<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

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

                                   FORM 10-Q


[X]  Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
     Act of 1934 for the Quarterly Period Ended June 30, 1998.

                                      OR

[_]  Transition Report Pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the Transition Period from _______ to _______.


                       Commission File Number 000-22647
                       --------------------------------

                        Peritus Software Services, Inc.
                        -------------------------------
            (Exact Name of Registrant as Specified in its Charter)


             Massachusetts                                 04-3126919
             -------------                                 ----------
     (State or Other Jurisdiction of                    (I.R.S. Employer
     Incorporation or Organization)                    Identification No.)


2 Federal Street, Billerica, Massachusetts                    01821
------------------------------------------                    -----
(Address of Principal Executive Offices)                    (Zip Code)


                                (978) 670-0800
                                --------------

             (Registrant's Telephone Number, Including Area Code)

                                Not Applicable
                                --------------

             (Former Name, Former Address and Former Fiscal Year,
                         If Changed Since Last Report)

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

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

     Title of Class                  Shares outstanding at August 10, 1998
     --------------                  -------------------------------------

Common Stock, $0.01 par value                      16,299,990 
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
                                   FORM 10-Q
                 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998
                               TABLE OF CONTENTS
--------------------------------------------------------------------------------
<TABLE> 
<CAPTION> 
                                                                                    Page
<S>     <C>                                                                         <C> 
PART I.  FINANCIAL INFORMATION
Item 1.  Financial Statements

           Consolidated Balance Sheet as of June 30, 1998 and December 31, 1997       3
 
           Consolidated Statement of Operations for the Three and Six Months Ended
             June 30, 1998 and 1997                                                   4
 
           Consolidated Statement of Cash Flows for the Six Months Ended
             June 30, 1998 and 1997                                                   5
 
           Notes to Unaudited Consolidated Financial Statements                       6
 
Item 2.  Management's Discussion and Analysis of Financial Condition and
           Results of Operations                                                      9
 
Item 3.  Quantitative and Qualitative Disclosures about Market Risk                  19
 
PART II.  OTHER INFORMATION
 
Item 1.  Legal Proceedings                                                           19
 
Item 2.  Changes in Securities and Use of Proceeds                                   19
 
Item 4.  Submission of Matters to a Vote of Security Holders                         20
 
Item 5.  Other Information                                                           20

Item 6.  Exhibits and Reports on Form 8-K                                            20
 
         Signatures                                                                  22


</TABLE>


                                       2
<PAGE>

Part I.  FINANCIAL INFORMATION

Item 1.  Financial Statements
 
                        PERITUS SOFTWARE SERVICES, INC.
                          CONSOLIDATED BALANCE SHEET
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)
                                  (UNAUDITED)
--------------------------------------------------------------------------------

<TABLE> 
<CAPTION> 
                                                                                     JUNE 30,       DECEMBER 31,
                                                                                       1998             1997
                                                                                   --------------   --------------
<S>                                                                                <C>              <C> 
ASSETS
Current assets:
   Cash and cash equivalents                                                        $     5,285      $    11,340
   Short-term investments                                                                 4,000            3,000
   Accounts receivable, net of allowance for doubtful accounts of $445 and $95,
     respectively and including amounts receivable from related parties
     of $944 and $289, respectively                                                      10,030           13,287
   Costs and estimated earnings in excess of billings on uncompleted contracts,
     including amounts on uncompleted contracts with related parties of $171
     and $250, respectively                                                               3,492            2,547
   Prepaid expenses and other current assets                                              2,249              710
                                                                                   --------------   --------------
      Total current assets                                                               25,056           30,884
   Property and equipment, net                                                            5,521            3,859
   Intangible and other assets, net                                                       5,220            5,787
                                                                                   --------------   --------------
                                                                                    $    35,797      $    40,530
                                                                                   ==============   ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Current portion of capital lease obligations                                     $        91      $        51
   Current portion of long-term debt                                                        292              292
   Accounts payable                                                                         970            1,650
   Billings in excess of costs and estimated earnings on uncompleted contracts            1,114              976
   Deferred revenue                                                                       1,708            2,886
   Other accrued expenses and other current liabilities                                   2,638            3,518
                                                                                   --------------   --------------
      Total current liabilities                                                           6,813            9,373
Capital lease obligations                                                                   347              144
Long-term debt                                                                              123              269
                                                                                   --------------   --------------
      Total liabilities                                                                   7,283            9,786
                                                                                   --------------   --------------
Minority interest in consolidated subsidiary                                                147              159
                                                                                   --------------   --------------
Stockholders' equity:
   Common stock, $.01 par value; 50,000,000 shares authorized;  16,283,735 and
     15,361,800 shares issued and outstanding at June 30, 1998 and December 31, 1997,
     respectively                                                                           163              154
   Additional paid-in capital                                                           105,056          103,808
   Accumulated deficit                                                                  (76,780)         (73,235)
   Note receivable from stockholder                                                           -              (58)
   Cumulative translation adjustment                                                        (72)             (84)
                                                                                   --------------   --------------
      Total stockholders' equity                                                         28,367           30,585
                                                                                   --------------   --------------
                                                                                    $    35,797      $    40,530
                                                                                   ==============   ==============
</TABLE> 

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

                                       3

<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
                     CONSOLIDATED STATEMENT OF OPERATIONS
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)
                                  (UNAUDITED)
--------------------------------------------------------------------------------

<TABLE> 
<CAPTION> 
                                                                                      THREE MONTHS             SIX MONTHS
                                                                                          ENDED                   ENDED
                                                                                         JUNE 30,                JUNE 30,
                                                                                     1998        1997         1998        1997
                                                                                  ----------  ----------   -----------  ----------
<S>                                                                               <C>         <C>          <C>          <C> 
Revenue:
  Outsourcing services, including $1,034, $978, $2,248, and $1,953
   from related parties, respectively                                              $  2,864    $  3,044     $   5,486    $  5,563
  License, including $277, $0, $277, and $0 from related
   parties, respectively                                                              4,501       4,643         9,263       8,787
  Other services, including $317, $0, $317, and $0 from
   related parties, respectively                                                      4,465       1,295         7,231       2,491
                                                                                  ----------  ----------   -----------  ----------
     Total revenue                                                                   11,830       8,982        21,980      16,841
                                                                                  ----------  ----------   -----------  ----------
Cost of revenue:
  Cost of outsourcing services, including $421, $592, $1,134 and $965
   from related parties, respectively                                                 1,886       2,358         3,991       4,403
  Cost of license                                                                       506         148         1,039         275
  Cost of other services, including $56, $0, $56, and $0 from related
   parties, respectively                                                              2,611       1,036         5,048       2,325
                                                                                  ----------  ----------   -----------  ----------
     Total cost of revenue                                                            5,003       3,542        10,078       7,003
                                                                                  ----------  ----------   -----------  ----------
Gross profit                                                                          6,827       5,440        11,902       9,838
                                                                                  ----------  ----------   -----------  ----------
Operating expenses:
  Sales and marketing                                                                 3,247       2,035         6,339       3,418
  Research and development                                                            1,957       1,969         4,979       3,603
  General and administrative                                                          1,286         875         3,022       1,800
  Restructuring charge                                                                1,439           -         1,439           -
                                                                                  ----------  ----------   -----------  ----------
     Total operating expenses                                                         7,929       4,879        15,779       8,821
                                                                                  ----------  ----------   -----------  ----------
     Income (loss) from operations                                                   (1,102)        561        (3,877)      1,017

Interest income (expense), net                                                          185          (7)          345          20
                                                                                  ----------  ----------   -----------  ----------
     Income (loss) before income taxes and minority interest in
       consolidated subsidiary                                                         (917)        554        (3,532)      1,037
Provision for income taxes                                                               25         124            25         172
                                                                                  ----------  ----------   -----------  ----------
     Income (loss) before income taxes and minority interest in
       consolidated subsidiary                                                         (942)        430        (3,557)        865
Minority interest in consolidated subsidiary                                             37          (8)          (12)         21
                                                                                  ----------  ----------   -----------  ----------
     Net income (loss)                                                             $   (979)        438     $  (3,545)        844
Accrual of cumulative dividends on Series A and B redeemable                      ==========               ===========
  convertible preferred stock                                                                      (444)                     (677)
Accretion to redemption of redeemable common stock rights                                           (31)                      (57)
                                                                                              ----------                ----------
Net income (loss) available to common stockholders                                             $    (37)                 $    110
                                                                                              ==========                ==========
Net income (loss) per common share:
  Basic                                                                            $  (0.06)   $  (0.01)    $   (0.22)   $   0.02
                                                                                  ==========  ==========   ===========  ==========
  Diluted                                                                          $  (0.06)   $  (0.01)    $  (0.22)    $   0.01
                                                                                  ==========  ==========   ===========  ==========
Weighted average common shares outstanding:
  Basic                                                                              16,179       6,000        16,082       5,944
                                                                                  ==========  ==========   ===========  ==========
  Diluted                                                                            16,179       8,587        16,082       8,531
                                                                                  ==========  ==========   ===========  ==========
</TABLE>


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

                                       4
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
                     CONSOLIDATED STATEMENT OF CASH FLOWS
                                (IN THOUSANDS)
                                  (UNAUDITED)
--------------------------------------------------------------------------------
<TABLE> 
<CAPTION> 
                                                                                               SIX MONTHS
                                                                                                  ENDED
                                                                                                 JUNE 30,
                                                                                           1998            1997
                                                                                      --------------  --------------
<S>                                                                                   <C>             <C> 
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
Cash flows from operating activities:
  Net income (loss)                                                                    $   (3,545)     $      844
  Adjustments to reconcile net income (loss) to net cash used for                       
    operating activities:                                                               
      Depreciation and amortization                                                         1,660             495
      Minority interest in consolidated subsidiary                                            (12)             21
      Changes in assets and liabilities, net of effects from acquisitions:              
        Accounts receivable                                                                 3,257          (3,833)
        Costs and estimated earnings in excess of billings on uncompleted contracts          (945)            224
        Unbilled license revenue from related parties                                           -             400
        Prepaid expenses and other current assets                                          (1,539)           (475)
        Other assets                                                                          (52)             10
        Accounts payable                                                                     (680)            427
        Billings in excess of costs and estimated earnings on uncompleted contracts           138             (52)
        Deferred revenue                                                                   (1,178)         (2,255)
        Other accrued expenses and other current liabilities                                 (880)            123
                                                                                      --------------  --------------
        Net cash used for operating activities                                             (3,776)         (4,071)
                                                                                      --------------  --------------
Cash flows from investing activities:                                                   
  Purchase of short-term investments                                                       (1,000)              -
  Investments in consolidated subsidiary                                                        -            (111)
  Purchases of property and equipment                                                      (2,415)           (779)
                                                                                      --------------  --------------
        Net cash used for investing activities                                             (3,415)           (890)
                                                                                      --------------  --------------
Cash flows from financing activities:                                                   
  Proceeds from long-term debt                                                                  -             200
  Principal payments on long-term debt                                                       (146)           (105)
  Principal payments on capital lease obligations                                             (45)            (34)
  Proceeds from exercise of stock options                                                   1,001              23
  Proceeds from sale of common stock                                                          256               -
  Proceeds from payment of note receivable from stockholder                                    58               -
                                                                                      --------------  --------------
        Net cash provided by financing activities                                           1,124              84
                                                                                      --------------  --------------
Effects of exchange rates on cash and cash equivalents                                         12             (38)
                                                                                      --------------  --------------
Net decrease in cash and cash equivalents                                                  (6,055)         (4,915)
Cash and cash equivalents, beginning of period                                             11,340           7,388
                                                                                      --------------  --------------
Cash and cash equivalents, end of period                                               $    5,285      $    2,473
                                                                                      ==============  ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS:                                                  
  Cash paid for income taxes                                                           $       78      $        -
  Cash paid for interest                                                                       34             109

</TABLE> 

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

                                       5
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
             NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

1.  BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements include the
accounts of Peritus Software Services, Inc. and its subsidiaries (the "Company")
and have been prepared by the Company without audit in accordance with the
Company's accounting policies, as described in the Company's Annual Report on
Form 10-K for the year ended December 31, 1997, as filed with the Securities and
Exchange Commission ("SEC"). In the opinion of management, the accompanying
unaudited consolidated financial statements contain all adjustments, consisting
only of those of a normal recurring nature, necessary for a fair presentation of
the Company's financial position, results of operations and cash flows at the
dates and for the periods indicated. While the Company believes that the
disclosures presented are adequate to make the information not misleading, these
financial statements should be read in conjunction with the audited consolidated
financial statements and related notes included in the Company's 1997 Annual
Report on Form 10-K. The operating results for the three and six months ended
June 30, 1998 are not necessarily indicative of the results to be expected for
the full year ending December 31, 1998.

2.  LEGAL PROCEEDINGS

The Company and certain of its officers and directors have been named as
defendants in purported class action lawsuits filed in the United States
District Court for the District of Massachusetts by Robert Downey on April 1,
1998, by Scott Cohen on April 7, 1998, by Timothy Bonnett on April 9, 1998, by
Peter Lindsay on April 17, 1998, by Harry Teague on April 21, 1998, by Jesse
Wijntjes on April 29, 1998, by H. Vance Johnson and H. Vance Johnson as Trustee
for the I.O.R.D. Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on
May 21, 1998 and by Helen Lee on May 28, 1998 (collectively, the "complaints").
The Downey complaint alleges a class period of October 22, 1997 to March 27,
1998. The Cohen, Bonnett, Wijntjes and Lee complaints allege a class period of
January 27, 1998 to March 27, 1998. The Lindsay, Teague and Johnson complaints
allege a class period of January 28, 1998 to March 27, 1998. The Howard
complaint alleges a class period of July 3, 1997 to March 27, 1998. The
complaints principally allege that the defendants violated federal securities
laws by making false and misleading statements and by failing to disclose
material information concerning the Company's December 1997 acquisition of
substantially all of the assets and assumption of certain liabilities of the
Millennium Dynamics, Inc. business from American Premier Underwriters, Inc.,
thereby allegedly causing the value of the Company's common stock to be
artificially inflated during the purported class periods. In addition, the
Howard complaint alleges violation of federal securities laws as a result of the
Company's purported failure to disclose material information in connection with
the Company's initial public offering on July 2, 1997, and also names Montgomery
Securities, Inc., Wessels, Arnold & Henderson, and H.C. Wainwright & Co., Inc.
as defendants. The complaints further allege that certain officers and/or
directors of the Company sold stock in the open market during the class periods
and seek unspecified damages. On or about June 1, 1998, all of the named
plaintiffs and additional purported class members filed a motion for the
appointment of several of those individuals as lead plaintiffs, for approval of
lead and liaison plaintiffs' counsel and for consolidation of the actions.
Although the Company believes that it and the other defendants have meritorious
defenses to the claims made in the complaints and intends to contest the
lawsuits vigorously, an adverse resolution of the lawsuits could have a material
adverse effect on the Company's financial condition and results of operations in
the period in which the litigation is resolved. The Company is not able to
reasonably estimate potential losses, if any, related to the complaints.

                                       6
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
             NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

3.  RESTRUCTURING CHARGE

In March 1998, the Company announced its intentions for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, and recorded a non-recurring charge of $1,439,000
consisting primarily of severance payments associated with the termination of
approximately 12% of the Company's employees in April 1998 (48 employees). At
June 30, 1998, all 48 employees had been terminated with no further terminations
remaining under the restructuring. In addition, a significant portion of the
restructuring charge related to the closure of two research and development and
outsourcing centers and support costs for a discontinued product. The amounts
accrued to and charged against restructuring costs during the second quarter of
1998 and the composition of the remaining balance at June 30, 1998 were as
follows:

<TABLE> 
<CAPTION> 
(in thousands)
                                                 Balance         Q2 1998     Q2 1998        Balance
                                              March 31, 1997     Accrual     Charges     June 30, 1998
                                             ----------------   ---------   ---------   ---------------  
<S>                                          <C>                <C>         <C>         <C> 
Provision for severance and benefit
    payments to terminated employees          $         -        $   947     $ (526)     $      421
Provisions related to closure of facilities             -            327          -             327
Other                                                   -            165        (41)            124
                                             ----------------   ---------   ---------   ---------------  
Total                                         $         -        $ 1,439     $ (567)     $      872
                                             ================   =========   =========   ===============

</TABLE> 

4.  COMPREHENSIVE INCOME (LOSS)

The Company adopted Statement of Financial Accounting Standards ("SFAS")
No. 130, "Reporting Comprehensive Income" effective January 1, 1998.  This
statement establishes standards for the reporting and display of comprehensive
income and its components. Comprehensive income is defined as the change in
equity of a business enterprise during a period from transactions and other
events and circumstances from non-owner sources.  It includes all changes in
equity during a period except those resulting from investments by owners and
distributions to owners.  This standard requires that an enterprise display an
amount representing total comprehensive income for the period.

For the three and six months ended June 30, 1998 and 1997, the Company's
comprehensive income (loss) was as follows:
<TABLE>
<CAPTION>
                                     Three months ended June 30,   Six months ended June 30,
                                     ---------------------------   -------------------------
                                        1998             1997           1998           1997
                                       ------           ------         ------         ------
<S>                                  <C>              <C>            <C>            <C>
Net income (loss)                    $(979,000)       $438,000       $(3,545,000)   $844,000
Cumulative translation adjustment       15,000         (31,000)           12,000     (38,000)
                                     ----------       ----------     -----------    ----------
                                     $(964,000)       $407,000       $(3,533,000)   $806,000
                                     ==========       ==========     ===========    =========
</TABLE>


5.  NET INCOME (LOSS) PER SHARE

    In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings per Share", which supersedes Accounting Principles Board
Opinion Accounting ("APB") No. 15 and specifies the computation, presentation
and disclosure requirements of earnings per share.  SFAS No. 128 requires the
presentation of "basic" earnings per share and "diluted" earnings per share.
Basic earnings per share is computed by dividing the net income (loss) available
to common stockholders by the weighted average shares of outstanding common
stock.  For purposes of calculating diluted earnings per share, the denominator
includes both the weighted average shares of common stock outstanding, when not
anti-dilutive, and dilutive potential common stock including outstanding stock 
options.

                                       7
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
             NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

The Company adopted SFAS No. 128 in the fourth quarter of 1997 and has restated
earnings per share amounts for all periods presented herein, as required.


6.  RECENTLY ISSUED ACCOUNTING STANDARDS

In October 1997, the Accounting Standards Executive Committee ("AcSEC") of the
American Institute of Certified Public Accountants issued Statement of Position
("SOP") 97-2, "Software Revenue Recognition". SOP 97-2 provides guidance on the
timing and amount of revenue recognition when licensing, selling, leasing or
otherwise marketing computer software and is effective for transactions entered
into during fiscal years beginning after December 15, 1997. On March 18, 1998,
the FASB cleared a new SOP that provides for the one-year deferral of certain
provisions of SOP 97-2 pertaining to its requirements for what constitutes
vendor-specific evidence of the fair value of multiple elements included in an
arrangement. It is AcSEC's stated intention to immediately begin a project to
consider whether guidance is needed on any restrictions that should be placed on
what constitutes evidence of fair value and, if so, what the guidance should be.
Because of the uncertainties with respect to the outcome of any such project,
the Company believes that the impact of the deferred provisions of SOP 97-2 on
its financial position or results of operations upon expiration of the one-year
deferral period is not currently determinable. However, the Company believes
that those provisions of SOP 97-2 that have not been deferred and, therefore,
were effective as of January 1, 1998, have not materially affected its financial
position or results of operations.

In February 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use". SOP 98-1 establishes the
accounting for costs of software products developed or purchased for internal
use, including when such costs should be capitalized. The Company does not
expect SOP 98-1, which is effective for the Company beginning January 1, 1999,
to have a significant impact on the Company's financial condition or results of
operations.

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" which supersedes SFAS No. 14. This statement
changes the way that public business enterprises report segment information,
including financial and descriptive information about their selected segment
information. Operating segments are defined as revenue-producing components of
the enterprise which are generally used internally for evaluating segment
performance. SFAS No. 131 will be effective for the Company's fiscal year ending
December 31, 1998 and will not affect the Company's financial position or
results of operations.

7.  SUBSEQUENT EVENT

In July 1998, the Company divested all of its interest in Persist, S.A.
("Persist"), the Company's majority owned Spanish subsidiary, for $600,000 cash
less adjustments for certain inter-company balances then outstanding.
Accordingly, the results of operations of Persist will no longer be
consolidated with the results of the Company. As a result of this transaction,
Persist became wholly owned by the former minority shareholders. During the six
months ended June 30, 1998, Persist had revenues of $1,090,000. The Company will
recognize a gain of approximately $300,000 in the three months ended September
30, 1998 as a result of this divestiture.

                                       8
<PAGE>
 
--------------------------------------------------------------------------------
 
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

OVERVIEW

Peritus Software Services, Inc. ("Peritus") was founded in 1991 to address the
growing market for managing and maintaining the installed base of software in
organizations. The Company focused its efforts on the delivery of software
maintenance outsourcing services until 1995, when it began to devote significant
resources to the development of software tools addressing the problems
associated with mass changes to application systems and their associated
databases, particularly the year 2000 problem. In 1996, the Company began
licensing its AutoEnhancer/2000 software, which was designed to address the year
2000 problem, to value added integrators and directly to end users. In 1996, the
Company expanded its research and development efforts through the acquisition of
Vista Technologies Incorporated ("Vista"), a developer of computer-aided
engineering software. In 1997, the Company expanded its products offerings by
releasing an enhanced version of the AutoEnhancer/2000 software which enables a
client to perform logic correction only changes with regard to year 2000
renovations, and through the acquisition of substantially all of the assets and
the assumption of certain liabilities of the business of Millennium Dynamics,
Inc. ("MDI"), a software tools company with year 2000 products for the IBM
mainframe and AS/400 platforms, from American Premier Underwriters, Inc.
("APU"). In 1998 the Company further emphasized its products and services by
selling and providing direct delivery of year 2000 renovation services.

The Company derives its revenue from software maintenance outsourcing services,
software and methodology licensing and other services (including direct delivery
of year 2000 renovation services) sold directly to end users or indirectly via
value added integrators and distributors, and its clients included primarily
Fortune 1000 companies and similarly sized business and government organizations
worldwide. The Company's products and services are marketed through its direct
sales force, both domestically and in Europe, through value added integrators
operating worldwide and through international distributors in Canada, Europe and
Japan.

THREE MONTHS ENDED JUNE 30, 1998 COMPARED TO THREE MONTHS ENDED JUNE 30, 1997

Revenue
Total revenue increased 31.7% to $11,830,000 in the three months ended June 30,
1998 from $8,982,000 in the three months ended June 30, 1997.  This increase in
revenue was due to an increase in year 2000 renovation sources performed by the
Company using the Auto Enhancer/2000 software and the Vantage YR2000 products.
During the three months ended June 30, 1998, one customer generated 30.2% of
total revenue.  International revenue increased 107.4% to $1,178,000 in 1998
from $568,000 in 1997.   On July 20, 1998, the Company divested its entire
interest in its majority owned Spanish subsidiary, Persist S.A. ("Persist") for
cash of $600,000 less adjustments for certain inter-company balances then
outstanding.  The former minority shareholders of Persist now own all of that
entity. Persist and value added integrators, distributors, and end users
generated 37.6% and 62.4%, respectively of the Company's international revenue
in the three months ended June 30, 1998.  Persist generated substantially all of
the Company's international revenue in 1997.

Outsourcing Services
Outsourcing services revenue decreased 5.9% to $2,864,000 in the three months
ended June 30, 1998 from $3,044,000 in the three months ended June 30, 1997.
The decrease in outsourcing services revenue in absolute dollars was primarily
attributable to the termination of one outsourcing contract and the recognition
of lesser amounts of revenue under the percentage-of-completion method on
existing outsourcing contracts that were in their later phases during 1998.  As
a percentage of total revenue, outsourcing services revenue decreased to 24.2%
in the three months ended June 30, 1998 from 33.9% in the three months ended
June 30, 1997.  The decrease in outsourcing services revenue as a percentage of
total revenue reflects the increased contribution of license and other services
revenue to total revenue during the three months ended June 30, 1998 when
compared to the comparable period for the prior year.  Outsourcing services
remain a major component of the solutions offered by the Company, and the
Company anticipates that such services will continue to account for a
significant portion of total revenue 

                                       9
<PAGE>
 
--------------------------------------------------------------------------------

for the foreseeable future. In July 1998, the Company announced its outsourcing
offerings, "Software Asset Maintenance for Software Providers" and "Software
Asset Maintenance for Information Systems", which are outsourcing solutions
designed specifically for the manufacturers of system software and software
products and for information technology departments that maintain application
software, respectively.

License
License revenue was $4,501,000 in the three months ended June 30, 1998 or 38.0%
of total revenue, compared to $4,643,000, or 51.7% of total revenue, in the
three months ended June 30, 1997.  The decrease in license revenue for the three
months ended June 30, 1998 was primarily attributable to the decrease in direct
delivery of licensed software to end users and to decreased license fees from
value added integrators.

Other Services
Other services revenue increased 244.8%  to $4,465,000 in the three months ended
June 30, 1998 from $1,295,000 in the three months ended June 30, 1997.  As a
percentage of total revenue, other services revenue was 37.7% in the three
months ended June 30, 1998 and 14.4% in the three months ended June 30, 1997.
The increase in other services revenue in absolute dollars was primarily
attributable to an increase in year 2000 renovation services performed by
Company personnel using the Company's year 2000 products.

Cost of Revenue

Cost of Outsourcing Services Revenue
Cost of outsourcing services revenue consists primarily of salaries, benefits
and overhead costs associated with delivering outsourcing services to clients.
The cost of outsourcing services revenue decreased 20.0% to $1,886,000 in the
three months ended June 30, 1998 from $2,358,000 for the three months ended June
30, 1997.  Cost of outsourcing services revenue as a percentage of outsourcing
services revenue decreased to 65.9% in the three months ended June 30, 1998 from
77.5% in the three months ended June 30, 1997.  The decrease in costs of
outsourcing services revenue in absolute dollars was due primarily to the
reduction of resources related to the termination of one outsourcing contract.

Cost of License Revenue
Cost of license revenue consists primarily of salaries, benefits, amortization
expense of intangibles related to the MDI acquisition and related overhead costs
associated with license-related materials packaging and freight. Cost of license
revenue was $506,000 in the three months ended June 30, 1998, or 11.2% of
license revenue compared to $148,000 or 3.2% of license revenue, in the three
months ended June 30, 1997. The increase in cost of license revenue in absolute
dollars was primarily attributable to the addition of employees and related
resources to support additional end users and value added integrators and the
amortization of intangibles related to the MDI acquisition.

Cost of Other Services Revenue
Cost of other services revenue consists primarily of salaries, benefits and
related overhead costs associated with delivering other services to clients.
Cost of other services revenue increased 152.0% to $2,611,000 in the three
months ended June 30, 1998 from $1,036,000 in the three months ended June 30,
1997.  Cost of the services revenue as a percentage of other services revenue
decreased to 58.5% in the three months ended June 30, 1998 from 80.0% in the
three months ended June 30, 1997.  Costs increased in absolute dollars in the
three months ended June 30, 1998 due to additional staffing the Company required
to support the demand for the Company's year 2000 renovation services.

                                       10
<PAGE>
 
--------------------------------------------------------------------------------

Operating Expenses

Sales and Marketing
Sales and marketing expenses consist primarily of salaries, commissions and
related overhead costs for sales and marketing personnel; sales referral fees to
third parties; advertising programs; and other promotional activities.  Sales
and marketing expenses increased 59.6% to $3,247,000 in the three months ended
June 30, 1998 from $2,035,000 in the three months ended June 30, 1997.  As a
percentage of total revenue, sales and marketing expenses increased to 27.4% in
the three months ended June 30, 1998 from 22.7% in the three months ended June
30, 1997.  The increase in expenses in absolute dollars and as a percentage of
revenue was primarily attributable to increased staffing, commissions, including
an increase in sales referral fees to third parties, and promotional activities
in conjunction with the Company's year 2000 software products and services in
1998.

Research and Development
Research and development expenses consist primarily of salaries, benefits and
related overhead costs for engineering and technical personnel and outside
engineering consulting services associated with developing new products and
enhancing existing products. Research and development expenses remained flat at
$1,957,000 in the three months ended June 30, 1998 from $1,969,000 in the three
months ended June 30, 1997. As a percentage of total revenue, research and
development expenses decreased to 16.5% in the three months ended June 30, 1998
from 21.9% in the three months ended June 30, 1997.

General and Administrative
General and administrative expenses consist primarily of salaries and related
costs for the finance and accounting, human resources, legal services,
information systems and other administrative departments of the Company, as well
as legal and accounting expenses and the amortization of intangible assets
associated with the Vista acquisition.  General and administrative expenses
increased 47.0% to $1,286,000 in the three months ended June 30, 1998 from
$875,000 in the three months ended June 30, 1997.  As a percentage of total
revenue, general and administrative expenses increased to 10.9% in the three
months ended June 30, 1998 from 9.7% in the three months ended June 30, 1997.
The increase in general and administrative expenses in absolute dollars was
primarily due to additions to the Company's administrative staff to support
growth, higher professional fees and increases in other general corporate
expenses as well as increased costs associated with being a publicly traded
company.

Restructuring Charge
In March 1998, the Company announced its intentions for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, by recording a non-recurring charge of $1,439,000 in
the three months ended June 30, 1998, consisting primarily of severance payments
associated with the termination of approximately 48 employees, costs associated
with closing two research and development and outsourcing service centers, and
support costs for a discontinued product.

Interest Income (Expense), Net
Interest income (expense), net is primarily composed of interest earned on cash
balances and interest expense on debt incuding capital lease obligations. The
Company had interest income, net of $185,000 in the three months ended June 30,
1998 compared to interest expense, net of $7,000 in the three months ended June
30, 1997. This change in interest income, net was primarily attributable to
increased interest income from increased cash balances resulting from the
Company's initial public offering in July 1997.

                                       11
<PAGE>
 
PERITUS SOFTWARE SERVICES, INC.
FORM 10-Q
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

Provision for Income Taxes
The Company's income tax provision was $25,000 and $124,000 in the three months
ended June 30, 1998 and 1997, respectively. The provision in 1998 reflects
potential international tax obligations.

Minority Interest in Consolidated Subsidiary
The minority interest in consolidated subsidiary represents the equity interest
in the operating results of Persist held by stockholders of Persist other than
the Company. The minority interest in consolidated subsidiary increased to a net
income of $37,000 in the three months ended June 30, 1998 from a loss of $8,000
in the three months ended June 30, 1997. This change was the result of the
increased profitability of Persist. At June 30, 1998 and 1997, the Company held
a 63.0% equity interest in Persist.

SIX MONTHS ENDED JUNE 30, 1998 COMPARED TO SIX MONTHS ENDED JUNE 30, 1997

Revenue
Total revenue increased 30.5% to $21,980,000 in the six months ended June 30,
1998 from $16,841,000 in the six months ended June 30, 1997.  This increase in
revenue was primarily due to an increase in year 2000 renovation services
performed by the Company using the Auto Enhancer/2000 software and Vantage
YR2000 products. During the six months ended June 30, 1998, one customer
generated 16.5% of total revenue.  International revenue increased 138.6% to
$3,102,000 in the six months ended June 30, 1998 from $1,300,000 in the six
months ended June 30, 1997. On July 20, 1998, the Company divested its entire
interest in its majority owned Spanish subsidiary, Persist S.A. ("Persist") for
cash of $600,000 less adjustments for certain inter-company balances then
outstanding.  The former minority shareholders of Persist now own all of that
entity.  Persist and value added integrators, distributors, and end users
generated 35.1% and 64.9%, respectively of the Company's international revenue
in the six months ended June 30, 1998.  Persist generated substantially all of
the Company's international revenue in the six months ended June 30, 1997.

Outsourcing Services
Outsourcing services revenue decreased 1.4% to $5,486,000 in the six months
ended June 30, 1998 from $5,563,000 in the six months ended June 30, 1997.  The
decrease in outsourcing services revenue in absolute dollars was primarily
attributable to the termination of one significant outsourcing contract and by
the recognition of lesser amounts of revenue under the percentage-of-completion
method on existing outsourcing contracts that were in their later phases during
1998.  As a percentage of total revenue, outsourcing services revenue decreased
to 25.0% in the six months ended June 30, 1998 from 33.0% in the six months
ended June 30, 1997.  The decrease in outsourcing revenue as a percentage of
total revenue reflects the increased contribution of license and renovation
services revenue to total revenue during the six months ended June 30, 1998.
Outsourcing services remain a major component of the solutions offered by the
Company, and the Company anticipates that such services will continue to account
for a significant portion of total revenue for the foreseeable future. In July
1998, the Company announced its outsourcing offerings, "Software Asset
Maintenance for Software Providers" and "Software Asset Maintenance for
Information Systems", which are outsourcing solutions designed specifically for
the manufacturers of system software and software products and for information
technology departments that maintain application software, respectively.

License
License revenue was $9,263,000 in the six months ended June 30, 1998 or 42.1% of
total revenue, compared to $8,787,000, or 52.2% of total revenue, in the six
months ended June 30, 1997.  The increase in license revenue for the six months
ended June 30, 1998 was primarily attributable to the delivery of licensed
software to additional end users and to increased license fees from value added
integrators.

                                       12
<PAGE>
 

Other Services
Other services revenue increased 190.3%  to $7,231,000 in the six months ended
June 30, 1998 from $2,491,000 in the six months ended June 30, 1997.  As a
percentage of total revenue, other services revenue was 32.9% in the six months
ended June 30, 1998 and 14.8% in the six months ended June 30, 1997.  The
increase in other services revenue in absolute dollars was primarily
attributable to an increase in year 2000 services performed by Company personnel
using Company's year 2000 products.

Cost of Revenue

Cost of Outsourcing Services Revenue
Cost of outsourcing services revenue consists primarily of salaries, benefits
and overhead costs associated with delivering outsourcing services to clients.
The cost of outsourcing services revenue decreased 9.4% to $3,991,000 in the six
months ended June 30, 1998 from $4,403,000 for the six months ended June 30,
1997.  Cost of outsourcing services revenue as a percentage of outsourcing
services revenue decreased to 72.7% in the six months ended June 30, 1998 and
from 79.2% in the six months ended June 30, 1997.  The decrease in costs of
outsourcing services revenue in absolute dollars was due primarily to the
termination of one outsourcing contract.

Cost of License Revenue
Cost of license revenue consists primarily of salaries, benefits, amortization
expense of intangibles related to the MDI acquisition and related overhead costs
associated with license-related materials packaging and freight. Cost of license
revenue was $1,039,000 in the six months ended June 30, 1998, or 11.2% of
license revenue compared to $275,000 or 3.1% of license revenue, in the six
months ended June 30, 1997. The increase in cost of license revenue in absolute
dollars was primarily attributable to the addition of employees and related
resources to support additional end users and value added integrators and the
amortization of intangibles related to the MDI acquisition.

Cost of Other Services Revenue
Cost of other services revenue consists primarily of salaries, benefits and
related overhead costs associated with delivering other services to clients.
Cost of other services revenue increased 117.1% to $5,048,000 in the six months
ended June 30, 1998 from $2,325,000 in the six months ended June 30, 1997.  Cost
of the services revenue as a percentage of other services revenue decreased to
69.8% in the six months ended June 30, 1997 from 93.3% in the three months ended
June 30, 1997.  Costs increased in absolute dollars in the six months ended June
30, 1998 due to additional staffing the Company required to support the demand
from the Company's year 2000 renovation products and services.

Operating Expenses

Sales and Marketing
Sales and marketing expenses consist primarily of salaries, commissions and
related overhead costs for sales and marketing personnel; sales referral fees to
third parties; advertising programs; and other promotional activities. Sales and
marketing expenses increased 85.5% to $6,339,000 in the six months ended June
30, 1998 from $3,418,000 in the six months ended June 30, 1997. As a percentage
of total revenue, sales and marketing expenses increased to 28.8% in the six
months ended June 30, 1998 from 20.3% in the three months ended June 30, 1997.
The increase in expenses in absolute dollars and as a percentage of revenue was
primarily attributable to increased staffing, commissions, including an increase
in sales referral fees to third parties, and promotional activities in
conjunction with the Company's year 2000 software products and services in 1998.

                                       13
<PAGE>
 
-------------------------------------------------------------------------------

Research and Development
Research and development expenses consist primarily of salaries, benefits and
related overhead costs for engineering and technical personnel and outside
engineering consulting services associated with developing new products and
enhancing existing products.  Research and development expenses increased 38.2%
to $4,979,000 in the six months ended June 30, 1998 from $3,603,000 in the six
months ended June 30, 1997.  As percentage of total revenue, research and
development expenses increased to 22.7% in six months ended June 30, 1998 from
21.4% in the six months ended June 30, 1997.  The increase in research and
development expenses in absolute dollars was primarily attributable to increased
staffing for the product development efforts for the Company's year 2000
products and services and mass change technologies, including an increase in
staffing effected through new hires and internal transfers.

General and Administrative
General and administrative expenses consist primarily of salaries and related
costs for the finance and accounting, human resources, legal services,
information systems and other administrative departments of the Company, as well
as legal and accounting expenses and the amortization of intangible assets
associated with Vista acquisition.  General and administrative expenses
increased 67.9% to $3,022,000 in the six months ended June 30, 1998 from
$1,800,000 in the six months ended June 30, 1997.  As a percentage of total
revenue, general and administrative expenses increased to 13.7% in the six
months ended June 30, 1998 from 10.7% in the six months ended June 30, 1997.
The increase in general and administrative expenses in absolute dollars was
primarily due to additions to the Company's administrative staff to support
growth, higher professional fees and increases in other general corporate
expenses as well as increased costs associated with being a publicly traded
company.

Restructuring Charge
In March 1998, the Company announced its intentions for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, by recording a non-recurring charge of $1,439,000 in the
three months ended June 30, 1998, consisting primarily of severance payments
associated with the termination of approximately 48 employees, costs associated
with closing two research and development and outsourcing service centers and
support costs for a discontinued product.

Interest Income (Expense), Net
Interest income (expense), net is primarily composed of interest income earned
on cash balances and interest expense on debt including capital lease
obligations. The Company had interest income, net of $345,000 in the six months
ended June 30, 1998 compared to interest income, net of $20,000 in the six
months ended June 30, 1997. This change in interest income, net was primarily
attributable to increased interest income from increased cash balances resulting
from the Company's initial public offering.

Provision for Income Taxes
The Company's income tax provision was $25,000 and $172,000 in the six months
ended June 30, 1998 and 1997, respectively.  The provision in the six months
ended June 30, 1998 reflects potential international tax obligations.

Minority Interest in Consolidated Subsidiary
The minority interest in consolidated subsidiary represents the equity interest
in the operating results of Persist held by stockholders of Persist other than
the Company. The minority interest in consolidated subsidiary decreased to a
loss of $12,000 in the six months ended June 30, 1998 from income of $21,000 in
the six months ended June 30, 1997. This change was the result of the decreased
profitability of Persist. As of June 30, 1998 and 1997, the Company held a 63.0%
equity interest in Persist.

                                       14
<PAGE>

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

LIQUIDITY AND CAPITAL RESOURCES

Historically, the Company has financed its operations and capital expenditures
primarily with the proceeds from sales of the Company's convertible preferred
stock and common stock, borrowings and advance payments for services from
clients. The Company's cash balances were $5,285,000 and $11,340,000 at June 30,
1998 and December 31, 1997, respectively. The Company's working capital was
$18,243,000 and $21,511,000 at June 30, 1998 and December 31, 1997,
respectively. The Company's operating activities used cash of $3,776,000 and
$4,071,000 during the six months ended June 30, 1998 and 1997, respectively. The
Company's use of cash during the six months ended June 30, 1998 was primarily
caused by net loss of $3,545,000 less non-cash depreciation and amortization
expense of $1,660,000, an increase in prepaid expenses and other current assets
of $1,539,000 and a decrease in accounts payable, deferred revenue and other
accrued expenses and current liabilities of $2,738,000. These uses of cash were
partially offset by a decrease in accounts receivable of $3,257,000.

The Company used cash of $3,415,000 and $890,000 for investing activities during
the six months ended June 30, 1998 and 1997, respectively.  Investing activities
in the six months ended June 30, 1998 consisted principally of the purchases of
property and equipment, most notably computer equipment and software, furniture
and fixtures and leasehold improvements related to the Company's relocations of
its headquarters and regional offices.   Although the Company has no significant
commitments for capital expenditures in the remainder of 1998, the Company
expects to continue to purchase property and equipment to further develop its
infrastructure.

The Company's financing activities provided cash of $1,124,000 and $84,000
during the six months ended June 30, 1998 and 1997, respectively.   Financing
activities in the six months ended June 30, 1998 primarily reflect proceeds from
the exercise of stock options.

In September 1996, the Company obtained a revolving line of credit facility from
a bank which bears interest at the bank's prime rate plus 0.5% (9.00% at June
30, 1998). The Company has obtained approval of amendments of its credit
facility providing for among other terms, renewal and increase of its line of
credit. Maximum borrowing under this line of credit, as amended, is $5,000,000
and is limited to 75% of certain receivables plus 50% of cost and estimated
earnings in excess of billings on uncompleted contracts, as defined by the line
of credit agreement. The line of credit expires and all borrowings are payable
in full on June 30, 1999. In addition to this line of credit, the Company also
entered into an equipment financing agreement in September 1996. Under this
agreement, the bank agreed to provide up to $1,500,000 for the purchase of
certain equipment (as defined by the agreement) through June 30, 1997. Ratable
principal and interest payments are payable during the period July 1, 1997
through June 1, 2000, and bear interest at the bank's prime rate plus 1% (9.50%
at June 30, 1998). Both of these agreements require the Company to comply with
certain financial covenants and are secured by all of the assets of the Company.
As of June 30, 1998, the Company was in compliance with such financial covenants
as waived or amended, there were no borrowings outstanding, and $5,000,000
remained available, under the revolving credit facility and $415,000 was
outstanding under the equipment financing agreement.

To date, the Company has not invested in derivative securities or any other
financial instruments that involve a high level of complexity or risk.  Excess
cash has been, and the Company contemplates that it will continue to be invested
in interest-bearing, investment grade securities.

                                       15
<PAGE>
 
-------------------------------------------------------------------------------

The Company anticipates that the net proceeds from the sale of common stock in
its July 1997 initial public offering, together with cash generated from
operations, existing cash balances and advances available under its revolving
credit line agreement will be adequate to finance its operations through 1998.
Thereafter, the Company's cash requirements will depend on the results of future
operations, which cannot be foreseen. To the extent that such sources are
insufficient to finance the Company's capital requirements, the Company will be
required to raise additional funds through bank borrowings or equity and/or debt
financing. No assurance can be given that the Company will be able to borrow
under, extend or increase its bank borrowings, or that such financings will be
available on terms acceptable to the Company and, if available, such financings
may result in further dilution to the Company's stockholders and higher interest
expense.

FOREIGN CURRENCY

Assets and liabilities of the Company's subsidiaries are translated into United
States dollars at exchange rates in effect at the balance sheet date. Income and
expense items are translated at average exchange rates for the period.
Accumulated net translation adjustments are included in stockholders' equity.

INFLATION

To date, inflation has not had a material impact on the Company's results of
operations.

RECENTLY ISSUED ACCOUNTING STANDARDS

In October 1997, the Accounting Standards Executive Committee ("AcSEC") of the
American Institute of Certified Public Accountants issued Statement of Position
("SOP") 97-2, "Software Revenue Recognition."  SOP 97-2 provides guidance on the
timing and amount of revenue recognition when licensing, selling, leasing or
otherwise marketing computer software and is effective for transactions entered
into during fiscal years beginning after December 15, 1997.  On March 18, 1998,
the Financial Accounting Standards Board ("FASB") cleared a new SOP that
provides for the one-year deferral of certain provisions of SOP 97-2 pertaining
to its requirements for what constitutes vendor specific evidence of the fair
value of multiple elements included in an arrangement. It is AcSEC's stated
intention to immediately begin a project to consider whether guidance is needed
on any restrictions that should be placed on what constitutes evidence of fair
value and, if so, what the guidance should be. Because of the uncertainties with
respect to the outcome of any such project, the Company believes that the impact
of the deferred provisions of SOP 97-2 on its financial position or results of
operations upon expiration of the one-year deferral period is not currently
determinable. However, the Company believes that those provisions of SOP 97-2
that have not been deferred and, therefore, were effective as of January 1,
1998, have not materially affected its financial position or results of
operations.

In February 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use".  SOP 98-1 establishes the
accounting for costs of software products developed or purchased for internal
use, including when such costs should be capitalized.  The Company does not
expect SOP 98-1, which is effective for the Company beginning January 1, 1999,
to have a significant impact on the Company's financial condition or results of
operations.

                                       16
<PAGE>
 
-------------------------------------------------------------------------------

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" which supersedes SFAS No. 14.  This
statement changes the way that public business enterprises report segment
information, including financial and descriptive information about their
selected segment information.  Operating segments are defined as revenue-
producing components of  the enterprise which are generally used internally for
evaluating segment performance.  SFAS No. 131 will be effective for the
Company's fiscal year ending December 31, 1998 and will not affect the Company's
financial position or results of operations.

FACTORS THAT MAY AFFECT FUTURE RESULTS

From time to time, information provided by the Company or statements made by its
employees may contain "forward-looking" statements, as that term is defined in
the Private Securities Litigation Reform Act of 1995.  For this purpose, any
statements contained herein that are not statements of historical fact may be
deemed to be forward-looking statements.  Without limiting the foregoing, the
words "believes", "anticipates", "plans", "expects", and similar expressions are
intended to identify forward-looking statements.

This Quarterly Report on Form 10-Q may contain forward looking statements which
involve risks and uncertainties.  The Company's actual results may differ
materially from the results discussed in such statements.  Certain factors that
could cause such a difference include, without limitation, the risks
specifically described in the Company's Annual Report on Form 10-K for the year
ended December 31, 1997 and other public documents, filed by the Company with
the Securities and Exchange Commission (the "Commission"), which factors are
incorporated herein by reference, and other factors such as the Company's
limited operating history, the dependence on the year 2000 market, the need to
develop additional products and services, the concentration of clients and
credit risk, the management of growth and increases in expenditures in sales and
marketing, research and development and finance and administration, the
dependence upon third-party channels and potential for channel conflict, the
impact of competitive products and services and pricing, competition for
qualified technical personnel, the offering of fixed-price, fixed time-frame
contracts rather than contracts on a time and materials basis, the potential for
contract liability related to the provision of year 2000 and other products and
services, the potential for software errors or bugs in the Company's products,
the operating difficulties and expenditures associated with acquisitions
including the Company's MDI acquisition, limited protection of proprietary
rights, dependence on third party technology, rapid technological change, risks
associated with international operations and dependence on Indian offshore
software development centers, the impact of the government regulation of
immigration, dependence on government contracts, product or services demand and
market acceptance risks, product development and services capacity,
commercialization and technological difficulties, capacity and supply
constraints or difficulties and the effect of general business or economic
conditions.

In addition, the Company's quarterly revenue, expenses and operating results
have varied significantly in the past and are likely to vary significantly from
quarter to quarter in the future.  A significant portion of the Company's
revenue in any quarter is typically derived from a limited number of large
client transactions.  In addition, the sales cycle associated with these
transactions is lengthy and is subject to a number of uncertainties, including
clients' budgetary constraints, the timing of clients' budget cycles and
clients' internal approval processes.  Accordingly, the timing of significant
transactions is unpredictable and, as a result, the Company's revenue and
results of operations for any particular period are subject to significant
variability.  The complexity of certain projects and the requirements of
generally accepted accounting principles can also result in a deferral of
revenue recognition, in whole or in part, on a particular contract during a
quarter, even though the contract has been executed or payment has actually been
received by the Company.  Quarterly fluctuations may also result from other
factors such as new product and service introductions or announcements of new
products and services by the Company's 

                                       17
<PAGE>
 
-------------------------------------------------------------------------------

competitors, changes in the Company's or its competitors' pricing policies,
changes in the mix of distribution channels through which the Company's products
and services are sold, the timing and nature of sales and marketing expenses,
changes in operating expenses, the financial stability of major clients, changes
in the demand for software maintenance products and services, foreign currency
exchange rates and general economic conditions.

The Company began an assessment of certain of its internal computer hardware and
software in connection with the year 2000 problem and expects to complete its
assessment of such hardware and software in 1998.  The Company expects that its
business systems installed in 1997 will be year 2000 compliant through upgrades
and maintenance thereto.  The Company expects that costs related to providing
that its internal computer hardware and software will be year 2000 compliant
will not be material to the financial condition or results of operations of the
Company and are not expected to be significant.

In some cases, the Company warrants to its clients that its software will be
year 2000 compliant generally subject to certain limitations or conditions.  The
Company also provides solutions consisting of products and services to address
the year 2000 problem involving key aspects of a client's computer systems.  A
failure in a client's system or failure of the Company's software to be year
2000 compliant would result in substantial damages and therefore have a material
adverse effect on the Company's business, financial condition and results of
operations.

                                       18
<PAGE>

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

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

The Company and certain of its officers and directors have been named as
defendants in purported class action lawsuits filed in the United States
District Court for the District of Massachusetts by Robert Downey on April 1,
1998, by Scott Cohen on April 7, 1998, by Timothy Bonnett on April 9, 1998, by
Peter Lindsay on April 17, 1998, by Harry Teague on April 21, 1998, by Jesse
Wijntjes on April 29, 1998, by H. Vance Johnson and H. Vance Johnson as Trustee
for the I.O.R.D. Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on
May 21, 1998 and by Helen Lee on May 28, 1998 (collectively, the "complaints").
The Downey complaint alleges a class period of October 22, 1997 to March 27,
1998.  The Cohen, Bonnett, Wijntjes and Lee complaints allege a class period of
January 27, 1998 to March 27, 1998.  The Lindsay, Teague and Johnson complaints
allege a class period of January 28, 1998 to March 27, 1998.  The Howard
complaint alleges a class period of July 3, 1997 to March 27, 1998.  The
complaints principally allege that the defendants violated federal securities
laws by making false and misleading statements and by failing to disclose
material information concerning the Company's December 1997 acquisition of
substantially all of the assets and assumption of certain liabilities of the
Millennium Dynamics, Inc. business from American Premier Underwriters, Inc.,
thereby allegedly causing the value of the Company's common stock to be
artificially inflated during the purported class periods.  In addition, the
Howard complaint alleges violation of federal securities laws as a result of the
Company's purported failure to disclose material information in connection with
the Company's initial public offering on July 2, 1997, and also names Montgomery
Securities, Inc., Wessels, Arnold & Henderson, and H.C. Wainwright & Co., Inc.
as defendants.  The complaints further allege that certain officers and/or
directors of the Company sold stock in the open market during the class periods
and seek unspecified damages.   On or about June 1, 1998, all of the named
plaintiffs and additional purported class members filed a motion for the
appointment of several of those individuals as lead plaintiffs, for approval of
lead and liaison plaintiffs' counsel and for consolidation of the actions.
Although the Company believes that it and the other defendants have meritorious
defenses to the claims made in the complaints and intends to contest the
lawsuits vigorously, an adverse resolution of the lawsuits could have a material
adverse effect on the Company's financial condition and results of operations in
the period in which the litigation is resolved.  The Company is not able to 
reasonably estimate potential losses, if any, related to the complaints.

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS

The Company is furnishing the following information with respect to the use of
proceeds from its initial public offering of common stock, $0.01 par value per
share on July 2, 1997:

(1)  The effective date of the registration statement of the offering and the
     commission file number were July 1, 1997 and 333-27087, respectively.

(4)(vi) The net offering proceeds to the Company after expenses were
        approximately $40,664,000.

(4)(vii) From July 1, 1997 to June 30, 1998, $500,000 of the offering proceeds
         were used to repay certain indebtedness under a secured subordinated
         note, $30,000,000 were paid to APU in connection with the MDI
         acquisition and $3,404,000 were used to fund the Company's operations.
         The balance of

                                       19
<PAGE>
 
-------------------------------------------------------------------------------


     the offering proceeds ($6,760,000) was invested in commercial paper,
     corporate bonds and money market accounts.

Except for the $30,000,000 paid to APU which, as a result of the MDI
acquisition, owns 10% or more of the Company's common stock, payment of the
offering proceeds were to persons other than directors, officers, general
partners of the Company or their associates, persons owning 10% or more of the
equity securities of the Company or affiliates of the Company.

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

On June 10, 1998, the Company held its Annual Meeting of Stockholders ( the
"Annual Meeting"). Douglas C. Catalano, Henry F. McCance, and William W. Verity
were elected Class I Directors at the Annual Meeting. In addition to the
foregoing individuals, the term of the office as a director of Arthur Carr,
Dominic K. Chan, Allen K. Deary, W. Michael Humphreys, Axel Leblois and Roland
D. Pampel, continued after the Annual Meeting.

At the Annual Meeting, the votes cast for each matter described below were as
follows:

   (a). Election of Three Class I Directors.
        
        (i). Douglas A. Catalano  For: 13,583,679   Withheld: 212,489
        (ii). Henry F. McCance    For: 13,591,581   Withheld: 204,587
        (iii). William F. Verity  For: 13,638,224   Withheld: 157,944
 
   (b). Approval of an Amendment to the Company's 1997 Stock Incentive Plan
        increasing the number of shares of Common Stock authorized for issuance
        thereunder from 1,950,000 to 3,950,000.
        
        For: 8,458,187  Against: 973,025  Abstain: 14,443
        Broker non-votes: 4,350,513

   (c). Approval of Amendments to the Company's 1997 Employee Stock Purchase
        Plan (i) increasing the number of shares of Common Stock authorized for
        issuance thereunder from 200,000 to 300,000 and (ii) increasing the
        number of shares authorized for issuance under the third and last
        plan periods from 50,000 to 100,000 per 
        plan period.

        For: 9,022,257  Against: 407,912 Abstain: 15,486
        Broker non votes: 4,350,513

ITEM 5.  OTHER INFORMATION

Stockholder Proposals for 1999 Annual Meeting

As set forth in the Company's Proxy Statement for its 1998 Annual Meeting 
of Stockholders, any proposal that a stockholder of the Company wishes to be 
considered for inclusion in the Company's proxy materials for the Company's 1999
Annual Meeting of Stockholders (the "1999 Annual Meeting") must be submitted to 
the Clerk of the Company at its offices, 2 Federal Street, Billerica, 
Massachusetts 01821, no later than January 5, 1999.

In addition, in accordance with recent amendments to Rules 14a-4, 14a-5 and
14a-8 under the Securities Exchange Act of 1934, as amended, if a stockholder of
the Company wishes to present a proposal before the 1999 Annual Meeting, but 
does not wish to have the proposal considered for inclusion in the Company's 
proxy materials, such stockholder must also give written notice to the Clerk of 
the Company at the address noted above. Such notice must be received by the 
Company on or before March 23, 1999 in order to be considered timely for 
purposes of Rule 14a-4. If a stockholder fails to provide timely notice of a 
proposal to be presented at the 1999 Annual Meeting, the proxies designated by 
the Board of Directors of the Company will have discretionary authority to vote 
on any such proposal.

   
ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(a)  Exhibits:

Documents listed below, except for documents identified by footnotes, are
being filed as exhibits herewith.  Documents identified by footnotes, if any,
are not being filed herewith and, pursuant to Rule 12b-32 of the General Rules
and Regulations promulgated by the Commission under the Securities Exchange Act
of 1934 (the "Exchange Act") reference is made to such documents as previously
filed as exhibits with the Commission.  The Company's file number under the
Exchange Act is 000-22647.


                                       20
<PAGE>
 
-------------------------------------------------------------------------------

     Exhibit 10.1. Employment Agreement dated as of May 18, 1998 between the
                   Company and Richard Wilkie
     Exhibit 10.2. Employment Agreement dated as of May 18, 1998 between the
                   Company and Peter Espinosa
     Exhibit 10.3. Promissory Note of Peter Espinosa payable to the Company
                   dated May 29, 1998
     Exhibit 10.4. Service Agreement dated as of November 18, 1997 by and
                   between the Company and Great American Insurance Company
     Exhibit 11.   Statement re computation of per share earnings
     Exhibit 27.   Financial Data Schedule
   
     (b) Reports on Form 8-K  
         None. 

                                      21
<PAGE>
 
-------------------------------------------------------------------------------


                                  SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


Dated:  August 14, 1998



                                        Peritus Software Services, Inc.
                                        By:  /s/ Allen K. Deary
                                        -------------------------------
                                        Allen K. Deary
                                        Vice President, Finance and
                                        Chief Financial Officer (Principal
                                        Financial Officer)

                                       22
<PAGE>

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

  EXHIBIT NO.                                DESCRIPTION

     Exhibit 10.1.   Employment Agreement dated as of May 18, 1998 between the
                     Company and Richard Wilkie 
     Exhibit 10.2.   Employment Agreement dated as of May 18, 1998 between the 
                     Company and Peter Espinosa 
     Exhibit 10.3.   Promissory Note of Peter Espinosa payable to the Company 
                     dated May 29, 1998
     Exhibit 10.4.   Service Agreement dated as of November 18, 1997 by and 
                     between the Company and Great American Insurance Company 
     Exhibit 11.     Statement re computation of earnings per common share 
     Exhibit 27.     Financial Data Schedule

                                       23