<PAGE>   1
                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    Form 10-Q

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

                  For the quarterly period ended June 28, 1997

                                       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: 0-27422

                             ARTHROCARE CORPORATION
             (Exact name of registrant as specified in its charter)

         DELAWARE                                        94-3180312 
(State of incorporation)                    (I.R.S. Employer Identification No.)

                            595 North Pastoria Avenue
                           Sunnyvale, California 94086
                    (Address of principal executive offices)

                                 (408) 736-0224
              (Registrant's telephone number, including area code)


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 
                                      -----     -----

The number of shares outstanding of the registrant's common stock as of August
4, 1997 was 8,809,967


                            EXHIBIT INDEX ON PAGE 33

<PAGE>   2
                             ARTHROCARE CORPORATION

                                      INDEX


<TABLE>
<CAPTION>
                                                                                                Page
                                                                                                ----
<S>       <C>                                                                                   <C>
PART 1:  FINANCIAL INFORMATION

     ITEM 1.  FINANCIAL STATEMENTS

          Condensed Balance Sheets as of June 28, 1997 and                                        
             December 28, 1996.                                                                   3

          Condensed Statements of Operations for the quarters and
             the six months ended June 28, 1997 and June 29, 1996.                                4

          Condensed Statements of Cash Flows for the six months
             ended June 28, 1997 and June 29, 1996.                                               5

          Notes to the Condensed Financial Statements                                             6

     ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF
        FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                           8-27

PART II:  OTHER INFORMATION

     ITEM 1.  LEGAL PROCEEDINGS                                                                  28
     ITEM 2.  CHANGES IN SECURITIES                                                              28
     ITEM 3.  DEFAULTS UPON SENIOR SECURITIES                                                    28
     ITEM 4.  SUBMISSION OR MATTERS TO VOTE OF SECURITY HOLDERS                                  28
     ITEM 5.  OTHER INFORMATION                                                                  28
     ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K                                                  29-31

SIGNATURE                                                                                        32
</TABLE>



                                  Page 2 of 33
<PAGE>   3
                         PART 1 - FINANCIAL INFORMATION

                          ITEM 1. FINANCIAL STATEMENTS

                             ARTHROCARE CORPORATION
                            CONDENSED BALANCE SHEETS
                                 (In thousands)


<TABLE>
<CAPTION>
                                                          June 28,     December 28,
                                                            1997           1996
                                                          --------     ------------
                                                         (Unaudited)
<S>                                                       <C>            <C>     
                                     ASSETS

Current assets
     Cash and cash equivalents                            $ 17,143       $ 11,359
     Available-for-sale securities                           3,139         12,281
     Accounts receivable, net                                1,229          1,251
     Inventory                                               1,276            759
     Prepaid expenses and other current assets                 326            155
                                                          --------       --------
          Total current assets                              23,113         25,805

Property and equipment, net                                  1,473          1,484
Related party receivables                                      232            298
Available-for-sale securities                                4,833          5,641
Other assets                                                    63             69
                                                          --------       --------
               Total assets                               $ 29,714       $ 33,297
                                                          ========       ========

                                   LIABILITIES

Current liabilities
     Accounts payable                                     $  1,184       $  1,001
     Related party payables                                     34             54
     Accrued liabilities                                     1,491          1,245
     Capital lease obligation, current                          32             37
                                                          --------       --------
          Total current liabilities                          2,741          2,337

Capital lease obligation, net of current portion                 3             21
Deferred rent                                                  160            157
                                                          --------       --------
               Total liabilities                             2,904          2,515
                                                          --------       --------

       STOCKHOLDERS' EQUITY

Common stock                                                     9              9
Additional paid in capital                                  48,927         48,862
Notes receivable from stockholders                             (92)           (92)
Deferred compensation                                         (309)          (388)
Accumulated deficit                                        (21,774)       (17,618)
Unrealized gain on investments                                  49              9
                                                          --------       --------
     Total stockholders' equity                             26,810         30,782
                                                          --------       --------
          Total liabilities and stockholders' equity      $ 29,714       $ 33,297
                                                          ========       ========
</TABLE>


               The accompanying notes are an integral part of the
                         condensed financial statements



                                  Page 3 of 33
<PAGE>   4
                             ARTHROCARE CORPORATION
                       CONDENSED STATEMENTS OF OPERATIONS
                      (In thousands, except per share data)
                                   (Unaudited)


<TABLE>
<CAPTION>
                                           Three months ended:          Six months ended:
                                          ---------------------       ---------------------
                                          June 28,      June 29,      June 28,     June 29,
                                            1997          1996          1997         1996
                                          -------       -------       -------       -------
<S>                                       <C>           <C>           <C>           <C>    
Net sales                                 $ 2,832       $ 1,406       $ 5,093       $ 2,565
Cost of sales                               1,994         1,236         3,673         2,301
                                          -------       -------       -------       -------
Gross margin                                  838           170         1,420           264
                                          -------       -------       -------       -------

Operating expenses:
     Research and development                 873           950         1,753         1,814
     Sales and marketing                    1,386           872         2,751         1,530
     General and administrative               927           527         1,818         1,103
                                          -------       -------       -------       -------
          Total operating expenses          3,186         2,349         6,322         4,447
                                          -------       -------       -------       -------

Loss from operations                       (2,348)       (2,179)       (4,902)       (4,183)
Interest and other income, net                359           444           746           707
                                          -------       -------       -------       -------
Loss before income tax provision           (1,989)       (1,735)       (4,156)       (3,476)
Income tax provision                         --            --            --               2
                                          -------       -------       -------       -------
Net loss                                  $(1,989)      $(1,735)      $(4,156)      $(3,478)
                                          =======       =======       =======       =======
Net loss per share                        $ (0.23)      $ (0.20)      $ (0.47)      $ (0.45)
                                          =======       =======       =======       =======
Shares used in per share calculation        8,806         8,675         8,795         7,758
                                          =======       =======       =======       =======
</TABLE>


               The accompanying notes are an integral part of the
                         condensed financial statements




                                  Page 4 of 33
<PAGE>   5
                             ARTHROCARE CORPORATION
                       CONDENSED STATEMENTS OF CASH FLOWS
                                 (In thousands)

<TABLE>
<CAPTION>
                                                                                 Six months ended:
                                                                              June 28,        June 29,
                                                                               1997           1996
                                                                             --------       -------- 
                                                                                    (Unaudited)
<S>                                                                          <C>            <C>      
Cash flows from operating activities:
     Net loss                                                                $ (4,156)      $ (3,478)
     Adjustments to reconcile net loss to net cash used in
       operating activities:
          Depreciation and amortization                                           304            158
          Write-off of property and equipment                                       -            233
          Amortization of deferred compensation                                    79             81
          Provision for doubtful accounts                                          52             53
          Provision for excess and obsolete inventory                             149            113
          Deferred rent                                                             3             15
          Changes in operating assets and liabilities:
               Accounts receivable                                                (30)        (1,017)
               Related party receivables                                           66            (37)
               Inventory                                                         (666)          (898)
               Prepaid expenses and other current assets                         (171)           557
               Accounts payable                                                   163           (284)
               Accrued liabilities                                                246            450
               Other assets                                                         6            (20)
                                                                             --------       -------- 
                    Net cash used in operating activities                      (3,955)        (4,074)
                                                                             --------       -------- 

Cash flows from investing activities:
     Purchases of property and equipment                                         (293)          (733)
     Net maturities (purchases) of available-for-sale securities                9,990        (11,162)
                                                                             --------       -------- 
                    Net cash provided by (used in) investing activities         9,697        (11,895)
                                                                             --------       -------- 

Cash flows from financing activities:
     Repayment of capital leases                                                  (23)           (16)
     Proceeds from issuance of Common Stock                                        65         31,916
                                                                             --------       -------- 
                    Net cash provided by financing activities                      42         31,900
                                                                             --------       -------- 
Net increase in cash and cash equivalents                                       5,784         15,931
Cash and cash equivalents, beginning of period                                 11,359          4,774
                                                                             --------       -------- 
Cash and cash equivalents, end of period                                     $ 17,143       $ 20,705
                                                                             ========       ========

Supplemental schedule of non-cash investing and financing activities:
     Issuance of common stock on conversion of preferred stock               $      -       $ 15,704
     Net unrealized gain (loss) on available-for-sale securities             $     40       $    (35)
</TABLE>


               The accompanying notes are an integral part of the
                         condensed financial statements



                                  Page 5 of 33
<PAGE>   6
                             ARTHROCARE CORPORATION
                     NOTES TO CONDENSED FINANCIAL STATEMENTS
                                   (Unaudited)

1.  Basis of Presentation

         In the opinion of management, the accompanying unaudited condensed
financial statements contain all adjustments (all of which are normal and
recurring in nature) necessary to present fairly the financial position, results
of operations and cash flows of ArthroCare Corporation ("the Company"). Interim
results of operations are not necessarily indicative of the results to be
expected for the full year. The notes to the financial statements contained in
the Form 10-K for the year ended December 28, 1996 should be read in conjunction
with these condensed financial statements. The balance sheet at December 28,
1996 was derived from audited financial statements; however, the financial
statements in this report do not include all disclosures required by generally
accepted accounting principles.

2.  Computation of Net Loss Per Share

         The net loss per share is based upon the weighted average number of
common and common equivalent shares outstanding. Common equivalent shares from
stock options, warrants and preferred stock are excluded from the computation as
their effect is anti-dilutive, except that, pursuant to the Securities and
Exchange Commission Staff Accounting Bulletin No. 83, common and common
equivalent shares issued by the Company during the twelve months preceding the
initial public offering at prices substantially below the initial public
offering price have been included in the calculations as if they were
outstanding for all of the periods prior to February, 1996 (using the treasury
stock method and the public offering price per share).

3.  Components of Inventory (in thousands):

<TABLE>
<CAPTION>
                                          June 28, 1997        December 28, 1996
                                          -------------        -----------------
                                          (Unaudited)
<S>                                          <C>                     <C>   
Inventory:
      Raw materials                          $  366                 $  345
      Work-in-process                           260                     32
      Finished goods                            650                    382
                                             ------                 ------
                                             $1,276                 $  759
                                             ======                 ======
</TABLE>

4.    Recent Accounting Pronouncements

         In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per
Share," which specifies the computation, presentation and disclosure
requirements for earnings per share. SFAS 128 supersedes Accounting Principles
Board Opinion No. 15 and will be effective for the Company's fiscal year 1998.
SFAS 128 requires restatement of all prior-



                                  Page 6 of 33
<PAGE>   7
period earnings per share data presented after the effective date. SFAS 128 will
not have a material impact on the Company's earnings per share.








                                  Page 7 of 33
<PAGE>   8
PART 1. FINANCIAL INFORMATION (continued)

                  ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
                OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

         Since commencing operations in April 1993, ArthroCare Corporation (the
"Company" or "ArthroCare") has primarily engaged in the design, development,
clinical testing, manufacturing and sale of its Arthroscopic System. The
Arthroscopic System consists of a disposable, bipolar ArthroWand, a radio
frequency controller that powers the ArthroWand and a cable that connects the
ArthroWand to the controller. The ArthroWand ablates (removes) soft tissue with
minimal damage to surrounding healthy tissue, and simultaneously achieves
hemostasis (sealing of small bleeding vessels).

         The Company has a limited history of operations. The Company received
clearance of its 510(k) premarket notification from the FDA in March 1995 to
market its Arthroscopic System in the United States for use in arthroscopic
surgery of the knee, shoulder, elbow and ankle. The Company has since received
clearance for use in the wrist and hip. In December 1995, the Company
commercially introduced its Arthroscopic System through a network of
distributors in the United States. The Company's arthroscopic strategy includes
placing controllers that are intended to generate future wand revenues. The
Company's long-term strategy includes applying its proprietary platform
technology to a range of other soft tissue surgical procedures in the fields of
urology, dermatology, dental surgery, and gynecology. In that regard, the
Company has received 510(k) clearance for use of its technology in the field of
urology, dental surgery and general dermatology. The Company is seeking
additional IDE and 510(k) approvals for specific dermatology markets which it
hopes to enter. The Company is continuing to work with the FDA to obtain 510(k)
clearance for use of its technology in the field of gynecology. There can be no
assurance that the Company's applications for its gynecology and dermatology
systems under development will be cleared by the FDA on a timely basis, if at 
all, or that these products or any of the Company's products, if cleared for 
marketing, will ever achieve commercial acceptance. See "Additional Factors 
that Might Affect Future Results -- Uncertainty of New Product Development", 
" -- Limited Domestic and International Marketing and Sales Experience" and 
" -- Uncertainty of Approvals; Extensive Governmental Regulation."

         This Report on Form 10-Q contains certain forward looking statements
regarding future events with respect to the Company. Actual events or results
may differ significantly as a result of the factors described herein and in the
documents incorporated herein by reference including, in particular, those
factors described under "Additional factors that might affect future results."



                                  Page 8 of 33
<PAGE>   9
Results of Operations

                             ARTHROCARE CORPORATION
                       CONDENSED STATEMENTS OF OPERATIONS
                                 (In thousands)
                                   (Unaudited)

<TABLE>
<CAPTION>
                                               Three months ended:                                 Six months ended:
                                  -----------------------------------------------   ----------------------------------------------- 
                                  June 28,            June 29,                 %    June 28,           June 29,                 %
                                    1997         %     1996          %        Chg     1997         %     1996          %       Chg
                                  -------       ---   -------       ---       ---   -------       ---   -------       ---        -- 
<S>                               <C>           <C>   <C>           <C>       <C>   <C>           <C>   <C>           <C>        <C>
Net sales                         $ 2,832       100%  $ 1,406       100%      101%  $ 5,093       100   $ 2,565       100%       99%
Cost of sales                       1,994        70%    1,236        88%       61%    3,673        72%    2,301        90%       60%
                                  -------             -------                       -------             -------
Gross margin                          838        30%      170        12%      393%    1,420        28%      264        10%      438%
                                  -------             -------                       -------             -------                     
Operating expenses:
   Research & development             873        31%      950        68%       -8%     1,753       34%    1,814        70%       -3%
   Sales & marketing                1,386        49%      872        62%       59%    2,751        54%    1,530        60%       80%
   General & administrative           927        33%      527        37%       76%    1,818        36%    1,103        43%       65%
                                  -------             -------                       -------             -------   
      Total operating expenses      3,186       113%    2,349       167%       36%    6,322       124%    4,447       173%       42%
                                  -------             -------                       -------             ------- 
Loss from operations               (2,348)      -83%   (2,179)     -155%        8%   (4,902)      -96%   (4,183)     -163%       17%
Interest and other income, net        359        13%      444        32%      -19%      746        15%      707        28%        6%
                                  -------             -------                       -------             -------   
Loss before income tax provision   (1,989)      -70%   (1,735)     -123%       15%   (4,156)      -81%   (3,476)     -135%       20%
Income tax provision                 --           0%     --           0%      n/m      --           0%        2         0%      n/m
                                  -------             -------                       -------             -------
Net loss                          $(1,989)      -70%  $(1,735)     -123%       15%  $(4,156)      -81%  $(3,478)     -135%       20%
                                  =======             =======                       =======             ======= 
</TABLE>

Revenues

         For the three month period ended June 28, 1997 revenues were $2.8
million as compared to $1.4 million for the three month period ended June 29,
1996. The $1.4 million increase is due to both higher unit volume wand sales and
higher wand average selling price (ASP) compared to the year ago quarter.
Revenues for the six month period ended June 28, 1997 were $5.1 million as
compared to $2.6 million for the six month period ended June 29, 1996. The $2.5
million increase is due primarily to higher unit volume wand sales and higher
wand ASP. The increased wand revenues in the 1997 period were partially offset
by decreased controller revenues resulting from initial dealer stocking orders
in the first two quarters of 1996 that did not recur in the 1997 period. The
Company's strategy in arthroscopy is to increase the installed base of
controllers by offering aggressive promotional programs which bundle a
discounted controller with a minimum wand purchase and first year purchase
commitment. This strategy has had an adverse impact on controller revenue,
controller ASP and gross margins, partially offsetting the positive impact of
increased wand sales.



                                  Page 9 of 33
<PAGE>   10
         During the second quarter of 1997, the installed base of controllers
increased by 222 units to a total installed base of 970 units, which includes
718 units shipped to doctors and hospitals. The entire installed base of
controllers generated sales of approximately 22,000 wands during the second
quarter of 1997.

         Overall, wands were sold at or near list price during the second
quarter and for the first half of 1997. The wand ASP was higher in the three
month period ended June 28, 1997 than in the three month period ended June 29,
1996 due to the large number of wands sold to dealers at discounts in the prior
year quarter as dealers stocked initial inventory. The same was true for the six
month period ended June 28, 1997 as compared to the six month period ended June
29, 1996. The Company does not expect wand ASP to continue to increase.

         During the three and six month periods ended June 28, 1997, controller
ASP was adversely impacted by promotional programs which offer discounted
controller prices when packaged with volume wand purchases or purchase
commitments. In the three and six month periods ended June 29, 1996, the
controller ASP was higher as dealers were purchasing their demonstration
controllers and the current controller promotional programs were not being
offered. The Company expects to continue these promotional programs as a
strategy to increase controller placements which could result in increased wand
sales.

Wands and controllers as percentage of total revenues:

<TABLE>
<CAPTION>
                        Three months ended:           Six months ended:
                  ----------------------------  ----------------------------
                  June 28, 1997  June 29, 1996  June 28, 1997  June 29, 1996
                  -------------  -------------  -------------  -------------
<S>                    <C>            <C>            <C>            <C>
Wands                  91%            77%            92%            67%

Controllers             9%            23%             8%            33%
</TABLE>

         The revenue mix between wands and controllers in the three month period
ended June 28, 1997 was approximately 91% wands and 9% controllers. During the
three month period ended June 29, 1996 the approximate mix of wands and
controllers was 77% wands and 23% controllers. During the six month period ended
June 28, 1997 the revenue mix was approximately 92% wands and 8% controllers.
The increasing wand percentages in both periods compared with the year ago
periods were due to increased wand sales and continued promotional pricing of
controllers. This trend was slightly offset in both periods by initial stocking
orders shipped to international dealers during the second quarter of 1997. The
Company expects wand sales to remain the primary component of revenues in the
future.

         During the three and six month periods ended June 28, 1997,
approximately 80% of revenue was from sales of its Arthroscopic System to
doctors and hospitals. The three and six month periods ended June 29, 1996 were
the Company's first full periods of 



                                 Page 10 of 33
<PAGE>   11
shipments, and revenues were heavily weighted toward dealers as they bought
initial stocking inventory. The Company expects sales to doctors and hospitals
to remain high as a percentage of overall sales in the future.

         The Company believes that, in its first six quarters of product
shipments, it has penetrated over 2% of the arthroscopic surgical tools market
in the United States and that approximately 60% of the Company's wand revenue is
being generated by wands purchased for use in shoulder procedures. The Company
believes that shoulder procedures are the fastest growing segment of the
arthroscopic market, and knee procedures represent the largest segment of
arthroscopic surgery in terms of the absolute number of procedures. In the
quarter ended June 28, 1997, the Company estimates that approximately $1.0
million in wand revenues were generated by knee procedures, an increase of 250%
over the wand revenues from knee procedures in the quarter ended June 29, 1996.
In order to achieve increasing wand sales over time, the Company must further
penetrate the market for knee procedures. The Company has introduced additional
wand styles designed to be used in both knee and shoulder arthroscopic
procedures which are intended to increase wand sales in both markets. There can
be no assurance that those wand styles will be adopted by doctors.

         The Company has limited sales and marketing experience and can make no
assurance that current trends in sales and product acceptance will continue. See
"Additional Factors that Might Affect Future Results -- Uncertainty of Market
Acceptance" and " -- Limited Domestic and International Marketing and Sales
Experience."


Cost of Sales

         Cost of sales was $2.0 million, or 70% of sales for the three months
ended June 28, 1997. During the three month period ended June 29, 1996, cost of
sales was $1.2 million or 88% of sales. Cost of sales for the six month period
ended June 28, 1997 was $3.7 million or 72% of sales. During the six month
period ended June 29, 1996, cost of sales was $2.3 million or 90% of sales. As a
percentage of sales, cost of sales decreased as the fixed and semi-fixed costs
were spread over higher wand manufacturing volume resulting in improved
manufacturing efficiency. Improvements to the manufacturing process also reduced
costs by improving efficiency. The $0.8 million and $1.4 million year over year
cost of sales increases for the three and six month periods, respectively, were
due to higher volume wand and controller shipments.

         The improved gross margin includes the effect of the controller
promotional programs during the quarter. The Company believes that if its
promotional programs maintain the same or higher number of wands bundled with a
discounted controller, and if the demand for the disposable wands increases over
a growing installed base of controllers, then the cost of sales will continue to
decrease as a percentage of revenue and 



                                 Page 11 of 33
<PAGE>   12
gross margins will continue to increase. However, there can be no assurance the
Company will be successful in maintaining the mix of wands to discounted
controllers in its promotional programs or increasing demand for its disposable
wands. See "Additional Factors that Might Affect Future Results -- History of
Losses; Fluctuations in Operating Results; Substantial Losses Expected to
Continue."

Operating Expenses

         Research and development expense, which includes expenditures for
regulatory compliance and quality assurance, was $873,000 in the three months
ended June 28, 1997, only slightly less than the $950,000 for the three month
period ended June 29, 1996 due to lower spending on parts, supplies and outside
engineering services in the current period. This was partially offset by an
increase in staffing. The same was true for the $61,000 decrease to $1,753,000
for the six month period ended June 28, 1997 from $1,814,000 for the six month
period ended June 29, 1996.

         The Company believes that continued investment in its platform
technology is essential if it is to maintain its competitive position. On July
9, 1997 the Company announced the appointment of Dr. Hira V. Thapliyal as its
Chief Technology Officer. As Dr. Thapliyal focuses his attention in this area,
the Company expects to continue to make substantial expenditures on new product
development, regulatory affairs, clinical studies, and to increase research and
development spending and headcount. See "Additional Factors that Might Affect
Future Results -- Competition."

         Sales and marketing expense increased substantially to $1,386,000 in
the three month period ended June 28, 1997 from $872,000 in the three month
period ended June 29, 1996. During the six month period ended June 28, 1997
sales and marketing expense was $2,751,000 as compared to $1,530,000 for the six
month period ended June 29, 1996. The increases are primarily due to higher
dealer commissions resulting from higher revenues and promotional, staffing and
trade show expenses due to a higher level of sales and marketing activity.

         The Company currently anticipates that sales and marketing spending
will continue to increase due to dealer commissions, promotional, demonstration
and sample expenses, and additional investment in sales, marketing and support
staff necessary to market its products.

         General and administrative expense increased to $927,000 for the three
month period ended June 28, 1997 from $527,000 for the three month period ended
June 29, 1996 due to increased staffing, including management personnel,
recruiting and relocation expenses related to the hiring of Michael A. Baker the
Company's new President and CEO. Higher expenditures also include the cost of
business development activities, and consulting fees and expenses necessary to
expand the corporate infrastructure. General and administrative expense
increased for the six month period 



                                 Page 12 of 33
<PAGE>   13
ended June 28, 1997 to $1,818,000 from $1,103,000 for the six month period ended
June 29, 1996 for similar reasons. The Company expects that general and
administrative expense will continue to increase as the Company further expands
its staffing and other support operations.

Interest and Other Income

         Net interest and other income decreased to $359,000 for the three month
period ended June 28, 1997 from $444,000 in the three month period ended June
29, 1996 due to investments being converted to cash for use in the business over
time. During the six month period ended June 28, 1997, interest and other income
was $746,000 and for the six month period ended June 29, 1996, interest and
other income was $707,000. The $39,000 increase is due to a higher level of
investments in the current period resulting from the proceeds of the February,
1996 initial public offering of the Company's common stock. The Company expects
that interest income will continue to decrease as investments are reduced to
meet the cash needs of the business.

Net Loss

         Net loss was $2.0 million for the three month period ended June 28,
1997 compared to $1.7 million in the three month period ended June 28, 1996. The
increased loss is due to higher operating expenses resulting from increased
business activities associated with supporting a higher revenue base as noted
above. The higher operating expenses and lower interest income were partially
offset by an improved gross margin.

         Net loss for the six months ended June 28, 1997 were $4.2 million as
compared to $3.5 million for the six month period ended June 29, 1996. The
increased loss is due to substantially the same reasons as for the three month
period. The higher operating expense was partially offset by an improved gross
margin and higher interest income.

LIQUIDITY AND CAPITAL RESOURCES

         At June 28, 1997, the Company had $20.4 million in working capital and
its principal sources of liquidity consisted of $25.1 million in cash, cash
equivalents, and available-for-sale securities which include long-term
available-for-sale securities. The cash and cash equivalents are highly liquid
with original maturities of ninety days or less. The available-for-sale
securities consist mainly of bank notes, commercial paper, corporate bonds,
foreign debt securities rated A1/P1, A1/A or better and U.S. government
securities.

         The Company's cash used in operating activities decreased to $4.0
million for the six month period ended June 28, 1997 from $4.1 million for the
six month period ended June 29, 1996 due to higher levels of cash collections
from customers.



                                 Page 13 of 33
<PAGE>   14
         Accounts receivable of $1.2 million as of June 28, 1997 were slightly
below the December 28, 1996 balance at $1.3 million due to an improved rate of
collections from customers. The Company expects accounts receivable to increase
in the future in line with growing sales and longer terms on international
sales.

         Inventories increased to $1.3 million as of June 28, 1997 compared to
$759,000 as of December 28, 1996 due to the higher level of manufacturing
activity in support of higher sales. The Company expects future inventory levels
to grow in absolute value.

         As of June 28, 1997, net property and equipment was unchanged from $1.5
million at December 28, 1996. In the remainder of 1997, the Company has planned
but has not committed to approximately $1.3 million in capital expenditures
consisting primarily of computers, computer networking equipment and molds.

         The Company plans to finance its capital needs principally from cash,
cash equivalents, and available-for-sale securities which include long-term
available-for-sale securities and related interest, existing capital resources
and to the extent available, lines of credit. The Company currently has no
commitments for any credit facilities such as revolving credit agreements or
lines of credit that could provide additional working capital. The Company
believes that its current cash, cash equivalents and available-for-sale
securities, together with interest thereon and the Company's existing capital
resources, will be sufficient to fund its operations at least through fiscal
1998. The Company's future liquidity and capital requirements will depend on
numerous factors including the Company's success of commercializing the
Arthroscopic System, the ability of the Company's suppliers to continue to meet
the demands of the Company by providing sufficient quantities at current prices,
obtaining and enforcing patents important to the Company's business, the status
of regulatory approvals and competition. There can be no assurance that the
Company will not be required to raise additional capital or that such capital
will be available on acceptable terms, if at all.

         In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per
Share," which specifies the computation, presentation and disclosure
requirements for earnings per share. SFAS 128 supersedes Accounting Principles
Board Opinion No. 15 and will be effective for the Company's fiscal year 1998.
SFAS 128 requires restatement of all prior-period earnings per share data
presented after the effective date. SFAS 128 will not have a material impact on
the Company's earnings per share.

ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS

         ArthroCare became a public company in February 1996. Included here are
risk factors as updated from the Company's Annual Report on Form 10-K filed
March 28, 1997. The following factors represent current challenges to the
Company that create risk and uncertainty. Failure to adequately overcome any of
the following challenges, either



                                 Page 14 of 33
<PAGE>   15
singularly or in combination, could have a materially adverse effect on the
Company's results of operations, business, or financial position.

Dependence Upon Arthroscopic System

         The Company commercially introduced the Arthroscopic System in December
1995 and by the quarter ended June 28, 1997, had reported 19 months of sales.
The Arthroscopic System is the Company's only commercial product and will
account for substantially all of the Company's revenue for the foreseeable
future. As such, the Company is highly dependent on its Arthroscopic System.
Currently, the majority of the Company's sales come from the United States. The
Company has established distribution capability in Europe, Australia, Korea and
parts of South and Central America. Before the Arthroscopic System can be sold
outside these regions, the Company will have to obtain additional foreign
regulatory approvals and establish additional distribution capability in other
geographic regions. If such regulatory approval is obtained, there can be no
assurance that the Company will be able to establish a successful distribution
capability.

Uncertainty of Market Acceptance

         Physicians will not use the Company's products unless they determine,
based on experience, clinical data and other factors, that these systems are an
attractive alternative to conventional means of tissue ablation. The
Arthroscopic System was introduced in December 1995 and no independent published
clinical reports exist to support the Company's marketing efforts, which may
have an adverse effect on its ability to obtain physician acceptance. The
Company believes that continued recommendations and endorsements by influential
physicians are essential for market acceptance of its products. If the
Arthroscopic System does not continue to receive broad-based physician
acceptance and endorsment by influential physicians, the Company's business,
financial condition and results of operations would be materially adversely
affected.

Limited Operating History

         The Company has a limited history of operations that, to date, has
consisted primarily of research and development, product engineering, obtaining
FDA clearance of its Arthroscopic System, developing a network of distributors
in the United States to market the Arthroscopic System and 19 months of product
sales. The Company has started to realize revenues from the sale of its
products, but continues to generate operating losses and anticipates generating
losses in the future. Whether the Company can successfully manage the transition
to a larger-scale commercial enterprise will depend upon increasing sales of
disposable ArthroWands from its distribution network, obtaining additional
foreign regulatory approvals for the Arthroscopic System, obtaining domestic and
foreign regulatory approvals for potential new products and maintaining its
financial and management systems, procedures and controls.



                                 Page 15 of 33
<PAGE>   16
Limited Domestic and International Marketing and Sales Experience

         The Company has shipped over 970 Arthroscopic System controller units
and more than 82,000 ArthroWands through the end of the second quarter of 1997.
The Company is marketing and selling its Arthroscopic System in the United
States through a network of independent orthopedic distributors. These
distributors sell orthopedic arthroscopy devices for a number of other
manufacturers, and there can be no assurance that they will commit the necessary
resources to effectively market and sell the Company's Arthroscopic System, or
that they will be successful in closing sales with doctors and hospitals. The
Company has offered its controller to these independent distributors at
substantial discounts and may be required to continue to offer such discounts on
its controller to generate demand for its ArthroWands. The inability to sell
sufficient quantities of ArthroWands would have a material adverse effect on the
Company's business, financial condition and results of operations.

         The Company has signed distribution agreements with independent
distributors to sell and market the Arthroscopic Systems in Europe, Australia,
Mexico, Brazil, Argentina and Korea. In other international markets, the Company
intends to collaborate with one or more marketing partners to establish
marketing and distribution channels for the Arthroscopic System and to assist
with regulatory requirements in such distributors' jurisdictions. However,
regulatory requirements vary by region, and compliance with such regulations may
be costly and time-consuming. Accordingly, the distribution, pricing and
marketing structure to be established by the Company may vary from country to
country.

         No assurance can be given that the Company will successfully sell its
product through its distributors in Europe, Australia, Mexico, Brazil, Argentina
or Korea, that the Company will secure marketing partners for other
international markets, successfully sell its Arthroscopic System in foreign
markets or that any of its foreign distributors and marketing partners will
commit the necessary resources to obtain additional necessary foreign regulatory
approvals on behalf of the Company and successfully sell the Arthroscopic System
in foreign markets.

Limited Manufacturing Experience

         The Company's manufacturing operations consist of an in-house assembly
operation for the manufacturing of ArthroWands. The Company has manufactured and
sold approximately 82,000 ArthroWands through the end of the second quarter of
1997. As a result, the Company has limited experience manufacturing the
ArthroWands in the volumes necessary for the Company to achieve additional
commercial sales, and there can be no assurance that reliable, high-volume
manufacturing can be achieved at commercially reasonable cost. In April 1995,
the Company filed an application with the State of California for a license to
manufacture medical devices. In September 1995, the State of California required
the Company to cease shipping products until a manufacturing license was
obtained, and the FDA, following a Good Manufacturing



                                 Page 16 of 33
<PAGE>   17
Practices ("GMP") audit, instructed the Company to correct certain
record-keeping practices and enter into a written contract with the third party
that sterilizes the ArthroWand. There can be no assurance that the Company will
not encounter any further manufacturing difficulties, or that any of its
contract manufacturers will not experience similar difficulties, including
problems involving production yields, quality control and assurance, supplies of
components or shortages of qualified personnel.

         In October 1995, the Company discovered that the ArthroWand packaging
was subject to cracking due to a flawed design of the packaging tray and
undertook a voluntary product recall of the 61 ArthroWands affected. The Company
completed execution of its corrective action and received written confirmation
from the FDA that the recall has been closed. There can be no assurances that
there will be no further product recalls or required redesign of the Company's
packaging or products.

History of Losses; Fluctuations in Operating Results; Losses Expected to
Continue

         The Company has experienced significant operating losses since
inception and, as of June 28, 1997, had an accumulated deficit of $21.8 million.
The Company expects to generate additional losses due to increased operating
expenditures primarily attributable to the expansion of marketing and sales
activities, increased research and development, and activities to support
regulatory applications. Results of operations may fluctuate significantly from
quarter to quarter due to the timing of such expenditures, absence of a backlog
of orders, timing of the receipt of orders, promotional discounts of the
Company's products, re-use of the Company's disposable products, in addition to
those detailed above. The Company's revenues and profitability will be
critically dependent on whether it can successfully continue to market its
Arthroscopic System. In addition, the Company's gross margins may be adversely
affected due to the necessity to promote and sell its product at significantly
reduced prices. There can be no assurance that significant profitability will
ever be achieved.

Patents and Proprietary Rights

         The Company's ability to compete effectively will depend in part on its
ability to develop and maintain proprietary aspects of its platform technology.
The Company owns four issued United States patents, 18 pending United States
patent applications and international patent applications in Europe (covering 16
separate countries), Japan, Canada, Australia and New Zealand corresponding to
three of the United States filings relating to its multielectrode technology.
The initial patent is currently set to expire in 2008, and the other three
issued patents are currently expected to expire between 2008 and 2012. Although
the Company believes that the issued patents cover the core technology used in
the Company's Arthroscopic System, none of the issued patents have specific
arthroscopic claims. There can be no assurance that the patents that have been
issued to the Company or any patents which may be issued as a result of the
Company's United States or international patent applications will provide any
competitive advantages for the Company's products or that they will not be
successfully challenged, invalidated 



                                 Page 17 of 33
<PAGE>   18
or circumvented in the future. In addition, there can be no assurance that
competitors, many of which have substantial resources and have made substantial
investments in competing technologies, will not seek to apply for and obtain
patents that will prevent, limit or interfere with the Company's ability to
make, use and sell its products either in the United States or in international
markets.

         A number of medical device and other companies, universities and
research institutions have filed patent applications or have issued patents
relating to monopolar and/or bipolar electrosurgical methods and apparatus. If
third-party patents or patent applications contain claims infringed by the
Company's technology and such claims are ultimately determined to be valid,
there can be no assurance that the Company would be able to obtain licenses to
those patents at a reasonable cost, if at all, or be able to develop or obtain
alternative technology, either of which would have a material adverse effect on
the Company's business, financial condition and results of operations. There can
be no assurance that the Company will not be obligated to defend itself in court
against allegations of infringement of third-party patents.

         In addition to patents, the Company relies on trade secrets and
proprietary know-how, which it seeks to protect, in part, through
confidentiality and proprietary information agreements. The Company requires its
key employees and consultants to execute confidentiality agreements upon the
commencement of an employment or consulting relationship with the Company. These
agreements generally provide that all confidential information, developed or
made known to the individual by the Company during the course of the
individual's relationship with the Company, is to be kept confidential and not
disclosed to third parties. These agreements also generally provide that
inventions conceived by the individual in the course of rendering services to
the Company shall be the exclusive property of the Company. There can be no
assurance that such agreements will not be breached, that the Company would have
adequate remedies for any breach or that the Company's trade secrets will not
otherwise become known to or be independently developed by competitors.

Patent Litigation

         The medical device industry has been characterized by extensive
litigation regarding patents and other intellectual property rights, and
companies in the medical device industry have employed intellectual property
litigation to gain a competitive advantage. There can be no assurance that the
Company will not become subject to patent infringement claims or litigation or
interference proceedings declared by the United States Patent and Trademark
Office ("USPTO") to determine the priority of inventions. The defense and
prosecution of intellectual property suits, USPTO interference proceedings and
related legal and administrative proceeds are both costly and time-consuming.
Litigation may be necessary to enforce patents issued to the Company, to protect
trade secrets or know-how owned by the Company or to determine the
enforceability, scope and validity of the proprietary rights of others. Any
litigation or interference proceedings will result in substantial expense to the
Company and significant 



                                 Page 18 of 33
<PAGE>   19
diversion of effort by the Company's technical and management personnel. An
adverse determination in litigation or interference proceedings to which the
Company may become a party could subject the Company to significant liabilities
to third parties, require disputed rights to be licensed from third parties or
require the Company to cease using such technology. Although patent and
intellectual property disputes in the medical device area have often been
settled through licensing or similar arrangements, costs associated with such
arrangements may be substantial and could include ongoing royalties.
Furthermore, there can be no assurance that necessary licenses would be
available to the Company on satisfactory terms, if at all. Adverse
determinations in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent the Company from manufacturing and selling its
products, which would have a material adverse effect on the Company's business,
financial condition and results of operations.

Competition

         The arthroscopic medical device industry is intensely competitive. The
Company competes with providers of laser systems, electrosurgical systems,
manual instruments and power shavers. Many of these competitors have
significantly greater financial, manufacturing, marketing, distribution and
technical resources than the Company. There can be no assurance that the Company
can effectively compete against such competitors. In addition, there can be no
assurance that these or other companies will not succeed in developing
technologies and products that are more effective than the Company's or that
would render the Company's technology or products obsolete or noncompetitive.

         Smith & Nephew Endoscopy, Inc. (which owns Acufex Microsurgical, Inc.
and Dyonics, Inc.), Bristol-Meyers Squibb Company (including its Linvatec
division) and Stryker Corp. each have large shares of the market for manual
instruments, power shavers and arthroscopes. These companies offer broad product
lines, which they may offer as a single package; have substantially greater
resources and name recognition than the Company; and frequently offer
significant discounts as a competitive tactic. In addition, Pfizer Inc.
(including its Valley Labs division) and Bristol-Meyers Squibb Company each have
large shares of the market for electrosurgical systems, and Trimedyne, Inc. and
Stryker Corp. each have large shares of the market for laser systems. The
Company expects that competition from these and other well-established
competitors will increase as will competition from start-up and development
stage medical device companies such as Gyrus Medical Ltd., a company based in
the United Kingdom, Electroscope Inc., a company based in Boulder, Colorado and
Oratec Interventions, Inc., a company based in Menlo Park, California. The
Company is aware that Mitek (a division of Johnson & Johnson) is marketing a
bipolar electrosurgical tool developed by Gyrus Medical Ltd. Such competition
could have a material adverse effect on the Company's business, financial
conditions and results of operations.



                                 Page 19 of 33
<PAGE>   20
Uncertainty of Approvals; Extensive Governmental Regulation

United States

         The Company's products are regulated in the United States as medical
devices by the FDA under the Federal Food, Drug, and Cosmetic Act ("FDC Act")
and require premarket clearance or approval by the FDA prior to
commercialization. In addition, certain material changes or modifications to
medical devices also are subject to FDA review and clearance or approval.
Pursuant to the FDC Act, the FDA regulates the research, testing, manufacture,
safety, labeling, storage, recordkeeping, advertising, distribution and
production of medical devices in the United States. Noncompliance with
applicable requirements can result in warning letters, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, failure of the government to grant premarket clearance or premarket
approval for devices, and criminal prosecution. Medical devices are classified
into one of three classes, Class I, II or III, on the basis of the controls
deemed by the FDA to be necessary to reasonably ensure their safety and
effectiveness. Class I devices are subject to general controls (e.g., labeling,
premarket notification for non-exempt devices and adherence to GMPs or QS
Regulations for most devices). Class II devices are subject to general controls
and to special controls (e.g., performance standards, postmarket surveillance,
patient registries, and FDA guidelines). Generally, Class III devices are those
that must receive premarket approval by the FDA to ensure their safety and
effectiveness (e.g., life-sustaining, life-supporting and implantable devices,
or new devices that have not been found substantially equivalent to legally
marketed devices), and generally require clinical testing to ensure safety and
effectiveness and FDA approval prior to marketing and distribution. The FDA also
has the authority to require clinical testing of Class I and Class II devices. A
PMA application must be filed if the proposed device is not substantially
equivalent to a legally marketed Class I or Class II predicate device or if it
is a Class III device for which the FDA has called for such applications.

         If human clinical trials of a device are required and if the device
presents a "significant risk," the manufacturer or the distributor of the device
is required to file an investigational device exemption ("IDE") application
prior to commencing human clinical trials. The IDE application must be supported
by data, typically including the results of animal and, possibly, mechanical
testing. If the FDA does not object to the IDE application within 30 days from
filing of the application, human clinical trials may begin as defined in the
IDE. Sponsors of clinical trials are permitted to sell investigational devices
distributed in the course of the study, provided such costs do not exceed
recovery of the costs of manufacture, research, development and handling. The
clinical trials must be conducted under the auspices of an independent
Institutional Review Board ("IRB") established pursuant to FDA regulations, and
with appropriate informed consent.

         Generally, before a new device can be introduced into the market in the
United States, the manufacturer or distributor must obtain FDA clearance of a
510(k) notification or approval of a PMA application. If a medical device
manufacturer or distributor can



                                 Page 20 of 33
<PAGE>   21
establish that a device is "substantially equivalent" to a legally marketed
Class I or Class II device, or to a Class III device for which the FDA has not
called for PMAs, the manufacturer or distributor may seek clearance from the FDA
to market the device by filing a 510(k) notification. The 510(k) notification
will need to be supported by appropriate data establishing the claim of
substantial equivalence to the satisfaction of the FDA. The FDA recently has
been requiring a more rigorous demonstration of substantial equivalence.

         Following submission of the 510(k) notification, the manufacturer or
distributor may not place the device into commercial distribution until an order
is issued by the FDA. No law or regulation specifies the time limit by which the
FDA must respond to a 510(k) notification. At this time, the FDA typically
responds to the submission of a 510(k) notification within 150 to 200 days, but
it may take longer. An FDA order may declare that the device is substantially
equivalent to another legally marketed device and allow the proposed device to
be marketed in the United States. The FDA, however, may determine that the
proposed device is not substantially equivalent or require further information,
including clinical data, to make a determination regarding substantial
equivalence. Such determination or request for additional information could
delay market introduction of the products that are the subject of the 510(k)
notification.

         The Company has received clearance of 510(k) premarket notifications to
market its Arthroscopic System for surgery of the knee, shoulder, elbow, wrist,
hip and ankle joints. In addition, the Company received clearance of 510(k)
premarket notifications to market products based upon its proprietary core
technology to treat certain dermatological, urological and periodontal
conditions. There can be no assurance that the Company will be able to obtain
necessary clearances or approvals to market any other products on a timely
basis, if at all, and delays in receipt or failure to receive such clearances or
approvals, the loss of previously received clearances or approvals, or failure
to comply with existing or future regulatory requirements could have a material
adverse effect on the Company's business, financial condition and results of
operations.

         If a manufacturer or distributor of medical devices cannot establish
that a proposed device is substantially equivalent to a legally marketed device,
the manufacturer or distributor must seek premarket approval of the proposed
device through submission of a PMA application. A PMA application must be
supported by extensive data, including, in many instances, preclinical and
clinical trial data, as well as extensive literature to prove the safety and
effectiveness of the device. Following receipt of a PMA application, if the FDA
determines that the application is sufficiently complete to permit a substantive
review, the FDA will "file" the application. Under the FDC Act, the FDA has 180
days to review a PMA application, although the review of such an application
more often occurs over a protracted time period, and generally takes
approximately one year or more from the date of filing to complete.

         The PMA application approval process can be expensive, uncertain and
lengthy. A number of devices for which premarket approval has been sought have
never been 



                                 Page 21 of 33
<PAGE>   22
approved for marketing. The review time is often significantly extended by the
FDA, which may require more information or clarification of information already
provided in the submission. During the review period, an advisory committee
likely will be convened to review and evaluate the application and provide
recommendations to the FDA as to whether the device should be approved. In
addition, the FDA will inspect the manufacturing facility to ensure compliance
with the FDA's GMP or QS Regulations requirements prior to approval of an
application. If granted, the approval of the PMA application may include
significant limitations on the indicated uses for which a product may be
marketed.

         If necessary, the Company will file a PMA application with the FDA for
approval to sell its potential products commercially in the United States when
it has developed such products. There can be no assurance that the Company will
be able to obtain necessary PMA application approvals to market such products on
a timely basis, if at all, and delays in receipt or failure to receive such
approvals, the loss of previously received approvals, or failure to comply with
existing or future regulatory requirements could have a material adverse effect
on the Company's business, financial condition and results of operations.

         The Company is also required to register as a medical device
manufacturer with the FDA and state agencies, such as the California Department
of Health Services ("CDHS") and to list its products with the FDA. As such, the
Company is subject to inspections by both the FDA and the CDHS for compliance
with the FDA's GMP or QS Regulations and other applicable regulations. These
regulations require that the Company maintain its documents in a prescribed
manner with respect to manufacturing, testing and control activities. Further,
the Company and the third party manufacturers of its products are required to
comply with various FDA requirements for design, safety, advertising and
labeling. In April 1995, the Company filed an application with the State of
California for a license to manufacture medical devices. In September 1995, the
State of California required the Company to cease shipping products until a
manufacturing license was obtained, and the FDA, following a GMP audit,
instructed the Company to correct certain record-keeping practices and enter
into a written contract with the third party that sterilizes the ArthroWand.
There can be no assurance that the Company will not encounter any further
manufacturing difficulties, or that any of its contract manufacturers will not
experience similar difficulties, including problems involving production yields,
quality control and assurance, supplies of components or shortages of qualified
personnel.

         The Company is required to provide information to the FDA on death or
serious injuries alleged to have been associated with the use of its medical
devices, as well as product malfunctions that would likely cause or contribute
to death or serious injury if the malfunction were to recur. In addition, the
FDA prohibits a cleared or approved device from being marketed for uncleared or
unapproved applications. If the FDA believes that a company is not in compliance
with the law, it can institute proceedings to detain or seize products, issue a
recall, enjoin future violations and assess civil and criminal 



                                 Page 22 of 33
<PAGE>   23
penalties against the Company, its officers and its employees. Failure to comply
with the regulatory requirements could have a material adverse effect on the
Company's business, financial condition and results of operations.

         The advertising of most FDA-regulated products is subject to both FDA
and Federal Trade Commission jurisdiction. The Company also is subject to
regulation by the Occupational Safety and Health Administration and by other
governmental entities.

         Regulations regarding the manufacture and sale of the Company's
products are subject to change. The Company cannot predict the effect, if any,
that such changes might have on its business, financial condition or results of
operations.

International

         International sales of the Company's products are subject to the
regulatory agency product registration requirements of each country. The
regulatory review process varies from country to country. The Company has
obtained regulatory clearance to market the Arthroscopic System in Australia and
Europe but has not obtained any other international regulatory approvals
permitting sales of its products outside of the United States. The Company
intends to seek regulatory approvals in certain other international markets.
There can be no assurance, however, that such approvals will be obtained on a
timely basis or at all.

         In Europe, the Company and its third party manufacturers have received
ISO 9001 certification and the CE mark. ISO 9001 certification standards for
quality operations have been developed to ensure that companies know, on a
worldwide basis, the standards of quality to which they will be held. The
European Union has promulgated rules that require that medical products receive
by mid-1998 the CE mark, an international symbol of quality and compliance with
applicable European medical device directives. Failure to maintain the CE mark
will prohibit the Company from selling its products in Europe. ISO 9001
certification is one of the CE mark requirements. There can be no assurance that
the Company will be successful in maintaining certification requirements.

Uncertainty Relating to Third-Party Reimbursement

         In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices, such as the Company's Arthroscopic
System and potential products, generally rely on third-party payers, principally
federal Medicare, state Medicaid and private health insurance plans, to
reimburse all or part of the cost of the procedure in which the medical device
is being used. In addition, certain health care providers are moving toward a
managed care system in which such providers contract to provide comprehensive
health care for a fixed cost per person. Managed care providers are attempting
to control the cost of health care by authorizing fewer elective surgical
procedures, such as certain knee, shoulder, ankle, wrist, elbow and hip
arthroscopic procedures.



                                 Page 23 of 33
<PAGE>   24
         The Company is unable to predict what changes will be made in the
reimbursement methods used by third-party health care payers. Furthermore, the
Company could be adversely affected by changes in reimbursement policies of
governmental or private health care payers, particularly to the extent any such
changes affect reimbursement for procedures in which the Company's products are
used. Failure by physicians, hospitals and other users of the Company's products
to obtain sufficient reimbursement from health care payers for procedures in
which the Company's products are used or adverse changes in governmental and
private third-party payers, policies toward reimbursement for such procedures
would have a material adverse effect on the Company's business, financial
condition and results of operations.

         If the Company obtains the necessary foreign regulatory approvals,
market acceptance of the Company's products in international markets would be
dependent, in part, upon the availability of reimbursement within prevailing
health care payment systems. Reimbursement and health care payment systems in
international markets vary significantly by country, and include both
government-sponsored health care and private insurance. The Company intends to
seek international reimbursement approvals, although there can be no assurance
that any such approvals will be obtained in a timely manner, if at all.

Dependence on Single Contract Manufacturers and Sole Source Suppliers

         The Company subcontracts the manufacturing of its controllers to a
single contract manufacturer. The agreement between the Company and the contract
manufacturer requires the Company to purchase all of its controllers from the
contract manufacturer through July 1998. The Company and its contract
manufacturer are required to operate in conformance with QS Regulation
requirements, in order to produce products for sale in the United States, and
ISO 9001 standards, in order to produce products for sale in Europe. There can
be no assurance that the contract manufacturer will remain in compliance with QS
Regulations or ISO 9001 standards. Any failure by the Company or its contract
manufacturer to remain in compliance with QS Regulation or ISO 9001 standards
could have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, the ArthroWand is sterilized
by a single subcontractor, and the connector housings at each end of the cable
are available only from a single source. There can be no assurance that an
alternate contract manufacturer, sterilizer or connector housing supplier could
be established if necessary or that available inventories would be adequate to
meet the Company's product needs during any prolonged interruption of supply. A
reduction or stoppage in supply of the sole-source component, or the Company's
inability to secure an alternative contract manufacturer or sterilizer, if
required, would limit its ability to manufacture the Arthroscopic System and
would have a material adverse effect on the Company's business, financial
condition and results of operations.

         Although the Company believes that its contract manufacturer,
subcontractors and suppliers are in compliance with applicable regulations,
there can be no assurance that the 



                                 Page 24 of 33
<PAGE>   25
FDA, or a state, local or foreign regulator, will not take action against a
contract manufacturer, subcontractor or supplier found to be violating such
regulations.

Uncertainty of New Product Development

         The Company has undertaken preliminary animal studies and development
for the use of its ablation technology with its controller in urology,
dermatology, periodontics and gynecology. The Company has received 510(k)
premarket notifications for clearance to market tissue ablation products to
treat certain urological, dermatological and periodontal conditions and has
filed 510(k) premarket notification for clearance to market specific
dermatological conditions. In addition, the FDA had indicated that 510(k)
submissions for expanded dermatological conditions and gynecological conditions
must be supported by clinical trials.

         Each of these products are at an early stage of development, and the
Company will be required to undertake time-consuming and costly development
activities and seek regulatory approval of these devices. There can be no
assurance that product development will ever be successfully completed, that
PMAs or 510(k)s, if applied for, will be granted by the FDA on a timely basis,
if at all, or that the products will ever achieve commercial acceptance. Failure
by the Company to develop, obtain necessary regulatory approval for or to
successfully market new products could have a material adverse effect on the
Company's business, financial condition and results of operations.

Product Liability Risk; Limited Insurance Coverage

         The development, manufacture and sale of medical products entail
significant risk of product liability claims. The Company's current product
liability insurance coverage limits are $5,000,000 per occurrence and $5,000,000
in the aggregate. There can be no assurance that such coverage limits are
adequate to protect the Company from any liabilities it might incur in
connection with the development, manufacture and sale of its Arthroscopic System
and potential products. In addition, the Company may require increased product
liability coverage if any potential products are successfully commercialized.
Product liability insurance is expensive and in the future may not be available
to the Company on acceptable terms, if at all. The Company has been selling its
product since December 1995 and has not experienced any product liability claims
to date. However, a successful product liability claim or series of claims
brought against the Company in excess of its insurance coverage could have a
material adverse effect on the Company's business, financial condition and
results of operations.

Dependence on Key Personnel and Key Consultants

         The Company is dependent upon a number of key management and technical
personnel. The loss of the services of one or more key employees or consultants
could have a material adverse effect on the Company. The Company's success will
also depend on its ability to attract and retain additional highly qualified
management and technical



                                 Page 25 of 33
<PAGE>   26
personnel. The Company faces intense competition for qualified personnel, many
of whom are often subject to competing employment offers, and there can be no
assurance that the Company will be able to attract and retain such personnel.
Furthermore, the Company's scientific advisory board members all are otherwise
employed on a full-time basis. As a result, the scientific advisory board
members are not available to devote their full time or attention to the
Company's affairs.

         A significant portion of the Company's research and development is
performed by Philip E. Eggers, a director of the Company, pursuant to a
consulting agreement between the Company and Eggers & Associates Inc. ("E&A"), a
corporation wholly owned by Mr. Eggers. Mr. Eggers is not employed by the
Company on a full-time basis and, as a result, may not be available to devote
his full time or attention to the Company's affairs.

Control by Directors, Executive Officers and Affiliated Entities

         The Company's directors, executive officers and entities affiliated
with them, in the aggregate, beneficially own approximately 46.11% of the
Company's outstanding common stock. These stockholders, if acting together, will
have significant influence over all matters requiring approval by the
stockholders of the Company, including the election of directors and the
approval of mergers or other business combination transactions.

Potential Volatility of Stock Price

         The stock markets have experienced price and volume fluctuations that
have particularly affected medical technology companies, resulting in changes in
the market prices of the stocks of many companies that may not have been
directly related to the operating performance of those companies. Such broad
market fluctuations may adversely affect the market price of the Company's
common stock. In addition, the market price of the Company's common stock may be
highly volatile. Factors such as variations in the Company's financial results,
comments by security analysts, announcements of technological innovations or new
products by the Company or its competitors, changing government regulations and
developments with respect to FDA submissions, patents, proprietary rights or
litigation may have a significant adverse effect on the market price of the
common stock.

Anti-Takeover Effect of Stockholder Rights Plan and Certain Charter and Bylaw
Provisions

         In November 1996, the Company's Board of Directors adopted a
Stockholder Rights Plan. The Stockholder Rights Plan provides for a dividend
distribution of one Preferred Shares Purchase Right (a "Right") on each
outstanding share of the Company's common stock. Each Right entitles
shareholders to buy 1/1000th of a share of the Company's Series A participating
preferred stock at an exercise price of $50.00. The Rights will become
exercisable following the tenth day after a person or group announces



                                 Page 26 of 33
<PAGE>   27
acquisition of 15 percent or more of the Company's common stock, or announces
commencement of a tender offer, the consummation of which would result in
ownership by the person or group of 15 percent or more of the Company's common
stock. The Company will be entitled to redeem the Rights at $0.01 per Right at
any time on or before the tenth day following acquisition by a person or group
of 15 percent or more of the Company's common stock.

         The Stockholder Rights Plan and certain provisions of the Company's
Certificate of Incorporation and Bylaws may have the effect of making it more
difficult for a third party to acquire, or of discouraging a third party from
attempting to acquire control of the Company. This could limit the price that
certain investors might be willing to pay in the future for shares of the
Company's common stock. Certain provisions of the Company's Certificate of
Incorporation and Bylaws allow the Company to issue preferred stock without any
vote or further action by the stockholders, eliminate the right of stockholders
to act by written consent without a meeting, specify procedures for director
nominations by stockholders and submission of other proposals for consideration
at stockholder meetings, and eliminate cumulative voting in the election of
directors. Certain provisions of Delaware law applicable to the Company could
also delay or make more difficult a merger, tender offer or proxy contest
involving the Company, including Section 203, which prohibits a Delaware
corporation from engaging in any business combination with any interested
stockholder for a period of three years unless certain conditions are met. The
Stockholder Rights Plan, the possible issuance of preferred stock, the
procedures required for director nominations and stockholder proposals and
Delaware law could have the effect of delaying, deferring or preventing a change
in control of the Company, including without limitation, discouraging a proxy
contest or making more difficult the acquisition of a substantial block of the
Company's common stock. These provisions could also limit the price that
investors might be willing to pay in the future for shares of the Company's
common stock.

Lack of Dividends

         The Company has not paid any dividends and does not anticipate paying
any dividends in the foreseeable future.






                                 Page 27 of 33
<PAGE>   28
                           PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

         None

ITEM 2.  CHANGES IN SECURITIES

         None

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

         None

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


         The annual meeting of stockholders was held May 22, 1997.
Matters voted on at that meeting were (i) the election of six directors
and (ii) the ratification of the appointment of Coopers & Lybrand
L.L.P. as the Company's independent auditors for the fiscal year ending
January 3, 1998. Tabulation for each proposal and individual director
were as follows.


 PROPOSAL I.  ELECTION OF DIRECTORS

<TABLE>
<CAPTION>
         Directors                                 For            Withheld
         ---------                                 ---            --------
         <S>                                    <C>                <C>   
         Annette J. Campbell-White              7,355,318          18,716
         Phillip E. Eggers                      7,348,269          25,765
         John S. Lewis                          7,354,718          19,316
         C. Raymond Larkin, Jr.                 7,354,518          19,516
         Robert R. Momsen                       7,355,018          19,016
         Hira V. Thapliyal                      7,348,269          25,765
</TABLE>

 PROPOSAL II.  RATIFICATION OF APPOINTMENT OF COOPERS & LYBRAND LLP

             For        Against    Abstained          No Vote
             ---        -------    ---------          -------
         7,368,122       4,116       1,796          1,419,719



ITEM 5.  OTHER INFORMATION

         None



                                 Page 28 of 33
<PAGE>   29
ITEM 6. EXHIBITS AND REPORTS ON FORM 8 - K.

        a)  Exhibits

<TABLE>
            <S>         <C>
            (1) 3.2     Certificate of Incorporation of the Registrant.

            (1) 3.3     Bylaws of the Registrant.

            (1) 4.1     Specimen Common Stock Certificate.

            (1)10.1     Form of Indemnification Agreement between the Registrant and each of  its
                        directors and officers.

            (1)10.2     Incentive Stock Plan and form of Stock Option Agreement thereunder.

            (1)10.3     Director Option Plan and form of Director Stock Option Agreement thereunder.

            (1)10.4     Employee Stock Purchase Plan and forms of agreements thereunder.

            (1)10.5     Form of Exclusive Distribution Agreement.

            (1)10.6     Form of Exclusive Sales Representative Agreement.

            (1)10.7     Consulting Agreement, dated May 10, 1993, between the Registrant and Philip E.
                        Eggers, and amendment thereto.

            (1)10.8     Consulting Agreement, dated May 20, 1993, between the Registrant and Eggers &
                        Associates, Inc., and amendment thereto.

            (1)10.9+    Development and Supply Agreement, dated March 1, 1994, between the Registrant and
                        SeaMed Corporation.

            (1)10.10    Lease Agreement, dated September 15, 1994, between Registrant and The Arrillaga
                        Foundation and the Perry Foundation for the Registrant's facility located at 595 North
                        Pastoria Avenue, Sunnyvale, California 94086.

            (1)10.11    Employment Letter Agreement, dated October 21, 1994, between the Registrant and Allan
                        Weinstein and amendment thereto.
</TABLE>



                                 Page 29 of 33
<PAGE>   30
<TABLE>
            <S>         <C>
            (1)10.12    Purchase Assistance Promissory Note, dated January 19, 1995, between Registrant
                        and Allan Weinstein.

            (1)10.13    Sublease Agreement, dated February 1, 1995, between Registrant and Guided
                        Medical Systems, Inc. for the Registrant's former facility at 453   Ravendale
                        Drive, Mountain View, California, 94043.

            (1)10.14    Mortgage Assistance Promissory Note Agreement, dated February 5, 1995, between
                        the Registrant and Allan Weinstein.

            (1)10.15    Restricted Stock Purchase and Security Agreement, dated February 5, 1995,
                        between the Registrant and Allan Weinstein.


            (1)10.16    Employment Letter Agreement, dated July 18, 1995, between the Registrant and
                        Robert T. Hagan.

            (1)10.17    Restricted Stock Purchase and Security Agreement, dated August 1, 1995, between
                        the Registrant and Robert T. Hagan.

            (1)10.18    Employment Letter Agreement, dated September 3, 1995, between the Registrant
                        and A. Larry Tannenbaum.

            (1)10.19+   Radiation Services Agreement, dated September 13, 1995, between the Registrant
                        and SteriGenics International.

            (1)10.20    Amended and Restated Stockholder Rights Agreement, dated October 16, 1995, between
                        the Registrant and certain holders of the Registrant's securities.

            (1)10.21    Contribution Agreement, dated March 31, 1995, by and among Philip E. Eggers,
                        Robert S. Garvie, Anthony J. Manlove, Hira V. Thapliyal and the Registrant.

            (2)10.22    Preferred Stock Rights Agreement, dated November 14, 1996, between the Registrant
                        and Norwest Bank Minnesota, N.A.

            (3)10.23+   Exclusive Distributor Agreement, dated April 15, 1997, between the Registrant and
                        Arthrex, Gmbh.
</TABLE>



                                 Page 30 of 33
<PAGE>   31
<TABLE>
            <S>         <C>
               10.24++  Employment Letter Agreement, dated June 20, 1997, between the Registrant and
                        Michael A. Baker.

               11.1     Computation of Net Loss per Share.

               27.1     Financial Data Schedule.
</TABLE>


(1)   Incorporated herein by reference to the same-numbered exhibit previously
      filed with the Registrant's Registration Statement on Form S-1
      (Registration No. 33-80453).

(2)   Incorporated here in by reference to exhibit 5 previously filed with the
      Registrant's Registration Statement on Form 8-A (Registration No.
      000-27422).

+     Confidential treatment granted.

(3)   Incorporated herein by reference to the same-numbered exhibit previously
      filed with the Registrant's Quarterly Report on form 10-Q for the period
      ended March 29, 1997.

++    Confidential treatment requested.

         b) Reports on Form 8-K

         None





                                 Page 31 of 33
<PAGE>   32
SIGNATURE

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


                               ARTHROCARE CORPORATION
                               a Delaware corporation

Date: August  8, 1997

                                /s/ A. LARRY TANNENBAUM
                               -------------------------------------------------
                               A. Larry Tannenbaum
                               Vice President, Finance & Administration, Chief
                               Financial Officer and Assistant Secretary
                               (Principal Financial Officer and Duly Authorized
                               Officer)


Date: August  8, 1997

                               /s/ MICHAEL A. BAKER
                               -------------------------------------------------
                               Michael A. Baker.
                               President, Chief Executive Officer and Director





                                 Page 32 of 33
<PAGE>   33
                                  EXHIBIT INDEX


<TABLE>
<CAPTION>
Exhibit
Number                        Exhibit Description
-------                       -------------------
<S>               <C> 
10.24++           Employment Letter Agreement dated June 20, 1997  between the
                  Registrant and Michael A. Baker.

11.1              Computation of Net Loss per Share.

27.1              Financial Data Schedule.
</TABLE>

------
++Confidential treatment requested.