transfer of inventory to equipment                                                   --               110,385                    --

</TABLE>

See accompanying notes.



                                    Page F-5
<PAGE>


                              SpectraSCIENCE, Inc.

                          Notes to Financial Statements

                                December 31, 1997


1. Business

     The Company was  incorporated  on May 4, 1983 as GV Medical,  Inc.  and was
engaged in the development of laser angioplasty catheter systems.  Subsequently,
the Company changed its name to SpectraScience,  Inc. on October 16, 1992, which
was approved by the  shareholders  on May 13,  1993.  The Company is now focused
primarily on the design,  development,  manufacturing  and  marketing of medical
products for the  diagnosis  and  facilitation  of treatment of a broad range of
human diseases.

2. Summary of Significant Accounting Policies

Cash Equivalents

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

Fixed Assets

     Fixed assets are stated at cost.  The Company  depreciates  the cost of the
property  over its  estimated  useful life of five years using the straight line
method.

Long-Lived Assets

     Impairment  losses are recorded on  long-lived  assets when  indicators  of
impairment are present and the undiscounted cash flows estimated to be generated
by the assets are less than the carrying amount of such assets.

Inventory

     Inventories  are stated at the lower of cost or market.  Cost is determined
on a first-in, first-out basis.

Use of Estimates

     The  preparation  of financial  statements  in  conformity  with  generally
accepted  accounting  principles  requires  management  to  make  estimates  and
assumptions  that affect the amounts  reported in the financial  statements  and
accompanying notes. Actual results could differ from the estimates.

Stock-Based Compensation

     The Company follows Accounting  Principles Board Opinion No. 25, Accounting
for Stock  Issued to  Employees  ("APB  25"),  and  related  interpretations  in
accounting for its stock options. Under APB 25, when the exercise price of stock
options equals the market price of the underlying stock on the date of grant, no
compensation expense is recognized.

     In October 1995, the Financial  Accounting Standards Board issued Statement
of  Financial   Accounting   Standards  No.  123,   Accounting  for  Stock-Based
Compensation   ("Statement  123").  The  Company  adopted  the  disclosure  only
provisions  of  Statement  123.  Accordingly,  the  Company  has made pro  forma
disclosures  of what  net  loss  and loss  per  share  would  have  been had the
provisions of Statement 123 been applied to the Company's stock options.





                                    Page F-6
<PAGE>

                              SpectraSCIENCE, Inc.

                    Notes to Financial Statements (continued)


2. Summary of Significant Accounting Policies (continued)

Income Taxes

     The Company accounts for income taxes under the liability method.  Deferred
tax assets  and  liabilities  are  recognized  for the  future tax  consequences
attributable to temporary  differences  between the financial statement carrying
amount of assets and liabilities and their respective tax bases.

Net Loss Per Share

     In 1997, the Financial Accounting Standards Board issued Statement No. 128,
Earnings per Share  (Statement  128).  Statement 128 replaced the calculation of
primary and fully diluted earnings per share with basic and diluted earnings per
share.  Unlike primary earnings per share, basic earnings per share excludes any
dilutive  effects of options,  warrants,  and  convertible  securities.  Diluted
earnings per share is very similar to fully diluted earnings per share under the
previous  rules.  All  earnings  per share  amounts  for all  periods  have been
presented  and,  where  necessary,  restated  to  conform to the  Statement  128
requirements.  Diluted  earnings per share is not  presented  separately  as the
effect of outstanding options and warrants is antidilutive.

3. Capital Stock and Warrants

     During 1994, the Company granted warrants to the participants in the bridge
financing  agreements  it had entered into,  to purchase  100,000  shares of the
Company's common stock at $3.00 per share. The warrants are exercisable for five
years from the date of the grant.

     During 1995, the Company,  in connection with additional  bridge financing,
granted  warrants to the participants to purchase 74,998 shares of the Company's
common stock at $3.00 per share.  The warrants  are  exercisable  for five years
from the date of grant.

     From  March  1995  to  June  1995,  the  Company  sold  500,000  shares  of
convertible  preferred stock, Series A at $3.00 per share in a private placement
for  $1,500,000  less related costs of $60,000.  Upon  completion of the sale of
convertible  preferred  stock,  bridge  loans of $525,000  were  converted  into
174,998 shares of convertible  preferred stock at a price of $3.00 per share. In
addition, the Company issued warrants to the investors to purchase 58,335 shares
of the Company's  common stock at $5.00 per share.  The warrants are exercisable
for three years from the date of grant. In March 1996, the nondividend  yielding
shares of convertible  preferred stock were converted into an equivalent  number
of shares of common stock.  Holders of the shares of the  convertible  preferred
stock also received  warrants to purchase 166,665 shares of the Company's common
stock at $5.00 per share. The warrants are exercisable for three years from date
of grant.  During 1996, Series A preferred stock detachable warrants to purchase
33,333  shares of common stock were  exercised at $5.00 per share.  In addition,
the Company issued  warrants to the underwriter to purchase 20,000 shares of the
Company's common stock at $3.00 per share. The warrants are exercisable for five
years from the date of grant.  The  Company  issued  additional  warrants to the
underwriter to purchase 6,667 shares of the Company's  common stock at $5.00 per
share.  The  warrants  are  exercisable  for three years from the date of grant.
During 1997, Series A preferred stock detachable  warrants to purchase 6,111 and
10,000 shares of common stock were exercised at $5.00 and $3.00, respectively.




                                    Page F-7
<PAGE>


                              SpectraSCIENCE, Inc.

                    Notes to Financial Statements (continued)


3. Capital Stock and Warrants (continued)

     In December 1995, the Company sold 792,500 shares of convertible  preferred
stock,  Series B at $5.00 per share in a private  placement for $3,962,500  less
related costs of $435,875.  Holders of shares of the convertible preferred stock
also received  warrants to purchase 264,175 shares of the Company's common stock
at $9.50 per share.  The warrants are  exercisable for three years from the date
of grant.  In  addition,  the  Company  issued  warrants to the  underwriter  to
purchase  79,250  shares of the Company's  common stock at $5.00 per share.  The
warrants  are  exercisable  for five years from the date of grant.  The  Company
issued  additional  warrants to the underwriter to purchase 26,418 shares of the
Company's  common  stock at $9.50 per share,  conditional  upon  exercise of the
previous  warrant issued to the  underwriter.  The warrants are  exercisable for
five years from the date of grant.

     In January 1997, the Company converted all of its outstanding  Series A and
Series B  preferred  stock  into an  equivalent  number of shares of issued  and
outstanding common stock.


4. Stock Options

     The Company has one stock option plan under which  selected  employees  and
non-employees  may be granted  incentive and  non-qualified  options to purchase
common stock of the Company.  The options granted are exercisable  over a period
of no longer than ten years and are granted at 100% of the fair market  value of
the common stock as of the date of grant.

     The following table summarizes the stock option activity for the plan:

                           Shares Available    Stock Options    Weighted Average
                               for Grant     Outstanding Under      Exercise
                                                 the Plans       Price Per Share
                           -----------------------------------------------------

Balance December 31, 1994       (139,182)          600,272           $3.49
  Amendment to plan              540,000
  Options granted               (320,000)          320,000            3.17
  Options exercised                  --           (148,000)           2.57
  Options forfeited                5,000            (5,000)           3.00
  Options canceled                 5,000            (5,000)           2.50
  Option plans terminated        (30,890)              --
                           -------------------------------------
Balance December 31, 1995         59,928           762,272            3.37
  Amendment to plan              500,000
  Options exercised                  --            (46,200)           3.20
  Options forfeited               35,493           (35,493)           5.00
  Options granted               (145,000)          145,000            6.73
                           -------------------------------------
Balance December 31, 1996        450,421           825,579            3.95
  Options granted               (461,065)          461,065            4.07
  Options exercised                  --            (10,069)           3.47
  Options canceled               249,931          (249,931)           3.13
                           -------------------------------------
Balance December 31, 1997        239,287         1,026,644           $4.19
                           =====================================




                                    Page F-8
<PAGE>


                              SpectraSCIENCE, Inc.

                    Notes to Financial Statements (continued)


4. Stock Options (continued)

     The  weighted  average  fair value of options  granted in 1997 and 1996 was
$2.84 and $4.92,  respectively.  The exercise  price of options  outstanding  at
December 31, 1997 ranged from $3.00 to $11.25 per share,  as  summarized  in the
following table:


                           Shares Outstanding              Shares Exercisable
                -------------------------------------- -------------------------
                                 Weighted    Weighted                 Weighted
                    Shares       Average      Average                  Average
                Outstanding at  Remaining    Exercise    Number of    Exercise
   Range of       December 31, Contractual     Price       Shares       Price
Exercise Price      1997           Life      per Share  Exercisable   Per Share
--------------- -------------------------------------- -------------------------

$3.00 to $ 5.00    879,065     6.52 years     $ 3.65      397,333      $ 3.17
 5.01 to   8.00    120,079     8.90 years       6.70       50,410        6.50
 8.01 to  11.25     27,500     4.82 years      10.35       27,500       10.35
               -----------                              ---------
  Total          1,026,644     6.75 years     $ 4.19      475,243      $ 3.94
               ===========                              =========


     The Company has elected to follow  Accounting  Principles Board Opinion No.
25,   Accounting   for  Stock  Issued  to  Employees   ("APB  25")  and  related
Interpretations  in  accounting  for its  employee  stock  options  because,  as
discussed below,  the alternative fair value accounting  provided for under FASB
Statement No. 123,  Accounting for Stock-Based  Compensation  ("Statement 123"),
requires  use of option  valuation  models  that were not  developed  for use in
valuing employee stock options.  Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying stock
on the date of grant, no compensation expense is recognized.

     Pro forma information  regarding net loss and loss per share is required by
Statement  123, and has been  determined as if the Company had accounted for its
employee  stock options  under the fair value method of Statement  123. The fair
value  for  these  options  was  estimated  at  the  date  of  grant  using  the
Black-Scholes   option   pricing  model  with  the  following   weighted-average
assumptions for 1997 and 1996,  respectively:  risk-free  interest rates ranging
from  5.65% to 6.3%;  volatility  factor  of the  expected  market  price of the
Company's common stock of .851 and .904,  respectively,  and a  weighted-average
expected life of the option of five to seven years.

     The  Black-Scholes   option  valuation  model  was  developed  for  use  in
estimating  the fair value of traded  options which vest by one-third  each year
from the date of the grant  and are  fully  transferable.  In  addition,  option
valuation models require the input of highly subjective assumptions. Because the
Company's employee stock options have  characteristics  significantly  different
from  those of traded  options,  and  because  changes in the  subjective  input
assumptions  can  materially  affect the fair value  estimate,  in  management's
opinion,  the  existing  models do not  necessarily  provide a  reliable  single
measure of the fair value of its employee stock options.

     For  purposes of pro forma  disclosures,  the  estimated  fair value of the
options is amortized to expense over the options' vesting period.  The Company's
pro forma information is as follows:




                                    Page F-9
<PAGE>


                              SpectraSCIENCE, Inc.

                    Notes to Financial Statements (continued)


4. Stock Options (continued)



                                       1997           1996            1995
                                 ---------------------------------------------
   Pro forma net loss              $(2,258,579)   $(1,846,282)    $(1,453,448)
   Pro forma net loss per share       $(.51)         $(.56)          $(.51)

     These pro forma  amounts may not be  indicative  of future  years'  amounts
since the  Statement  provides for a phase-in of option  values  beginning  with
those granted in 1995.


5. Commitments

     The Company had an operating lease agreement for certain  premises within a
building  in  Minneapolis,  Minnesota  that had a term which  expired in October
1996. The Company moved to a new location in Minneapolis during 1996 and entered
into a new building lease  agreement that has a term extending  through  October
2001. The new lease requires  annual base rent of  approximately  $53,000 plus a
sharing of certain expenses.  Various other equipment operating leases were also
entered into during 1996 expiring during future years.

     Future lease commitments are as follows:

      1998                                               $  65,000
      1999                                                  62,000
      2000                                                  58,000
      2001                                                  49,000
      2002                                                      --
                                                         ----------
      Total                                              $ 234,000
                                                         ==========


     The Company  incurred total lease and rental  expenses of $67,000,  $45,000
and $36,000 for the years ended December 31, 1997, 1996, and 1995, respectively.

     In 1995, the Company entered into a clinical  research  agreement for up to
two years with a hospital.  Under the terms of the agreement, the Company agreed
to pay  approximately  $400,000 for the study, of which $50,000 and $200,000 was
charged  to  expense  in 1997  and  1996,  respectively.  In 1997,  the  Company
terminated the agreement.

     The Company entered into three different clinical testing agreements during
1997 with domestic  hospitals.  Under the terms of these one-year agreements the
Company has a maximum commitment of $173,000 for the related project costs. Some
of these costs have  already  been paid by the  Company and will  continue to be
paid as testing goes into 1998.

     The Company entered into a license agreement with  Massachusetts  Institute
of  Technology  (MIT)  for  the  use of  certain  patents.  Under  terms  of the
agreement, the Company has agreed to pay $50,000 a year through October 2003 and
$30,000 a year  thereafter  until  the  expiration  of the  patent  rights.  The
agreement can be  terminated by MIT if the monthly  payments are not made within
thirty days.


                                   Page F-10
<PAGE>


                              SpectraSCIENCE, Inc.

                    Notes to Financial Statements (continued)


6. Income Taxes

     The tax effect of the Company's deferred tax assets is as follows:


                                                       December 31
                                                 1997               1996
                                            ----------------------------------
   Net operating loss carryforward           $ 15,955,000       $ 15,345,000
   Accrued liabilities                            101,000             93,000
   Inventory reserve                               39,000             28,000
   Tax credits                                    788,000            770,000
                                            ----------------------------------
                                               16,883,000         16,236,000
   Valuation allowance                        (16,883,000)       (16,236,000)
                                            ----------------------------------
                                             $         --       $         --
                                            ==================================

     At December 31, 1997, the Company had net operating loss  carryforwards  of
approximately $44,318,000 that expire at various times through the year 2012. In
addition,  the Company has research and  development  tax credits that expire at
various  times through 2012.  As a result of previous  stock  transactions,  the
Company  is  limited  as to the  amount  of net  operating  loss and tax  credit
carryforwards  which may be utilized in any one year.  The annual  limitation is
approximately $1,000,000.


7. Employee Benefit Plan

     The  Company  has  a  401(k)  profit  sharing  and  savings  plan  covering
substantially  all  employees.  The plan allows  employees to defer up to 15% of
their  annual  earnings.  The  Company  will  match  50% of the  first 6% of the
employee  contributions.  The contributions by the Company totaled approximately
$17,000, $5,000 and $4,000 for 1997, 1996 and 1995, respectively.


8. Subsequent Events

     In February  1998, an option holder  exercised its option to purchase 6,667
shares of common stock at $3.00 per share.  This resulted in net proceeds to the
Company of $20,001.

     In March 1998, various warrant holders exercised their warrants to purchase
111,112 shares of common stock at $5.00 per share. This resulted in net proceeds
to the Company of $555,560.


                                   Page F-11