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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

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

                                   FORM 10-K

(MARK ONE)

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996

                                      OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934

              FOR THE TRANSITION PERIOD FROM          TO

                        COMMISSION FILE NUMBER 0-19155

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

                            STATE OF THE ART, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

              CALIFORNIA                               95-3664592
                                                    (I.R.S. EMPLOYER
    (STATE OR OTHER JURISDICTION OF                IDENTIFICATION NO.)
    INCORPORATION OR ORGANIZATION)


                                                          92618
   56 TECHNOLOGY, IRVINE, CALIFORNIA
                                                       (ZIP CODE)
    (ADDRESS OF PRINCIPAL EXECUTIVE
               OFFICES)

      Registrant's telephone number, including area code: (714) 753-1222

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

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

                                 COMMON STOCK
                               (TITLE OF CLASS)

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

  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (17 CFR (S) 229.405) is not contained herein, and will
not be contained, to the best of Registrant's knowledge, in the definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [_]

  The aggregate market value of the voting stock of Registrant held by non-
affiliates of the Registrant on March 17, 1997, based upon the closing sale
price on that date on the Nasdaq Stock Market of $11.875 per share, was
$133,909,580.

  The number of shares of the Registrant's Common Stock outstanding as of
March 17, 1997, was 11,276,597.

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

                      DOCUMENTS INCORPORATED BY REFERENCE

  Part III incorporates information by reference from the Registrant's
definitive proxy statement for Registrant's Annual Meeting of Shareholders to
be held on May 29, 1997, which proxy statement in definitive form will be
filed no later than 120 days after the close of the Registrant's fiscal year
ended December 31, 1996.

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                                    PART I

ITEM 1. BUSINESS

THE COMPANY

  State of the Art, Inc. ("State of the Art" or the "Company") was
incorporated in California on April 7, 1981. On December 30, 1994, Manzanita
Software Systems ("Manzanita") became a wholly-owned subsidiary of the Company
through a merger transaction that was treated as a pooling of interests for
accounting purposes. The Company develops, produces, markets and supports
accounting and financial management software products for microcomputers and
NT servers, together with certain related products and services, for a variety
of hardware and operating system environments. The Company's various products
are differentiated by the hardware platforms on which they operate and by the
size of business they are designed to serve.

  The Company currently markets three product lines for DOS, Windows(TM), NT,
UNIX and client/server operating environments. The Company's award-winning
MAS(R) and MAS 90 for Windows(R) product line, a mid-range product used by
businesses across a broad range of industries, currently consists of 27
separate application modules for the DOS environment and 11 application
modules for the Windows and NT environments. Both the DOS and Windows product
lines offer interoperability that allows DOS and Windows modules to be mixed
while still working together. These application modules can be integrated into
a comprehensive accounting and financial management system and operate in six
industry standard operating environments: single-user DOS, Windows, DOS
network, Windows network, NT and UNIX. The BusinessWorks(R) and BusinessWorks
for Windows product lines, originally developed by Manzanita, each consist of
10 separate modules designed to meet the needs of smaller businesses which do
not need the comprehensive feature-set of MAS 90 but do require more
functionality than is available in retail accounting software products. These
product lines operate in single-user DOS, DOS network and Windows
environments. The Acuity Financials(TM) product line was introduced in October
1996. The product line was natively designed for the Windows, NT and Microsoft
SQL Server environments and initially consists of the 3 application modules of
General Ledger, Accounts Payable and Accounts Receivable. These core
application modules can support multi-currency capabilities with the purchase
of multi-currency, an enhancement that is sold separately. Because of its
component object model architecture and design, Acuity Financials is easily
adaptable to third party products which operate under the same environments.
To complement Acuity Financials's 3 base application modules, the Company
offers Payroll, Human Resource Management and Fixed Assets from Best Software
Corporation, Crystal Reports from Seagate and FRx, a detailed financial report
writer from FRx Corporation. The product line is intended for companies either
downsizing from mainframe and minicomputer platforms, or upgrading their
existing accounting systems to client/server technology.

  During 1996 the Company sold its Apple product lines, FlexWare(R) and
MacP&L(R) and no longer offers any products that operate under the Apple
Macintosh platforms.

  The Company distributes its MAS 90, MAS 90 for Windows, BusinessWorks and
BusinessWorks for Windows products to end-users through a network of more than
3,000 Authorized Resellers located throughout the United States and Canada,
whose sales efforts are supported by a national network of more than 7,000
Software Consultants and Client Advisors. Acuity Financials is currently
distributed through a select group of 56 Value Added Resellers ("VARs") who
have demonstrated their expertise in selling to larger companies and have
qualified staffing to support the more complex needs of client/server
installations. These specialized VARs are supported by 8 regional sales
personnel that the Company has trained to provide sales and technical support.

  In addition to increasing the productivity and efficiency of the user's
internal accounting and financial management functions, the Company's software
products enhance the quality of decision-making by providing accurate and
timely information that is useful to management. The Company's products
achieve these results by providing a structured, automated framework within
which standard internal accounting functions are performed, and by offering a
system by which accounting and financial information can be organized and
presented in a wide variety of ways that may be particularly useful to
different businesses.

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  To complement its software product lines, the Company offers related
products and services. The Company's ClientCare(R) program provides a variety
of fee-based software support programs to end-users of the Company's software
products, and the Company's wholly-owned subsidiary, State of the Art Business
Forms, Inc., designs, produces and sells business forms that are compatible
with the Company's software products. In addition, through its University of
State of the Art ("U StartSM") program, the Company offers educational classes
in the use of its products to Authorized Resellers, Software Consultants,
Client Advisors and end-users. In 1997 the Company plans to implement
maintenance programs for all purchasers of MAS 90, MAS  90 for Windows and
Acuity Financials which will be priced from 12% to 20% of the suggested list
price of the product. The program provides for regular updates and maintenance
releases of the products to end-users.

MERGER WITH MANZANITA

  On December 30, 1994, State of the Art and Manzanita completed a merger in
which Manzanita became a wholly-owned subsidiary of the Company. As
consideration for the merger, State of the Art agreed to issue an aggregate of
1,999,935 shares of the Company's Common Stock to the former shareholders of
Manzanita. Of this amount, 1,653,091 shares were issued at the closing to the
Manzanita shareholders, and an additional 346,844 shares were reserved for
issuance upon the exercise of employee stock options that had been granted by
Manzanita and were assumed by State of the Art.

  The acquisition of Manzanita provided a number of important strategic
benefits. First, the merger enabled the Company to broaden its product
offerings by providing a good fit between the respective product lines of the
two companies. The BusinessWorks products address the market niche between
entry-level retail products and mid-range products such as MAS 90. Second, the
Manzanita BusinessWorks products have a solid reputation in the industry and
provide the Company's distribution channel the opportunity to expand their
businesses and end-users the ability to migrate to the MAS 90 product as their
business needs change. The Company also benefited from the efforts of the
Manzanita employees, who have successfully brought a Windows accounting
product to market in the development and completion of the MAS 90 for Windows
and Acuity Financials product lines.

  The merger with Manzanita was treated as a pooling of interests for
accounting purposes, and as a result the Company's financial statements for
prior periods have been restated to reflect the combined operations of
Manzanita and State of the Art.

BACKGROUND

  The market for microcomputer accounting and financial management software
has grown with the proliferation of microcomputers in a wide variety of
businesses. As microcomputers have become more powerful, their capacity to
serve the accounting needs of businesses has significantly increased, and as a
result there have emerged several niche markets for accounting software,
defined by the size and accounting needs of the business customers in each
market. One challenge to microcomputer accounting software developers has been
to develop a variety of products that are tailored to the various market
segments, in terms of feature set, ease of use and price.

  The "mid-range" market requires products that are powerful and sophisticated
enough to serve mid-size and larger businesses but that are also easy to use.
Such products are full-featured and sophisticated as well as thoroughly
supported so that users can implement and use them effectively. Suggested list
prices for general accounting modules of mid-range accounting software
products typically begin at approximately $800 per module.

  The complexity of such sophisticated accounting and financial management
applications requires that trained personnel assist the end-user in selecting
and implementing the software and then support the software as it is used.
This support is needed not only to permit smooth operation of the software,
but also to help the end-user more fully realize the benefits that it offers.
The Company believes that conventional microcomputer software retailers are
not well suited to effectively sell mid-range microcomputer accounting and
financial

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management software or to perform the necessary support functions because
their personnel do not have the requisite skill and knowledge. Therefore, the
Company markets its MAS 90 and BusinessWorks product lines through public
accounting firms and VARs. In the case of Acuity Financials, an even higher
standard of expertise is required to sell, install and support larger
companies which often have their own management information services
departments and require product integration into in-house data bases and
existing developed information systems.

  As the microcomputer industry as a whole moves toward Windows, NT and other
graphical user interface ("GUI") environments, there is a growing demand for
mid-range accounting software products that are designed for such
environments. The Company's MAS 90 for Windows, BusinessWorks for Windows and
Acuity Financials address this demand.

  The trend of microcomputer hardware becoming increasingly more powerful and
less expensive has also created opportunities in the accounting software
market for smaller businesses. In this arena, the challenge has been to
develop a product that offers a spectrum of basic accounting capabilities, at
a price that is consistent with the resources available to small businesses.
At one level are "entry-level" products, which retain the modular approach and
some of the more advanced features of the mid-range products, but which are
less complex and are offered at a lower price, with list prices typically
starting at approximately $400 per module. Although they do not provide the
comprehensive functionality of mid-range products, entry level products are
sophisticated and powerful enough to require skilled and knowledgeable support
in order for the end user to fully benefit from their use. As a result the
BusinessWorks and BusinessWorks for Windows products are distributed through
the Company's same professional channels.

  The evolution of microcomputing operating system and hardware capabilities
has changed the dimensions of the upper end of the microcomputer accounting
software market, creating an emerging "high-end" market segment. The customers
in this market are businesses who are either upgrading their accounting
systems due to growth, or who are downsizing from mainframe and minicomputer
systems, and who use the new, more powerful microcomputers to implement
client/server systems. Accounting software targeting this market must provide
a sophisticated and comprehensive feature set, compatibility with industry-
standard relational databases, true client/server architecture and ease of
adaptability. The Company's client/server product Acuity Financials addresses
this market.

  By providing product support services, business forms and product education
classes that complement its software products, the Company is able to
capitalize on its name recognition and reputation among its installed base of
software customers. These complementary products and services, together with
periodic updates and enhancements to its software products, also provide the
Company with sources of recurring revenue, in addition to the revenue
generated by the initial sale of its software products.

PRODUCTS

 MAS 90 and MAS 90 for Windows

  The Company believes that its MAS 90 and MAS 90 for Windows products are
distinguished from other mid-range accounting and financial management
software products by their balanced combination of extensive features, ease of
use and the availability of a variety of fully integrated vertical
applications and business productivity products. The products' features
include the ability to generate sophisticated financial and historical
reports, to readily adapt the software to a customer's specific requirements,
to efficiently support large multi-user configurations, and to verify data in
real time. In addition, the MAS 90 and MAS 90 for Windows sophisticated file
system facilitates high volume transaction processing while maintaining data
integrity. Ease of use results from the product's clear and logical user
interface, pull-down menu system, and context sensitive help text. Further,
the Company's comprehensive and well organized user manuals minimize training
time and facilitate product installation. MAS 90 for Windows, which began
shipping 2nd quarter 1996, offers the same extensive features of MAS 90 in
addition to the benefits of graphical user interface capabilities including
drill down

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features, multiple window usage, graphic reporting and presentation and easy
data transfer of data to other Windows applications. The Company believes that
acceptance of MAS 90 for Windows was very successful in 1996, with
approximately 10,000 end-users and resellers purchasing or upgrading to the
product line, significantly higher than any of the Company's competition for
Windows product offerings in the mid-range market.

  MAS 90 and MAS 90 for Windows provide a wide variety of application modules
which can be integrated into a comprehensive accounting and financial
management system. The modules are designed to share a common database so that
information entered through one module can be posted to other modules.
Although each module may be operated independently, a business may improve the
speed and accuracy with which it produces financial information by adding and
integrating modules. The Company's modular approach and interoperable
capabilities of DOS and Windows applications permits a business to select only
those modules which are required to meet its initial needs, and to add
additional modules as necessary. These modules can be divided into categories,
as described below.

  General Accounting Modules. These modules provide the essential accounting
functions that are required in a wide range of businesses. The 9 modules
included in this group are General Ledger; Accounts Receivable; Accounts
Payable; Payroll; Inventory Management; Sales Order Processing; Purchase Order
Processing; Bank Reconciliation and Fixed Assets. All modules are available
under both MAS 90 and MAS 90 for Windows with the exception of Payroll and
Fixed Assets, which have not been released under the MAS 90 for Windows
product line. The Windows version of the Payroll module is scheduled for
release in June, 1997.

  Vertical Application Modules. These modules address the unique needs of
specific industries or groups of industries. The 8 modules included in this
group are Job Cost, designed for project oriented businesses that require
individual job costing such as general contractors, architects and engineers;
Bill of Materials, Work Order Processing, Materials Requirements Planning
(MRP) and Bar Code Master which address the accounting needs of manufacturers
and distributors; Time and Billing, intended for service businesses such as
accounting, consulting and law firms, who bill on the basis of time expended;
Point of Sale, which enables retail businesses to capture transaction data at
the time of sale and Client Write-up, which addresses the Public Accountant's
financial statement preparation and bookkeeping functions for small business.
These modules, which are interoperable with MAS 90 for Windows modules, are
only available under the MAS 90 product line as of this date. The first
release of a Windows vertical application module, Job Cost, is scheduled for
June, 1997.

  Business Productivity Modules. These MAS 90 modules enable businesses to
make more efficient use of their accounting information. The 9 modules
included in this group are EXPLORER(TM), an inquiry tool which allows users to
easily navigate among the many inquiry screens in all of the MAS 90 modules;
F9, which provides a direct interface between the MAS 90 General Ledger module
and Lotus 1-2-3, the industry-standard spreadsheet software product; Magnetic
Media Reporting, which enables businesses to comply with Federal tax
requirements that they report withholding amounts on disk media; Import
Master, which allows a business to import data into MAS 90 modules from a
variety of other file formats; PostMaster, which allows a business to create
and maintain a custom database, for use in direct mail and other business
communications; MAS 90 AutoGraph(TM), an executive information systems ("EIS")
module that enables individuals within an organization to access, organize and
present graphically the specific information from the accounting database that
is relevant to their particular job function; TeleMagic, a contact management
system for sales personnel; TimeCard, which automates the input of time worked
by employees and integrates with the Payroll and Job Cost modules and
FaxMaster, which allows the direct fax of statements, invoices or data
directly from the various accounting modules.

  Library Master with Report Master. In addition to any of the individual
modules described above that a customer may select, every MAS 90 installation
must also include the Library Master with Report Master module, which provides
system management and custom report generation capabilities. MAS 90 for
Windows ships with Crystal Reports which allows easy generation and formatting
of Windows reports that access the products database.

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  The suggested end-user list prices for most of the DOS-based general
accounting modules in this product line are $899.00 each, Windows applications
are $1,149.00 each, while vertical market applications are list priced at
$1,099.00 and business productivity products, as well as the Library Master
with Report Master or Crystal Reports module, range in list price from $349.00
to $1,399.00 each. The Company does not suggest list prices for its UNIX
products, but Authorized Resellers and Software Consultants typically charge
between $1,000 and $2,000 per module in this operating environment. Effective
March 1, 1997, the Company raised the price of both DOS and Windows modules
approximately $200 per module to include a standard one year maintenance plan
on the products.

  The Company's international revenues have been immaterial to date. In 1993
the Company released a Canadian version of MAS 90, and the Company plans in
1997 to implement international features such as multi-currency, value added
tax and multi-lingual capabilities into its future products to allow for
additional international revenue opportunities.

 MAS 90 client/server edition

  The Company plans to introduce a client/server edition of MAS 90 in the
first half of 1997. The product line is designed to run on Microsoft NT
Servers in association with Windows or NT clients. The product will have the
same extensive feature set of MAS 90 and MAS 90 for Windows modules, but take
advantage of powerful NT server environments. The product will include a GUI
and offers a significant performance enhancement or upgrade path for users
that require larger network performance than the traditional MAS 90 and MAS 90
for Windows product line offers. While pricing has not been set as of this
date, it is anticipated that MAS 90 client/server product line will be
approximately double the price of MAS 90 for Windows.

 BusinessWorks and BusinessWorks for Windows

  The BusinessWorks products are designed to address an emerging market niche
for small businesses which have outgrown the capabilities of retail accounting
software packages but are not yet large enough for the complexity, power and
expense of mid-range products such as MAS 90 and MAS 90 for Windows. The
BusinessWorks and BusinessWorks for Windows product lines each consist of 10
modules. The accounting modules are General Ledger, Accounts Payable, Accounts
Receivable, Inventory Control & Purchasing, Order Entry, Payroll and Job Cost.
Each BusinessWorks installation also requires the System Manager module. In
addition, the Company distributes third-party report writers that integrate
with BusinessWorks and a Business Forms module that prints forms on laser
printers. The Windows version of BusinessWorks was first released in February
1993, and to date upgrades to both product lines have been released
simultaneously, so that they both offer identical functionality. In 1996, the
Windows version of BusinessWorks significantly outsold the DOS version. The
Company expects this trend to continue and as a result, the Company has
stopped future enhancements to the DOS product line and has begun development
efforts on a significantly more powerful and feature rich version of the
Windows product which is expected to begin shipping the fourth quarter of
1997.

  Suggested list prices for BusinessWorks and BusinessWorks for Windows are
$395 for the accounting modules, with other modules ranging in price from $95
to $395.

 Acuity Financials

  Acuity Financials was introduced in the fourth quarter of 1996. The new
product line incorporates many of the feature strengths of MAS 90, but has
also been designed to provide more powerful and advanced features that address
the accounting and financial management needs of larger businesses. Acuity
Financials specifically is targeted for companies that are upgrading their
accounting requirements or downsizing from mainframe and minicomputer systems.
The product line which was natively designed for Microsoft's Windows, NT and
SQL Server is based 100 percent on Microsoft's latest tools and technologies.
Acuity Financials is considered by the Company to be the first mid-range
client/server accounting product that is fully Internet-ready by providing
direct interface and reporting capabilities to the Internet. In February 1997,
within 90 days of its initial release Acuity Financials won top honors for
technology integration in Microsoft's middle market accounting BackOffice(TM)
Challenge at SoftEx held in Los Angeles, California.

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  Initial modules of Acuity Financials consists of the core accounting
applications of General Ledger, Accounts Payable and Accounts Receivable and
have multi-currency capabilities with the purchase of the multi-currency
enhancement. The product line is supported by a select number of third party
applications which integrate with Acuity Financials core financial
applications. These third party applications consists of Best Software's Fixed
Assets, Payroll and Human Resource Management; FRx, an extensive and robust
financial reporting module and Seagate's Crystal Reports, a comprehensive
report writer for all standard reports. FRx and Crystal Reports ship with each
Acuity Financials. Best Software modules are available for separate purchase.
Pricing for this product is significantly higher than the MAS 90 for Windows
product line, with base application modules priced in the $5,000 to $10,000
per module range, depending upon the number of users and applications
purchased. Pre-sales support, installation consulting and on-going support are
considered important factors in successfully penetrating this market and the
Company has established a regional sales force of 8 individuals to assist the
select number of VARs that are authorized to sell the product line. In
addition, the Company has established a special customer support group
dedicated to installations, ongoing maintenance, support and technical advice
on the product. The product is entirely new and its commercial acceptance is
still in the early phases and could be influenced by factors that are beyond
the control of the Company. See the discussion under "Product Development"
below.

 Master Developers

  To complement the Company's MAS 90 product line, niche-market vertical
applications are developed by approximately 160 "Master Developers," who are a
select group of the Company's Authorized Resellers and Software Consultants.
The Company licenses its MAS 90 source code to its Master Developers in order
to enable them to modify standard modules by incorporating software features
desired by an individual customer, and to develop new applications such as
vertical applications aimed at specific industries and international
accounting applications. In order to inform potential customers of the
availability of these products, the Company publishes and distributes a
directory of Master Developers with hundreds of their products and services.
By facilitating the development of enhancements and new applications, the
Company creates the opportunity to sell not only additional copies of the
modified application module, but also to sell each new customer complementary
modules from its standard product inventory. The Company supports these Master
Developers by providing mandatory training programs and technical assistance.
The Company has generated substantial revenues from its MAS 90 Master
Developers Program.

 Maintenance, Updates and Enhancements

  The Company is committed to providing customers with affordable, easy to
implement product updates and enhancements that increase the value and
functionality of its products. These updates and enhancements include
Maintenance Releases, which provide improvements and refinements to existing
versions of the software, and Enhancement Releases, which provide new features
and capabilities. These product updates and enhancements are periodically
released and generate additional revenue for the Company. In 1997, the Company
instituted standard maintenance plans for the MAS 90, MAS 90 for Windows and
Acuity Financials product lines. New customers for these product lines pay a
percentage of the suggested list price of the product which range from 12% to
20%. The maintenance contracts provide for twelve months of maintenance
support for the product. The Company expects standard maintenance contracts to
become a significant component of the Company's total revenues in future
periods.

 Business Forms

  In October 1992, the Company established State Of The Art Business Forms,
Inc., a Georgia corporation (the "Forms Company"), as a wholly-owned
subsidiary of the Company. This action resulted from a recognition of the
increasing volume of business forms the Company's customers require in
connection with their use of the Company's software products, coupled with the
Company's belief that its customers in general prefer to do business with the
Company for all their accounting software-related needs, particularly since
the business forms distributed by the Forms Company are compatible with
current versions of the Company's software products.

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The Forms Company designs, manufactures, markets and sells standard and
customized business forms and related products to the Company's Authorized
Resellers, Software Consultants and end-users. The Forms Company currently
supplies forms that are compatible with MAS 90, MAS 90 for Windows, Acuity
Financials, BusinessWorks, FlexWare and MacP&L.

DISTRIBUTION

 MAS 90, MAS 90 for Windows, BusinessWorks & BusinessWorks for Windows

  The Company distributes its MAS 90, MAS 90 for Windows, BusinessWorks and
BusinessWorks for Windows products through a network of more than 3,000
Authorized Resellers located throughout the United States and Canada
consisting of VARs and public accounting firms. The sales efforts of
Authorized Resellers are supported by a national network of more than 7,000
Software Consultants and Client Advisors comprised predominantly of public
accounting firms. The Company has chosen these distribution channels because
it believes that mid-range accounting software is best marketed by a sales
force that is thoroughly conversant with the accounting needs of a range of
businesses, and which has access to and the confidence of a large number of
potential end-users, and because public accounting firms and VARs either have
or can readily be provided with the knowledge and skills needed to provide
consultative services in the choice, implementation and effective use of
sophisticated accounting and financial management software.

 Acuity Financials

  The Company distributes its Acuity Financials product through a very select
group of qualified VARs or Resellers that have shown the expertise and
technical staffing to handle the sophistication of client/server technology.
Resellers for Acuity Financials are authorized based upon a number of criteria
and qualifications that assure proper customer installation and adequate
technical support to meet customers' needs. To date the Company has authorized
56 Resellers for the product line. The Company complements the sales and
support efforts of Acuity Financial Resellers by 8 regional sales personnel
that provide help on customer demonstrations, proposals and technical
requirement definitions. The Company has also established a dedicated support
group to assist in installations, technical advice and on-going support for
the product line. The Company expects to expand the Reseller distribution
channel for Acuity Financials to approximately 200 VARs.

 Public Accounting Firms

  There are approximately 48,000 public accounting firms in the United States
employing more than 128,000 accountants. These firms include international,
regional and local firms. In addition to the approximately 7,000 public
accounting firms that represent the Company as Authorized Resellers, Software
Consultants and Client Advisors, there are approximately 10,000 more public
accounting firms that have purchased all or a portion of the Company's product
line. While these firms have not sought or maintained status as Authorized
Resellers, Software Consultants or Client Advisors, they may from time to time
recommend the Company's products to their clients.

  Recognizing the credibility of an accountant's recommendation to his or her
client, the Company has found this channel to be a very effective means of
marketing its products. Although public accounting firms have historically
provided traditional accounting services such as accounting, auditing and tax
advice and return preparation, many firms have expanded the scope of their
practices by offering a variety of consulting services, including
microcomputer consulting services. Providing microcomputer-based accounting
solutions to clients enables the accountant to differentiate his or her
practice from other firms and to generate additional revenue through the sale
of the software itself and/or from consultative services for system
installation and implementation, and related training. In addition, automated
accounting solutions free the accountant to focus more on the provision of
business management and other higher value services.

  Public accounting firms may act as Authorized Resellers, Software
Consultants or Client Advisors. Authorized Resellers may sell the Company's
products to end-users, while Software Consultants may provide

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accounting software consultation and advice, but refer customers to Authorized
Resellers for the actual sale of the software, and Client Advisors use the
software for their own internal business needs and may recommend it to their
clients.

 Value-Added Resellers

  VARs are independent sales and service organizations that provide computer
installation, systems integration and consulting services to large and small
businesses, in addition to implementation services and related training. VARs
typically specialize with respect to the industry they serve and often
recommend systems and software for their clients. Once a recommendation is
accepted, VARs may implement the solution, provide software training and
support the client on an ongoing basis.

  The Company's Authorized Resellers include approximately 1,000 VARs of which
56 VARs are authorized to sell Acuity Financials. The Company seeks to attract
VARs who understand the fundamentals of bookkeeping, accounting procedures and
internal controls, and who exhibit the desire and ability to provide quality
product support.

  The Company recognizes the potential benefits of cooperation between VARs
and public accounting firms, and therefore the Company assists VARs in
developing business relationships with such firms through a marketing alliance
program. Under these arrangements, VARs and accounting firms work together to
provide the client with a complete microcomputer accounting software solution.
For example, under such an arrangement the accounting firm might provide
software consulting services and the VAR it is affiliated with might provide
the software and implement the solution recommended by the accounting firm.

  The Company's agreements with its Authorized Resellers and Software
Consultants do not require them to offer the Company's products exclusively,
and may be terminated by either party without cause. Although the Company
seeks to develop long-term relationships with its Authorized Resellers and
Software Consultants, no assurance can be given that any public accounting
firm or VAR will continue to represent the Company's products. The Company
imposes certain minimum purchase requirements on its Resellers as a condition
to maintaining their authorization. In addition, as a condition to becoming an
Authorized Reseller, Software Consultant or Client Advisor each public
accounting firm and VAR is required to purchase the Company's Reference
Library and subsequent updates to the Reference Library. The Reference Library
may be used by the accountant or VAR for microcomputer consulting or its own
internal accounting uses, but may not be resold.

MARKETING

  Historically, the Company's marketing efforts for its mid-range products
have been primarily directed to public accounting firms and VARs, and are
intended to expand the number of Authorized Resellers, Software Consultants
and Client Advisors and to increase their sales productivity. The Company
engages in consistent and targeted direct mail campaigns to attract a pool of
potential accounting software consultants and resellers, from which the
Company selects those meeting its qualification standards. These campaigns
provide educational and business expansion materials, new product information
and periodic promotions. The Company reinforces these campaigns with
telemarketing programs. These efforts include a number of programs that are
designed to demonstrate the potential opportunities of being an Authorized
Reseller, Software Consultant or Client Advisor, to increase product awareness
and the Company's name recognition and to provide Authorized Resellers,
Software Consultants and Client Advisors with continuing assistance in
marketing the Company's products. The Company seeks to develop long-term
relationships with its Authorized Resellers, Software Consultants and Client
Advisors and facilitates this process by providing product support and
training programs.

  In 1994 and 1995, the Company also began pursuing new marketing strategies
for its mid-range products. These new strategies include specific industry
advertising and other programs to increase corporate and brand name
recognition among potential end-users and to generate additional leads for the
Company's Authorized Resellers. The new marketing strategies also include the
Company's Competitive Edge(TM) Reseller Forums,

                                       8
<PAGE>

which are held throughout the country and are designed to increase the
effectiveness of the Company's Authorized Resellers by providing direct
assistance in their advertising, public relations and marketing efforts.

  With the introduction of the Company's next generation products of MAS 90
for Windows and Acuity Financials, the Company began aggressive advertising
campaigns in the third and fourth quarters of 1996 with the intent of
establishing brand awareness of the products. The Company believes that
establishing a consistent and regular advertising program that provides for
recognition of its products to potential end-users is key to the future
success and revenue growth of the products. In 1997 the Company plans to
continue its advertising and media presence with regular media advertising in
business magazines, journals and trade literature to attract new customers to
the products.

  The Company markets its business forms products, ClientCare support services
and product education classes to end-users by direct mail campaigns, by
including information about these products and services in the packaging of
the Company's software products, and by telemarketing programs. The MAS 90,
MAS 90 for Windows, BusinessWorks, BusinessWorks for Windows and Acuity
Financials product lines include a feature that requires end-users to register
the products with the Company. Mandated registration results in a Company
database that includes a high percentage of all customers who purchase these
products. Such mandated registration significantly enhances the Company's
ability to market its complementary products and services to end-users.

CUSTOMER SUPPORT

  State of the Art believes that high quality product support services are
essential to its success. The Company's primary support strategy is to design
products that are easy to use and logical in operation, thereby minimizing the
end-user's need to seek support beyond that contained in the software itself
and the accompanying documentation. In addition, the Company has designed on-
line help features to assist end-users in the use of the software. The Company
also emphasizes the preparation of comprehensive and well organized product
documentation, using its in-house staff of technical writers for that purpose.

  When an end-user must turn to an outside source of support, the Company's
objective is to ensure that high quality responses to such demands are
delivered as quickly as possible. The Company believes that outside support
can be most effectively provided by assuring that its Authorized Resellers and
Software Consultants are fully equipped to provide the front line of support
for any question or challenge the end-user might encounter. The Company
provides comprehensive seminars to instruct Authorized Resellers and Software
Consultants on the use of the Company's mid-range products, thereby enhancing
their ability to represent these products and respond to end-users' inquiries.
In addition, the Company provides telephone consultation and product support
for its MAS 90, MAS 90 for Windows, BusinessWorks, BusinessWorks for Windows
and Acuity Financials products to all of its Authorized Resellers and Software
Consultants. The level of support offered the Authorized Resellers and
Software Consultants is dependent upon the type of plan they purchased or
qualified under associated with sales volume. The Company also encourages its
Authorized Resellers, Software Consultants, Client Advisors and end-users to
purchase the Company's Technical Reference and Support Guide for both MAS 90
and BusinessWorks and enroll in for training seminars on the Company's product
lines. Both programs provide additional information on issues related to
installation, support and maintenance of the products. Finally, as a
complement to the support services provided by its Authorized Resellers and
Software Consultants, the Company offers its ClientCare and U Start programs,
which provide fee-based support and product education services to end-users.
In the first quarter of 1997 the Company implemented required maintenance for
all new end-users of the MAS 90, MAS 90 for Windows and Acuity Financials
product lines that provides for regular and standard maintenance releases of
the products.

 ClientCare

  Recognizing that Authorized Resellers and Software Consultants could not
always meet all of a customer's support needs, and that many customers prefer
the security of being able to obtain supplementary support directly from the
Company, the Company markets ClientCare, a technical support and service
program for end-users

                                       9
<PAGE>

of MAS 90, MAS 90 for Windows, BusinessWorks, BusinessWorks for Windows and
Acuity Financials. The ClientCare program is intended to be complementary to,
rather than competitive with, the support services offered by the Company's
Authorized Resellers and Software Consultants.

  The most significant features of ClientCare are guaranteed response times,
automatic software updates, regular communications and alternate fee options.
The program offers end-users a choice of various technical support plans. Each
plan provides varied levels of service and response times, enabling customers
to match their specific needs to the available options. All plans include a
subscription to one or more Company publications. Pricing on the ClientCare
program varies according to the chosen plan, the call response time selected,
and, in the case of mid-range and entry-level products, the number of modules
in the customer's library.

 U Start

  Through its University of State of the Art program, the Company offers
product education classes to end-users, in addition to the training provided
to the Company's Authorized Resellers and Software Consultants. These classes
are conducted by U Start "professors," Company employees who are thoroughly
trained and familiar with the Company's products. Classes are offered both at
the Company's training facility at its headquarters in Irvine, California, and
at regional locations throughout the United States. U Start classes offer
hands-on training with instructional discussions on the Company's MAS 90, MAS
90 for Windows, BusinessWorks, BusinessWorks for Windows and Acuity Financials
products, and are focused on education in the actual use of the products, as
contrasted with marketing seminars that are focused on influencing a potential
customer's purchase decision. U Start will develop and begin offering classes
for the MAS 90 client/server product line when it is launched in 1997. In
addition to the University of State of the Art program, the Company in 1996
implemented Authorized Training Centers ("ATCs") operated by Resellers of the
product lines that have been trained and qualified to conduct training
classes. These ATCs expanded the Company's ability to offer more localized
training for both end-users and resellers of the Company's products.

PRODUCT DEVELOPMENT

  The Company maintains an active program to develop new products and improve
its existing ones. For a description of the amounts spent on Company-sponsored
research and development activities, see the discussion of research and
development expenses at "Research and Development" under "Results of
Operations" in Item 7, Management's Discussion and Analysis of Financial
Condition and Results of Operations, of this Annual Report on Form 10-K.

  In 1995 the Company formed a client/server division within the Company to
focus a major portion of the Company's product development effort on the
emerging client/server technology. In July 1995, the Company enhanced this
division by transitioning the employees of Systems Engineering Group, a
Michigan corporation that had significant experience in the support and
development of high-end accounting products for the client/server market, to
become State of the Art employees. This transition was done to augment the
development effort of its Acuity Financials client/server product line. The
Company currently employs approximately 30 development personnel in Troy,
Michigan dedicated to the on-going development of the Company's Acuity
Financials client/server product line.

  In addition to its internal development program, the Company expands its
product offerings by obtaining distribution rights or ownership of software
products developed by others. With respect to licensed products, the Company
provides support to its customers and has the right to obtain support from the
licensor, and the licensor is responsible for maintenance and enhancement of
the product. With respect to acquisitions, responsibility for the support,
maintenance and enhancement of the products is assumed by the Company's
internal staff.

  The Company actively solicits suggestions from its Authorized Resellers,
Software Consultants, Client Advisors and end-users for new products and
product improvements. These suggestions, which may be received unsolicited, or
in response to the Company's inquiries, or through the Company's pre-release
product testing procedures, are a key source of information on which the
Company bases its plans for new products, and oftentimes new product features.

                                      10
<PAGE>

  The Company's development staff includes a quality assurance group that
tests all products before they are released for sale. This group employs test
procedures and automated test procedures designed to verify the functionality
of the products to the Company's specifications, ensure product consistency,
and verify that product documentation properly describes and corresponds to
the software. In addition, all new product releases and major enhancement
releases are beta-tested, whereby the product is tested at selected outside
sites over an extended period of time, using a testing schedule designed by
the Company.

  The microcomputer software industry is characterized by rapid technological
change and product obsolescence. The Company's success will depend primarily
on the continued market acceptance of its existing products, the Company's
ability to enhance its existing products and the Company's ability to develop
and introduce new products that meet both the changing needs of business and
the changing industry standards with respect to operating environments and
hardware platforms. There can be no assurance that the Company will be able to
avoid obsolescence of its products. Unexpected delays in completing or
shipping products, including the Company's MAS 90 client/server product line
or additional application modules and enhancements for MAS  90 for Windows,
BusinessWorks for Windows and Acuity Financials, or design, production or
undetected product quality problems, may adversely affect the Company. There
can be no assurance that any new products will be competitive or achieve
market acceptance. Moreover, the manner and timing of the introduction of new
products may also adversely affect sales of the Company's existing product
lines. No assurance can be given that new products will be introduced in a way
that will not have such an effect.

  In particular, it should be noted that the MAS 90 for Windows, MAS 90
client/server product line and Acuity Financials are completely new products
based on new technology. As such, there can be no assurance that these
products will or continue to be competitive and achieve dominant market
acceptance. Certain competing mid-range and high-end accounting software
products for GUI environments are already in release, and many may have a
competitive advantage by virtue of their earlier availability. On the other
hand, however, MAS 90 for Windows in the Company's opinion has already
established market leadership in the mid-range Windows accounting marketplace
by its initial wide acceptance and number of shipments of the products during
1996. While the popularity of Windows, NT and other GUI environments is
accelerating, it is much more difficult for companies to change their
accounting software than it is, for example, to change their word processing
software. As a result, businesses may switch to GUI environments for all their
other software applications while continuing to use their present accounting
software for some period of time. Other factors that may delay the acceptance
of mid-range accounting applications include the limited number of competing
products currently available, which hinders the ability of a business to make
a purchase decision based on a comparative analysis of various products, and
the fact that businesses upgrading their present systems to GUI environments
are faced with significant additional expenses for the hardware required to
operate these environments. As a result of these and other factors, the
Company's experience indicates that sales of character-based mid-range
accounting software will continue to be in demand, but will most certainly
decline since GUI environments are now market standard environments. The
Company is fully committed to continuing to support, maintain and enhance its
MAS 90 product line for the foreseeable future.

PRODUCTION

  The production of the Company's software products includes the printing of
user manuals, the duplication of diskettes, assembly of purchased components
and final packaging. The printing and preparation of user manuals is performed
by outside sources in accordance with the Company's specifications. The
Company generally performs diskette and compact disk duplication procedures,
assembles purchased product components and performs final packaging internally
at its Irvine, California facility. During 1995 the Company transferred the
former Manzanita production operations for BusinessWorks and BusinessWorks for
Windows from the Roseville, California facility to the Irvine facility.
Quality control tests are performed on finished goods by Company employees.
The Company generally ships the next business day after receipt of an order
and has no meaningful backlog.

                                      11
<PAGE>

  The principal materials used in the Company's products include diskettes,
binders and printed materials. All of these materials are readily available
from various vendors.

  The Company's products may be returned for replacement if found to be
defective in materials or packaging, subject to the terms of the Company's
license agreement. To date, returns of defective products have been
immaterial.

COMPETITION

  The entry-level, mid-range and client/server accounting software markets are
highly competitive. The Company's principal competitors are other independent
vendors of microcomputer accounting software. The Company believes that in its
main mid-range market there is no dominant market leader, but rather a
significant number of medium to small sized companies that all compete for a
portion of the market. The Company is of the opinion that within the NT SQL
client/server mid-range market there also is currently no dominant leader.
Currently there are few accounting software vendors that offer natively
designed client/server solutions for Microsoft's NT and SQL Server technology.
The Company targets its potential customers for these solutions to companies
with revenues in the range of twenty-five to one hundred and fifty million
dollars. The Company considers the entry-level retail market is primarily
dominated by Intuit, while the high-end client/server market is dominated by
SAP whose products primarily address companies with revenues over one hundred
million dollars per year. The Company believes that the principal competitive
factors relevant to end-users in these markets are the features and
capabilities of the software, its ability to run on a variety of industry
standard platforms, the breadth of and integration among the modules that make
up the manufacturer's product line, the availability and quality of product
support and product pricing.

  The Company also competes for access to its chosen channels of distribution
for mid-range and entry-level products: public accounting firms and VARs. Due
to the high costs associated with building the expertise necessary to sell a
particular accounting software solution, the public accounting firms and VARs
who participate in the distribution of accounting software typically do not
actively market more than one or two accounting software solutions. The
Company regards the primary competitive factors relevant to attracting and
retaining public accounting firms and VARs are the same as those for end-users
but also include the protection offered against channel conflict. The Company
considers that its ability to attract public accounting firms and VARs is
enhanced by the fact that it does not sell its mid-range and entry-level
products through the competing retail channel or in the case of its new
client/server products through a direct sales force that competes with its
resellers. There can be no assurance, however, that other companies will not
be more successful than the Company in securing and retaining the services of
resellers of accounting software.

  The retail market for microcomputer accounting software is also highly
competitive. The Company does not offer any products sold through retail
distributors but believes entry-level retail products such as those offered by
Intuit and other retail competitors does affect demand and increases
competition on other entry-level business accounting products, such as the
Company's BusinessWorks product line and to a lesser degree, MAS 90 and MAS 90
for Windows which is sold through professional distribution channels. The
Company believes that the primary competitive factors in gaining the attention
of end-users is product knowledge of the reseller, brand recognition, pricing,
features and support of the product.

  In addition, the Company faces competition for end-users from outside the
microcomputer accounting software market. End-users may select minicomputer or
mainframe-based solutions as alternatives to microcomputer systems. Further,
the Company competes against other methods of delivery of business accounting
services, including internally developed computerized accounting systems,
client write-up services offered by public accounting firms, payroll and other
services offered by service bureaus, and traditional manual accounting
systems.

  Certain of the Company's competitors, both inside and outside of the
microcomputer accounting software market, may have greater financial,
marketing and technological resources than the Company. There can be no
assurance that other companies have not developed or marketed or will not
develop or market software products

                                      12
<PAGE>

that are superior to those of the Company, that are offered at substantially
lower prices than those of the Company, or that have achieved or will achieve
greater market acceptance than those of the Company. In addition, there can be
no assurance that alternate methods of delivering business accounting services
will not provide increased competition in the future.

  The competitive marketplace for higher end solutions such as Acuity
Financials is often characterized by vendors offering their products through
direct sales personnel. The Company is developing a high-end Reseller
distribution channel to represent and sell the product which will need to
compete with direct sales personnel from other software vendors that may have
significantly more resources to reach and penetrate potential new customers.
There can be no assurances that the reseller channel the Company is developing
will be successful and be competitive with other vendors in the mid-range
client/server marketplace.

PROPRIETARY RIGHTS

  The Company's MAS 90 software products are written in a development language
known as Business Basic and utilizes a compiler and tool development language
called ProvideX which allows the products to run either in a Windows, NT or
DOS environment. The Company's other products are written in standard
programming languages that are available from a number of sources. The Company
licenses ProvideX and related tools pursuant to an agreement effective
February 22, 1996, with an initial term of three years.

  The Company regards certain features of its internal operations, software
and documentation as proprietary and relies on a combination of contract,
copyright, and trade secret laws and other measures to protect its proprietary
information. Existing United States copyright laws afford only limited
protection, and under the existing patent laws of the United States and most
foreign countries, software products such as those marketed by the Company
generally cannot be patented. The Company's software products are shipped in
shrink wrapped packages on which a notice is prominently displayed informing
the end-user that by breaking the seal of the packaging, the end-user agrees
to be bound by the license agreement contained in the package. The license
agreement includes limitations on the end-user's authorized use of the
product, as well as restrictions on disclosure and transferability. The legal
and practical enforceability and extent of liability for violations of license
agreements that purport to become effective upon such opening of a sealed
package are unclear.

  The unauthorized copying and distribution of microcomputer software products
is a persistent and significant concern to the Company, and it attempts to
monitor such activity to find more effective technological and other means of
detection and deterrence. Despite the steps taken by the Company to protect
its software products, users may still make unauthorized copies of the
Company's products for their own use and for sale to others.

EMPLOYEES

  As of December 31, 1996 the Company had a total of 366 employees. None of
the Company's employees is subject to a collective bargaining agreement and
the Company has not experienced any work stoppage. The Company believes that
its employee relations are good.

  The Company believes its future success depends upon its ability to attract
and retain skilled employees, who are in great demand. The Company has in the
past experienced difficulty in recruiting sufficient numbers of trained
personnel to accommodate the Company's needs. There is no assurance that the
Company will be able to attract and retain a sufficient number of qualified
individuals to meet the needs of the Company's business.

ITEM 2. PROPERTIES

  The Company's executive offices and product development and distribution
center are housed in two adjacent buildings in Irvine, California, containing
approximately 71,000 square feet and approximately 21,000 square feet,
respectively. The Company occupies the larger facility under a lease that
expires in June 2000, and occupies the smaller facility under a lease that
initially expires in August 1998, but that may be renewed at the

                                      13
<PAGE>

option of the Company to expire in June 2000, the same date as its main
facility. In addition, the Company occupies a facility in Roseville,
California, near Sacramento, containing approximately 23,000 square feet,
which houses product development for the BusinessWorks and BusinessWorks for
Windows products, as well as certain customer support and sales functions. The
Company occupies this facility under a lease that expires in 2002. The Company
also occupies a facility in Mississauga, Ontario, Canada, near Toronto,
containing approximately 1,400 square feet, which houses the development team
for the Company's MAS 90 for Windows product. The Company currently occupies
this facility pursuant to a lease that expires in 2000 and has an early
termination option effective in 1998. The Company has leased a facility in
Troy, Michigan, containing approximately 7,400 rentable square feet. This
lease expires in March 2001, but allows the Company to extend the term of the
lease for another five years. The Company uses the Troy facility as the
Company's midwestern region client/server development and support facility.

ITEM 3. LEGAL PROCEEDINGS

  The Company is engaged in litigation with Charles Milden, who was the
Company's president from 1981 to 1985. This litigation commenced in December
1990 when the Company filed a complaint against Mr. Milden in the California
Superior Court for Orange County, seeking damages and an injunction against
disclosures of the Company's proprietary information by Mr. Milden.

  Following the filing of the Company's complaint against Mr. Milden, Mr.
Milden and his wife filed a complaint against the Company and other
defendants, including the Company's directors, T.A. Associates, Robertson,
Stephens & Company, and Frank A. Barcott Security & Investigation. This action
was also filed in the Orange County, California Superior Court, and was
consolidated with the Company's action against Mr. Milden. The Mildens'
complaint alleged, among other things, that the Company acted improperly in
connection with the repurchase of his 90,271 shares of common stock in March
1990, pursuant to a right of first refusal, and that the Company interfered
with his business relationships. Mr. Milden sought rescission of the Company's
purchase of his stock and substantial monetary damages.

  In October 1991, Mr. Milden and his wife filed a petition under Chapter 11
of the Bankruptcy Code in the United States Bankruptcy Court located in Orange
County, California. In October 1992, the Mildens' Chapter 11 proceeding was
converted to a Chapter 7, and a trustee was appointed to liquidate their
estate. The trustee and the Company agreed to settle the Mildens' claims
against the Company for an amount that will be fully paid by the Company's
insurance carrier and that is substantially less than the litigation costs
that the Company would have incurred to take this matter to trial. Both the
bankruptcy court and the state court have approved this settlement agreement,
and on March 14, 1994, the state court dismissed both of the pending state
court actions with prejudice. The Mildens have appealed from this dismissal.
Briefing has been completed and the parties are awaiting the court's
determination of a date for oral argument. The Mildens have also appealed the
Bankruptcy Court's order approving the settlement, as well as a number of
related Bankruptcy Court orders, to the United States District Court for the
Central District of California, where all of the Bankruptcy Court's orders
were upheld. The Mildens then appealed the District Court's ruling to the
United States Court of Appeals for the Ninth Circuit. Briefing of this appeal
has also been completed, and the appeals court heard oral argument in January
1997. The appeals court has not rendered its decision. Management believes,
based in part on discussions with its counsel, that the Mildens' appeals of
the state court dismissal and bankruptcy court orders are without merit, and
the Company intends to vigorously contest the appeals.

  The Company is also engaged in litigation with Rapidforms, Inc. In April of
1995, Rapidforms filed a complaint against the Company and the Company's
subsidiary, Manzanita, in the United States District Court for the District of
New Jersey. The complaint alleges that Manzanita breached two written
agreements under which Rapidforms was to supply standard and customized
printed business forms to users of Manzanita's accounting software. The
original complaint further alleges that the Company tortiously interfered with
Manzanita's contractual relations with Rapidforms by causing Manzanita to
breach the written agreements. The original complaint contains causes of
action for breach of contract, breach of the covenant of good faith and fair

                                      14
<PAGE>

dealing, tortious interference with contractual relations, and tortious
interference with prospective economic advantage. Rapidforms seeks
compensatory and punitive damages, as well as attorneys' fees, interest, and
court costs.

  On or about July 6, 1995, the Company and Manzanita, through their attorneys
in New Jersey, filed answers and counterclaims, in which the companies deny
liability and assert that Rapidforms breached its obligations under the two
written agreements by, among other things, failing to pay commissions due and
owing to Manzanita. The counterclaim seeks damages as well as an accounting of
previously paid and past due commissions owing to Manzanita. The Company
intends to continue to defend the plaintiff's claims, and to prosecute the
Company's claims, vigorously.

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

  No matter was submitted to a vote of security holders of the Company during
the fourth quarter of the fiscal year ended December 31, 1996.

                                      15
<PAGE>

                                    PART II

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

  The Company's common stock trades on The Nasdaq Stock Market under the
symbol SOTA. The approximate number of shareholders of record of common stock
at March 17, 1997 was 147, some of which are street name holders and
depository trusts representing beneficial shareholders. The Company has more
than 400 beneficial holders of common stock.

  The Company has not paid any cash dividends on its common stock and does not
intend to pay cash dividends in the foreseeable future.

  On March 17, 1997, the closing sales price of the Company's Common Stock was
$11.875 per share. The following table sets forth the price range of the high
and low closing sale prices per share of Common Stock as reported by the
Nasdaq Stock Market for each quarter of 1995 and 1996.

<TABLE>
<CAPTION>
                                                                   LOW $  HIGH $
                                                                   ------ ------
      <S>                                                          <C>    <C>
      1995:
      First Quarter...............................................  7.875  12.00
      Second Quarter..............................................   9.00  11.75
      Third Quarter...............................................   7.50  12.00
      Fourth Quarter..............................................  9.375  11.25

      1996:
      First Quarter............................................... 9.1875 13.625
      Second Quarter..............................................  12.00  19.50
      Third Quarter...............................................  11.75  18.75
      Fourth Quarter..............................................  11.25 13.875
</TABLE>

                                      16
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

  The following selected financial data should be read in conjunction with the
consolidated financial statements and notes thereto included elsewhere herein.

<TABLE>
<CAPTION>
                                                   FIVE YEAR SUMMARY
                                                YEAR ENDED DECEMBER 31,
                                        ---------------------------------------
                                         1996    1995    1994    1993    1992
                                        ------- ------- ------- ------- -------
                                         (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                     <C>     <C>     <C>     <C>     <C>
STATEMENTS OF INCOME DATA(1):
  Net revenues......................... $52,046 $46,118 $37,340 $33,074 $24,950
  Cost of revenues.....................  10,377  10,268   7,904   6,758   4,319
                                        ------- ------- ------- ------- -------
  Gross profit.........................  41,669  35,850  29,436  26,316  20,631
  Operating expenses:
    Sales and marketing................  22,246  16,547  13,822  12,431   8,297
    Research and development...........  11,610   7,682   6,732   3,035   1,408
    General and administrative.........   4,896   4,259   4,549   4,123   2,989
    Merger and acquisition costs(1)....      --      --     900      --      --
    Write-off of capitalized software
     development costs(2)..............      --      --      --   4,094      --
                                        ------- ------- ------- ------- -------
  Total operating expenses.............  38,752  28,488  26,003  23,683  12,694
  Operating income.....................   2,917   7,362   3,433   2,633   7,937
  Interest income......................   1,381   1,234   1,035     930     827
                                        ------- ------- ------- ------- -------
  Income before income taxes and
   extraordinary item and change in
   accounting principle................   4,298   8,596   4,468   3,563   8,764
  Provision for income taxes...........   1,406   2,933   1,584     968   3,472
                                        ------- ------- ------- ------- -------
  Income before extraordinary item and
   change in accounting principle......   2,892   5,663   2,884   2,595   5,292
  Extraordinary item--tax benefit of
   net operating loss carryforward.....      --      --      --      --     147
  Cumulative effect of change in
   accounting principle................      --      --      --     324      --
                                        ------- ------- ------- ------- -------
  Net income........................... $ 2,892 $ 5,663 $ 2,884 $ 2,919 $ 5,439
                                        ======= ======= ======= ======= =======
  Net income per share................. $  0.25 $  0.51 $  0.27 $  0.27 $  0.48
                                        ======= ======= ======= ======= =======
  Weighted average common shares and
   equivalents(3)......................  11,674  11,212  10,838  10,893  11,223
                                        ======= ======= ======= ======= =======
BALANCE SHEET DATA(1):
  Working capital...................... $40,292 $35,869 $29,336 $26,943 $25,242
  Total assets.........................  52,331  47,632  40,097  36,333  32,839
  Long-term obligations, net of current
   portions............................     244     202     219     322   1,209
  Shareholders' equity.................  47,012  42,250  34,414  31,738  28,630
</TABLE>
--------
(1) In the fourth quarter 1994, the Company merged with Manzanita Software
    Systems, Inc. which was accounted for as a pooling of interests. See Notes
    1 and 2 of Notes to Consolidated Financial Statements.
(2) In the fourth quarter 1993, the Company took a write-off of certain
    capitalized software development costs that were determined to no longer
    have a net realizable value to the Company. See Note 1 of Notes to
    Consolidated Financial Statements.
(3) See Notes 1 and 9 of Notes to Consolidated Financial Statements for an
    explanation of the method used to determine the number of shares used in
    per share computations.

                                      17
<PAGE>

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

OVERVIEW

  The Company was formed in 1981 to develop, produce and market microcomputer
accounting software. The Company shipped its first product in 1982 and in 1983
introduced its first product for IBM and compatible microcomputers. From 1982
through 1985 the Company sold its products predominantly through the retail
distribution channel. In 1986 the Company introduced a new product line, MAS
90, which had substantially improved technical features and accounting
functions. At the same time, the Company changed its distribution channel from
retail computer stores to VARs and public accounting firms. Since 1986 the
Company has increased revenues over each subsequent year. On December 30,
1994, State of the Art merged under a pooling of interests business
combination with Manzanita and the financial results presented reflect the
combined operations of both companies. In the most recent year ended December
31, 1996, the Company's consolidated net revenues increased $5,928,000 or 13%
to $52,046,000 as compared to consolidated net revenues of $46,118,000 in
1995. The Company has been profitable for the past ten years. For the period
ended December 31, 1996, the Company's consolidated net income was $2,892,000,
a decrease of $2,771,000 or 49% when compared to consolidated net income of
$5,663,000 in 1995. For the past four years the Company has significantly
increased its research and development expense to bring new graphics and
client/server accounting products to market. In 1996 the Company began
shipping two new product lines, MAS 90 for Windows and Acuity Financials,
designed for the Windows and Windows NT operating system environments. The
Company believes that these new product lines will produce continued revenue
growth for the Company.

FORWARD LOOKING INFORMATION:

  This Annual Report on Form 10-K contains forward looking statements,
including, without limitation, statements concerning the Company's product
development and product release plans, future research and development, sales
and marketing expenditures and future revenue growth. These forward looking
statements involve risks and uncertainties, which could cause actual results
to differ from those projected. These risks and uncertainties include
technological risks involved in the development and testing of new products,
the impact of competitive products and pricing, and the uncertainties of which
operating systems and hardware platforms will dominate, and which emerging
technologies could impact the demand for the Company's products.

RESULTS OF OPERATIONS:

  The following table sets forth certain financial data as a percentage of net
revenues for each of the years in the three year period ended December 31,
1996.
<TABLE>
<CAPTION>
                                                                 YEAR ENDED
                                                                DECEMBER 31,
                                                               ----------------
                                                               1996  1995  1994
                                                               ----  ----  ----
      <S>                                                      <C>   <C>   <C>
      Net revenues............................................ 100%  100%  100%
      Cost of revenues .......................................  20    22    21
                                                               ---   ---   ---
      Gross profit ...........................................  80    78    79
      Operating expenses:
        Sales and marketing ..................................  43    36    37
        Research and development .............................  22    17    18
        General and administrative ...........................   9     9    12
        Merger and acquisition costs..........................  --    --     3
                                                               ---   ---   ---
      Total operating expenses ...............................  74    62    70
      Operating income........................................   6    16     9
      Interest income.........................................   3     3     3
                                                               ---   ---   ---
      Income before income taxes..............................   9    19    12
      Provision for income taxes..............................   3     7     4
                                                               ---   ---   ---
      Net income .............................................   6%   12%    8%
                                                               ===   ===   ===
</TABLE>

                                      18
<PAGE>

  Net Revenues. Consolidated net revenues in 1996 increased $5,928,000 or 13%,
to $52,046,000, as compared to 1995 consolidated net revenues of $46,118,000,
and in 1995 consolidated net revenues increased $8,778,000 or 24%, when
compared to consolidated net revenues of $37,340,000 in 1994. The increase in
1996 consolidated net revenues was primarily the result of increased software
license revenues from the MAS 90 for Windows and Acuity Financials product
lines combined with increases in support and business forms revenues. License
revenues from the Company's BusinessWorks, Flexware and MacP&L product lines
decreased $1,407,000 or 18% in 1996 as compared to 1995. The Company sold its
Apple product lines, Flexware and MacP&L, in the second quarter of 1996 and no
longer offers accounting products for the Apple operating systems. In 1995 the
BusinessWorks product line increased $1,380,000 or 24% as compared to 1994.
Apple products decreased in 1995 by $420,000 or 30% when compared to 1994. In
1996 the Company introduced MAS 90 for Windows and Acuity Financials, two new
graphic product lines, which produced $14,264,000 or 27% of the Company's
revenue for the year. The increase was partially offset by a decrease of
$7,857,000 or 27% in the Company's flagship MAS 90 character product line,
which runs under the DOS operating system, when compared to 1995. The Company
believes that the new generation graphic product lines of MAS 90 for Windows
and Acuity Financials will grow at a rapid rate that will outpace the
anticipated decline from the older MAS 90 for DOS product line. Acuity
Financials, a natively designed NT SQL client/server product line, was
released in October 1996 and contributed $992,000 or 2% of the Company's
revenue in 1996. Software license revenues accounted for approximately 82% of
the Company's total revenues in 1996 as compared to 80% in 1995 and 79% in
1994. The increase in consolidated net revenues in 1995 was primarily the
result of increased license, support and business forms revenues. License
revenues from MAS 90 and BusinessWorks in 1995 increased $7,287,000 or 25%
over 1994 to $36,534,000 and accounted for 79% of the Company's total revenues
as compared to 78% of the Company's revenues in 1994. Service revenues
increased $752,000 or 20% as compared to 1994 and business forms revenues
increased $1,160,000 or 41% to $4,019,000 and accounted for 9% of the
Company's total revenues in 1995 as compared to 8% of the Company's revenues
in 1994.

  Service revenues in 1996 increased $512,000 or 11% to $5,118,000 when
compared to 1995. Business forms revenues of $4,434,000 in 1996 increased
$415,000 or 10% over 1995 and accounted for approximately 9% of the Company's
total 1996 revenues as compared to 9% of the total Company's revenues in 1995.
The increase in business forms and support revenues was the result of
increased unit volume. The increase in license fee revenues in 1996 was
positively impacted as a result of increased pricing for the MAS 90 and MAS 90
for Windows products that were introduced in June 1996. Acuity Financials, a
new product line which addresses a significantly higher priced market segment
than the Company's traditional MAS 90 and BusinessWorks product lines produced
$992,000 in revenue for 1996 and was the result of increased unit volume. The
Company no longer offers entry-level products sold through retail distribution
channels.

  The Company's revenue and operating results are subject to significant
fluctuations as a result of new product introductions, product upgrade
revenues, commencement of sales and marketing promotions, seasonality of
customer buying trends and general economic conditions. The Company operates
with no significant backlog, thereby making quarterly revenue and associated
operating results difficult to forecast. In the last twenty-four quarters, the
Company's revenue pattern indicates that revenue and normal operating income,
before non-recurring charges and accruals, have been materially higher in the
fourth quarter than in the other three quarters of the year. This historically
higher revenue volume and associated operating income in the fourth quarter
has been largely due to two factors: higher end-user demand for the Company's
software products as customers prepare to automate their businesses at the
beginning of each new year, and the release of the Company's annual payroll
tax update program. Management believes this pattern will continue in 1997.

  Cost of Revenues. Cost of revenues consists primarily of documentation,
packaging, diskettes, royalties, software development amortization and
associated manufacturing, labor and overhead costs. In 1996 cost of revenues
were 20% of net revenues as compared to 22% of net revenues in 1995, a
decrease of two percentage points. The decrease was primarily the result of
lower material and production costs than in 1995. The decrease in material and
production costs, expressed as a percentage of net revenues, in 1996 was
principally due to less

                                      19
<PAGE>

expensive package design on a per unit basis and higher pricing on the MAS 90
and Acuity product lines than in 1995. In 1995 cost of revenues increased one
percentage point to 22% as compared to 21% in 1994 and was the result of
higher royalty and material costs than in 1994. While the Company continues to
pursue cost reduction opportunities whenever practicable, there can be no
assurance that it will be able to maintain its current level of cost of
revenues as a percentage of net revenues.

  Sales and Marketing. Sales and marketing expenses primarily include
compensation for the Company's sales, marketing, customer service and product
support staffs, advertising costs and other related expenses. Sales and
marketing expenses in 1996 were 43% of net revenues, an increase of seven
percentage points from 36% of net revenues in 1995. This represented a dollar
increase of $5,699,000 and a percentage increase of 34% over 1995 expenses and
was primarily the result of increased costs for salaries and benefits,
contract labor, advertising and lead generation activities, promotional events
and direct overhead costs. In 1996, sales and marketing personnel costs
increased approximately 15% or $1,178,000 over similar levels in 1995 and was
the result of increased salaries and benefit costs, rather than headcount
increases. Advertising and lead generation expense in 1996 increased 83% or
$2,195,000 over 1995 and was primarily related to the launch of new products
into the marketplace and a new emphasis on identifying potential end-users.
The cost of promotional events held by the Company increased $327,000 and
general corporate overhead expenses increased $940,000 over similar costs in
1995. Contract labor and travel and entertainment costs primarily accounted
for the remaining increase in sales and marketing costs in 1996. In 1995 sales
and marketing expenses, at 36% of net revenues, decreased one percentage point
from 37% of net revenues in 1994. This represented a dollar increase of
$2,725,000, and a percentage increase of 20% over 1994 expenses, and was
primarily the result of increased costs for salaries and benefits, contract
labor, promotional events and direct overhead costs. In 1995 salaries and
benefits increased 15% or $1,051,000 over 1994 and was primarily the result of
increased headcount which grew by 22% over the prior year. Promotional event
costs increased $604,000 over similar costs in 1994, while additional expenses
incurred in contract labor and direct overhead costs primarily accounted for
the remaining increase.

  The Company believes that substantial investments in sales and marketing,
including customer service and product support, are important to its revenue
growth. Accordingly, the Company expects these expenses to continue to be
significant. In 1997, the Company plans to increase expenses for advertising
and lead generation activities and customer support expense to provide
increased levels of customer satisfaction.

  Research and Development. Research and development expenses in 1996, net of
capitalized software development costs, increased 51% or $3,928,000 to 22% of
net revenues, as compared to $7,682,000 or 17% of net revenues in 1995 and
$6,732,000 or 18% of net revenues in 1994. The increase in research and
development expenses of $3,928,000 in 1996 can primarily be attributed to
personnel costs which increased 44% or $2,386,000, consultant expenses which
increased $827,000 and general overhead costs which increased $696,000 when
compared to 1995. The increase in research and development expenses is
primarily associated with new product development of the MAS 90 for Windows
and Acuity Financials product lines which were released and began shipping in
1996. In 1995 research and development expenses increased as the result of
increases in personnel, consultant and general overhead costs. Personnel and
consultant expense in 1995 increased 13% or $767,000 as compared to 1994 and
increases in general overhead costs including travel expenses accounted for
the remaining increase. Increases in research and development costs in 1995
were primarily focused on new product development and product enhancements.

  The Company expects to increase research and development costs in future
periods as a result of product development efforts for existing and future
products related to new operating platforms and market segments. However, as a
result of the successful introduction of MAS 90 for Windows and Acuity
Financials a major milestone in the technology development effort has been
achieved and expense in this area is expected to decrease. Development efforts
in bringing additional products to market under the same technology base will
be the concentration in 1997, which will result in additional development
expense. The Company does, however, expect the percentage of research and
development costs when expressed as a percentage of revenues to decrease in
1997.

                                      20
<PAGE>

  General and Administrative. General and administrative costs in 1996 totaled
$4,896,000, an increase of $637,000 or 15% over 1995 general and
administrative costs. When expressed as a percentage of net revenues, general
and administrative expenses in 1996 remained at 9% of net revenues. The
increase in general and administrative expense can primarily be attributed to
increased personnel and contract labor costs which increased $636,000 or 26%
over similar costs in 1995. General and administrative costs decreased from
12% of revenues in 1994 to 9% of revenues in 1995. The decrease of 6% or
$290,000 in 1995 general and administrative costs when compared to 1994 can
primarily be attributed to decreased overhead costs as a result of a favorable
lease renewal on the Company's headquarters.

  Merger and Acquisition Costs. The Company incurred $900,000 of merger and
acquisition costs in 1994 related to the merger of State of the Art, Inc. and
Manzanita Software Systems. These costs consisted primarily of investment
banking fees, legal, accounting and certain personnel costs related to
severance payments.

  Interest Income. Interest income in 1996 increased $147,000 or 12% over
1995. In 1995 interest income increased $199,000 or 19% over 1994. In all
three years interest income represented 3% of Company revenues. The increase
in interest income in both 1996 and 1995 was primarily the result of higher
cash balances and short term investments which were generated from profitable
operations. In addition, interest earned on the Company's cash balances was
positively impacted by generally higher interest rates in 1995 than in 1994.

  Income Taxes. The Company's effective tax rate in 1996 was 33% as compared
to 34% in 1995 and 36% in 1994. The decrease in the effective tax rate in 1996
and 1995 was primarily the result of additional tax credits available to the
Company primarily associated with increased expenditures in qualified research
and development expenses. In 1996 the Company had more qualified research and
development expenses expressed as a percentage of net revenues than were
incurred in 1995, and in 1995 the Company had more qualified research and
development expenses than in 1994. See Note 4 to Consolidated Financial
Statements for further analysis and explanation on the Company's income taxes.

                                      21
<PAGE>

LIQUIDITY AND CAPITAL RESOURCES

  The Company has funded its operations for the past eleven years through
positive cash flow from operations. On December 31, 1996 the Company's working
capital totaled $40,292,000, an increase of $4,423,000 or 12% over working
capital as of December 31, 1995. The Company also has an unsecured line of
credit in the amount of $10,000,000 with Wells Fargo Bank that expires in
April 1998. Currently there is no outstanding balance on the line of credit.
The Company believes that funds generated from operations, existing cash
balances, short term investments and its bank line of credit will be
sufficient to finance the Company's operations for at least the next 12
months.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

  The financial statements of the Company follow hereafter, beginning on page
23. See Financial Statement Index at Item 14(a)(1).


                                      22
<PAGE>

                         INDEPENDENT AUDITORS' REPORT

The Board of Directors and Shareholders
State of the Art, Inc.:

  We have audited the consolidated financial statements of State of the Art,
Inc. and subsidiaries, as listed in the accompanying index at Item 14(a)(i).
In connection with our audits of the consolidated financial statements, we
also have audited the consolidated financial statement schedule as listed in
the accompanying index at Item 14(a)(2). These consolidated financial
statements and the consolidated financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated financial statements and the consolidated
financial statement schedule based on our audits.

  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of State of
the Art, Inc. and subsidiaries as of December 31, 1996 and 1995 and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1996 in conformity with generally
accepted accounting principles. Also, in our opinion, the related consolidated
financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.

                                          KPMG Peat Marwick LLP

Orange County, California
January 21, 1997

                                      23
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS

                           DECEMBER 31, 1996 AND 1995
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)


<TABLE>
<CAPTION>
                                                                 1996    1995
                                                                ------- -------
                            ASSETS
                            ------
<S>                                                             <C>     <C>
Current assets:
  Cash and cash equivalents.................................... $22,029 $16,681
  Short-term investments.......................................  15,064  17,102
  Accounts receivable, less allowance for doubtful accounts of
   $116 in 1996 and $115 in 1995...............................   5,407   5,175
  Inventories (note 3).........................................   1,494   1,086
  Prepaid expenses.............................................   1,180     768
  Income tax receivable (note 4)...............................     109      --
  Deferred income taxes (note 4)...............................      84     237
                                                                ------- -------
    Total current assets.......................................  45,367  41,049
                                                                ------- -------
Property and equipment, net (note 5)...........................   5,334   4,357
Capitalized software development costs, less accumulated
 amortization of $5,329 in 1996 and $4,529 in 1995.............   1,441   1,398
Deferred income taxes (note 4).................................      49      25
Other assets...................................................     140     803
                                                                ------- -------
                                                                $52,331 $47,632
                                                                ======= =======
             LIABILITIES AND SHAREHOLDERS' EQUITY
             ------------------------------------
Current liabilities:
  Accounts payable............................................. $ 2,481 $ 1,965
  Accrued expenses.............................................   1,544   1,270
  Deferred revenue.............................................   1,046   1,165
  Income taxes payable (note 4)................................      --     769
  Notes payable and current portion of long-term debt..........       4      11
                                                                ------- -------
    Total current liabilities..................................   5,075   5,180
                                                                ------- -------
Accrued rent...................................................     244     195
Other noncurrent liabilities...................................      --       7
                                                                ------- -------
    Total liabilities..........................................   5,319   5,382
                                                                ------- -------
Shareholders' equity (notes 2 and 8):
  Preferred stock, 1,000,000 shares authorized, none issued and
   outstanding.................................................      --      --
  Common stock, no par value, 25,000,000 shares authorized;
   11,157,477 and 10,923,436 shares issued and outstanding in
   1996 and 1995, respectively.................................  18,330  16,460
  Retained earnings............................................  28,682  25,790
                                                                ------- -------
    Total shareholders' equity.................................  47,012  42,250
                                                                ------- -------
                                                                $52,331 $47,632
                                                                ======= =======
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       24
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

                       CONSOLIDATED STATEMENTS OF INCOME

                  YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
                                                         1996    1995    1994
                                                        ------- ------- -------
<S>                                                     <C>     <C>     <C>
Net revenues........................................... $52,046 $46,118 $37,340
Cost of revenues.......................................  10,377  10,268   7,904
                                                        ------- ------- -------
Gross profit...........................................  41,669  35,850  29,436
Operating expenses:
  Sales and marketing..................................  22,246  16,547  13,822
  Research and development.............................  11,610   7,682   6,732
  General and administrative...........................   4,896   4,259   4,549
  Merger and acquisition costs.........................      --      --     900
                                                        ------- ------- -------
Total operating expenses...............................  38,752  28,488  26,003
                                                        ------- ------- -------
Operating income.......................................   2,917   7,362   3,433
Interest income........................................   1,381   1,234   1,035
                                                        ------- ------- -------
Income before income taxes.............................   4,298   8,596   4,468
Provision for income taxes (note 4)....................   1,406   2,933   1,584
                                                        ------- ------- -------
Net income............................................. $ 2,892 $ 5,663 $ 2,884
                                                        ======= ======= =======
Net income per share (note 9).......................... $   .25 $   .51 $   .27
                                                        ======= ======= =======
Weighted average common shares and equivalents
 (note 9)..............................................  11,674  11,212  10,838
                                                        ======= ======= =======
</TABLE>


          See accompanying notes to consolidated financial statements.

                                       25
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

                  YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
                                             COMMON STOCK
                                          -------------------  RETAINED
                                            SHARES    AMOUNT   EARNINGS  TOTAL
                                          ----------  -------  -------- -------
<S>                                       <C>         <C>      <C>      <C>
Balance at December 31, 1993............  10,348,303  $14,495  $17,243  $31,738
Common stock issuance under stock option
 plan, including tax benefit of $60
 (note 8)...............................      46,091      175       --      175
Common stock issuance pursuant to
 warrants (note 8)......................       5,344        3       --        3
Common stock issuance under employee
 stock purchase plan (note 8)...........      84,866      127       --      127
Repurchase and retirement of common
 stock (note 8).........................    (100,000)    (513)      --     (513)
Net income..............................          --       --    2,884    2,884
                                          ----------  -------  -------  -------
Balance at December 31, 1994............  10,384,604   14,287   20,127   34,414
Common stock issuance under stock option
 plan, including tax benefit of $448
 (note 8)...............................     507,484    1,923       --    1,923
Common stock issuance (note 8)..........      31,348      250       --      250
Net income..............................          --       --    5,663    5,663
                                          ----------  -------  -------  -------
Balance at December 31, 1995............  10,923,436   16,460   25,790   42,250
Common stock issuance under stock option
 plan, including tax benefit of $544
 (note 8)...............................     234,041    1,870       --    1,870
Net income..............................          --       --    2,892    2,892
                                          ----------  -------  -------  -------
Balance at December 31, 1996............  11,157,477  $18,330  $28,682  $47,012
                                          ==========  =======  =======  =======
</TABLE>


          See accompanying notes to consolidated financial statements.

                                       26
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

                  YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                      1996     1995     1994
                                                     -------  -------  -------
<S>                                                  <C>      <C>      <C>
Cash flows from operating activities:
  Net income........................................ $ 2,892  $ 5,663  $ 2,884
  Adjustments to reconcile net income to net cash
   provided by operating activities:
    Common stock issued as compensation.............      --      250       --
    Depreciation and amortization...................   2,807    2,367    1,913
    Loss on disposal of fixed assets................      --        2        6
    Provision for deferred income taxes.............     129       15      355
    Changes in assets and liabilities:
      Accounts receivable...........................    (232)  (2,030)     (72)
      Inventories...................................    (408)     (32)     (74)
      Prepaid expenses..............................    (412)    (254)    (279)
      Other assets..................................     663     (572)      15
      Accounts payable..............................     516      307     (361)
      Accrued expenses..............................     274     (792)   1,191
      Deferred revenue..............................    (119)    (256)     185
      Income taxes payable..........................    (334)     905      372
      Notes payable.................................      (7)      --       --
      Accrued rent..................................      49       (7)     (40)
      Other noncurrent liabilities..................      (7)     (10)     (13)
                                                     -------  -------  -------
        Net cash provided by operating activities...   5,811    5,556    6,082
                                                     -------  -------  -------
Cash flows from investing activities:
  Sales (purchases) of short-term investments.......   2,038     (696)    (368)
  Proceeds from sale of property and equipment......      19        1        6
  Capital expenditures--property and equipment......  (3,003)  (2,458)  (1,714)
  Capital expenditures--software development costs..    (843)    (703)    (622)
                                                     -------  -------  -------
        Net cash used in investing activities.......  (1,789)  (3,856)  (2,698)
                                                     -------  -------  -------
Cash flows from financing activities:
  Repurchase of common stock........................      --       --     (513)
  Issuance of common stock under employee stock
   purchase plan....................................      --       --      127
  Proceeds from sale of common stock under stock
   option plan......................................   1,326    1,475      118
  Repayments of notes payable and long-term debt....      --       --     (176)
                                                     -------  -------  -------
        Net cash provided by (used in) financing
         activities.................................   1,326    1,475     (444)
                                                     -------  -------  -------
Net increase in cash and cash equivalents...........   5,348    3,175    2,940
Cash and cash equivalents at beginning of year......  16,681   13,506   10,566
                                                     -------  -------  -------
Cash and cash equivalents at end of year............ $22,029  $16,681  $13,506
                                                     =======  =======  =======
Supplemental disclosures of cash flow information:
  Interest paid..................................... $    15  $     6  $    18
                                                     =======  =======  =======
  Income taxes paid................................. $ 1,611  $ 1,951  $   731
                                                     =======  =======  =======
</TABLE>

          See accompanying notes to consolidated financial statements.


                                       27
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                 YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
                       (IN THOUSANDS, EXCEPT SHARE DATA)

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 Principles of Consolidation

  The consolidated financial statements include the accounts of State of the
Art, Inc., a California corporation, and its wholly owned subsidiaries (State
of the Art). All significant intercompany transactions have been eliminated in
consolidation.

 Basis of Presentation

  On December 30, 1994, State of the Art merged with Manzanita Software
Systems, Inc. (Manzanita) (collectively, the Company), which was accounted for
as a pooling of interests (note 2). Accordingly, all financial information has
been restated to reflect the combined operations of State of the Art and
Manzanita for all periods prior to the merger.

 Principal Activities

  State of the Art was incorporated in California on April 7, 1981. The
Company develops, produces, markets and supports microcomputer accounting
software and related products and services. The Company's customers are
primarily located throughout the United States. No single customer accounted
for more than 5% of the Company's sales in 1996, 1995 or 1994, and no account
receivable from any customer exceeded 5% of the Company's shareholders' equity
at December 31, 1996 or 1995.

 Cash and Cash Equivalents

  For purposes of the statements of cash flows, the Company considers all
highly liquid instruments with original maturities of three months or less and
with an insignificant interest rate risk to be cash equivalents.

 United States Government Securities

  Short-term investments at December 31, 1996 and 1995 include $15,064 and
$17,102 of various United States government securities with original
maturities of approximately six months to five years.

  United States government securities are carried at cost adjusted for the
accretion of discounts, which are recognized as adjustments to interest income
over their term using a method which approximates the level yield method.
Management has the intention and ability to hold the securities until
maturity. Adjusted cost approximates market value.

 Inventories

  Inventories are stated at the lower of cost or market (net realizable value)
under the first-in, first-out method of accounting for inventories.

 Capitalized Software Development Costs

  Software development costs incurred after the establishment of technological
feasibility are capitalized and later amortized to cost of revenues on a
product-by-product basis at the greater of the amount computed using the ratio
of current gross revenues for a product to the total of current and
anticipated future gross revenues or

                                      28
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

the straight-line method over the remaining estimated economic life of the
product. Generally, an original estimated economic life of five years is
assigned to capitalized software development costs. During 1996, 1995 and
1994, the Company capitalized $843, $274 and $261 (excluding $0, $429 and $361
of purchased software), respectively, and amortized $800, $866 and $860,
respectively, of software development costs.

 Fair Value of Financial Instruments

  In December 1991, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards (SFAS) No. 107, "Disclosures about Fair
Value of Financial Instruments." SFAS No. 107 requires all entities to
disclose the fair value of financial instruments, both assets and liabilities
recognized and not recognized on the balance sheet, for which it is
practicable to estimate fair value. SFAS No. 107 defines fair value of a
financial instrument as the amount at which the instrument could be exchanged
in a current transaction between willing parties. As of December 31, 1996, the
fair value of all financial instruments approximated carrying value.

 Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of

  The Company adopted the provisions of SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,"
on January 1, 1996. SFAS No. 121 requires that long-lived assets and certain
identifiable intangibles be reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows
expected to be generated by the asset. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which
the carrying amount of the assets exceed the fair value of the assets. Assets
to be disposed of are reported at the lower of the carrying amount or fair
value less costs to sell. Adoption of SFAS No. 121 did not have a material
impact on the Company's financial position, results of operations or
liquidity.

 Property and Equipment

  Property and equipment are stated at cost. Depreciation is provided on a
straight-line basis over estimated useful lives which range from three to ten
years. Amortization of leasehold improvements is charged to expense on a
straight-line basis over the shorter of the estimated useful lives of the
assets or the term of the underlying lease.

 Stock Options

  Prior to January 1, 1996, the Company accounted for its stock options in
accordance with the provisions of Accounting Principles Board (APB) Opinion
No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. As such, compensation expense would be recorded on the date
of grant only if the current market price of the underlying stock exceeded the
exercise price. On January 1, 1996, the Company adopted SFAS No. 123,
"Accounting for Stock-Based Compensation," which permits entities to recognize
as expense over the vesting period the fair value of all stock-based awards on
the date of grant. Alternatively, SFAS No. 123 also allows entities to
continue to apply the provisions of APB Opinion No. 25 and provide pro forma
net income and pro forma net income per share disclosures for employee stock
options granted in 1995 and subsequent years as if the fair-value-based method
defined in SFAS No. 123 had been applied. The Company has elected to continue
to apply the provisions of APB Opinion No. 25 and provide the pro forma
disclosure provisions of SFAS No. 123 (see note 8).

                                      29
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


 Use of Estimates

  Company management has made a number of estimates and assumptions relating
to the reporting of assets and liabilities in conformity with generally
accepted accounting principles. Actual results could differ from these
estimates.

 Revenue Recognition

  The Company recognizes revenue from licenses of accounting software upon
delivery. Revenue from maintenance agreements is recognized on a straight-line
basis over the maintenance period. Revenue from education services is
recognized as services are rendered.

  The American Institute of Certified Public Accountants issued a Statement of
Position (SOP) entitled "Software Revenue Recognition" on December 12, 1991.
Company management believes that the aforementioned revenue recognition
policies of the Company have been and are in compliance with the requirements
of the SOP.

 Income Taxes

  The Company accounts for income taxes under the asset and liability method,
whereby deferred tax assets and liabilities are determined based on
differences between the financial statement carrying amounts and the tax bases
of existing assets and liabilities using enacted tax rates in effect for the
year in which the differences are expected to reverse. The realization of
deferred tax assets is based on historical positions and expectations about
future taxable income. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.

 Net Income Per Share

  Net income per share was computed based on the weighted average number of
common shares and equivalents outstanding during the years presented (note 9).
Primary and fully diluted net income per share are approximately the same. The
Company has granted certain options (note 8) which have been treated as common
share equivalents in calculating net income per share.

                                      30
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


(2) BUSINESS COMBINATION

  On December 30, 1994, State of the Art merged with Manzanita, a California
corporation based in Roseville, California, which develops, manufactures,
markets and services microcomputer software used in medium- to small-sized
business environments. The merger was accounted for as a pooling of interests,
and, accordingly, the accompanying financial statements have been restated to
include the accounts and operations of Manzanita for all periods prior to the
merger. Manzanita became a wholly owned subsidiary of State of the Art and
each issued and outstanding share of Manzanita's common stock was converted
into the right to receive .53442 of a share of State of the Art's common stock
(Common Stock). Also pursuant to the merger, each issued and outstanding share
of Manzanita's Series B Convertible Preferred Stock was converted into the
right to receive .53442 shares of Common Stock. In addition, State of the Art
agreed to assume all outstanding options granted under the stock option plan
maintained by Manzanita. Each outstanding option was converted into an option
to purchase .53442 shares of Common Stock. As a result of the transaction, on
December 30, 1994, State of the Art issued 1,653,091 shares of Common Stock,
and reserved 346,844 shares of Common Stock for issuance upon exercise of
Manzanita's options. Separate results of the combined entities for the year
ended December 31, 1994 are as follows:

<TABLE>
     <S>                                                                 <C>
     Net revenues:
       State of the Art................................................. $30,173
       Manzanita........................................................   7,167
                                                                         -------
                                                                         $37,340
                                                                         =======
     Net income:
       State of the Art................................................. $ 2,635
       Manzanita........................................................     249
                                                                         -------
                                                                         $ 2,884
                                                                         =======
</TABLE>

  In connection with the merger, approximately $900 of merger costs and
expenses were incurred and charged to expense in 1994. These nonrecurring
costs and expenses consisted primarily of investment banking fees, legal,
accounting and certain personnel costs related to severance payments.

(3) INVENTORIES

  A summary of inventories follows:
<TABLE>
<CAPTION>
                                                                    1996   1995
                                                                   ------ ------
     <S>                                                           <C>    <C>
     Raw materials................................................ $1,306 $  701
     Work-in-process..............................................     19     43
     Finished goods...............................................    169    342
                                                                   ------ ------
                                                                   $1,494 $1,086
                                                                   ====== ======
</TABLE>

(4) INCOME TAXES

  The total provision for income taxes for the years ended December 31, 1996
and 1995 was allocated as follows:
<TABLE>
<CAPTION>
                                                               1996    1995
                                                              ------  ------
     <S>                                                      <C>     <C>
     Provision for income taxes included in consolidated
      statement of
      income................................................. $1,406  $2,933
     Income tax benefit included in shareholders' equity for
      compensation expense for tax purposes in excess of
      amounts recognized for financial reporting purposes....   (544)   (448)
                                                              ------  ------
                                                              $  862  $2,485
                                                              ======  ======
</TABLE>

                                      31
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


  The provision for income taxes attributable to income before taxes consists
of:

<TABLE>
<CAPTION>
                                                             1996   1995   1994
                                                            ------ ------ ------
     <S>                                                    <C>    <C>    <C>
     Current:
       Federal............................................. $1,116 $2,377 $1,009
       State...............................................    204    541    221
                                                            ------ ------ ------
                                                             1,320  2,918  1,230
                                                            ------ ------ ------
     Deferred:
       Federal.............................................     66     12    293
       State...............................................     20      3     61
                                                            ------ ------ ------
                                                                86     15    354
                                                            ------ ------ ------
                                                            $1,406 $2,933 $1,584
                                                            ====== ====== ======
</TABLE>

  The provision for income taxes differed from the amounts computed by
applying the U.S. Federal income tax rate of 34% to pretax income from
continuing operations as a result of the following:

<TABLE>
<CAPTION>
                                                          1996    1995    1994
                                                         ------  ------  ------
     <S>                                                 <C>     <C>     <C>
     Computed "expected" tax expense.................... $1,461  $2,923  $1,519
     State taxes, net of Federal income tax benefit.....    148     362     174
     General tax credit.................................   (247)   (357)   (234)
     Nondeductible acquisition costs....................     --      --     115
     Other..............................................     44       5      10
                                                         ------  ------  ------
                                                         $1,406  $2,933  $1,584
                                                         ======  ======  ======
</TABLE>

  The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities at December
31, 1996 and 1995 are presented below:

<TABLE>
<CAPTION>
                                                                      1996 1995
                                                                      ---- ----
     <S>                                                              <C>  <C>
     Deferred tax assets:
       State taxes................................................... $  7 $ 37
       Inventories, principally due to additional costs inventoried
        for tax purposes pursuant to the Tax Reform Act of 1986......  159  202
       Rent abatement................................................  106   84
       Non-compete agreement.........................................   --    3
       Tax credits...................................................   --   20
       Other.........................................................   85   79
                                                                      ---- ----
     Deferred tax assets.............................................  357  425
     Deferred tax liabilities:
       Depreciation..................................................   32  120
       Software capitalization.......................................  192   43
                                                                      ---- ----
     Net deferred tax assets......................................... $133 $262
                                                                      ==== ====
</TABLE>

  There was no valuation allowance for deferred tax assets as of December 31,
1996 or 1995.

                                      32
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


  Based on the Company's current and historical pretax earnings, management
believes it is more likely than not that the Company will realize the benefit
of the existing net deferred tax asset at December 31, 1996. Management
believes the existing net deductible temporary differences will reverse during
periods in which the Company generates net taxable income; however, there can
be no assurance that the Company will generate any earnings or any specific
level of continuing earnings in future years.

(5) PROPERTY AND EQUIPMENT

  A summary of property and equipment follows:

<TABLE>
<CAPTION>
                                                                  1996    1995
                                                                 ------- ------
     <S>                                                         <C>     <C>
     Computer equipment......................................... $ 6,748 $5,194
     Furniture and fixtures.....................................   2,527  2,287
     Office equipment...........................................   1,008    854
     Office equipment under capital lease.......................      60     60
     Leasehold improvements.....................................   1,669    926
                                                                 ------- ------
                                                                  12,012  9,321
     Less accumulated depreciation and amortization.............   6,678  4,964
                                                                 ------- ------
                                                                 $ 5,334 $4,357
                                                                 ======= ======
</TABLE>

(6) COMMITMENTS AND CONTINGENCIES

 Lease Commitments

  The Company leases its facilities and certain equipment under operating
leases which expire at various dates through 2002. Future minimum
noncancelable lease commitments are as follows:

<TABLE>
<CAPTION>
       YEAR
      ENDING
     DECEMBER                                                         OPERATING
        31,                                                            LEASES
     --------                                                         ---------
     <S>                                                              <C>
      1997...........................................................  $1,362
      1998...........................................................   1,384
      1999...........................................................   1,321
      2000...........................................................     786
      2001...........................................................     324
     Thereafter......................................................     296
                                                                       ------
     Total minimum lease payments....................................  $5,473
                                                                       ======
</TABLE>

  Rent expense was $1,616, $1,644 and $1,636 for the years ended 1996, 1995
and 1994, respectively.

 401(k) Profit Sharing Plan

  On January 1, 1990, State of the Art established a 401(k) Profit Sharing
Plan (the 401(k) Plan) which provides for retirement and certain other
benefits to their employees and their beneficiaries. State of the Art, at its
option, may make matching contributions to the 401k Plan based on salary
limitations. The 401k Plan is administered under a written Plan and Trust
Agreement entered into between State of the Art and their designated Trustee.
State of the Art's contributions for 1996, 1995 and 1994 were $247, $65 and
$38, respectively.

                                      33
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


  On March 1, 1993, Manzanita established a 401(k) Plan, which provides for
retirement and certain other benefits to their employees and their
beneficiaries. Manzanita makes matching contributions to the 401(k) Plan based
on salary limitations. The 401(k) Plan is administered under a written Plan
and Trust Agreement entered into between Manzanita and their designated
Trustee. Manzanita's contributions for 1995 and 1994 were $44 and $53,
respectively. On January 1, 1996, the Manzanita and State of the Art plans
were merged.

 Litigation

  The Company is subject to lawsuits which arise in the ordinary course of
business. Management is of the opinion, based in part upon opinions of its
counsel, that the liability of the Company, if any, arising from existing and
threatened lawsuits would not have a material adverse effect on the Company's
financial position or results of operations.

(7) REVOLVING CREDIT LINE

  On February 22, 1995, the Company entered into an agreement whereby it may
borrow, on a revolving credit line basis, up to $10,000. The revolving line is
unsecured. The Company has the option to pay interest on the revolving credit
line at the bank's prime interest rate, or the LIBOR Rate plus 1.5%. The
agreement requires the Company to maintain certain compensating balances and
has certain restrictive covenants. The agreement expires in April, 1998.

(8) SHAREHOLDERS' EQUITY

  On April 20, 1990, the Board of Directors adopted the 1990 Stock Option Plan
(the 1990 Plan), which allows for the issuance of both incentive and
nonqualified stock options. A total of 837,107 shares have been reserved for
issuance to selected employees and such other persons as deemed appropriate by
the Company under the 1990 Plan. The 1990 Plan is administered by the Board of
Directors of the Company or by a committee delegated by the Board of
Directors. Under the 1990 Plan, the exercise price of incentive stock options
granted will not be less than the fair market value of the Company's common
stock at the date of the grant. Options under the 1990 Plan are subject to
varying vesting periods as determined by the Board of Directors or its
appointed committee. The outstanding options are subject to vesting over
periods up to 5 years.

  In order to ensure the availability of sufficient numbers of options to
attract and retain key employees in the future, on February 17, 1994, the
Company's Board of Directors adopted the 1994 Incentive Stock Option, Non-
qualified Stock Option and Restricted Stock Purchase Plan (the 1994 Plan),
which allows for the issuance of incentive and nonqualified stock options and
restricted stock purchase agreements to employees of the Company. On April 25,
1996, an additional 1,000,000 shares of the Company's common stock was
approved to be reserved for the 1994 Plan. A total of 2,000,000 shares are
reserved for the 1994 Plan. In addition to the 1994 Plan, on March 1, 1994,
the Company's Board of Directors adopted a Stock Option Plan for Non-Employee
Directors (the Director's Plan). A total of 200,000 shares are reserved for
both initial and ongoing grants to nonemployee Directors of the Company. The
1994 Plan and Director's Plan is administered by the Board of Directors of the
Company or by a committee designated by the Board of Directors. Under both the
1994 Plan and Director's Plan, the exercise price of stock options granted
will not be less than the fair market value of the Company's common stock at
the date of the grant. Options under the 1994 Plan are subject to varying
vesting periods as determined by the Board of Directors or its appointed
committee. Under the Directors' Plan, both the size of option grants and the
vesting periods are specified in the plan.

  The per share weighted-average fair value of stock options granted during
1996 and 1995 was $5.66 and $4.14 on the date of grant using the Black Scholes
option-pricing model with the following weighted-average assumptions: Expected
dividend yield of 0%, risk-free interest rate of 6.29%, volatility of its
stock over the expected life of the options of .56, and an expected life of
3.68 years.

                                      34
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


  The Company applies APB Opinion No. 25 and related interpretations in
accounting for its stock-based compensation plans. Accordingly, no
compensation cost has been recognized for its stock option plans. Had
compensation costs for the Company's three stock-based compensation plans been
determined under SFAS No. 123, the Company's net income and net income per
share would have been reduced to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                                                    1996   1995
                                                                   ------ ------
     <S>                                                           <C>    <C>
     Net income:
       As reported................................................ $2,892 $5,663
       Pro forma..................................................  1,941  5,447
                                                                   ====== ======
     Net income per share:
       As reported................................................ $ 0.25 $ 0.51
       Pro forma..................................................   0.17   0.49
                                                                   ====== ======
</TABLE>

  Pro forma net income reflects only options granted in 1996 and 1995.
Therefore, the full impact of calculating compensation cost for stock options
under SFAS No. 123 is not reflected in the pro forma net income amounts
presented above because compensation cost is reflected over the options'
vesting period of four years and compensation cost for options granted prior
to January 1, 1995 is not considered.

  A summary of option activity and options outstanding under the plans
follows:

<TABLE>
<CAPTION>
                                                         NUMBER OF   PRICE PER
                                                          SHARES       SHARE
                                                         ---------  -----------
     <S>                                                 <C>        <C>
     Options outstanding at December 31, 1993...........   478,341  $ .38-12.25
       Granted.......................................... 1,248,774    1.50-8.44
       Exercised........................................   (46,091)    .38-3.00
       Canceled.........................................   (14,930)    .56-7.38
                                                         ---------  -----------
     Options outstanding at December 31, 1994........... 1,666,094  $ .38-12.25
       Granted..........................................   342,415   6.38-10.63
       Exercised........................................  (507,484)    .38-8.50
       Canceled.........................................  (202,903)   .38-12.25
                                                         ---------  -----------
     Options outstanding at December 31, 1995........... 1,298,122  $ .38-10.63
       Granted..........................................   558,350   5.88-14.75
       Exercised........................................  (234,041)   .38-10.63
       Canceled.........................................   (69,636)   .56-12.00
                                                         ---------  -----------
     Options outstanding at December 31, 1996........... 1,552,795  $ .38-14.75
                                                         =========  ===========
</TABLE>

  The majority of options granted in 1996, 1995 and 1994 were to attract and
retain key employees. The above share and price per share amounts include the
options assumed in the Manzanita pooling of interests (see note 2).

  The income tax effect of the nonqualified options exercised in 1996, 1995
and 1994 was $544, $448 and $60, respectively, which has been credited
directly to common stock in the accompanying Consolidated Balance Sheets and
treated as a noncash transaction for purposes of the accompanying Consolidated
Statements of Cash Flows.

  At December 31, 1996, options to purchase 738,362 shares of common stock
were exercisable at $.38 to $12.00 per share.

                                      35
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


  Under a stock repurchase plan authorized by the Company's Board of
Directors, State of the Art repurchased 100,000 shares of its common stock in
1994 for an aggregate price of approximately $513.

  Pursuant to a resolution of the Board of Directors of Manzanita in May 1993,
a noncompensatory employee stock purchase plan was put in place. The purpose
of this plan was to promote the interests of Manzanita and its shareholders by
providing incentive to employees. This plan was open to all employees. During
1994, 84,866 shares of common stock were issued at $1.50 per share under this
employee stock purchase plan.

  During 1995, the Company issued 31,348 shares of common stock for $7.975 per
share as compensation to some newly hired key employees.

(9) NET INCOME PER SHARE

  The computations of the weighted average common shares and equivalents
outstanding follows:

<TABLE>
<CAPTION>
                                                            YEAR ENDED DECEMBER
                                                                    31,
                                                            --------------------
                                                             1996   1995   1994
                                                            ------ ------ ------
     <S>                                                    <C>    <C>    <C>
     Weighted average common shares outstanding during the
      period..............................................  11,053 10,627 10,428
     Incremental shares assumed to be outstanding related
      to stock options granted............................     621    585    410
                                                            ------ ------ ------
     Weighted average common shares and equivalents
      outstanding.........................................  11,674 11,212 10,838
                                                            ====== ====== ======
</TABLE>

                                      36
<PAGE>

                    STATE OF THE ART, INC. AND SUBSIDIARIES

                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

                  YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                               ADDITIONS
                                    BALANCE AT CHARGED TO              BALANCE
                                    BEGINNING  COSTS AND    AMOUNTS    AT END
            DESCRIPTION             OF PERIOD   EXPENSES  WRITTEN-OFF OF PERIOD
            -----------             ---------- ---------- ----------- ---------
<S>                                 <C>        <C>        <C>         <C>
Year ended December 31, 1996:
  Allowance for doubtful accounts..    $115       $ 55       $ 54       $116
                                       ====       ====       ====       ====
  Reserve for inventory
   obsolescence....................    $ 95       $ 69       $ 69       $ 95
                                       ====       ====       ====       ====
Year ended December 31, 1995:
  Allowance for doubtful accounts..    $165       $ 48       $ 98       $115
                                       ====       ====       ====       ====
  Reserve for inventory
   obsolescence....................    $ 24       $184       $113       $ 95
                                       ====       ====       ====       ====
Year ended December 31, 1994:
  Allowance for doubtful accounts..    $143       $ 36       $ 14       $165
                                       ====       ====       ====       ====
  Reserve for inventory
   obsolescence....................    $ 51       $ 30       $ 57       $ 24
                                       ====       ====       ====       ====
</TABLE>

                                       37
<PAGE>

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

  None.

                                   PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

  This item has been omitted because the Company will file with the
Commission, not later than 120 days after the close of the Company's fiscal
year ended December 31, 1996, a definitive Proxy Statement pursuant to
Regulation 14A for the Annual Meeting of Shareholders of the Company scheduled
for May 29, 1997, involving, among other things, the election of directors.
The information required under this item is incorporated herein by this
reference to the section entitled "Election of Directors" in said Proxy
Statement.

ITEM 11. EXECUTIVE COMPENSATION

  This item has been omitted because the Company will file with the
Commission, not later than 120 days after the close of the Company's fiscal
year ended December 31, 1996, a definitive Proxy Statement pursuant to
Regulation 14A for the Annual Meeting of Shareholders of the Company scheduled
for May 29, 1997, involving, among other things, the election of directors.
The information required under this item is incorporated herein by this
reference to the section entitled "Executive Compensation" in said Proxy
Statement (provided, however, that the material appearing under "Compensation
Committee Report to Shareholders" and "Stock Price Performance Presentation"
in said Proxy Statement is expressly not incorporated herein by reference).

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  This item has been omitted because the Company will file with the
Commission, not later than 120 days after the close of the Company's fiscal
year ended December 31, 1996, a definitive Proxy Statement pursuant to
Regulation 14A for the Annual Meeting of Shareholders of the Company scheduled
for May 29, 1997, involving, among other things, the election of directors.
The information required under this item is incorporated herein by this
reference to the section entitled "Security Ownership of Management, Nominees
and Principal Security Holders" in said Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  This item has been omitted because the Company will file with the
Commission, not later than 120 days after the close of the Company's fiscal
year ended December 31, 1996, a definitive Proxy Statement pursuant to
Regulation 14A for the Annual Meeting of Shareholders of the Company scheduled
for May 29, 1997, involving, among other things, the election of directors.
The information required under this item is incorporated herein by this
reference to the section entitled "Transactions with Related Parties" in said
Proxy Statement.

                                      38
<PAGE>

                                    PART IV

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

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

    (1) Financial Statements

  The following financial statements of the Registrant are included in Part II,
Item 8:

<TABLE>
<CAPTION>
                                                                          PAGE
                                                                         NUMBER
                                                                           OF
                                                                          THIS
                                                                         REPORT
                                                                         ------
 <C>    <C> <S>                                                          <C>
        --Independent Auditors' Report                                    23
        --Consolidated Balance Sheets at December 31, 1996 and 1995       24
        --Consolidated Statements of Income, years ended December 31,     25
          1996, 1995, and 1994
        --Consolidated Statements of Shareholders' Equity, years ended    26
          December 31, 1996, 1995 and 1994
        --Consolidated Statements of Cash Flows, years ended December
          31, 1996, 1995 and 1994                                         27
        --Notes to Consolidated Financial Statements
    (2) Financial Statement Schedule
        --Valuation and Qualifying Accounts (Schedule II)                 37
    (3) Exhibit Index
  2.1   --Agreement and Plan of Reorganization by and among State Of      (vi)
         The Art, Inc., Manzanita Acquisition Corp., and Manzanita
         Software Systems
  3.1    a. Articles of Incorporation of State Of The Art, Inc., filed    (i)
             April 7, 1981.
         b. Certificate of Amendment of Articles of Incorporation,        (i)
             filed December 28, 1981.
         c. Certificate of Amendment of Articles of Incorporation         (i)
             filed February 5, 1982.
         d. Certificate of Amendment of Articles of Incorporation         (i)
             filed February 14, 1983.
         e. Certificate of Amendment of Articles of Incorporation,        (i)
             filed June 22, 1983.
         f. Certificate of Amendment of Articles of Incorporation,        (i)
             filed August 29, 1983.
         g. Certificate of Amendment of Articles of Incorporation,        (i)
             filed November 1, 1990.
  3.3   --Bylaws of State Of The Art, Inc., as amended.                   (i)
  4.1   --Amended and Restated 1990 Stock Option Plan                     (ii)
  4.2   --Form of amended and restated 1990 Nonqualified Stock Option     (ii)
          Agreement
  4.3   --1994 Incentive Stock Option, Nonqualified Stock Option and      (ii)
          Restricted Stock Purchase Plan
  4.4   --Form of Incentive Option Agreement used under the 1994          (ii)
          Incentive Stock Option, Nonqualified Stock Option and
          Restricted Stock Purchase Plan
  4.5   --Form of Nonqualified Option Agreement used under the 1994       (ii)
          Incentive Stock Option, Nonqualified Stock Option and
          Restricted Stock Purchase Plan
  4.6   --Form of Restricted Share Agreement used under the 1994          (ii)
          Incentive Stock Option, Nonqualified Stock Option and
          Restricted Stock Purchase Plan
  4.7   --Stock Option Plan for Non-Employee Directors                    (ii)
  4.8   --Form of Option Agreement (Past Service Options) used under      (ii)
          Stock Option Plan for
          Non-Employee Directors
  4.9   --Form of Option Agreement (Vesting Options) used under Stock     (ii)
          Option Plan for Non-Employee Directors
  4.10  --1997 Employee Stock Purchase Plan
  4.11  --Form of subscription agreement used under the 1997 Employee
          Stock Purchase Plan
  4.12  --Form of Notice of Withdrawal used under the 1997 Employee
          Stock Purchase Plan
 10.3    a. Standard Form Lease agreement dated September 5, 1989,        (i)
             between the Registrant and The Irvine Company.
         b. First Amendment to Lease dated May 15, 1990, between the      (i)
             Registrant and The Irvine Company.
</TABLE>

                                       39
<PAGE>

<TABLE>
<CAPTION>
                                                                          PAGE
                                                                         NUMBER
                                                                           OF
                                                                          THIS
                                                                         REPORT
                                                                         ------
 <C>    <C>    <S>                                                       <C>
            c. Second Amendment to Lease dated June 24, 1993, between    (i)
                the Registrant and the Irvine Company
            d. Lease between WRC Properties, Inc. as Landlord, and       (vii)
                State of the Art, Inc., as Tenant
 10.8   --Form of Indemnification Agreement                              (i)
 10.20  --Employment Agreement dated February 17, 1994, between the      (iv)
          Registrant and David W. Hanna
 10.23  --Non-Competition Agreement dated December 30, 1994 between      (vi)
          the Registrant and Corley M. Phillips
 10.24  --Employment Agreement dated December 30, 1994 between the       (vi)
          Registrant and Jeffrey E. Gold
 10.25  --Non-Competition Agreement dated December 30, 1994 between      (vi)
          the Registrant and Jeffrey E. Gold
 10.26  --Computer Software License Agreement for Bundled Application    (vi)
          Software dated January 26, 1995, between the Registrant and
          BASIS International Ltd.
  23    --Consent of KPMG Peat Marwick LLP                               42
  24    --Power of Attorney                                              41
--------

           (i) Incorporated by reference to the referenced exhibit
                number of the Company's Registration Statement on Form
                S-1, No. 33-39771.
          (ii) Incorporated by reference to the referenced exhibit
                number of the Company's Registration Statement on Form
                S-8, No. 33-86828.
         (iii) Incorporated by reference to the referenced exhibit
                number of the Company's Annual Report on Form 10-K for
                the fiscal year ended December 31, 1993.
          (iv) Incorporated by reference to the referenced exhibit
                number of the Company's Quarterly Report on Form 10-Q
                for the quarterly period ended March 31, 1994.
           (v) Incorporated by reference to the referenced exhibit
                number of the Company's Quarterly Report on Form 10-Q
                for the quarterly period ended June 30, 1994.
          (vi) Incorporated by reference to the referenced exhibit
                number of the Company's Annual Report on Form 10-K for
                the fiscal year ended December 31, 1994.
         (vii) Incorporated by reference to the referenced exhibit
                number of the Company's Annual Report on Form 10-K for
                the fiscal year ended December 31, 1995.
</TABLE>

  (b) Reports on Form 8-K.

  The Company filed no report on Form 8-K during the last quarter of the
Company's fiscal year ended December 31, 1996.

  (c) Exhibits.

  See Item 14(a)(3) "Exhibit Index."

  (d) Financial Statement Schedules.

  See Item 14(a)(2) "Financial Statement Schedule."

                                      40
<PAGE>

                                  SIGNATURES

  PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED
ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.

                                          State of the Art, Inc.

                                             /s/ David W. Hanna
                                          By: _________________________________
                                             David W. Hanna
                                             Chairman of the Board of
                                              Directors,
                                             Chief Executive Officer, and
                                              President

                                          Date: March 28, 1997

                               POWER OF ATTORNEY

  KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints David W. Hanna and James R. Eckstaedt, jointly
and severally, his or her attorney-in-fact, each with the power of
substitution, for him or her in any and all capacities, to sign any amendments
to this Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said attorneys-
in-fact, or his or their substitutes, may do or cause to be done by virtue
hereof.

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

<TABLE>
<CAPTION>
                NAME                             TITLE                    DATE
                ----                             -----                    ----
<S>                                  <C>                           <C>
        /s/ David W. Hanna
------------------------------------
           David W. Hanna            Chairman of the Board of
                                      Directors, President and
                                      Chief Executive Officer        March 28, 1997

      /s/ James R. Eckstaedt
------------------------------------
         James R. Eckstaedt          Vice President, Finance,
                                      Chief Financial Officer and
                                      Secretary (Principal
                                      Financial and Accounting
                                      Officer)                       March 28, 1997
        /s/ George Riviere
------------------------------------
           George Riviere            Director                        March 28, 1997

      /s/ Susan L. Rasinski
------------------------------------
         Susan L. Rasinski           Director                        March 28, 1997

        /s/ W. Frank King
------------------------------------
           W. Frank King             Director                        March 28, 1997

    /s/ James H. Clement, Jr.
------------------------------------
       James H. Clement, Jr.         Director                        March 28, 1997
</TABLE>

                                      41
<PAGE>

                             ACCOUNTANTS' CONSENT

The Board of Directors
State of the Art, Inc.

  We consent to incorporation by reference in the registration statement
(No. 333-10591) on Form S-8 of State of the Art, Inc. of our report dated
January 21, 1997, relating to the balance sheets of State of the Art, Inc. as
of December 31, 1996 and 1995 and the related statements of income, cash flows
and shareholders' equity for each of the years in the three-year period ended
December 31, 1996, which report appears in the December 31, 1996 annual report
on Form 10-K of State of the Art, Inc.

                                          KPMG Peat Marwick LLP

Orange County, California
March 28, 1997

                                      42