SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                 ---------------

                                    FORM 10-K
                 Annual Report Under Section 13 or 15(d) of the
                     Securities Exchange Act of 1934 
                  For the fiscal year ended December 31, 1996

                          Commission File Number 1-4373
                                                 ------

                            THREE-FIVE SYSTEMS, INC.
                    -----------------------------------------
                    (Name of Issuer Specified in Its Charter)

                  Delaware                            86-0654102
      -------------------------------             -------------------
      (State or Other Jurisdiction of             (I.R.S. Employer
      Incorporation or Organization)              Identification No.)

                  1600 North Desert Drive, Tempe, Arizona 85281
                  ---------------------------------------------
                    (Address of Principal Executive Offices)

                                 (602) 389-8600
                                ----------------
                (Issuer's Telephone Number, Including Area Code)

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

      Title of Each Class             Name of Each Exchange on Which Registered
      -------------------             -----------------------------------------

Common Stock, Par Value $.01 Per Share         New York Stock Exchange
--------------------------------------         -----------------------

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

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

         Check if there is no disclosure of delinquent  filers  pursuant to Item
405 of  Regulation  S-K  contained  in  this  form,  and no  disclosure  will be
contained,  to the  best of  registrant's  knowledge,  in  definitive  proxy  or
information  statements  incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. [X]

         State issuer's revenues for its most recent fiscal year:  $60,713,000

         As of March 6, 1997,  the  aggregate  market  value of the voting stock
held by  non-affiliates  of the issuer,  computed by  reference  to the price at
which stock was sold as of such date in the stock  market as reported on the New
York  Stock  Exchange,  was  $87,942,085.  Shares of Common  Stock  held by each
officer and director and by each person who owns 10% or more of the  outstanding
Common  Stock  have  been  excluded  in that  such  persons  may be deemed to be
affiliates. This determination of affiliate status is not necessarily conclusive
and does not constitute an admission of affiliate status.

         As of March 6, 1997, there were 7,759,629 shares of the issuer's Common
Stock outstanding.

         Documents   incorporated   by  reference:   Portions  of  the  issuer's
definitive  Proxy  Statement  for the 1997 Annual  Meeting of  Stockholders  are
incorporated by reference into Part III hereof.
<PAGE>
                            THREE-FIVE SYSTEMS, INC.

                           ANNUAL REPORT ON FORM 10-K

                      FOR THE YEAR ENDED DECEMBER 31, 1996

                                TABLE OF CONTENTS


<TABLE>
<CAPTION>

                                                       PART I

<S>               <C>                                                                                          <C>
ITEM 1.           DESCRIPTION OF BUSINESS.........................................................................1
ITEM 2.           DESCRIPTION OF PROPERTY........................................................................15
ITEM 3.           LEGAL PROCEEDINGS..............................................................................15
ITEM 4.           SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................15

                                                       PART II

ITEM 5.           MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................................16
ITEM 6.           SELECTED FINANCIAL DATA .......................................................................17
ITEM 7.           MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                  CONDITION AND RESULTS OF OPERATIONS............................................................18
ITEM 8.           FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................................................24
ITEM 9.           CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
                  ACCOUNTING AND FINANCIAL DISCLOSURE............................................................24

                                                      PART III

ITEM 10.          DIRECTORS AND EXECUTIVE OFFICERS ..............................................................24
ITEM 11.          EXECUTIVE COMPENSATION.........................................................................24
ITEM 12.          SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
                  MANAGEMENT.....................................................................................24
ITEM 13.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................................................24

                                                       PART IV

ITEM 14.          EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
                  ON FORM 8-K....................................................................................25

SIGNATURES.......................................................................................................27
                                                          i
</TABLE>
<PAGE>
ITEM 1.           DESCRIPTION OF BUSINESS

Introduction

         The Company  designs and  manufactures  a wide range of user  interface
devices for operational control and informational  display functions required in
the end  products  of original  equipment  manufacturers  ("OEMs").  Most of the
Company's sales consist of custom devices developed in close  collaboration with
its customers. Devices designed and manufactured by the Company find application
in cellular  telephones and other wireless  communication  devices as well as in
medical  equipment,  office automation  equipment,  industrial process controls,
instrumentation,   consumer  electronic  products,   automotive  equipment,  and
industrial and military control products.  The Company currently  specializes in
liquid crystal display  ("LCD") and light emitting diode ("LED")  components and
technology in providing its design and manufacturing services for its customers.
The Company markets its services  primarily in North America,  Europe,  and Asia
through direct technical sales persons and, to a much lesser extent,  through an
independent sales and distribution network.

         The Company experienced  substantial growth from 1993 through 1995 with
net sales  increasing  from $38.0 million in 1993 to $91.6 million in 1995.  The
Company's  growth  during that  period,  however,  depended  primarily  upon the
Company's participation in the substantial growth of the wireless communications
market and sales to a single  major  customer  in that  industry.  In 1996,  the
Company's  sales  declined  to  $60.7  million,  largely  as the  result  of the
phase-out by that major  customer of a  significant  family of programs in early
1996, and the Company  reported a loss in 1996 as a result of that phase-out and
the  significant  inventory  reserve taken during the third quarter.  The growth
that  occurred  during the period from 1993  through 1995 allowed the Company to
complete  construction of the highest volume passive matrix LCD glass production
facility  in  North  America,  which  will  enable  the  Company  to  produce  a
substantial  portion of its LCD glass  requirements,  as well as to attract  key
personnel,   expand  its  research  and  development   efforts,  and  build  its
infrastructure. The Company also has undertaken substantial efforts to diversify
its business, broaden its customer base, and expand its markets.

         The Company  believes  that it is  positioned to resume its growth as a
result of its efforts in expanding  its customer  base and the markets it serves
as well as its strength in designing,  prototyping,  and producing,  on a timely
and  cost-efficient  basis,  a  wide  range  of  innovative,   distinctive,  and
high-quality  user interface  devices  required in the end products of OEMs. The
Company also believes that its research and development  capabilities will allow
it to develop display  technologies and manufacturing  processes that will be of
benefit to its current and future  customers.  The  Company's  design  processes
utilize advanced  computer-aided design software to provide custom solutions for
customers'  products  in time  frames and on  cost-bases  that it  believes  are
competitive.  The Company utilizes advanced, flexible manufacturing systems that
can accommodate low-volume production runs or highly sophisticated  applications
in Arizona and high-volume, price sensitive runs in Manila, the Philippines.

         The Company  maintains  its principal  executive  offices at 1600 North
Desert Drive, Tempe,  Arizona 85281, and its telephone number is (602) 389-8600.
Unless the context indicates otherwise, all references to the "Company" refer to
Three-Five Systems, Inc., its subsidiaries and predecessors.

Technology

         Since the commercial introduction of the first light emitting diodes in
the 1960s and twisted nematic liquid crystal  displays in the 1970s,  the use of
LCD  and LED  indicators  has  become  widespread  in  industrial  and  consumer
electronic  products.  Prior to these  innovations,  the most common displays or
indicators had substantial  limitations as to their use,  especially in terms of
size, life, and power  consumption.  LCD and LED technologies  were developed in
order to overcome these limitations.

         An LCD modifies light that passes through or is reflected by it, rather
than emitting light like an LED. An LCD generally  consists of a layer of liquid
crystalline  material  suspended  between two glass plates.  The crystals  align
themselves in a predictable  manner,  and this alignment changes when stimulated
electrically.  This changed  alignment  produces a visual  representation of the
information desired when used in conjunction with a polarizer and either natural
ambient light or an external light source.
                                        1
<PAGE>
         An LED chip produces  light as the result of the  application of direct
current at a low voltage.  Different  wavelengths  (colors) can be produced in a
product depending upon the manufacturing process and the dopant (impurity) added
to the basic chip material, usually gallium arsenide or gallium phosphide. These
wavelengths  can be visible or  non-visible.  In the  visible  range,  LED chips
produce  red,  yellow,  green,  and  recently,  blue and  white  colors.  In the
non-visible  range  (infrared),  the  Company's  devices  utilize 880  nanometer
wavelength or 940 nanometer wavelength chips.

Industry Overview

         The Company has benefitted  from the  determination  by certain OEMs in
the  electronics  industry to  outsource  the design and  production  of certain
components included in the end products of those OEMs. The Company believes that
the following factors have contributed to this growing trend among OEMs:

         o        As  technology  has  become  increasingly   sophisticated  and
                  complex,  it has become  more  difficult  for even the leading
                  OEMs  to  maintain  the   necessary   technology,   expertise,
                  personnel,  and equipment to design and produce internally all
                  of the various components necessary for their products.

         o        Advanced   design   and   manufacturing    processes   require
                  increasingly greater investments for research and development,
                  personnel, and equipment.

         o        Competitive  market  conditions  require  OEMs to  reduce  the
                  period  of  time  from  product  conception  to  delivery,  to
                  differentiate  their products from those of their competitors,
                  to  improve  user  friendliness,  and to  continually  enhance
                  product  performance  and reduce  product cost during the life
                  cycle of the product.

         OEMs often design  their  products to contain  user  interface  devices
(including those relating to operational control and informational display) as a
highly  cost-effective  means of  differentiating  their products from competing
products.  OEMs then make the  decision of whether to use standard  devices,  to
design and produce the devices in-house,  or to outsource with a third party for
design and production.  In making this decision,  companies often recognize that
their greatest strengths consist of consumer  recognition of brand names, market
research  and product  development  expertise,  and highly  developed  sales and
distribution channels. OEMs also recognize that the desired devices often cannot
be  obtained  "off-the-shelf"  and that  time  constraints  and  limitations  on
available  resources  often  preclude  them  from  maintaining  the  specialized
in-house expertise and equipment necessary to design and manufacture the desired
devices.  OEMs  often  conclude  that the  logical  solution  is to focus  their
resources on those areas (such as marketing and distribution) where they possess
the greatest  leverage and to outsource the production of devices and components
in which they lack the requisite technology and expertise.

         Outsourcing enables OEMs to obtain the following desired benefits:

         o        To  gain  access  to  specialized   design  and  manufacturing
                  technology and expertise.

         o        To  accelerate  the design  process  and to reduce  design and
                  manufacturing  costs by utilizing the  specialized  personnel,
                  equipment, and facilities of the supplier.

         o        To reduce their own  investment in personnel,  equipment,  and
                  facilities  necessary for  specialized  design and  production
                  capabilities.

         o        To  streamline  their own  operations by  concentrating  their
                  resources on the design, production, and distribution of their
                  core products.

         By eliminating the duplication and overlap of investment and resources,
outsourcing  permits  the Company  and the OEMs to work  together  and grow at a
faster rate than would  otherwise be possible.  Outsourcing  greatly reduces the
Company's need to devote time and resources on market  development  for specific
products and allows
                                        2
<PAGE>
the Company to concentrate on the  development of its display  technologies  and
their applications to a multitude of products.

Products and Services

         The Company currently emphasizes custom designed user interface devices
for  operational  control  and  informational  display  functions.  The  Company
believes that custom  devices  represent the source of its greatest  profits and
growth  potential.  For each custom device,  the Company works directly with its
customer  to develop  and produce the  original  design and to  manufacture  the
device in  accordance  with the  customer's  specifications.  The  Company  also
designs and produces standard or "off-the-shelf"  devices, which involve designs
that are adaptable to various fixed end uses without modification.

         The  Company  pursues a strategy  designed  to enable it to enhance its
position as a major, worldwide supplier of custom-designed and manufactured user
interface   devices  for  products  of  leading  OEMs  in  various  high  growth
industries.  The  Company  attempts  to  identify  industries  that  present the
greatest  long-term  potential  for  growth at any  given  time.  The  Company's
research and development  activities then focus upon technological  developments
that attempt to meet the current and future  requirements  of those  industries.
The Company seeks to establish strong and long-lasting customer relationships by
aligning its  prospects  with those of its  customers and by seeking to make its
engineering  and advanced  manufacturing  functions  seamless  extensions of the
product design and production departments of its customers.  The Company engages
in a careful  customer  selection  process  because it  recognizes  that its own
growth and  development  will be closely aligned with the growth and development
of  the  customers  it  serves.   The  Company's   strategy  currently  involves
concentrating its efforts on providing design and production services to leading
companies in five primary  industries:  cellular  telephones  and other wireless
communications,   data  collection,  office  automation,  medical  devices,  and
industrial process controls.

Custom Devices

         LCD and LED custom  displays  currently  account for  approximately  91
percent of the Company's revenue. A manufacturer of a complete system or product
requiring  a specific  type of visual  display  (such as a  cellular  telephone,
medical  instrument,  business  machine,  or hand-held data  collection  device)
represents a typical buyer for a custom device.

         The Company has developed a  sophisticated  design  process to meet the
specific needs of its  customers'  applications.  Each design  project  normally
involves a  cross-functional  team of Company  engineers  who are  assigned to a
customer program. The team consults with the customer's engineers throughout the
design phase,  prototype  development,  and manufacturing  process.  The Company
continues to supply  value-added  engineering  support after the design solution
has been developed and integrated into the  manufacturing  process in an ongoing
effort  to  provide   customers  with  product   performance   enhancements  and
cost-reduction opportunities.

Standard Devices

         Standard devices encompass a wide variety of LCD and LED devices having
varied  applications.  "Visible" LCD and LED standard  devices include (i) solid
state lamps used for indicators,  status lights,  on-board circuit monitors, and
instrumentation;  (ii)  multi-digit  numerical  displays  used for  calculators,
industrial  controls,   data  terminals,   instrumentation   timers,   hand-held
instruments,  event counters,  and PCB diagnostics;  (iii)  integrated  displays
(with on-board  integrated  circuit drivers) and alpha numeric displays used for
hand-held terminals, minicomputers, telecommunications, and instrumentation word
processors; (iv) bar graph displays used for power meters in stereo systems, Ham
and CB radio meters,  VU meters in tape recorders,  process control meters,  and
replacements  for edge meters;  and (v)  multi-digit  numeric  displays used for
industrial   controls,   data  terminals,   test   equipment,   point  of  sale,
mini-computer readout, and home consumer applications.

         Standard  infrared  devices  include (a) infrared  emitters and silicon
detectors  used for TV remote  controls,  disk drives,  tape  drives,  printers,
encoders,  solid  state  relays,   photoelectric  controls,   slotted  switches,
reflective
                                        3
<PAGE>
switches,  intrusion alarms, touch screens,  wireless data entry and positioning
sensors;  and (b)  optocouplers  used for AC power controls,  DC power controls,
solid state relays, logic to power interfaces, and power supplies.

Manufacturing Services

         The Company has geographically organized its manufacturing capabilities
in a manner that optimizes the  combination  of technology and human  resources.
This enables the Company to compete  solely on the basis of cost,  if necessary,
with suppliers of similar products and services  throughout the world.  Advanced
manufacturing  techniques  include  surface mount  technologies,  chip-on-board,
chip-on-flex,  flip-chip,  tape automated  bonding,  and  sophisticated  testing
systems throughout the process.  The Company maintains at each of its facilities
quality systems and processes that meet or exceed the demanding standards set by
leading OEMs in targeted industries.

         The Company  seeks to increase its value to its  customers by providing
responsive,  flexible,  total  manufacturing  services.  To date,  manufacturing
services have been  concentrated  toward the manufacture of LCDs and assembly of
Company-designed  user interface  module  assemblies.  However,  the Company has
recognized an increased demand for extended  manufacturing services beyond these
core services. These extended services may include adding additional components,
such as a keypad,  microphone,  card reader,  product  housing,  or  non-display
electronic sub-assembly,  or the turn-key manufacture of a complete OEM product.
The Company  intends to pursue  extended  manufacturing  opportunities  in those
instances when the Company believes it will be profitable to do so.

Manufacturing Facilities

         The  Company  currently  conducts  manufacturing  operations  in Tempe,
Arizona and in Manila,  the Philippines.  The Company completed the construction
of its new principal U.S.  facility in March 1995. The Arizona facility houses a
Class 1000 "clean  room" and LCD  fabrication  and  prototyping  operation.  The
Company utilizes the facility primarily to conduct LCD research and development,
to produce prototype and  pre-production  runs of devices for customer approval,
to conduct full production runs of low-volume  devices,  and to develop advanced
manufacturing  processes  that  can  be  applied  in  Manila  during  full-scale
production.  In  addition,  the  facility  has the largest LCD glass  production
capacity in North America.  Now fully  operational,  this highly  automated line
enables the Company to reduce its dependence on foreign  suppliers of LCD glass.
Facility  personnel  include  a  team  of  experts  ranging  from  LCD  research
scientists to specialized engineers with backgrounds in electronics,  mechanics,
chemistry, physics, and manufacturing. The Company maintains a complete array of
state- of-the-art testing and quality control equipment at the facility.

         The Company is a party to an agreement (the  "Sub-Assembly  Agreement")
with Technology Electronic Assembly and Management Pacific Corporation ("TEAM"),
pursuant to which TEAM manufactures, assembles, and tests user interface devices
for the Company at a facility owned by TEAM located in Manila,  the Philippines.
The Company is also party to a lease agreement (the "Lease Agreement") with TEAM
pursuant  to which TEAM  leases  space to the  Company  for those  manufacturing
operations   performed   by  TEAM  under  the   Sub-Assembly   Agreement.   TEAM
manufactures,  assembles, and tests devices designed by the Company in the space
leased to the Company and pursuant to procedures  set forth in the  Sub-Assembly
Agreement in accordance with specifications supplied by the Company. The Company
owns the manufacturing,  assembling,  and testing equipment (including automated
die attach and wire bond equipment with automatic pattern  recognition  features
for  die  and  wire  placement  for  LED  die)  as  well  as the  processes  and
documentation    used  by  TEAM  at  the  Manila   facility.   Pursuant  to  the
Sub-Assembly  Agreement,  the Company supplies all direct materials to TEAM that
are necessary to meet forecasted production levels specified by the Company. The
Company pays TEAM for the  sub-assembly  of the  Company's  devices based upon a
negotiated  hourly  rate.  The  Company  also  employs  professional  personnel,
including  an  Operations   Manager,   with  a  support   staff   consisting  of
manufacturing,  quality,  and process engineers,  and logistics personnel at the
Manila facility.

         The Sub-Assembly  Agreement and Lease Agreement between the Company and
TEAM extend  through  December  31, 1999 and from year to year  thereafter.  The
Sub-Assembly Agreement requires minimum production levels to be maintained.  The
termination of the Lease Agreement or Sub-Assembly Agreement or the inability of
TEAM to fulfill its requirements under the Sub-Assembly  Agreement would require
the Company to acquire
                                        4
<PAGE>
additional  manufacturing facilities or to contract for additional manufacturing
services. The Philippines has been subject to volcanic eruptions,  typhoons, and
substantial civil  disturbances,  including attempted military coups against the
government.  These  circumstances  could affect the Company's  ability to obtain
products pursuant to the SubAssembly Agreement,  although there has not been any
material interruption of operations to date. The termination of or the inability
of the Company to obtain products pursuant to the Sub-Assembly  Agreement,  even
for a  relatively  short  period,  would have a material  adverse  effect on the
operations and profitability of the Company.

         The Company has implemented an aggressive quality control program.  The
program is based upon  Statistical  Process Control,  which advocates  continual
quantitative measurements of crucial parameters and uses those measurements in a
closed-loop feedback system to control the manufacturing  process.  Product life
testing is performed to help ensure long-term product  reliability.  The results
of life tests are analyzed and actions taken to refine the manufacturing process
or enhance the product design.

Sales and Marketing

         The Company  markets its services  primarily in North America,  Europe,
and Asia through  direct  technical  sales persons and, to a much lesser extent,
through an independent sales and distribution network. This network includes two
franchised  distributors in approximately 96 sales offices. A staff of in-house,
Arizona-based  sales and  marketing  personnel  directs and aids the  franchised
distributors. The Company also has sales offices in Arlington Heights, Illinois;
Flemington, New Jersey; and Tempe, Arizona.

         The Company's sales to customers in Europe represented approximately 46
percent of net sales in 1996. In addition to a direct technical sales force, the
Company  distributes  products  in Europe  through a  network  of  distributors,
augmented in some regions by marketing  representatives.  This network  receives
support from the marketing,  customer service, and support staff employed by the
Company's subsidiary,  Three-Five Systems Limited, located in Swindon,  England.
The European staff and network of distributors  provide  marketing,  consulting,
and product design input locally for customers throughout Western Europe.

Customers

         The Company's strategy involves  concentrating its efforts on providing
design and production  services to leading companies in five primary industries:
cellular telephones and other wireless communications,  data collection,  office
automation,  medical devices, and industrial process controls.  As a result, the
Company generally derives its revenue from services provided to a limited number
of customers.  The Company's  largest customer is Motorola,  Inc.  ("Motorola").
Sales to Motorola are made through 12 buyers  operating in five separate product
divisions. The Company currently designs and manufactures user interface devices
used in approximately 42 individual product programs for Motorola.  During 1996,
the five largest of these programs accounted for 9.6 percent,  7.5 percent,  6.6
percent,  4.9 percent,  and 2.5 percent,  respectively,  of the Company's  total
revenue,  and the  remaining  product  programs in the  aggregate  accounted for
approximately  34 percent of the Company's total revenue.  Devices that are used
in cellular telephones accounted for substantially all of the Company's sales to
Motorola in 1996. See "Special  Considerations - Substantial Reliance on Certain
Customers" contained in Item 1 of this Report.

Backlog

         As of  December  31,  1996,  the  Company  had a  backlog  of orders of
approximately $17.9 million, all of which orders are believed to be firm and all
of which are expected to be filled during fiscal 1997.  The backlog of orders at
December 31, 1995 was approximately  $21.3 million.  The Company's  business has
not been seasonal to date.

Patents and Trademarks

         The  Company's   business  does  not  depend  on  patent  or  trademark
protection.  The Company has recently  received a patent on a technology,  which
the Company refers to as LCiD(TM) or liquid crystal intense  display.  This is a
type of LCD that  incorporates a proprietary  approach to designing a dot matrix
LCD.
                                        5
<PAGE>
Raw Materials

         The principal raw  materials  used in producing the Company's  displays
consist of gallium arsenide and gallium  phosphorous  wafers and die, LCD glass,
driver die, circuit boards,  molded plastic parts, lead frames, wire, chips, and
packaging  materials.  The Company's  procurement  strategy provides alternative
sources of supplies for the majority of these materials. Many of such materials,
however, must be obtained from foreign suppliers,  which subjects the Company to
the risks inherent in obtaining materials from foreign sources, including supply
interruptions and currency  fluctuations.  The Company's suppliers currently are
meeting the requirements of the Company,  and strategic  supplier alliances have
further strengthened relations with offshore suppliers. The Company's ability to
produce a  significant  percentage of its  requirements  of LCD glass in its new
facility is expected to reduce the Company's  dependence  on foreign  suppliers.
See "Special  Considerations - Shortage of Raw Materials and Supplies" contained
in Item 1 of this Report.

Competition

         The Company  believes that Optrex  America,  Inc.,  Seiko-Epson,  Seiko
Instruments,  Vikay Industrial Pte. Limited, PCI Limited, and Philips Components
B.V.  constitute  the  principal  competitors  for the  Company's  LCD  devices.
Hewlett-Packard,  Rohm Co., Ltd., LiteOn, Inc., Siemens,  Inc., Stanley Electric
Company,   Ltd.,  and  Quality  Technologies  Corp.   constitute  its  principal
competitors for its LED devices.  Most of these  competitors are large companies
that have greater financial, technical, marketing,  manufacturing, and personnel
resources  than the  Company.  The  revenue,  profitability,  and success of the
Company depend substantially upon its ability to compete with other providers of
user interface devices. No assurance can be given that the Company will continue
to be able to compete successfully with such organizations.

         The  Company  currently  competes  principally  on  the  basis  of  the
technical  innovation and performance of its product solutions,  including their
ease of use and  reliability,  as well as on  their  cost,  timely  design,  and
manufacturing and delivery schedules.  The Company's  competitive position could
be adversely  affected if one or more of its customers,  particularly  Motorola,
determine to design and manufacture their user interface  devices  internally or
secure them from other  parties.  See  "Special  Considerations  -  Competition"
contained in Item 1 of this Report.

Research and Development

         The Company conducts an active and ongoing research,  development,  and
engineering  program that focuses on advancing  technology,  developing improved
design and  manufacturing  processes,  and improving the overall  quality of the
products  and  services  that the Company  provides.  Research  and  development
personnel  concentrate on LCD technology,  especially  improving  performance of
current products and expanding the technology to serve new markets. Research and
development  also is  conducted  in  manufacturing  processes,  including  those
associated with efficient, high-volume production and electronic packaging.

Environmental Regulation

         The  operations of the Company  result in the creation of small amounts
of hazardous waste, including various epoxies,  gases, inks, solvents, and other
wastes.  The amount of hazardous  waste  produced by the Company may increase in
the future  depending on changes in the  Company's  operations.  The disposal of
hazardous waste has received  increasing focus from federal,  state,  local, and
international  governments  and  agencies  and has been  subject  to  increasing
regulation. See "Special Considerations - Environmental Regulation" contained in
Item 1 of this Report.

         In 1991,  the Company  received a notice of potential  liability at the
Barkhamsted-New  Hartford  Landfill Site in  Barkhamsted,  Connecticut  from the
United States Environmental Protection Agency ("EPA"). No further administrative
action was taken  against the Company and the Company has recently  been advised
by a  representative  of the EPA that the Company  will have no  liability  with
respect to this matter.
                                        6
<PAGE>
         In a separate  matter,  the  Company  conducted  a clean-up  of limited
chemical   contamination   at  its  former  property   located  in  Barkhamsted,
Connecticut. The contamination was caused by the previous owner of the property,
and  not as a  result  of  any of the  Company's  operations.  The  Company  has
contracted  with an  environmental  consulting  firm  for  assistance  with  the
clean-up process and has complied with the requests and  recommendations  of the
Connecticut  Environmental Protection Agency throughout the process. The Company
believes that the source of the contamination has been removed from the property
and that the  clean-up  has been  completed.  Four  monitoring  wells  have been
installed to permit periodic chemical  analysis to be made at the property.  The
property  was sold on June 25,  1995,  subject  to the  Company  making its best
efforts  to  obtain  from  either  the  Connecticut  or  federal   Environmental
Protection  Agency  documentation  to the effect that the  property is clean and
that there is no actionable contamination in the vicinity of the property.

Employees

         As of December 31, 1996,  the Company  employed a total of 195 persons.
This number includes 148 full-time and  approximately 26 temporary  employees at
its  principal  U.S.  facility  in Tempe,  Arizona.  The Company  considers  its
relationship with its employees to be good, and none of its employees  currently
are represented by a union in collective bargaining with the Company.

         TEAM  provides the  personnel  engaged in the assembly of the Company's
devices in Manila pursuant to the Sub-Assembly Agreement between the Company and
TEAM. See "Description of Business - Manufacturing Facilities" contained in Item
1 of this Report. As of December 31, 1995, approximately 1,150 persons performed
direct  and  indirect  labor  operations  at the  Manila  facility  through  the
Sub-Assembly Agreement with TEAM.

Executive Officers

         The  following  table sets  forth  information  concerning  each of the
executive officers of the Company:

<TABLE>
<CAPTION>
Name                        Age                        Position
----                        ---                        --------

<S>                         <C>       <C>                                                          
David R. Buchanan           64         Chairman of the Board, President, and Chief Executive Officer
Vincent C. Hren             46         Vice President - Operations
Dan J. Schott               57         Vice President - Research and Development
James F. Bowser             55         Vice President - New Product Development
Bruce E. Sedlak             43         Vice President - Sales
Jeffrey D. Buchanan         41         Vice President - Finance, Administration, and Legal;
                                          Chief Financial Officer; Secretary; and Treasurer
Elizabeth A. Sharp          35         Vice President - Corporate Relations
</TABLE>

         David R.  Buchanan  has been  Chairman of the Board,  President,  Chief
Executive Officer, and a Director of the Company since its formation in February
1990.  Mr.  Buchanan  served as  Treasurer  of the  Company  from May 1990 until
January 1994 and as Chairman of the Board, Chief Executive  Officer,  President,
and a Director of one of the  predecessors  of the Company  from  October  1986,
February 1987, and November 1985,  respectively,  until the predecessor's merger
into the Company in May 1990.

         Vincent C. Hren has been Vice  President  -  Operations  of the Company
since August 1996 and served as Vice President -  Manufacturing  Operations from
January  1996 to August  1996.  Mr.  Hren  served as Vice  President - Worldwide
Automotive of Graco Inc. from 1994 to 1995.  Mr. Hren served as Vice President -
Worldwide  Operations  for  Fisher-Rosemount  Systems,  Inc.  from 1993 to 1994,
General  Manager  of  Rosemount  Analytical,  Inc.  from 1992 to 1993,  and held
various management positions with Fisher-Rosemount, Inc. from 1974 to 1992.

         Dan J. Schott has been Vice President - Research and Development of the
Company  since  January  1994.  From 1988 to  January  1994,  Mr.  Schott was an
Associate Director with Honeywell Inc., where his responsibilities included flat
panel display  research and  development.  From 1981 until 1987, he held various
engineering management and program management positions with Sperry Rand Corp.
                                        7
<PAGE>
         James F. Bowser has been Vice  President - New Product  Development  of
the Company since March 1997 and has served in a variety of executive  positions
with the Company since August 1990,  including as the Company's Vice President -
Sales and Marketing and Vice President - Manufacturing Operations.  From January
1985 until August 1990, he held a variety of executive  positions  with National
Computer Systems, Inc.

         Bruce E.  Sedlak has served as Vice  President  - Sales of the  Company
since  February  1997.  Mr.  Sedlak  served as Regional  Sales Manager of Auspex
Systems, Inc. from August 1994 until February 1997. From January 1993 to January
1995,  Mr.  Sedlak  served as President  and Chief  Executive  Officer of Summit
Solutions,  Inc. and from March 1991 to January 1993 he served as Vice President
and  General  Manager  of  VERSYSS  Southwest,  Inc.  Mr.  Sedlak  held  various
management positions with UNISYS Corporation (formerly Burroughs) from September
1975 until March 1991,  including  serving as Regional  Manager,  Western Region
from April 1989 until March 1991.

         Jeffrey D. Buchanan has been Vice President - Finance,  Administration,
and Legal, Chief Financial Officer, and Treasurer of the Company since June 1996
and Vice President - Administration and Legal and Secretary of the Company since
May  1996.  Mr.  Buchanan  served as a Senior  Partner  of  O'Connor,  Cavanagh,
Anderson,  Killingsworth  &  Beshears  from June 1986  until May 1996,  where he
practiced  as a business  lawyer with an  emphasis on mergers and  acquisitions,
joint ventures, and taxation. Mr. Buchanan was associated with the international
law firm of Davis Wright  Tremaine from 1984 to 1986,  and he was a senior staff
person at Deloitte & Touche from 1982 to 1984.  Mr.  Buchanan is a member of the
Arizona and  Washington  state bars and passed the certified  public  accounting
examination in 1983. Mr. Buchanan is the son of David R. Buchanan.

         Elizabeth A. Sharp has been Vice President - Corporate Relations of the
Company since May 1996.  Ms. Sharp served as Director of Human  Resources of the
Company from May 1992 until May 1996, as Corporate  Administrator of the Company
from April 1988 until May 1992, as Personnel Manager from April 1987 until April
1988,  and as  Administrative  Assistant to the  President  and Chief  Financial
Officer of the Company from May 1986 until April 1987.  From December 1981 until
March  1986,  Ms.  Sharp held a variety of  management  positions  with  Concept
Communications Corporation.


                             SPECIAL CONSIDERATIONS

Certain Factors Affecting Operating Results

         The  Company's  operating  results are  affected  by a wide  variety of
factors  which could  adversely  impact its net sales and  profitability.  These
factors,  many of which are  beyond  the  control of the  Company,  include  the
Company's ability to identify industries which have significant growth potential
and to establish strong and long- lasting  relationships with companies in those
industries;   the   Company's   ability  to  provide   significant   design  and
manufacturing services for those companies on a timely and cost-effective basis;
the Company's success in maintaining  customer  satisfaction with its design and
manufacturing   services;   market  acceptance  of  products  of  its  customers
incorporating  devices designed and  manufactured by the Company;  the level and
timing of orders  placed  by  customers  which the  Company  can  complete  in a
quarter;  customer order  patterns;  changes in order mix; the  performance  and
reliability of devices designed and manufactured by the Company; the life cycles
of its customers'  products;  the  availability and utilization of manufacturing
capacity; fluctuations in manufacturing yield and productivity; the availability
and cost of raw materials,  equipment,  and supplies; the timing of expenditures
in anticipation of orders; the cyclical nature of the industries and the markets
served by the Company;  technological  changes;  and competition and competitive
pressures on prices.

         The Company's ability to increase its design and manufacturing capacity
to meet customer demand and maintain  satisfactory delivery schedules will be an
important  factor in its long-term  prospects.  Although the  Company's  product
solutions  are  incorporated  into a wide variety of  communications,  consumer,
medical, office automation,  and industrial products, a majority of its sales in
1996 were  display  modules  for  cellular  products.  A slowdown  in demand for
customer products,  particularly cellular products,  which utilize the Company's
products,  as a result of economic or other  conditions  in the United States or
worldwide  markets  served by the  Company  or other  broadbased  factors  would
adversely affect the Company's operating results.
                                        8
<PAGE>
Dependence on New Products and Technologies

         The  Company  operates  in  fast  changing  industries.   Technological
advances,  the  introduction of new products,  and new design and  manufacturing
techniques could adversely affect the Company's operations unless the Company is
able to adapt to the resulting  changing  conditions.  As a result,  the Company
will  be  required  to  expend  substantial  funds  for and  commit  significant
resources to the conduct of continuing research and development activities,  the
engagement of additional engineering and other technical personnel, the purchase
of advanced design, production and test equipment, and the enhancement of design
and manufacturing processes and techniques.

         The  Company's  future  operating  results will depend to a significant
extent on its ability to continue to provide design and  manufacturing  services
for new products  that compare  favorably on the basis of time to  introduction,
cost, and performance with the design and manufacturing capabilities of OEMs and
other  third-party  suppliers.  The  success  of new  design  and  manufacturing
services  depends on  various  factors,  including  proper  customer  selection,
utilization of advances in technology,  innovative  development of new solutions
for customer products,  efficient and cost-effective services, timely completion
and delivery of new product  solutions,  and market acceptance of customers' end
products.  Because of the complexity of the Company's  design and  manufacturing
services,  the Company may experience delays from time to time in completing the
design and manufacture of new product  solutions.  In addition,  there can be no
assurance that any new product  solutions  will receive or maintain  customer or
market  acceptance.  If the  Company  were  unable  to  design  and  manufacture
solutions  for new  products  of its  customers  on a timely and  cost-effective
basis,  its  future  operating   results  would  be  adversely   affected.   See
"Description  of Business - Products and  Services"  contained in Item 1 of this
Report.

         Finally,   even   when  a  design   and   manufacturing   solution   is
satisfactorily  completed,  circumstances  outside of the Company's  control may
result in the loss of expected revenue. For example, a customer may terminate or
delay its own  program  for any  number of  reasons  unrelated  to the  Company,
including  problems  with  other  suppliers  to the  program  or lack of  market
acceptance of the customer's  product.  In such instances,  the future operating
results of the Company could be adversely affected.

Substantial Reliance on Certain Customers

         In the past few years,  the Company has  generated  most of its revenue
from sales to a few significant  customers.  The Company's  largest  customer is
Motorola, which accounted for 65 percent of the Company's revenue in 1996 and 81
percent of the Company's  revenue in 1995. Sales to Motorola are made through 12
buyers  operating in five  separate  product  divisions.  The Company  currently
designs and  manufactures  user interface  devices for use in  approximately  42
individual product programs for Motorola. During 1996, the five largest of these
programs accounted for 9.6 percent,  7.5 percent,  6.6 percent, 4.9 percent, and
2.5 percent,  respectively,  of the Company's  total revenue,  and the remaining
product programs in the aggregate  accounted for approximately 34 percent of the
Company's total revenue.  Devices that are used in cellular telephones accounted
for substantially  all of the Company's sales to Motorola in 1996.  Although the
percentage  of sales to Motorola  declined  in 1996,  and is expected to decline
further in 1997,  the Company  expects that a recent new customer  could account
for as much as 20 percent of the Company's revenue in 1997.

         The  Company  does  not  have  long-term   supply  contracts  with  any
customers,  and customers also  generally do not commit to long-term  production
schedules.  In addition,  customer orders  generally can be cancelled and volume
levels  changed or delayed.  The timely  replacement of cancelled,  delayed,  or
reduced  orders  cannot be assured.  The Company's  operating  results have been
materially  and  adversely  affected in the past by the  failure of  anticipated
orders to be realized and by deferrals or cancellations of orders as a result of
changes in customer  requirements.  Cancelled,  delayed,  or reduced commitments
from any of the Company's major customers,  particularly  Motorola or the recent
new  customer  referred to above,  would have a material  adverse  effect on the
Company's results of operations.
                                        9
<PAGE>
Manufacturing Operations in the Philippines

         The  Company  has  maintained  its  primary  manufacturing  facility in
Manila, the Philippines since 1986. TEAM, a third party subcontractor,  owns the
facility,  which is located on land it leases  from the  Philippine  government.
TEAM  operates  the  facility  under the  Sub-Assembly  Agreement  and the Lease
Agreement with the Company,  utilizing equipment,  processes,  and documentation
owned by the Company and  supervisory  personnel  employed by the Company.  TEAM
provides production personnel under the Sub-Assembly  Agreement and leases space
to the Company under the Lease Agreement.  TEAM also utilizes other space in the
facility to produce  products for other entities  unrelated to the Company.  The
Sub-Assembly  Agreement and the Lease  Agreement  have current  terms  extending
through  December  31, 1999 and from year to year  thereafter.  Since 1994,  the
Company  has made  advance  payments to TEAM to assist it in meeting its working
capital needs while it negotiates new financing  arrangements.  Advances, net of
amounts payable to TEAM,  totalled  approximately  $119,000 at December 31, 1996
and are secured by future payments for  sub-assembly  services to be provided to
the Company as well as other assets of TEAM.

         The Company has made cumulative capital  investments in the Philippines
amounting  to  approximately  $10.6  million  through  December  31,  1996.  The
Company's  reliance on  personnel  and  facilities  in the  Philippines  and its
maintenance  of  inventories  abroad expose the Company to certain  economic and
political  risks,   including  the  business  and  financial  condition  of  the
subcontractor,  political  instability  and  expropriation,  supply  disruption,
currency  controls,  and exchange  fluctuations  as well as changes in tax laws,
tariffs,  and freight rates.  The Company has not  experienced  any  significant
interruptions in its business  operations in the Philippines to date despite the
fact that the Philippines has been subject to volcanic eruptions,  typhoons, and
substantial civil  disturbances,  including attempted military coups against the
government.  The  Company  believes  that its  manufacturing  operations  in the
Philippines constitute one of the Company's most important resources and that it
would be difficult for it to replace the low-cost,  high-performance facility or
the  high-quality  and  hardworking   production  staff  if  its   manufacturing
operations in the  Philippines  were disrupted or terminated.  As a result,  the
Company's   operations  would  be  adversely   affected  if  operations  in  the
Philippines  or air  transportation  with  the  Philippines  were  disrupted  or
terminated,  even for a relatively  short period of time.  See  "Description  of
Business - Manufacturing Facilities" contained in Item 1 of this Report.

International Trade and Currency Exchange

         Approximately  46  percent  of the  Company's  net  sales in 1996  were
international sales. In addition, the Company purchases a substantial portion of
its raw materials and equipment from foreign suppliers and incurs labor costs in
foreign  locations.  The  foreign  sale  of  products  and the  purchase  of raw
materials and  equipment  from foreign  suppliers  may be adversely  affected by
political and economic  conditions  abroad.  Protectionist  trade legislation in
either the United States or foreign  countries,  such as a change in the current
tariff  structures,  export  compliance  laws,  or other trade  policies,  could
adversely  affect the Company's  ability to sell devices in foreign  markets and
purchase materials or equipment from foreign suppliers.

         A small portion of the Company's  foreign  transactions are denominated
in currencies other than the U.S. dollar.  Such transactions  expose the Company
to  exchange  rate  fluctuations  for the period of time from  inception  of the
transaction  until  it is  settled.  For  example,  the  Company's  Sub-Assembly
Agreement and Lease  Agreement with TEAM are based on a fixed  conversion  rate,
exposing the Company to exchange rate  fluctuations  with the  Philippine  peso.
Although the Company has not incurred any material  exchange  gains or losses to
date, there can be no assurance that fluctuations in the currency exchange rates
in the future will not have an adverse effect on the Company's  operations.  The
Company has entered and from time to time will enter into  hedging  transactions
in order to minimize its exposure to currency rate fluctuations.

Manufacturing Yields and Capacity

         The design and manufacture of user interface devices are highly complex
processes  that are sensitive to a wide variety of factors,  including the level
of contaminants in the  manufacturing  environment,  impurities in the materials
used, and the performance of the design and production  personnel and equipment.
As is typical in the
                                       10
<PAGE>
industry,  the Company from time to time has experienced  lower than anticipated
manufacturing  yields  and  lengthening  of  delivery  schedules.  This  may  be
particularly  true as the  Company  ramps  up its new  high-volume  LCD  line to
greater production levels in 1997. The Company continually reviews its processes
to increase its manufacturing productivity, achieve higher manufacturing yields,
and reduce design and manufacturing  errors. In addition,  the Company maintains
ongoing  procedures to assure its ability to meet delivery  schedules to satisfy
increased business.  The Company's operating results would be adversely affected
if it were  unable to  maintain  high  levels  of  productivity  or to  maintain
satisfactory  delivery schedules in either its Manila manufacturing plant or its
Arizona high-volume LCD line.

         Manufacturing yields and delivery schedules also may be affected as the
Company increases its use of the capacity of the Manila manufacturing  facility.
Other  companies  in the  industry  have  experienced  difficulty  in  expanding
manufacturing  output and capacity,  with such  difficulty  resulting in reduced
yields or delays in  product  deliveries.  No  assurance  can be given  that the
Company  will not  experience  manufacturing  yield or delivery  problems in the
future.  Such problems could materially affect the Company's  operating results.
See "Description of Business - Manufacturing  Facilities" contained in Item 1 of
this Report.

Utilization of New Facility

         The Company  has made  substantial  expenditures  in  constructing  and
equipping  its  new  headquarters  facility  in  Tempe,  Arizona,   including  a
high-volume LCD  manufacturing  line. The high-volume line was placed in service
in 1996,  although  the  Company  committed  a  significant  amount  of time and
resources in 1996 to the development of manufacturing processes on the line. The
Company intends to utilize the high-volume line to produce a substantial portion
of its own  requirements  for LCD glass.  The successful  utilization of the LCD
glass line will  require  the  Company  (i) to produce LCD glass on a timely and
cost-effective basis at quality levels at least equal to the LCD glass available
from  independent  suppliers  and (ii) to utilize  the LCD glass it  produces in
devices it designs and  manufactures in a manner  satisfactory to its customers.
The  Company  experienced  some  delays  in  fully  implementing  its LCD  glass
manufacturing operations in 1996, and no assurance can be given that the Company
will not experience problems or delays in the future in conducting its LCD glass
manufacturing  operations.  Any such problems could result in the lengthening of
the Company's  delivery  schedules,  reductions in the quality or performance of
the  Company's  design  and   manufacturing   services,   and  reduced  customer
satisfaction.  Such  problems also could require the Company to purchase its LCD
glass requirements from third parties and result in the inability of the Company
to recover its investment in the high-volume LCD line.

Management of Growth

         The Company's  revenue  expanded  substantially  during the period from
1993  through  1995,  but  declined  significantly  in 1996 as a  result  of the
discontinuation  of a few significant  programs from its major customer.  During
the last  half of  1996,  however,  the  Company  increased  the  number  of its
manufacturing  and design  programs and the Company plans to further  expand the
number and  diversity  of its  programs in the future.  At the end of 1996,  the
Company had 69  manufacturing  and design programs versus 47 at the end of 1995.
The Company's  ability to manage its planned growth  effectively will require it
to enhance its operational,  financial,  and management  systems,  to expand its
facilities  and  equipment,  and  to  successfully  hire,  train,  and  motivate
additional employees, including the technical personnel necessary to operate its
new LCD glass  production  facility  in  Arizona.  The failure of the Company to
manage its growth on an effective basis could have a material  adverse effect on
the Company's operations.

         The Company may be required to increase  staffing and other expenses as
well as its  expenditures  on capital  equipment and leasehold  improvements  in
order to meet the  anticipated  demand  of its  customers.  Customers,  however,
generally do not commit to firm production  schedules for more than a short time
in advance.  The  Company's  profitability  would be  adversely  affected if the
Company  increases its expenditures in anticipation of future orders that do not
materialize. Customers also may require rapid increases in design and production
services that place an excessive short-term burden on the Company's resources.
                                       11
<PAGE>
Dependence on Key Personnel

         The Company's  development and operations  depend  substantially on the
efforts  and  abilities  of  its  senior  management  and  technical  personnel,
including  David R. Buchanan,  who has served as the Chairman of the Board since
1986 and as President and Chief Executive Officer of the Company since 1987. The
competition  for qualified  management and technical  personnel is intense.  The
loss of services of one or more of its key employees or the inability to add key
personnel  (including those required for its new LCD glass production  facility)
could  have a  material  adverse  effect on the  Company.  See  "Description  of
Business - Executive  Officers"  contained in Item 1 of this Report. The Company
does not  have an  employment  agreement  with,  or key  person  life  insurance
covering,   any  officer  or   employee.   The   Company,   however,   maintains
noncompetition and nondisclosure agreements with its key personnel.

Possible Volatility of Stock Price

         The market price of the Company's  Common Stock increased  dramatically
during the three-year period ended December 31, 1994, but declined significantly
during  1995 and 1996.  See "Market  for Common  Equity and Related  Stockholder
Matters"  contained in Item 5 of this Report. The trading price of the Company's
Common Stock in the future could continue to be subject to wide  fluctuations in
response to various factors, including quarterly variations in operating results
of the Company, actual or anticipated  announcements of technical innovations or
new product developments by the Company or its competitors, changes in analysts'
estimates of the  Company's  financial  performance,  general  conditions in the
electronics  industry,  worldwide economic and financial  conditions,  and other
events or factors.  In addition,  the stock market has experienced extreme price
and volume  fluctuations which have particularly  affected the market prices for
many high  technology  companies  and which  often  have been  unrelated  to the
operating  performance of such companies.  These broad market  fluctuations  and
other  factors may  adversely  affect the market price of the  Company's  Common
Stock.

Competition

         The industries  which the Company serves are intensely  competitive and
have been  characterized  by price  erosion,  rapid  technological  change,  and
foreign competition.  The Company competes with major domestic and international
companies,  many of which have  greater  market  recognition  and  substantially
greater financial, technical, marketing,  distribution, and other resources than
the Company possesses.  Emerging companies also may increase their participation
in the user  interface  device  market.  The  ability of the  Company to compete
successfully depends on a number of factors both within and outside its control,
including the quality, performance, reliability, features, ease of use, pricing,
and diversity of its product solutions; foreign currency fluctuations, which may
cause a foreign competitor's  products to be priced significantly lower than the
Company's products; the quality of its customer services; its ability to address
the needs of its  customers;  its success in  designing  and  manufacturing  new
product   solutions,   including  those   implementing  new  technologies;   the
availability  of  adequate  sources  of raw  materials  and  other  supplies  at
acceptable  prices;  its efficiency of production;  the rate at which  customers
incorporate  the  Company's  user  interface  devices  into their own  products;
product solution introductions by the Company's competitors; the number, nature,
and  success  of its  competitors  in a given  market;  and  general  market and
economic conditions.  The Company currently competes principally on the basis of
the  technical  innovation  and  performance  of  its  user  interface  devices,
including  their  ease of use and  reliability,  as well as on cost  and  timely
design,  manufacturing,   and  delivery  schedules.  The  Company's  competitive
position could be adversely  affected if one or more of these customers increase
their own capacity and decide to design and manufacture their own user interface
devices, to use standard devices, or to outsource with a competitor. There is no
assurance that the Company will continue to be able to compete  successfully  in
the future.  See  "Description of Business - Competition" contained in Item 1 of
this Report.

Shortage of Raw Materials and Supplies

         The  principal raw  materials  used in producing the Company's  product
solutions  consist of gallium arsenide and gallium  phosphorous  wafers and die,
LCD glass, driver die, circuit boards, molded plastic parts, lead frames,
                                       12
<PAGE>
wire,  chips,  and  packaging  materials,  most of which are acquired from Asian
sources. The Company does not have long-term contracts with its suppliers.

         The Company believes that there are alternative sources of supplies for
most of these materials. Many of such materials,  however, must be obtained from
foreign suppliers, which subjects the Company to certain risks, including supply
interruptions  and currency price  fluctuations.  Purchasers of these materials,
including the Company, experience difficulty from time to time in obtaining such
materials.   The  Company's  suppliers  currently  are  adequately  meeting  the
requirements of the Company,  and the Company's ability to produce a substantial
portion of its own requirements for LCD glass in its new facility is expected to
reduce the Company's dependence on foreign suppliers of LCD glass.

The Electronics Industry: Cyclicity and Capital Requirements

         The electronics industry has experienced significant economic downturns
at various  times,  characterized  by  diminished  product  demand,  accelerated
erosion of average selling prices,  and production  over-capacity.  In addition,
the electronics  industry has been  characterized by cyclicity.  The Company has
sought to reduce its exposure to industry  downturns  and cyclicity by providing
design and  production  services  for  leading  companies  in rapidly  expanding
segments of the  electronics  industry.  However,  the  Company  may  experience
substantial period-to-period fluctuations in future operating results because of
general industry conditions or events occurring in the general economy. There is
no assurance that the Company will continue to experience increased demand.

         To remain  competitive,  the Company must continue to make  significant
investments in research and development,  equipment, and facilities. As a result
of the increase in fixed costs and operating  expenses  related to these capital
expenditures,  the Company's  operating results may be adversely affected if its
net sales do not  increase  sufficiently  to offset  the  increased  costs.  The
Company  from  time to time may seek  additional  equity  or debt  financing  to
provide  for the  capital  expenditures  required  to  maintain  or  expand  the
Company's design and production facilities and equipment.  The timing and amount
of any such capital  requirements cannot be predicted at this time. There can be
no assurance that any such financing will be available on acceptable  terms.  If
such financing is not available on satisfactory terms, the Company may be unable
to expand its  business or develop  new  customers  at the rate  desired and its
operating results may be adversely  affected.  Debt financing increases expenses
and must be repaid  regardless  of operating  results.  Equity  financing  could
result in  additional  dilution  to  existing  stockholders.  See  "Management's
Discussion  and  Analysis  of  Financial  Condition  and Results of Operations -
Liquidity and Capital Resources" contained in Item 7 of this Report.

Environmental Regulation

         The  operations of the Company  result in the creation of small amounts
of hazardous waste, including various epoxies,  gases, inks, solvents, and other
wastes.  The  Company,  therefore,  is  subject  to  federal,  state,  and local
governmental regulations related to the use, storage, discharge, and disposal of
toxic,  volatile,  or  otherwise  hazardous  chemicals  used in its  design  and
manufacturing  processes.  The amount of hazardous waste produced by the Company
may increase in the future depending on changes in the Company's operations. The
failure  by  the  Company  to  comply  with  present  or  future   environmental
regulations  could result in fines being  imposed on the Company,  suspension of
production, or a cessation of operations. Compliance with such regulations could
require the Company to acquire  costly  equipment or to incur other  significant
expenses.  Any  failure  by the  Company to  control  the use of, or  adequately
restrict the  discharge  of,  hazardous  substances  could  subject it to future
liabilities.

         In January 1991, the Company  received a notice of potential  liability
respecting a landfill site near the Company's  former  property in  Barkhamsted,
Connecticut from the United States  Environmental  Protection Agency. No further
administrative action was taken against the Company and the Company has recently
been  advised  by a  representative  of the EPA that the  Company  will  have no
liability  with respect to this matter.  In a separate  matter,  the Company has
removed  contamination and continues to conduct periodic chemical  monitoring at
the Company's former Connecticut property.  There can be no assurance that other
environmental  problems will not be discovered in the future which could subject
the  Company  to future  costs or  liabilities.  See  "Description of Business -
Environmental Regulation" contained in Item 1 of this Report.
                                       13
<PAGE>
Change in Control Provisions

         The Company's  Restated  Certificate  of  Incorporation  (the "Restated
Certificate")  and the Delaware  General  Corporation  Law (the "Delaware  GCL")
contain provisions that may have the effect of making more difficult or delaying
attempts by others to obtain  control of the Company,  even when these  attempts
may be in the best  interests of  stockholders.  The Restated  Certificate  also
authorizes the Board of Directors, without stockholder approval, to issue one or
more series of  Preferred  Stock which could have voting and  conversion  rights
that adversely affect or dilute the voting power of the holders of Common Stock.
The  Delaware  GCL also  imposes  conditions  on  certain  business  combination
transactions with "interested stockholders" (as defined therein).

Rights to Acquire Shares

         At December  31, 1996,  9,000 shares of Common Stock were  reserved for
issuance upon exercise of options  previously  granted under the Company's  1994
Automatic  Stock Option Plan;  197,000  shares of Common Stock were reserved for
issuance upon exercise of options  previously  granted under the Company's  1993
Stock Option Plan; and 345,776 shares of Common Stock were reserved for issuance
upon  exercise of options  previously  granted  under the  Company's  1990 Stock
Option Plan.  The weighted  average  exercise price of those shares is $6.92 per
share.  During  the terms of such  options,  the  holders  thereof  will have an
opportunity  to profit from an increase in the market price of Common Stock with
resulting dilution in the interests of holders of Common Stock. The existence of
such stock  options  may  adversely  affect the terms on which the  Company  can
obtain additional financing,  and the holders of such options can be expected to
exercise such options at a time when the Company,  in all  likelihood,  would be
able to obtain  additional  capital by  offering  shares of its Common  Stock on
terms more  favorable to the Company than those provided by the exercise of such
options.

Repurchase of Common Stock

         In August 1996, the Board of Directors  authorized the repurchase  from
time to time of up to one million  shares of the  Company's  Common Stock on the
open market or in negotiated  transactions,  depending on market  conditions and
other  factors.  The  repurchase  of  shares by the  Company  would  reduce  the
Company's capital.  If the Company obtains financing from other sources for such
repurchases,  the  liabilities of the Company would  increase.  The reduction in
capital or increase in liabilities  could adversely affect the Company's ability
to  expand  its  business  or  commit  resources  to  needed  expenditures.  See
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations  -  Liquidity  and  Capital  Resources"  contained  in Item 7 of this
Report. A significant  reduction in the number of shares outstanding on the open
market  could  also  increase  the  volatility  of the  stock as a result of the
reduced supply of available shares on the open market.

Shares Eligible for Future Sale; Potential Depressive Effect on Stock Price

         Currently,  Rule 144 under the  Securities Act of 1933, as amended (the
"Securities  Act"),  provides that each person who beneficially  owns restricted
securities  with respect to which at least two years has elapsed since the later
of the date the shares were  acquired  from the Company or an  affiliate  of the
Company may, every three months,  sell in ordinary brokerage  transactions or to
market  makers  an amount of shares  equal to the  greater  of 1 percent  of the
Company's then-outstanding Common Stock or the average weekly trading volume for
the four weeks  prior to the  proposed  sale of such  shares.  An  aggregate  of
741,262  shares of Common  Stock held by an officer and  director of the Company
currently are available for sale under Rule 144. Sales of substantial amounts of
Common  Stock by  stockholders  of the  Company or even the  potential  for such
sales, are likely to have a depressive  effect on the market price of the Common
Stock and could impair the Company's  ability to raise capital  through the sale
of its equity securities.

Dividends

         The Company has never paid any cash  dividends  on its Common Stock and
does not anticipate  that it will pay cash dividends in the near term.  Instead,
the Company  intends to apply any earnings to the expansion and  development  of
its  business.  See "Market for Common Equity and Related  Stockholder  Matters"
contained in Item 5 of this Report.
                                       14
<PAGE>
Cautionary Statement Regarding Forward-Looking Statements

         Certain  statements and information  contained in this Report under the
headings "Business," "Special  Considerations," and "Management's Discussion and
Analysis of Financial  Condition and Results of Operations"  concerning  future,
proposed, and anticipated activities of the Company, certain trends with respect
to the Company's revenue, operating results, capital resources, and liquidity or
with  respect to the  markets in which the Company  competes or the  electronics
industry in general,  and other  statements  contained in this Report  regarding
matters that are not historical facts are  forward-looking  statements,  as such
term is defined in the Securities Act.  Forward-  looking  statements,  by their
very  nature,  include  risks and  uncertainties,  many of which are  beyond the
Company's control.  Accordingly,  actual results may differ, perhaps materially,
from those expressed in or implied by such forward-looking  statements.  Factors
that could cause actual  results to differ  materially  include those  discussed
elsewhere under this Item 1, "Business - Special Considerations."


ITEM 2.           DESCRIPTION OF PROPERTY

         During  1995,  the  Company  completed  the  construction  of  its  new
principal  facility  to  house  its  U.S.-based  manufacturing  operations;  its
research,  development,  engineering,  design, and corporate functions;  and the
largest  LCD glass  manufacturing  operations  in North  America.  The  facility
contains  97,000  square feet of space  located on a 5.7 acre site in the Papago
Park Center in Tempe,  Arizona.  The Company entered into a ground lease through
December  31,  2069,  subject to renewal and  purchase  options as well as early
termination provisions. Costs to construct,  furnish, and equip the new facility
were approximately $24.0 million.

         The Company leases  approximately  3,500 square feet of office space in
Swindon,  United  Kingdom,  where it maintains its European  administrative  and
executive offices.

         The Company leases  approximately  60,000 square feet of  manufacturing
space in Manila, the Philippines. Approximately 40,000 square feet is subject to
a lease which expires on December 31, 1999, and the remaining 20,000 square feet
is subject to a lease which expires on March 31, 1997, with renewal  options for
two additional years.


ITEM 3.           LEGAL PROCEEDINGS

         There are no legal  proceedings  to which the  Company is a party or to
which any of its properties are subject,  other than routine litigation incident
to the Company's business which is covered by insurance or an indemnity or which
are not  expected  to have a  material  adverse  effect  on the  Company.  It is
possible,  however,  that the  Company  could  incur  claims for which it is not
insured or that exceed the amount of its insurance coverage.


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

         Not applicable
                                       15
<PAGE>
                                     PART II

ITEM 5.           MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         The  Company's  Common  Stock  has been  listed  on the New York  Stock
Exchange  ("NYSE") under the symbol "TFS" since December 29, 1994. The Company's
Common Stock was listed on the American Stock Exchange ("AMEX") from January 28,
1993 through  December 28, 1994.  The  Company's  Common Stock was listed on the
AMEX Emerging  Company  Marketplace  from March 18, 1992 until January 27, 1993,
and on the Nasdaq National Market system from May 1, 1990 until March 17, 1992.

         The following table sets forth the quarterly high and low prices of the
Company's  Common  Stock for the  periods  indicated,  adjusted  to reflect  the
two-for-one split of the Common Stock effected as a stock dividend in May 1994.
<TABLE>
<CAPTION>
                                                                                     High                 Low
                                                                                     ----                 ---
<S>                                                                             <C>                 <C>    
1993:
First Quarter.................................................................   $   3  7/8          $   1  3/4
Second Quarter................................................................       8                   3  7/16
Third Quarter.................................................................      12  1/16             6  3/8
Fourth Quarter................................................................      17  5/8             10  7/8

1994:
First Quarter.................................................................   $  30  7/8          $  16  9/16
Second Quarter................................................................      29  15/16           20
Third Quarter.................................................................      46  1/2             26  1/4
Fourth Quarter................................................................      50                  28  3/4

1995:
First Quarter.................................................................   $  38  3/8          $  20  5/8
Second Quarter................................................................      38  7/8             22  3/8
Third Quarter.................................................................      36  3/4             24  1/4
Fourth Quarter................................................................      26  1/2             16

1996:
First Quarter.................................................................   $  21  7/8          $  11  5/8
Second Quarter................................................................      14  1/8              9  1/8
Third Quarter.................................................................      13                   8  3/4
Fourth Quarter................................................................      14                  10  5/8

1997:
First Quarter (through March 6, 1997).........................................   $  16  1/8          $  12  1/4
</TABLE>

         As of March 6, 1997, there were  approximately  1,200 holders of record
of the Company's Common Stock.

         The  present  policy of the  Company is to retain  earnings  to provide
funds for the operation and expansion of its business.  The Company has not paid
dividends on its Common Stock and does not anticipate  that it will do so in the
near term. Furthermore,  the Company's line of credit with Wells Fargo Bank does
not permit the payment of dividends without the consent of Wells Fargo Bank. The
payment  of  dividends  in the  future  will  depend  on the  Company's  growth,
profitability,  financial  condition,  and other factors which the directors may
deem relevant.
                                       16
<PAGE>
ITEM 6.           SELECTED FINANCIAL DATA

         The following table summarizes certain selected consolidated  financial
data of the  Company  and is  qualified  in its  entirety  by the more  detailed
consolidated  financial statements and notes thereto appearing elsewhere herein.
The data have been derived from the  consolidated  financial  statements  of the
Company  audited by Arthur Andersen LLP,  independent  public  accountants.  All
share amounts and per share data have been  adjusted to reflect the  two-for-one
split of the Company's Common Stock effected as a stock dividend in May 1994.

<TABLE>
<CAPTION>
                                                                   1996          1995         1994         1993(1)          1992
                                                                   ----          ----         ----         -------          ----
<S>                                                              <C>           <C>          <C>            <C>            <C>    
Consolidated Statements of Income (Loss):                                  (in thousands, except per share amounts)
Net sales..................................................      $60,713       $91,585      $85,477        $38,002        $20,833
                                                                 -------       -------      -------        -------        -------
Costs and expenses:
  Cost of sales............................................       58,321        70,481       59,409         26,725         15,388
  Selling, general and administrative......................        5,351         5,386        4,867          3,853          3,469
  Research and development.................................        4,065         2,396        1,270            857            468
                                                                 -------       -------      -------        -------        -------
                                                                  67,737        78,263       65,546         31,435         19,325
                                                                 -------       -------      -------        -------        -------
Operating income (loss)....................................       (7,024)       13,322       19,931          6,567          1,508
                                                                 -------       -------      -------        -------        -------
Other income (expense)
  Interest, net............................................          412           765          859           (117)          (179)
  Other, net...............................................         (139)         (122)        (135)          (277)          (160)
                                                                 -------       -------      -------        -------        -------
                                                                     273           643          724           (394)          (339)
                                                                 -------       -------      -------        -------        -------
Income (loss) before provision for (benefit from)
  income taxes and cumulative effect of
  accounting change........................................       (6,751)       13,965       20,655          6,173          1,169
Provision for (benefit from) income taxes..................       (2,920)        5,548        8,109          2,043            147
                                                                 -------       -------      -------        -------        -------
Income (loss) before cumulative effect of
  accounting change........................................       (3,831)        8,417       12,546          4,130          1,022
Cumulative effect of accounting change.....................           --            --           --            924             --
                                                                 -------       -------      -------        -------        -------
Net income (loss)..........................................      $(3,831)      $ 8,417      $12,546        $ 5,054        $ 1,022
                                                                 =======       =======      =======        =======        =======
Earnings (loss) per common share and common share equivalent:
  Income (loss) before cumulative effect of
    accounting change......................................      $ (0.49)      $  1.04      $  1.59        $  0.59        $  0.14
  Cumulative effect of accounting change...................           --            --           --           0.13             --
                                                                 -------       -------      -------        -------        -------
Net income (loss)..........................................      $ (0.49)      $  1.04      $  1.59        $  0.72        $  0.14
                                                                 =======       =======      =======        =======        =======

Weighted average number of common
  shares and common share equivalents outstanding..........        7,766         8,084        7,882          7,040          7,225

Consolidated Balance Sheet Data
(at end of period):

Working capital............................................      $21,513       $22,400      $37,638        $ 7,427        $ 4,450
Total assets...............................................       62,569        63,780       56,280         17,470          9,811
Notes payable to banks and long-term debt..................           --         3,000          182            223          2,184
Stockholders' equity.......................................       51,184        55,224       46,561         10,202          4,661
</TABLE>
-----------------
(1)      The Company  adopted  Statement of Financial  Accounting  Standards No.
         109,  "Accounting  for Income  Taxes,"  effective  January 1, 1993. The
         presentation  above  includes  the  cumulative  effect of the change in
         accounting  principle which increased net income by $924,000,  or $0.13
         per share, for the year ended December 31, 1993.
                                       17
<PAGE>
ITEM 7.           MANAGEMENT'S  DISCUSSION  AND ANALYSIS OF FINANCIAL  CONDITION
                  AND RESULTS OF OPERATIONS

Results of Operations

Annual Table: Percentages of Net Sales

         The  following  table  sets  forth,  for  the  periods  indicated,  the
percentage  of  net  sales  of  certain  items  in  the  Consolidated  Financial
Statements of the Company.  The table and the discussion below should be read in
conjunction with the Consolidated Financial Statements and Notes thereto.
<TABLE>
<CAPTION>
                                                                                           Year Ended December 31,
                                                                                            -----------------------
                                                                                       1996         1995         1994
                                                                                       ----         ----         ----
<S>                                                                                    <C>          <C>          <C>   
Net sales..................................................................            100.0%       100.0%       100.0%
                                                                                       -----        -----        -----
Costs and expenses
  Cost of sales............................................................             96.1         77.0         69.5
  Selling, general, and administrative.....................................              8.8          5.9          5.7
  Research and development.................................................              6.7          2.6          1.5
                                                                                       -----        -----        -----
                                                                                       111.6         85.5         76.7
Operating income (loss)....................................................            (11.6)        14.5         23.3
Other income (expense)    
  Interest, net............................................................              0.7          0.8          1.0
  Other, net...............................................................             (0.2)        (0.1)        (0.1)
                                                                                       -----        -----        -----
                                                                                         0.5          0.7          0.9
                                                                                       -----        -----        -----
Income (loss) before provision for (benefit from) income taxes.............            (11.1)        15.2         24.2
Provision for (benefit from) income taxes..................................             (4.8)         6.1          9.5
                                                                                       -----        -----        -----
Net income (loss)..........................................................             (6.3)%        9.1%        14.7%
                                                                                       ======        =====        =====
</TABLE>
Year Ended December 31, 1996 Compared with Year Ended December 31,1995

         Net sales were $60.7  million  for 1996,  a  decrease  of 33.7  percent
compared  with net sales of $91.6  million  for 1995.  The  sales  decrease  was
primarily a result of lower order rates from the  Company's  major  customer for
existing  product  programs.  During the first quarter of 1996,  that  customer,
which is in the wireless communications  industry,  informed the Company that it
had made an  unexpected  decision to begin  phasing out certain of its  cellular
products that used display modules which comprised the Company's highest volume,
longest running programs. Subsequently, the phase-out of those programs occurred
even more quickly than the Company had anticipated or its customer had initially
indicated.  The  sudden  and  unexpected  reduction  of those  programs  was the
greatest   contributor  to  the  reduced  revenue  in  1996.  The  long  product
development  time in the custom  business  prevented  the Company  from  quickly
replacing the  phased-out  programs.  In 1996,  the Company's  largest  customer
accounted  for net  sales  of $39.5  million  compared  with net  sales of $73.7
million to that customer for 1995, for an overall decrease of 46.4 percent.  The
Company's  major customer  accounted for  approximately  65.1 percent of the net
sales for 1996  compared  with  approximately  80.5 percent for 1995.  All other
customers  accounted  for net sales of $21.2  million for 1996 compared with net
sales of $17.9 million for 1995.

         Cost of sales, as a percentage of net sales,  increased to 96.1 percent
for 1996 as compared with 77 percent for 1995. The corresponding  decline in the
gross  margin  was the  result  of a  number  of  factors,  including  increased
provisions for excess and obsolete inventory,  manufacturing variances occurring
as a result of decreased manufacturing volume and material purchases,  and sales
of low-margin products. In the third quarter of 1996, the Company took a special
one-time  provision  for excess and  obsolete  inventory  related  primarily  to
end-of-life  programs for which the majority of shipments,  expected to occur in
the latter  part of 1996,  never  materialized.  Furthermore,  the  Company  was
required to make significant design modifications to a new product, which also
                                       18
<PAGE>
resulted in obsolete  inventory.  The Company has since  implemented  procedures
that attempt to balance the benefits of responsiveness to customer needs against
the  risks of  purchasing  inventory  too soon by  discussing,  allocating,  and
sharing inventory risk with its customers.  Without the provision for excess and
obsolete  inventory  taken  in the  third  quarter,  the  cost  of  sales,  as a
percentage of net sales, would have been 84.5 percent for 1996.

         Selling, general, and administrative expense was $5.4 million for 1996,
the same as in 1995. As a result of reduced revenue in 1996,  however,  selling,
general,  and  administrative  expense rose to 8.8 percent of net sales from 5.9
percent of net sales in 1995.

         Research and development  expense totaled $4.1 million,  or 6.7 percent
of net sales,  for 1996 as  compared  with $2.4  million,  or 2.6 percent of net
sales,  for 1995.  Research and  development  expense  consists  principally  of
salaries and benefits to  scientists  and other  personnel,  related  facilities
costs,  including  certain  expenses  associated with the start-up and continued
operations of the LCD line in Tempe, Arizona, and various expenses for projects.
Research and  development  expense has  increased as the Company has invested in
new technologies and manufacturing processes,  developed new potential products,
and  continued  its  in-house  process   development   efforts  related  to  the
high-volume   manufacturing  LCD  line.  The  Company  believes  that  continued
investments in research and development relating to manufacturing  processes and
new display  technology are necessary to remain  competitive in the marketplace,
as well as to provide opportunities for growth.

         Interest  income (net) for 1996 was  $412,000,  down from  $765,000 for
1995. The decrease in interest  income was the result of investing lower average
cash balances  during the year.  Other expenses (net)  increased to $139,000 for
1996 from  $122,000  for 1995.  An increase in closed  facilities  expenses  and
foreign  exchange losses in 1996 was partially offset by decreased net losses on
the sale of assets.

         There was a benefit  from income  taxes of $2.9  million  for 1996,  as
compared to a provision for income taxes of $5.5 million for 1995. This resulted
primarily  from having a loss in 1996 as compared  with  reporting net income in
1995.  The reported  tax rate for the Company in the fourth  quarter of 1996 was
lower than normal  because of an adjustment  related to the  difference  between
1995 tax accruals and taxes actually incurred.  This adjustment was $371,000 and
was  reflected  in the  reduced  tax  provision  in the fourth  quarter of 1996.
Overall,  the tax rate for the Company for 1996 was 43.3  percent as compared to
39.7  percent  for 1995.  The  Company  expects  that the tax rate for 1997 will
approximate 40 percent.

         For 1996, the Company reported a net loss of $3.8 million, or $0.49 per
share, as compared to net income of $8.4 million,  or $1.04 per share, for 1995.
Without  the  provision  for excess and  obsolete  inventory  taken in the third
quarter,  the Company would have  reported net income of $158,000,  or $0.02 per
share in 1996.

Year Ended December 31, 1995 Compared with Year Ended December 31,1994

         Net sales were $91.6  million  during 1995,  an increase of 7.1 percent
compared with net sales of $85.5 million during 1994. The sales increase in 1995
was   primarily  a  result  of  higher   order  rates  from  a  major   wireless
communications  customer for existing as well as new product programs.  The rate
of sales growth decreased significantly in 1995 as compared with 1994, primarily
as a result of the  Company's  inability  to bring two new major  programs  into
production  during the  period,  as well as the loss of sales  from other  older
programs that were being phased out of production.

         Cost of sales, as a percentage of net sales, increased to 77 percent in
1995 as compared  with 69.5 percent in 1994.  This increase was primarily due to
manufacturing inefficiencies from design delays, new program introductions,  and
product mix.

         Selling,  general, and administrative expense increased to $5.4 million
during 1995 from $4.9 million  during 1994. The 10.2 percent  increase  resulted
primarily from expenses related to expanding the Company's sales force,
                                       19
<PAGE>
offset by decreased bonus accruals. Selling, general, and administrative expense
increased as a percentage  of net sales to 5.9 percent for 1995 from 5.7 percent
for 1994.

         Research and development  expense totaled $2.4 million,  or 2.6 percent
of net sales,  in 1995 as  compared  with $1.3  million,  or 1.5  percent of net
sales,  in 1994. The increase in research and  development  expense  represented
in-house  development  efforts related to the LCD laboratory and the high-volume
manufacturing line located in Tempe, Arizona.

         Interest  income (net) for 1995 was  $765,000,  down from  $859,000 for
1994. The decrease in interest  income was the result of investing lower average
cash balances  during the year.  Other  expense (net)  decreased to $122,000 for
1995 from  $135,000 for 1994.  The decrease was due  primarily to decreased  net
foreign  exchange  losses  and  decreased  net losses on  dispositions  of fixed
assets.

         The provision  for income taxes  decreased to $5.5 million in 1995 from
$8.1 million in 1994. This resulted  primarily from lower pre-tax income in 1995
as compared with 1994.

         Net income decreased to $8.4 million,  or $1.04 per share, in 1995 from
$12.5 million, or $1.59 per share, in 1994.

Quarterly Results of Operations

         The following table presents unaudited  consolidated  financial results
for each of the eight  quarters  in the period  ended  December  31,  1996.  The
Company  believes that all necessary  adjustments  have been included to present
fairly the quarterly  information when read in conjunction with the Consolidated
Financial Statements.  The operating results for any quarter are not necessarily
indicative of the results for any subsequent quarter.
<TABLE>
<CAPTION>
                                                                            Quarters Ended
                                      -------------------------------------------------------------------------------------------
                                                         1996                                            1995
                                      -------------------------------------------     -------------------------------------------
                                      Mar 31      June 30     Sept 30      Dec 31     Mar 31     June 30      Sept 30      Dec 31
                                      -------     -------     -------     -------     -------     -------      -------    -------
                                                                (in thousands, except  per share amounts)
<S>                                   <C>         <C>         <C>         <C>         <C>         <C>          <C>        <C>    
Net sales............................ $18,082     $14,457     $13,118     $15,056     $24,483     $22,105      $24,217    $20,780
                                      -------     -------     -------     -------     -------     -------      -------    -------

Costs and expenses:
 Cost of sales.......................  14,401      11,944      19,798      12,178      17,582      16,138       19,790     16,971
 Selling, general, and administrative   1,459       1,471       1,316       1,105       1,272       1,213        1,419      1,482
 Research and development............   1,010         820       1,074       1,161         405         401          770        820
                                      -------     -------     -------     -------     -------     -------      -------    -------
                                       16,870      14,235      22,188      14,444      19,259      17,752       21,979     19,273
                                      -------     -------     -------     -------     -------     -------      -------    -------
Operating income (loss)..............   1,212         222      (9,070)        612       5,224       4,353        2,238      1,507
Other income (expense):
 Interest, net.......................      19         133          90         170         342         279          120         24
 Other, net..........................     (27)        (72)        (17)        (23)        (42)         27          (14)       (93)
                                      -------     -------     -------     -------     -------     -------      -------    -------
Income before provision for
   (benefit from) income taxes.......   1,204         283      (8,997)        759       5,524       4,659        2,344      1,438
Provision for (benefit from)
   income taxes......................     482         113      (3,519)          4       2,210       1,840          961        537
                                      -------     -------     -------     -------     -------     -------      -------    -------
Net income (loss)....................   $ 722       $ 170    $ (5,478)     $  755     $ 3,314     $ 2,819      $ 1,383      $ 901
                                        =====       =====    ========      ======     =======     =======      =======      =====

Earnings (loss) per common share
   and common share equivalent.......   $0.09       $0.02     $(0.70)       $0.09       $0.41       $0.35        $0.17      $0.11
                                        =====       =====    =======       ======     =======     =======      =======      =====
Weighted average number of
  common shares and common
  share equivalents outstanding......   8,040       8,032      7,779        8,049       8,086       8,094        8,088      8,053
</TABLE>
                                       20
<PAGE>
Liquidity and Capital Resources

         During  1996,  the Company  generated  $12.2  million in cash flow from
operations as compared with $1.3 million  during 1995. The increase in cash flow
from  operations  with  substantially  lower  earnings was  primarily due to the
significant increase in the Company's depreciation expense and inventory reserve
provisions,  as well as the substantial reduction of its accounts receivable and
inventory and an increase in its accounts payable and accrued  liabilities.  The
increase  in  depreciation  expense  was  as a  result  of the  start-up  of the
high-volume  LCD  manufacturing  line in Tempe,  Arizona.  The  high-volume  LCD
manufacturing  line is  depreciated  on a units-of-  production  method based on
units started. It is anticipated that depreciation will rise in 1997 as a result
of an expected  higher number of starts for the  high-volume  LCD  manufacturing
line in 1997 versus 1996, as well as having additional  capital  expenditures in
1997. The increase in accrued liabilities  primarily relates to compensation and
customs obligations. The Company's working capital was $21.5 million at December
31, 1996, down slightly from the $22.4 million that it had at December 31, 1995.
The Company's current ratio at December 31, 1996 was 3.2-to-1 as compared with a
current  ratio of 4.0-to-1 at December  31,  1995.  Including  its cash and loan
commitments,  the  Company had over $32  million in readily  available  funds on
December 31, 1996.

         During 1996, the Company's primary financing activity was to repay with
cash flow from  operations  $3  million of debt that was  outstanding  under the
revolving  line of credit at December  31,  1995.  In August  1996,  the Company
modified its $15 million unsecured  revolving line of credit,  which matures May
31, 1997, with its primary lender, Wells Fargo Bank (formerly,  First Interstate
Bank of Arizona).  At December 31, 1996, no borrowings  were  outstanding  under
this credit  facility.  Advances  under the revolving  line may be made as Prime
Rate Advances, which accrue interest payable monthly at the bank's prime lending
rate,  or as LIBOR Rate  Advances  which bear  interest  at 150 basis  points in
excess of the LIBOR Base Rate.  The  Company's  subsidiary,  Three-Five  Systems
Limited,  has  established an annually  renewable  credit facility with a United
Kingdom  bank,  Barclays  Bank  PLC,  in  order  to  fund  its  working  capital
requirements.  The facility provides  $350,000 of borrowing  capacity secured by
accounts  receivable  of  Three-Five  Systems  Limited.  Advances  are  based on
accounts  receivable,  as defined.  Advances  under the credit  facility  accrue
interest,  which is payable  quarterly,  at the bank's  base rate plus 200 basis
points.  The United Kingdom credit  facility  matures June 20, 1997.  Three-Five
Systems  Limited  had no  borrowings  outstanding  under  this line of credit at
December 31, 1996.

         On Monday,  August 19,  1996,  the Board of  Directors  authorized  the
repurchase from time to time of up to one million shares of the Company's Common
Stock on the open  market or in  negotiated  transactions,  depending  on market
conditions and other factors. The closing price of the Company's Common Stock on
Friday,  August 16, 1996, was $8.75. In October 1996, the Company entered into a
new $5 million  non-revolving  line of credit/term loan with Wells Fargo Bank to
provide  financing for the  acquisition  of any treasury  shares (the  "Treasury
Stock Loan").  The Treasury  Stock Loan is available for advances  until October
24, 1997,  followed by a three-year  amortization period in which principal will
be payable  quarterly in equal  installments.  Advances under the Treasury Stock
Loan will be made as either Prime Rate Advances,  which accrue interest  payable
monthly, at the bank's prime lending rate, or as LIBOR Rate Advances, which bear
interest  at 225 basis  points in excess of the LIBOR Base Rate.  At maturity of
the draw period,  the Company may choose either a fixed rate at 250 basis points
in excess of the  Treasury  Rate or a variable  rate of either the Prime Rate or
LIBOR Rate. The Treasury  Stock Loan is secured by all equipment  located in the
state of Arizona and a non-filed  negative  pledge on the Company's  real estate
located in Tempe,  Arizona. The Company must apply all proceeds from the sale of
any treasury stock to the  outstanding  principal  balance of the Treasury Stock
Loan. As of December 31, 1996,  22,500 treasury shares had been purchased by the
Company  at a  total  cost  of  $253,000,  but  the  Company  had no  borrowings
outstanding under the Treasury Stock Loan.

         Capital  expenditures  during  1996  were  approximately  $948,000,  as
compared with $27.1 million during 1995. Capital expenditures for 1996 consisted
primarily of manufacturing and office equipment for the Company's  operations in
Manila and  Arizona and  laboratory  equipment  for  research  and  development.
Expenditures  for 1995  consisted  primarily  of payments  to  complete  its new
manufacturing and headquarters  facility in Tempe,  Arizona as well as equipment
for its operations in Manila and Arizona.  The Company  anticipates that it will
increase its capital
                                       21
<PAGE>
expenditures during 1997, although those capital  expenditures should not have a
significant  effect on the Company's  liquidity because the expenditures  should
not be in excess  of its 1997  depreciation  expense.  Those  expenditures  will
primarily relate to advanced manufacturing  processes, the high-volume LCD line,
and necessary manufacturing equipment.

         The Company  anticipates  that accounts  receivable  and inventory will
rise in 1997 if revenue levels  increase as currently  anticipated.  The Company
believes that its existing  capital and  anticipated  cash flow from  operations
will  provide  adequate  sources to fund  operations  and  planned  expenditures
throughout 1997 without any need for borrowings.  Should the Company  purchase a
significant  amount of treasury shares or encounter  unexpected  additional cash
requirements,  however,  the Company believes that its existing loan commitments
of $20 million  will be  adequate.  The Company  also  expects that its existing
capital,  anticipated cash flow from  operations,  and existing loan commitments
will  provide  adequate   sources  for  its  long-term   liquidity  and  capital
requirements,  such as expansion of its manufacturing  facilities oversees.  The
Company does not anticipate such expansion for two to three years.

Effects of Inflation and Foreign Currency Exchange Fluctuations

         The results of operations of the Company for the periods discussed have
not been significantly  affected by inflation or foreign currency  fluctuations.
The Company  generally  sells its products and services and negotiates  purchase
orders with its foreign suppliers in United States dollars.  An exception is the
Company's sub-assembly  agreement in the Philippines,  which is based on a fixed
conversion  rate,  exposing the Company to exchange rate  fluctuations  with the
Philippine  peso.  Although the Company has not  incurred any material  exchange
gains or losses to date, there can be no assurance that fluctuations in currency
exchange  rates in the future will not have an adverse  effect on the  Company's
operations. The Company from time to time may enter into hedging transactions in
order to minimize its exposure to currency rate fluctuations.

Business Outlook and Risk Factors

         The Company intends to continue its efforts to expand and diversify its
sales base in 1997,  an area in which the Company  believes  that it already has
made significant strides. The Company's major customer,  which had accounted for
as much as 80 percent of the  Company's  business in past years,  accounted  for
only 53 percent of the  Company's  business in the fourth  quarter of 1996.  The
current  business  plan of the Company  targets that  customer to account for no
more than 40 percent of its revenue in 1997. This  percentage  reduction in 1997
is expected to occur for two  reasons.  First,  although  the number of programs
that the Company has with its major  customer  have  continued to increase,  the
average  selling  price of the products  sold to that  customer  have  declined.
Second,  the business plan of the Company  calls for a  substantial  increase in
sales to other  customers.  In 1997, the Company expects that all  communication
products  will  account  for less than 50 percent of its  revenue  with a strong
growth in office automation products.  The Company also is planning to introduce
more  standard  product  lines  late in 1997 in  order  to  mitigate  the  risks
associated  with  custom  design  modules.  Using  the  last  half  of 1996 as a
baseline,  the Company is planning for modest  revenue  growth  during the first
half of 1997 and a more  rapid  growth in the last  half of the  year.  Although
increased  competition  in the display  module  industry  from Asian  suppliers,
partially  as a result of a strong  dollar,  have reduced  margins,  the Company
expects  that a variety  of  factors,  including  a more  diverse  product  mix,
proprietary  products,  and greater  manufacturing  efficiencies  as a result of
increased production,  should enable the Company over time to increase its gross
margins to the low- or mid-twenties as a percentage of revenue.

         As the Company  expands and  diversifies its product and customer base,
it will have to  increase  its selling and  administrative  expenses.  Serving a
myriad of  customers  with  complex  and  differing  issues  requires  increased
personnel committed to those customers. As a result, the actual dollar amount of
the selling,  general,  and  administrative  expenses in 1997 should be 10 to 25
percent greater than in 1996, although SG&A expenditures should decrease in 1997
as a percent of net sales.
                                       22
<PAGE>
         The Company will also continue its research and development efforts. In
1996, the Company expanded and intensified its research and development to focus
on  proprietary   display  products  rather  than  just  manufacturing   process
improvements.  Use of the LCD manufacturing line in Tempe, Arizona is the key to
the  development of these  products,  some of which will be proprietary  and not
available  from other display  manufacturers.  This focus will continue in 1997.
The  Company  believes  that  the key to its  future  is to be a  leader  in the
development of new passive matrix display  technology.  As a result,  the actual
dollar amount of such  expenditures  in 1997 should be 10 to 15 percent  greater
than  in  1996,  although  R & D  expenditures  should  decrease  in  1997  as a
percentage of net sales.

         The  Company's  future  operating  results  may be  affected by various
trends,  developments,  and factors that the Company must successfully manage in
order to achieve its goals.  In addition,  there are trends,  developments,  and
factors  beyond  the  Company's  control  that may affect  its  operations.  The
cautionary  statements  and risk  factors set forth below and  elsewhere in this
document,  and in the Company's  other filings with the  Securities and Exchange
Commission, identify important trends, factors, and currently known developments
that  could  cause  actual  results  to  differ  materially  from  those  in any
forward-looking  statements  contained in this report and in any written or oral
statements of the Company.  Forward-looking  statements  in this report  include
revenue,  margin,  expense,  and  earnings  analysis  for  1997  as  well as the
Company's expectations relating to future design and production orders.

         As noted  previously,  one  customer  is  currently  responsible  for a
majority  of the  Company's  business.  Although  that  customer  is expected to
account for only 40 percent of the  Company's  revenue in 1997,  the majority of
the Company's business in 1997 will still likely come from a core customer base.
For example, it is expected that one of the Company's recent new customers could
account for as much as 20 percent of the Company's  revenue in 1997.  Thus,  any
material delay,  cancellation,  or reduction of orders from one or more of those
core customers could have a material adverse effect on the Company's operations.

         Although  the trend of the Company is to enter into more  manufacturing
contracts with its  customers,  the principal  benefit of these  contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase commitments.  The Company has no firm
long-term  volume  purchase  commitments  from  its  customers.  Thus,  customer
commitments  can be  canceled,  and  expected  volume  levels  can be changed or
delayed.  The timely replacement of canceled,  delayed,  or reduced  commitments
cannot be assured and, among other things,  could result in the Company  holding
excess and obsolete inventory or having  manufacturing  variances as a result of
under-absorption.  These  risks  are  exacerbated  because  a  majority  of  the
Company's  expected  sales  will  be to  customers  in  the  retail  electronics
industry, which is subject to severe competitive pressures,  rapid technological
change, and obsolescence.

         Another  risk,  which  is  inherent  in  custom  manufacturing,  is the
satisfactory  completion of design  services and securing of production  orders.
Completion of the design is dependent on the  customer's  changing needs and not
every design is  successful in meeting  those needs.  In addition,  some designs
test new theories or applications and may not meet the desired results.  Failure
of a design order to achieve the  customer's  desired  results could result in a
material adverse effect on the Company's  operations if the expected  production
order  for  that  product  was  significant.  Finally,  even  when a  design  is
satisfactorily  completed,  the customer may terminate or delay the program as a
result of  marketing  or other  pressures.  It is  expected  that a  significant
portion of the  Company's  anticipated  revenue for 1997 will come from programs
still in the design or pilot production stage at the end of 1996.

         The Company  designs and  manufactures  products  based on firm quotes.
Thus,  the Company  bears the risk of  component  price  increases,  which could
adversely affect the Company's gross margins.  In addition,  the Company depends
on certain  suppliers,  and the  unavailability  or shortage of materials  could
cause  delays or lost  orders,  either of which  could have a  material  adverse
effect on the Company.

         Finally,  the Company's success,  especially in penetrating new markets
and increasing its OEM customer base, depends to a large extent upon the efforts
and abilities of key managerial and technical employees. The loss
                                       23
<PAGE>
of services of certain key personnel could have a material adverse effect on the
Company.  The  Company's  business  also depends upon its ability to continue to
attract and retain senior managers and skilled employees. Failure to do so could
adversely affect the Company's operations.

         As a result of the foregoing  and other  factors,  the Company's  stock
price may be subject to  significant  volatility,  particularly  on a  quarterly
basis.  Any shortfall in revenue or earnings from levels  expected by investors,
analysts,  and brokers could have an immediate and significant adverse effect on
the  trading  price  of  the  Company's   Common  Stock  in  any  given  period.
Additionally,  the  Company  may not learn of such  shortfalls  until  late in a
fiscal quarter,  which could result in an even more immediate and adverse effect
on the trading price of the  Company's  Common Stock.  Finally,  other  factors,
which generally affect the market for stocks of high technology companies, could
cause the price of the Company's  Common Stock to fluctuate  substantially  over
short periods for reasons unrelated to the Company's performance.


ITEM 8.           FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         Reference is made to the financial statements,  the report thereon, the
notes thereto and the supplementary  data commencing at page F-1 of this Report,
which financial  statements,  report,  notes and data are incorporated herein by
reference.

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

         Not applicable.


                                    PART III

ITEM 10.          DIRECTORS AND EXECUTIVE OFFICERS

         The  information  required by this Item  relating to  directors  of the
Company is  incorporated  by reference to the definitive  Proxy  Statement filed
pursuant to  Regulation  14A of the Exchange Act for the  Company's  1997 Annual
Meeting of  Stockholders.  The  information  required  by this Item  relating to
executive  officers of the Company is  included  in  "Description  of Business -
Executive Officers" contained in Item 1 of this Report.


ITEM 11.          EXECUTIVE COMPENSATION

         The  information  required  by this  Item  is  incorporated  herein  by
reference to the definitive  Proxy Statement filed pursuant to Regulation 14A of
the Exchange Act for the Company's 1997 Annual Meeting of Stockholders.


ITEM 12.          SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The  information  required  by this  Item  is  incorporated  herein  by
reference to the definitive  Proxy Statement filed pursuant to Regulation 14A of
the Exchange Act for the Company's 1997 Annual Meeting of Stockholders.


ITEM 13.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Not applicable.
                                       24
<PAGE>
                                     PART IV

ITEM 14.          EXHIBITS AND REPORTS ON FORM 8-K

(a)      Financial Statements and Financial Statement Schedule

         (1)      Financial  Statements  are  listed in the  Index to  Financial
                  Statements on page F-1 of this Report.
         (2)      Financial Statement Schedule:

                  Schedule II Valuation and Qualifying  Accounts and Reserves is
                  set forth on page S-1 of this Report.

         Other  schedules  are  omitted  because  they are not  applicable,  not
required  or  because  required  information  is  included  in the  consolidated
financial statements or notes thereto.

(b)      Reports on Form 8-K

         Not applicable.

(c)      Exhibits

Exhibit
Number                                Exhibits
------                                --------

2                 Amended and Restated Agreement and Plan of Reorganization(1)
3(a)              Restated Certificate of Incorporation of the Company(2)
3(b)              Bylaws of the Company(1)
10(a)             1990 Incentive Stock Option Plan(1)
10(b)             Line of  Credit  Agreements  between  the  Company  and  First
                  Interstate Bank of Arizona, N.A.(3)
10(c)             Line of Credit Agreement  between  Three-Five  Systems Limited
                  and Barclays Bank, PLC(1)
10(d)             Sub-Assembly  Agreement between Three-Five  Systems,  Inc. and
                  TEAM Pacific Corporation dated February 22, 1995(3)
10(g)             Form  of  Three-Five  Systems,   Inc.  Distributor   Franchise
                  Agreement(4)
10(h)             Form  of  Three-Five   Systems,   Inc.  Sales   Representative
                  Agreement(4)
10(j)             1993 Stock Option Plan(4)
10(k)             1994 Automatic Stock Option Plan(5)
10(l)             Lease Agreement  between  Technology  Electronic  Assembly and
                  Management   (T.E.A.M.)  Pacific  Corporation  and  Three-Five
                  Systems Pacific, Inc.(6)
10(m)             Lease  Agreement   between  Regent  Apparel   Corporation  and
                  Three-Five Systems Pacific, Inc.(6)
10(n)             Second  Modification  Agreement between First Interstate Bank,
                  N.A. and  Three-Five  Systems,  Inc.,  together with Revolving
                  Promissory Note for $15,000,000(6)
10(o)             Lease dated April 1, 1994,  between  Papago Park Center,  Inc.
                  and Three-Five Systems, Inc.
10(p)             Third  Modification  Agreement  dated August 5, 1996,  between
                  Wells Fargo Bank of Arizona,  National  Association  (formerly
                  First  Interstate  Bank  of  Arizona,   N.A.)  and  Three-Five
                  Systems, Inc.)
0(q)              Fourth Modification  Agreement dated October 24, 1996, between
                  Wells Fargo Bank of Arizona,  National  Association  (formerly
                  First  Interstate  Bank  of  Arizona,   N.A.)  and  Three-Five
                  Systems, Inc.)
10(r)             Promissory  Note dated  October  24,  1996,  in the  principal
                  amount of $5,000,000  issued by Three- Five Systems,  Inc., as
                  Maker, to Wells Fargo Bank, National Association, as Payee.
                                       25
<PAGE>
Exhibit
Number                                Exhibits
------                                --------


10(s)             Security  Agreement dated October 24, 1996, between Three-Five
                  Systems, Inc. and Wells Fargo Bank, National Association.
11                Statement re: Computation of Per Share Earnings
21                List of Subsidiaries(6)
23                Consent of Arthur Andersen LLP
27                Financial Data Schedule
-------------

(1)      Incorporated by reference to the Registration  Statement on Form S-4 of
         TF Consolidation,  Inc.  (Registration No. 33-33944) as filed March 27,
         1990 and declared effective March 27, 1990.
(2)      Incorporated  by  reference  to the  Registrant's  Form  10-QSB for the
         quarter ended March 31, 1994, as filed with the  Commission on or about
         May 12, 1994.
(3)      Incorporated  by  reference  to the  Registrant's  Form  10-KSB for the
         fiscal year ended  December 31, 1994 filed with the Commission on March
         22, 1995, as amended by Form  10-KSB/A as filed with the  Commission on
         April 28, 1995.
(4)      Incorporated  by  reference to the  Registration  Statement on Form S-1
         (Registration  No. 33-74788) as filed on February 3, 1994, and declared
         effective March 15, 1994.
(5)      Incorporated  by  reference to the  Registration  Statement on Form S-8
         (Registration No. 33-88706) as filed on January 24, 1995.
(6)      Incorporated by reference to the Registrant's  Form 10-K for the fiscal
         year ended December 31, 1995, as filed with the Commission on March 13,
         1996.
                                       26
<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.

                                      THREE-FIVE SYSTEMS, INC.


Date: March 12, 1997                  By /s/ David R. Buchanan                  
                                      ------------------------------------------
                                      David R. Buchanan, Chairman of the Board, 
                                      President, and Chief Executive Officer    
                                      

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

<TABLE>
<CAPTION>
                 Name                                            Title                                 Date
                 ----                                            -----                                 ----

<S>                                      <C>                                                     <C>
/s/ David R. Buchanan                    Chairman of the Board, President,                        March 12, 1997
---------------------------------------  and Chief Executive Officer
David R. Buchanan                        (Principal Executive Officer)

/s/ Jeffrey D. Buchanan                  Vice President - Finance, Administration, and            March 12, 1997
---------------------------------------  Legal; Chief Financial Officer; Secretary;
Jeffrey D. Buchanan                      and Treasurer (Principal Financial and
                                         Accounting Officer)

/s/ David C. Malmberg                    Director                                                 March 12, 1997
---------------------------------------
David C. Malmberg

/s/ Burton E. McGillivray                Director                                                 March 12, 1997
---------------------------------------
Burton E. McGillivray

/s/ Jeffrey A. Wilson                    Director                                                 March 12, 1997
---------------------------------------
Jeffrey A. Wilson

/s/ Gary R. Long                         Director                                                 March 12, 1997
---------------------------------------
Gary R. Long

/s/ Kenneth M. Julien                    Director                                                 March 12, 1997
---------------------------------------
Kenneth M. Julien
</TABLE>
                                                        27
<PAGE>
                            THREE-FIVE SYSTEMS, INC.


                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS






                                                                       Page

Report of Independent Public Accountants .............................. F-2

Consolidated Balance Sheets as of December 31, 1996 and 1995 .......... F-3

Consolidated Statements of Income (Loss) for the years ended
   December 31, 1996, 1995 and 1994.....................................F-4

Consolidated Statements of Stockholders' Equity for the
   years ended December 31, 1996, 1995 and 1994.........................F-5

Consolidated Statements of Cash Flows for the years ended
   December 31, 1996, 1995 and 1994.................................... F-6

Notes to Consolidated Financial Statements .............................F-7
                                      F-1
<PAGE>
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To Three-Five Systems, Inc.:


We have  audited the  accompanying  consolidated  balance  sheets of  THREE-FIVE
SYSTEMS,  INC. (a Delaware corporation) and subsidiaries as of December 31, 1996
and  1995,   and  the  related   consolidated   statements  of  income   (loss),
stockholders'  equity and cash  flows for each of the three  years in the period
ended December 31, 1996. These financial  statements are the  responsibility  of
the Company's  management.  Our responsibility is to express an opinion on these
financial statements based on our audits.

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

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects,  the financial position of Three-Five  Systems,  Inc. and
subsidiaries  as of  December  31,  1996  and  1995,  and the  results  of their
operations  and their cash flows for each of the three years in the period ended
December 31, 1996, in conformity with generally accepted accounting principles.

Our  audits  were  made for the  purpose  of  forming  an  opinion  on the basic
financial  statements  taken as a whole.  The  schedules  listed in the index of
financial statements are presented for purposes of complying with the Securities
and  Exchange  Commission's  rules  and are  not  part  of the  basic  financial
statements.  These  schedules  have been  subjected to the  auditing  procedures
applied in the audits of the basic  financial  statements  and, in our  opinion,
fairly state in all  material  respects the  financial  data  required to be set
forth therein in relation to the basic financial statements taken as a whole.


Arthur Andersen LLP


Phoenix, Arizona,
   January 17, 1997.
                                       F-2
<PAGE>
                            THREE-FIVE SYSTEMS, INC.

                           CONSOLIDATED BALANCE SHEETS

                      (in thousands, except share amounts)



<TABLE>
<CAPTION>
                                                 ASSETS

                                                                                       December 31,
                                                                                 -----------------------
                                                                                    1996          1995
                                                                                 ----------   ----------
<S>                                                                              <C>          <C>       
CURRENT ASSETS:
   Cash and cash equivalents                                                     $   12,580   $    4,551
   Accounts receivable, net (Note 2)                                                  6,830        9,346
   Inventories, net (Note 2)                                                          4,606       13,703
   Deferred tax asset (Note 7)                                                        5,930        1,826
   Other current assets                                                               1,384          491
                                                                                 ----------   ----------

                  Total current assets                                               31,330       29,917

PROPERTY, PLANT AND EQUIPMENT, net (Note 2)                                          30,913       33,493

COST IN EXCESS OF NET ASSETS ACQUIRED, net (Note 2)                                     130          170

OTHER ASSETS (Note 2)                                                                   196          200
                                                                                 ----------   ----------

                                                                                 $   62,569   $   63,780
                                                                                 ==========   ==========

                                  LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
   Accounts payable                                                              $    4,289   $    3,199
   Accrued liabilities (Note 2)                                                       4,524        1,318
   Current maturities of long-term debt (Note 3)                                         -         3,000
   Current taxes payable (Note 7)                                                     1,004           -
                                                                                 ----------   ---------

                  Total current liabilities                                           9,817        7,517
                                                                                 ----------   ----------


DEFERRED TAX LIABILITY (Note 7)                                                       1,568        1,039
                                                                                 ----------   ----------

COMMITMENTS AND CONTINGENCIES (Note 8)

STOCKHOLDERS' EQUITY (Notes 4 and 5):
   Preferred stock, $.01 par value; 1,000,000 shares authorized                          -            -
   Common stock, $.01 par value; 15,000,000 shares authorized, 7,779,829 shares
     issued, 7,757,329 shares outstanding at December 31, 1996; 7,735,745 shares
     issued and outstanding at December 31, 1995                                         78           77
   Additional paid-in capital                                                        32,329       32,286
   Retained earnings                                                                 19,016       22,847
   Cumulative translation adjustment                                                     14           14
   Less- Treasury stock, at cost (22,500 shares)                                       (253)          -
                                                                                 ----------   ----------

                  Total stockholders' equity                                         51,184       55,224
                                                                                 ----------   ----------

                                                                                 $   62,569   $   63,780
                                                                                 ==========   ==========
</TABLE>
                     The accompanying notes are an integral
                   part of these consolidated balance sheets.

                                       F-3
<PAGE>
                            THREE-FIVE SYSTEMS, INC.


                    CONSOLIDATED STATEMENTS OF INCOME (LOSS)

                      (in thousands, except share amounts)
<TABLE>
<CAPTION>
                                                                                 Years Ended December 31,
                                                                        ----------------------------------------
                                                                           1996            1995           1994
                                                                        ----------     ----------      ---------

<S>                                                                     <C>            <C>             <C>      
NET SALES (Notes 2, 6 and 9)                                            $   60,713     $   91,585      $  85,477
                                                                        ----------     ----------      ---------

COSTS AND EXPENSES:
   Cost of sales                                                            58,321         70,481         59,409
   Selling, general and administrative                                       5,351          5,386          4,867
   Research and development                                                  4,065          2,396          1,270
                                                                        ----------     ----------      ---------

                                                                            67,737         78,263         65,546
                                                                        ----------     ----------      ---------

   Operating income (loss)                                                  (7,024)        13,322         19,931
                                                                        ----------     ----------      ---------

OTHER INCOME (EXPENSE):
   Interest, net                                                               412            765            859
   Other, net                                                                 (139)          (122)          (135)
                                                                        ----------     ----------      ---------

                                                                               273            643            724
                                                                        ----------     ----------      ---------

INCOME (LOSS) BEFORE PROVISION FOR
   (BENEFIT FROM) INCOME TAXES                                              (6,751)        13,965         20,655

   Provision for (benefit from) income taxes (Note 7)                       (2,920)         5,548          8,109
                                                                        ----------     ----------      ---------

NET INCOME (LOSS)                                                       $   (3,831)    $    8,417      $  12,546
                                                                        ==========-    ==========      =========

EARNINGS (LOSS) PER COMMON SHARE AND 
 COMMON SHARE EQUIVALENT (Notes 2 and 4):
     Net income (loss)                                                    $ (0.49)       $   1.04        $  1.59
                                                                          =======        ========        =======

WEIGHTED AVERAGE NUMBER OF COMMON
   SHARES AND COMMON SHARE EQUIVALENTS
   OUTSTANDING (Notes 2 and 4)                                           7,765,838      8,083,551      7,882,011
                                                                        ==========     ==========      =========
</TABLE>
                          The accompanying notes are an
                integral part of these consolidated statements.
                                      F-4
<PAGE>
                            THREE-FIVE SYSTEMS, INC.



                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

              FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994

                      (in thousands, except share amounts)

<TABLE>
<CAPTION>
                                                                 Common Stock                                  
                                                       ---------------------------      Additional
                                                           Shares                         Paid-in         Retained       
                                                           Issued          Amount         Capital         Earnings       
                                                       ------------        ------     -------------  -----------------   

<S>                                                    <C>                 <C>        <C>              <C>              
BALANCE, December 31, 1993                                6,641,944         $   66     $    8,243       $    1,884       

     Stock options exercised                                 49,580              1             64               -        
     Tax benefit from early disposition
       of incentive stock options (Note 5)                       -              -             500               -        
     Sale of common stock, net                            1,000,000             10         23,245               -        
     Net income                                                  -              -              -            12,546       
     Translation adjustment                                      -              -              -                -        
                                                       ------------         ------     ----------       ----------       

BALANCE, December 31, 1994                                7,691,524             77         32,052           14,430       

     Stock options exercised                                 44,221             -              32               -        
     Tax benefit from early disposition
       of incentive stock options (Note 5)                       -              -             202               -        
     Net income                                                  -              -              -             8,417       
     Translation adjustment                                      -              -              -                -        
                                                       ------------         ------     ----------       ----------       

BALANCE, December 31, 1995                                7,735,745             77         32,286           22,847       

     Stock options exercised                                 44,084              1             11               -        
     Tax benefit from early disposition
       of incentive stock options (Note 5)                       -              -              32               -        
     Net loss                                                    -              -              -            (3,831)      
     Translation adjustment                                      -              -              -                -        
     Purchase of treasury stock                                  -              -              -                -        
                                                       ------------         ------     ----------       ----------       

BALANCE, December 31, 1996                                7,779,829         $   78     $   32,329       $   19,016       
                                                       ============         ======     ==========       ==========       
</TABLE>
<TABLE>
<CAPTION>
                                               Cumulative                                    
                                               Translation          Treasury                 
                                               Adjustment             Stock          Total   
                                            ----------------    --------------  ----------   
                                                                                             
<S>                                             <C>               <C>           <C>          
BALANCE, December 31, 1993                      $       9         $      -      $    10,202  
                                                                                             
     Stock options exercised                           -                 -               65  
     Tax benefit from early disposition                                                      
       of incentive stock options (Note 5)             -                 -              500  
     Sale of common stock, net                         -                 -           23,255  
     Net income                                        -                 -           12,546  
     Translation adjustment                            (7)               -               (7) 
                                                ---------         ---------     -----------  
                                                                                             
BALANCE, December 31, 1994                              2                -           46,561  
                                                                                             
     Stock options exercised                           -                 -               32  
     Tax benefit from early disposition                                                      
       of incentive stock options (Note 5)             -                 -              202  
     Net income                                        -                 -            8,417  
     Translation adjustment                            12                -               12  
                                                ---------         ---------     -----------  
                                                                                             
BALANCE, December 31, 1995                             14                -           55,224  
                                                                                             
     Stock options exercised                           -                 -               12  
     Tax benefit from early disposition                                                      
       of incentive stock options (Note 5)                               -               32  
     Net loss                                          -                 -           (3,831) 
     Translation adjustment                            -                 -               -   
     Purchase of treasury stock                        -               (253)           (253) 
                                                ---------         ---------     -----------  
                                                                                             
BALANCE, December 31, 1996                      $      14         $    (253)    $    51,184  
                                                =========         =========     ===========  
</TABLE>
                          The accompanying notes are an
                integral part of these consolidated statements.
                                      F-5
<PAGE>
                            THREE-FIVE SYSTEMS, INC.


                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                 (in thousands)
<TABLE>
<CAPTION>
                                                                                     Years Ended December 31,
                                                                           -----------------------------------------
                                                                               1996           1995           1994
                                                                           ----------      ---------      ----------
<S>                                                                        <C>             <C>            <C>       
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income (loss)                                                       $   (3,831)     $   8,417      $   12,546
   Adjustments to reconcile net income to net cash provided
     by operating activities-
       Depreciation and amortization                                            3,551          2,278           1,215
       Provision (recovery) of accounts receivable valuation reserves              47             (1)            205
       Provision for  inventory valuation reserves                              4,015          1,218             857
       Loss on disposal of assets                                                  12             24              54

   Changes in assets and liabilities-
     (Increase) decrease in accounts receivable                                 2,469           (624)         (3,609)
     (Increase) decrease in inventories                                         5,082         (5,264)         (3,406)
     Increase in other assets                                                  (1,070)           (32)           (225)
     Increase (decrease) in accounts payable and accrued liabilities            4,296         (3,170)          1,788
     Increase (decrease) in taxes payable, net                                 (2,358)        (1,568)          1,065
                                                                           ----------      ---------      ----------

                  Net cash provided by operating activities                    12,213          1,278          10,490
                                                                           ----------      ---------      ----------

CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchase of property, plant and equipment                                     (948)       (27,051)         (7,412)
   Proceeds from sale of property, plant and equipment                              5            326               5
                                                                           ----------      ---------      ----------

                  Net cash used for investing activities                         (943)       (26,725)         (7,407)
                                                                           ----------      ---------      ----------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Net proceeds from (payments on) notes payable to banks                      (3,000)         3,000             (17)
   Principal payments on and retirement of long-term debt                          -            (182)            (24)
   Stock options exercised                                                         12             32              65
   Proceeds from sale of common stock, net (Note 4)                                -              -           23,255
   Purchase of treasury stock                                                    (253)            -               -
                                                                           ----------      ---------      ----------

                  Net cash provided by (used for) financing activities         (3,241)         2,850          23,279
                                                                           ----------      ---------      ----------

   Effect of exchange rate changes on cash                                         -              12              (7)
                                                                           ----------      ---------      ----------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                            8,029        (22,585)         26,355

CASH AND CASH EQUIVALENTS, beginning of year                                    4,551         27,136             781
                                                                           ----------      ---------      ----------

CASH AND CASH EQUIVALENTS, end of year                                     $   12,580      $   4,551      $   27,136
                                                                           ==========      =========      ==========

SUPPLEMENTAL CASH FLOW INFORMATION:
   Interest paid                                                           $       60      $      12      $       21
                                                                           ==========      =========      ==========

   Income taxes paid                                                       $    1,832      $   7,296      $    7,103
                                                                           ==========      =========      ==========
</TABLE>
                          The accompanying notes are an
                integral part of these consolidated statements.
                                       F-6
<PAGE>
                            THREE-FIVE SYSTEMS, INC.


                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                        DECEMBER 31, 1996, 1995 AND 1994




(1)   ORGANIZATION:

Three-Five  Systems,  Inc. (the Company) was incorporated  under the laws of the
state of Delaware on February 13, 1990, under the name of TF Consolidation, Inc.
On February 14, 1990, the Company entered into an amended and restated agreement
and plan of  reorganization  providing  for the  merger of  Electronic  Research
Associates, Inc. (ERA; a New Jersey corporation) and Three-Five Systems, Inc. (a
privately  owned  Delaware  corporation)  into the  Company.  The merger  became
effective  May 1, 1990,  following  stockholder  approval.  The  Company was the
surviving  corporation;  the separate corporate existences of ERA and Three-Five
Systems,  Inc. ceased;  and the Company changed its corporate name to Three-Five
Systems, Inc.

The Company designs and manufactures a wide range of user interface  devices for
operational  control and  informational  display  functions  required in the end
products  of  original  equipment  manufacturers.  Most of the  Company's  sales
consist of custom user interface devices developed in close  collaboration  with
its  customers.  The Company  maintains  its primary  manufacturing  facility in
Manila, the Philippines. A third-party subcontractor operates the facility under
a sub-assembly  agreement with the Company  utilizing  equipment,  processes and
documentation  owned by the Company.  The  sub-assembly  agreement has a current
term extending through December 31, 1999, and from year to year thereafter,  but
may be terminated by either party upon 180 days written notice.  The termination
of or  the  inability  of  the  Company  to  obtain  products  pursuant  to  the
sub-assembly  agreement,  even  for a  relatively  short  period,  would  have a
material  adverse  effect on the operations  and  profitability  of the Company.
Since December 1994, the Company has made advances totaling  approximately  $1.7
million to the  subcontractor  to help the  subcontractor in meeting its working
capital  needs.  The balance of the  advances  outstanding  in excess of amounts
payable to the subcontractor at December 31, 1996, was $119,000.  These advances
are secured by future payments for subcontracting services to be provided to the
Company as well as other assets of the subcontractor.

Three-Five Systems Limited (Limited),  a wholly owned subsidiary of the Company,
is  incorporated  in the  United  Kingdom.  Limited  sells and  distributes  the
Company's products to customers on the European continent.

During  1994,  the Company  dissolved  its wholly  owned  subsidiary,  Certified
Electronics Ltd. (CEL). CEL, a Taiwan  corporation,  had procured materials from
Taiwanese vendors. This function is now performed directly by the Company.
                                      F-7
<PAGE>
During 1995, the Company formed a wholly owned  subsidiary,  Three-Five  Systems
Pacific, Inc. (Pacific).  Pacific, a Philippines corporation,  procures supplies
primarily from Philippine vendors.

(2)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

         Principles of Consolidation and Preparation of Financial Statements

The consolidated  financial  statements  include the accounts of the Company and
its wholly-owned subsidiaries.  All material intercompany transactions have been
eliminated.

The preparation of financial  statements in conformity  with generally  accepted
accounting principles requires management to make estimates and assumptions that
affect  the  reported  amounts  of assets  and  liabilities  and  disclosure  of
contingent  assets and  liabilities at the date of the financial  statements and
the  reported  amounts of revenues  and expenses  during the  reporting  period.
Actual results could differ from those estimates.

         Cash and Cash Equivalents

For purposes of the statements of cash flows, all highly liquid investments with
a maturity of three months or less at the time of purchase are  considered to be
cash equivalents. Cash equivalents consist primarily of United States government
agencies'   obligations   classified  as  held-to-maturity  in  accordance  with
Statement of  Financial  Accounting  Standards  (SFAS) No. 115,  Accounting  for
Certain  Investments  in Debt  and  Equity  Securities.  Cash  equivalents  were
$11,243,000   and   $114,000  at  December  31,  1996  and  December  31,  1995,
respectively.

         Inventories

Inventories  are  stated  at the  lower  of cost  (first-in,  first-out)  or net
realizable value. Reserves are established against Company-owned inventories for
excess,  slow-moving  and obsolete  items and for items where the net realizable
value is less than cost. The reserve for obsolete  inventory totaled  $6,782,000
and $2,767,000 at December 31, 1996 and December 31, 1995, respectively.

Inventories at December 31 consist of the following:

                                                 1996           1995
                                              ---------      ----------
                                                    (in thousands)

                  Raw materials               $   3,147      $    9,257
                  Work-in-process                   780           2,002
                  Finished goods                    679           2,444
                                              ---------      ----------
                                              $   4,606      $   13,703
                                              =========      ==========

         Revenue Recognition

The  Company  recognizes  revenues  upon  shipment.  The  Company's  distributor
agreements provide for stock (inventory) rotation and price protection. Reserves
are provided for each of these programs based on past return  experience.  These
reserves  are  established  at the time of  shipment  and reduce  gross sales to
arrive at net sales as presented in the accompanying  
                                      F-8
<PAGE>
consolidated  statements  of income  (loss).  These  reserves are reflected as a
reserve  against  accounts  receivable  from sales to  distributors  and totaled
$89,000 and $140,000 at December 31, 1996 and 1995, respectively.  The Company's
distributors  generally  offset any returns and allowances  against  payments on
accounts  receivable.  The Company  also  provides  reserves  for  uncollectible
accounts  receivable.  These reserves  totaled $560,000 and $463,000 at December
31, 1996 and 1995, respectively. The Company performs ongoing credit evaluations
of all of its  customers  and  considers  various  factors in  establishing  its
allowance for doubtful accounts.

         Property, Plant and Equipment

Property,  plant and equipment is recorded at cost and is generally  depreciated
using the straight-line method over the estimated useful lives of the respective
assets,  which range from 3 to 39 years.  During 1996,  the Company  placed into
service  a  high-volume  LCD  glass  manufacturing  line in its  Tempe,  Arizona
manufacturing facility. The Company is depreciating the LCD glass line using the
units of production method.  Depreciation expense recorded using this method may
be subject to significant  fluctuation  from year to year resulting from changes
in  actual  production  levels  and  ongoing  analysis  of the  capacity  of the
equipment.  Property,  plant  and  equipment  at  December  31  consist  of  the
following:

                                                     1996           1995
                                                  ----------     -----------
                                                        (in thousands)

          Building and improvements               $   10,431     $    10,375
          Furniture and equipment                     28,776          27,971
                                                  ----------     -----------
                                                      39,207          38,346
          Less-accumulated depreciation               (8,294)         (4,853)
                                                  ----------     -----------

                                                  $   30,913     $    33,493
                                                  ==========     ===========

The Company  intends to utilize a  significant  portion of the  high-volume  LCD
glass  manufacturing  line facility to produce a substantial  portion of its own
requirements  for LCD glass.  The successful  utilization  of the  manufacturing
facility  will  require  the  Company  (i) to produce  LCD glass on a timely and
cost-effective basis at quality levels at least equal to the LCD glass available
from  independent  suppliers  and (ii) to utilize  the LCD glass it  produces in
devices it designs and  manufactures in a manner  satisfactory to its customers.
Although   management   believes  that  the   manufacturing   facility  will  be
successfully  utilized,  no  assurance  can be given that the  Company  will not
experience  problems  or  delays in  implementing  or  conducting  its LCD glass
manufacturing operations. Such problems could require the Company to continue to
purchase  its LCD  glass  requirements  from  third  parties  and  result in the
inability  of the  Company  to  recover  its  investment  in  the  manufacturing
facility.

During 1996, the Company  entered into a  transaction,  in which it conveyed its
Tempe,  Arizona  facility  and  certain  improvements  to the  City of  Tempe as
consideration  for a  rent-free  75-year  lease.  The  Company has the option to
repurchase the facility for $1,000 after ten years.
                                      F-9
<PAGE>
         Accrued Liabilities

Accrued liabilities includes accrued compensation of approximately  $988,000 and
$441,000 at December 31, 1996 and 1995, respectively.

         Foreign Currency Translation

Financial information relating to the Company's foreign subsidiaries is reported
in accordance with SFAS No. 52, Foreign Currency  Translation.  The gain or loss
resulting from the  translation of the  subsidiaries'  financial  statements has
been included as a separate  component of stockholders'  equity. The net foreign
currency  transaction  loss in 1996,  1995 and 1994  was  $46,000,  $32,000  and
$41,000,   respectively,  and  has  been  included  in  other  expenses  in  the
accompanying statements of income (loss).

         Earnings (Loss) Per Common Share

Earnings  (loss) per share is computed by dividing  net  earnings  (loss) by the
weighted  average number of common shares and common share  equivalents  assumed
outstanding  during the year.  For the year ended  December 31, 1996,  no common
share  equivalents  were  considered in the calculation of loss per share as the
effect  was   antidilutive.   For  all  other  periods  presented  common  share
equivalents  have been included in the calculation of earnings per share.  Fully
diluted earnings (loss) per share is considered equal to primary earnings (loss)
per share in all periods presented.

         Recently Issued Accounting Standards

The Financial Accounting Standards Board issued SFAS No. 121, Accounting for the
Impairment of  Long-Lived  Assets and for  Long-Lived  Assets to Be Disposed Of,
which  established a new accounting  principle for accounting for the impairment
of certain loans, certain investments in debt and equity securities,  long-lived
assets that will be held and used including certain identifiable intangibles and
goodwill related to those assets, and long-lived assets and certain identifiable
intangibles  to be disposed  of. The  implementation  of SFAS 121 did not have a
material impact on the Company's financial position or results of operations.
                                      F-10
<PAGE>
(3)   LONG-TERM DEBT:

Long-term debt at December 31 consists of the following:
<TABLE>
<CAPTION>
                                                                                    1996           1995
                                                                                 ---------       ---------
                                                                                       (in thousands)
<S>                                                                              <C>             <C>      
         $15,000,000  revolving  line of  credit,  interest  due  monthly at the
         bank's  prime rate  (8.25% at December  31,  1996) or at the LIBOR base
         rate (5.5% to 5.6% at December 31, 1996) plus 1.50%, unpaid balance due 
         May 31, 1997                                                            $      -        $   3,000

         $5,000,000 non-revolving line of credit/term loan, interest due monthly
         at the bank's  prime rate (8.25% at December  31, 1996) or at the LIBOR
         base rate (5.5% to 5.6% at December  31,  1996) plus  2.25%,  principal
         payable in equal  installments  commencing October 1997, unpaid balance
         due October 2000,  secured  by  all  equipment  located in the State of
         Arizona                                                                        -               -

         $350,000 United Kingdom credit facility,  interest due quarterly at the
         bank's base rate (6.00% at December 31, 1996) plus 2%,  unpaid  balance
         due June 20, 1997, secured by United Kingdom accounts receivable               -               -
                                                                                 ---------       ---------
                                                                                        -            3,000
         Less- current maturities                                                       -           (3,000)
                                                                                 ---------       ---------

                                                                                 $      -        $      -
                                                                                 =========       =========
</TABLE>
In August 1996, the Company modified its $15.0 million unsecured  revolving line
of credit which  matures May 31, 1997.  The weighted  average  interest  rate on
borrowings  outstanding  under the line of credit  during  1996 was  7.31%.  The
Company paid down the outstanding balance under the line of credit during fiscal
1996 and had  classified  the  balance as current  on the  accompanying  balance
sheets as of December 31, 1995.

In October 1996, the Company entered into a $5.0 million  non-revolving  line of
credit/term  loan to provide  financing for the acquisition of treasury  shares.
The amount of the term loan is available  for advances  until  October 24, 1997,
followed by a three-year  amortization period in which principal will be payable
quarterly in equal  installments.  Advances  under the term loan will be made as
either Prime Rate Advances, which accrue interest payable monthly, at the bank's
prime lending  rate, or as LIBOR Rate Advances  which bear interest at 225 basis
points in excess of the LIBOR  Base  Rate.  At the end of the draw  period,  the
Company  may  choose  either a fixed  rate at 250 basis  points in excess of the
Treasury  Rate or a variable  rate of either the Prime Rate or LIBOR  Rate.  The
term loan will be secured by all equipment located in the State of Arizona.  The
Company  must  apply all  proceeds  from the sale of any  treasury  stock to the
outstanding principal balance of the term loan.
                                      F-11
<PAGE>
The lines of credit contain certain restrictive  covenants which include,  among
other things,  restrictions  on the  declaration or payment of dividends and the
amount of capital expenditures. The lines also require the Company to maintain a
specified net worth, as defined, to maintain a required debt to equity ratio and
to maintain certain other financial ratios.

Advances  under  the  United  Kingdom  credit  facility  are  based on  accounts
receivable,  as defined.  Management  intends to renew the United Kingdom credit
facility and does not anticipate any material changes to the existing terms.

(4)   STOCKHOLDERS' EQUITY:

During 1994, the Company's Board of Directors declared a two-for-one stock split
effected  in the form of a 100  percent  stock  dividend  whereby  the number of
common  shares  outstanding  was  increased  from  3,824,622 to  7,649,244.  The
3,824,622  additional shares of common stock were distributed on May 4, 1994, to
holders of record on April 22, 1994.  All share  amounts and per share data have
been  restated for all periods  presented  to reflect  this split.  In addition,
during 1994, the Company's stockholders approved an amendment to the Certificate
of  Incorporation  which  increased the authorized  shares of common stock,  par
value  $.01  per  share,   from  5,000,000  to  15,000,000  and  eliminated  the
authorization  to issue  shares of Class A Preferred  stock,  par value $.01 per
share,  Class B Preferred  stock, no par value, and Class C Preferred stock, par
value $.01 per share.  The  Company's  authorized  capital  stock also  includes
1,000,000 shares of serial preferred stock, par value $.01 per share.

In March 1994, the Company  completed a public offering of 2,120,000  shares, of
which  1,000,000  shares of common stock were sold by the Company and  1,120,000
were  sold  by a  selling  stockholder.  Net  proceeds  to the  Company  totaled
approximately $23.3 million, net of issuance costs of $1,745,000.

(5)   BENEFIT PLANS:

The Company has three stock option plans, the 1994 Non-Employee  Directors Stock
Option Plan (1994 Plan),  the 1993 Stock  Option Plan (1993 Plan),  and the 1990
Stock Option Plan (1990 Plan).

         1994 Non-Employee Directors Stock Option Plan

The  Non-Employee  Directors  Stock  Option  Plan (1994 Plan)  provides  for the
automatic  grant of stock  options to  non-employee  directors to purchase up to
100,000  shares.  Under the 1994 Plan,  options to acquire  500 shares of common
stock will be automatically granted to each non-employee director at the meeting
of the  Board of  Directors  held  immediately  after  each  annual  meeting  of
stockholders,  with such options to vest in a series of 12 equal and  successive
monthly installments commencing one month after the annual automatic grant date.
In addition, each non-employee director serving on the Board of Directors on the
date the 1994  Plan was  approved  by the  Company's  stockholders  received  an
automatic  grant of  options to acquire  1,000  shares of common  stock and each
subsequent  newly  elected  non-employee  member of the Board of Directors  will
receive an automatic grant of options to acquire 1,000 shares of common stock on
the date of their first appointment or election to the Board of Directors. Those
options  become  exercisable  and vest in a series of three equal and successive
                                      F-12
<PAGE>
annual  installments,  with the first such installment  becoming  exercisable 13
months after the  automatic  grant date. A  non-employee  member of the Board of
Directors  is not  eligible to receive the 500 share  automatic  option grant if
that option grant date is within 30 days of such  non-employee  member receiving
the 1,000 share automatic  option grant.  The exercise price per share of common
stock  subject to options  granted  under the 1994 Plan will be equal to 100% of
the fair market value of the Company's common stock on the date such options are
granted. There were outstanding options to acquire 9,000 shares of the Company's
common stock under the 1994 Plan at December 31, 1996.

         1993 Stock Option Plan

The 1993 Stock  Option Plan (1993 Plan)  provides for the granting of options to
purchase up to 385,454  shares of the  Company's  common stock  (which  includes
85,454 shares  previously  reserved for issuance  under the Company's 1990 Stock
Option Plan),  the direct granting of common stock (stock awards),  the granting
of stock appreciation  rights (SARs) and the granting of other cash awards (cash
awards) (stock awards, SARs and cash awards are collectively  referred to herein
as  Awards).  Under  the 1993  Plan,  options  and  Awards  may be issued to key
personnel  and  others  providing  valuable  services  to the  Company  and  its
subsidiaries.  The options issued may be incentive stock options or nonqualified
stock options.  If any option or SAR  terminates or expires  without having been
exercised  in full,  stock not  issued  under  such  option or SAR will again be
available for the purposes of the 1993 Plan. There were  outstanding  options to
acquire  197,000  shares of the  Company's  common  stock under the 1993 Plan at
December 31, 1996.

To the extent that granted  options are incentive  stock options,  the terms and
conditions  of  those  options  must  be  consistent   with  the   qualification
requirement set forth in the Internal Revenue Code of 1986. The expiration date,
maximum  number of shares  purchasable  and the other  provisions of the options
will be established at the time of grant. Options may be granted for terms of up
to ten years and become  exercisable in whole or in one or more  installments at
such  time as may be  determined  by the plan  administrator  upon  grant of the
options.  The  exercise  prices  of  options  will  be  determined  by the  plan
administrator,  but may not be less than 100 percent  (110 percent if the option
is granted  to a  stockholder  who at the time the option is granted  owns stock
representing  more than ten percent of the total  combined  voting  power of all
classes of stock of the Company) of the fair market value of the common stock at
the time of the grant.  The 1993 Plan will  remain in force until  February  24,
2003.

         1990 Stock Option Plan

In conjunction with the 1990 merger with ERA, the Three-Five Systems,  Inc. 1987
Incentive  Stock Option Plan (1987 Plan) was replaced with a new Incentive Stock
Option Plan ("1990 Plan"). Options issued under the 1987 Plan were assumed under
the 1990  Plan.  Under the 1990  Plan,  there are  345,776  options  issued  but
unexercised as of December 31, 1996. In conjunction with stockholder approval of
the 1993 Plan,  the Board  terminated  the 1990 Plan with  respect  to  unissued
options to  purchase  85,454  shares of common  stock  which  remained  and were
unissued as of the date the 1993 Plan was adopted.  The 1990 Plan will remain in
force through May 1, 2000.
                                      F-13
<PAGE>
The  expiration  date,  maximum  number  of  shares  purchasable,  and the other
provisions of the options  granted under the 1990 Plan were  established  at the
time of grant.  Options  were  granted  for terms of up to ten years and  become
exercisable  in  whole  or in one or more  installments  at such  times  as were
determined by the Board of Directors upon grant of the options.

The exercise price of incentive stock options granted and assumed under the 1990
Plan range from $0.255 to $1.595 per share.  These exercise  prices are not less
than 100% (110% if the option was granted to a  stockholder  who at the time the
option was granted owned stock  representing more than 10% of the total combined
voting  power of all classes of stock of the  Company) of the closing  price the
day before the date of original grant.

Tax benefits from early  disposition of common stock by optionees under the 1993
and 1990 Plans and from the  exercise of  non-qualified  options are credited to
additional paid-in capital.

Pursuant  to  the  provisions  of  SFAS  No.  123,  Accounting  for  Stock-Based
Compensation,  the Company accounts for transactions with its employees pursuant
to Accounting  Principles  Board Opinion No. 25,  Accounting for Stock-Issued to
Employees,   under  which  no  compensation   cost  has  been  recognized.   Had
compensation cost for these plans been determined  consistent with SFAS No. 123,
the Company's net income (loss) and earnings (loss) per share would have been as
follows (in thousands, except per share data):

                                                   1996              1995
                                                -----------      -----------

         Net income (loss):    As reported       $ (3,831)        $   8,417
                               Pro forma           (4,076)            8,327

         Earnings (loss)
           per share:          As reported       $ (0.49)         $    1.04
                               Pro forma           (0.52)              1.03

The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes   option   pricing  model  with  the  following   weighted-average
assumptions for grants in 1996 and 1995, respectively:  risk-free interest rates
of 6.31%  for all  Plans  for both  years;  expected  dividend  yields  of zero;
expected lives of 6.1 and 5.7 years for all Plans options;  expected  volatility
(a measure  of the  amount by which a price has  fluctuated  or is  expected  to
fluctuate during a period) of 61.9% and 58.7%.

Because the SFAS No. 123 method of  accounting  has not been  applied to options
granted prior to January 1, 1995, the resulting pro forma  compensation cost may
not be  representative  of that to be expected  in future  years.  The  weighted
average fair value of shares sold in 1996 was $11.66.
                                      F-14
<PAGE>
A summary of the status of the  Company's  three stock  option plans at December
31, 1996 and 1995 and changes  during the years then ended is  presented  in the
table and narrative below:

<TABLE>
<CAPTION>
                                                                 1996                           1995
                                                     -----------------------------  ------------------------------
                                                                       Weighted                       Weighted
                                                                        Average                        Average
                                                                       Exercise                       Exercise
                                                         Shares          Price         Shares           Price
                                                     -------------     -----------  -------------    -------------

<S>                                                   <C>              <C>          <C>              <C>      
   Outstanding at beginning of year                        539,576     $    8.06          465,326    $    4.68
   Granted                                                 250,100     $   11.89          178,000    $   22.15
   Exercised                                               (44,900)    $    0.49          (44,250)   $    0.75
   Expired                                                (193,000)    $   18.04          (59,500)   $   29.24
                                                     -------------                  -------------

         Outstanding at end of year                        551,776     $    6.92          539,576    $    8.06
                                                     -------------                  -------------

   Exercisable at end of year                              294,982     $    2.40          308,940    $    1.31
                                                     =============                  =============
   Weighted average fair value of
     options granted                                   $    7.57                      $   13.19
                                                       =========                      =========
</TABLE>
Of the 551,776 options  outstanding at December 31, 1996,  268,276 have exercise
prices between $0.25 and $9.00,  with a weighted average exercise price of $1.01
and a  weighted  average  remaining  contractual  life of 3.8  years.  Of  these
options,  267,776 are  exercisable  with a weighted  average  exercise  price of
$1.01.  Of the 551,776  options  outstanding at December 31, 1996,  277,000 have
exercise prices between $9.00 and $20.00, with a weighted average exercise price
of $12.15 and a weighted  average  remaining  contractual  life of 8.2 years. Of
these options,  22,374 are exercisable with a weighted average exercise price of
$13.54.  Of the 551,776  options  outstanding  at December 31, 1996,  6,500 have
exercise  prices between  $20.00 and $34.38,  with a weighted  average  exercise
price of $27.89 and a weighted average remaining  contractual life of 7.6 years.
Of these options,  4,832 are exercisable  with a weighted average exercise price
of $27.56.  No  dividends  were  declared  during the periods used in the option
pricing method.

         401(k) Profit Sharing Plan

Effective  September 1, 1990, the Company  adopted a profit sharing plan (401(k)
Plan)  pursuant to Section  401(k) of the  Internal  Revenue  Code of 1986.  The
401(k)  Plan  covers   substantially  all  full-time   employees  who  meet  the
eligibility  requirements  and  provides  for  a  discretionary  profit  sharing
contribution  by  the  Company  and an  employee  elective  contribution  with a
discretionary  Company matching  provision.  The Company expensed  discretionary
contributions  pursuant  to the 401(k)  Plan in the amount of  $65,000,  $0, and
$94,000 for the years ended December 31, 1996, 1995, and 1994, respectively.

(6)   MAJOR CUSTOMERS:

The Company's  strategy  involves  concentrating its efforts on providing design
and production services to leading companies in a limited number of fast growing
industries.  Sales to the Company's  largest customer are made through 12 buyers
operating in five separate product
                                      F-15
<PAGE>
divisions.  During 1996, the Company  manufactured  approximately  42 individual
products for this  customer.  The  percentage of net sales to this customer were
65%, 81% and 84% during the fiscal years ended December 31, 1996, 1995 and 1994,
respectively.

The  significant  amount  of sales  to a  single  customer  results  in  certain
concentrations of credit risk for the Company. The Company's accounts receivable
balance, including the accounts receivable of the Company's largest customer, is
comprised of a large  number of  customers,  primarily  in the  cellular  phone,
computer hardware and other electronic products industries.  These customers are
located primarily in the United States and Europe.

(7)   INCOME TAXES:

SFAS No. 109,  Accounting  for Income  Taxes,  requires  the use of an asset and
liability  approach in  accounting  for income  taxes.  Deferred  tax assets and
liabilities  are  recorded  based  on  the  differences  between  the  financial
statement  and tax bases of assets and  liabilities  and the tax rates in effect
when these differences are expected to reverse.

The provision  for income taxes for the years ended  December 31 consists of the
following:
<TABLE>
<CAPTION>
                                                                              1996          1995         1994
                                                                          ----------    ----------      --------
                                                                                      (in thousands)
<S>                                                                       <C>           <C>             <C>     
         Current, net of operating loss carryforwards
           and tax credits utilized
                Federal, net of tax benefit from early
                  termination of incentive stock options                  $      556    $    2,775      $  5,102
                State                                                             58           790         1,389
                Foreign                                                            9         1,681         1,403
                                                                          ----------    ----------      --------
                                                                                 623         5,246         7,894

         Deferred provision (benefit)                                         (3,575)          100          (285)
         Tax benefit from early termination of incentive
           stock options, reflected in stockholders' equity                       32           202           500
                                                                          ----------    ----------      --------

                Provision (benefit) for income taxes                      $   (2,920)   $    5,548      $  8,109
                                                                          ==========    ==========      ========
</TABLE>
In  accordance  with SFAS No.  109, a tax benefit  for net  operating  losses of
approximately  $102,000,  $67,000, and $363,000 and tax credits of approximately
$938,000,   $1,478,000,   and  $537,000   utilized  in  1996,   1995  and  1994,
respectively,  are included as a reduction of the  provision for income taxes in
the consolidated statements of income.
                                      F-16
<PAGE>
The components of deferred taxes at December 31 are as follows:
<TABLE>
<CAPTION>
                                                                              1996           1995
                                                                           ---------       --------
                                                                                 (in thousands)
<S>                                                                        <C>             <C>     
         Net long-term deferred tax liabilities:
           Accelerated tax depreciation                                    $   1,535       $  1,002
           Other                                                                  33             37
                                                                           ---------       --------

                                                                           $   1,568       $  1,039
                                                                           =========       ========
         Net short-term deferred tax assets:
           Tax effect of regular U.S. net operating loss carryforward      $     189       $    212
           Inventory reserve                                                   3,755          1,080
           Uniform capitalization                                              1,868            456
           Allowance for doubtful accounts                                       196            159
           Other                                                                  76            101
                                                                           ---------       --------
                                                                               6,084          2,008
           Valuation allowance                                                  (154)          (182)
                                                                           ---------       --------

                                                                           $   5,930       $  1,826
                                                                           =========       ========
</TABLE>
SFAS No. 109  requires  the  reduction  of  deferred  tax assets by a  valuation
allowance if, based on the weight of available evidence,  it is more likely than
not that some or all of the  deferred  tax  assets  will not be  realized.  As a
result of certain  limitations  on the use of net operating  loss  carryforwards
acquired in the ERA acquisition,  a valuation allowance has been established for
those net operating losses not likely to be realized.

A reconciliation of the U.S. federal  statutory rate to the Company's  effective
tax rate is as follows:

                                            1996         1995            1994
                                           ------       ------          ----

         Statutory federal rate                34%          34%            35%
         Effect of foreign operations          -            -               4
         Effect of state taxes                  6            6              7
         Effect of tax credits                 -            -              (7)
         Other                                  3           -              -
                                           ------       ------          -----

                                               43%          40%            39%
                                           ======       ======          =====

Net operating loss carryforwards for federal tax purposes totaled  approximately
$557,000 at December  31,  1996.  The use of these  carryforwards  is limited to
$67,000 per year and they expire through 2003.

(8)   COMMITMENTS AND CONTINGENCIES:

In March 1995, the Company entered into a non-cancelable operating lease for its
primary  manufacturing  facility in Manila,  the Philippines.  The lease expires
December  31, 1999.  In April 1995,  the Company  entered into a  non-cancelable
operating  lease  for  an  additional  manufacturing  facility  in  Manila,  the
Philippines. The lease expires March 31, 1997.
                                      F-17
<PAGE>
Rent  expense was  approximately  $477,000,  $683,000 and $280,000 for the years
ended December 31, 1996, 1995, and 1994, respectively.

In April 1994, the Company  entered into a ground lease (with purchase  options)
on a 5.7 acre site in Tempe,  Arizona.  Annual lease  payments  under the ground
lease,  which will expire on March 31,  2069,  subject to renewal  and  purchase
options as well as termination  provisions,  will average approximately $100,000
over the term of the lease  subject  to  certain  escalation  provisions.  A new
design,   manufacturing,   and  corporate   headquarters   facility   containing
approximately  97,000 square feet was completed on the land in 1995 at a cost of
approximately $10.4 million.

The Company's future lease commitments under the non-cancelable operating leases
as of December 31, 1996, are as follows:

                  1997                                 $     377,000
                  1998                                       357,000
                  1999                                       357,000
                  2000                                       100,000
                  2001                                       100,000
                  Thereafter                               6,725,000
                                                       -------------
                                                       $   8,016,000
                                                       =============

On January 24, 1991, the Company  received from the United States  Environmental
Protection Agency (EPA) a notice of potential  liability at the  Barkhamsted-New
Hartford Landfill site in Barkhamsted, Connecticut. The notice was to notify the
Company of its  potential  liability  with  respect to the site and  request the
Company's voluntary participation in undertaking cleanup activities at the site.
On January 9, 1992,  the Company  received an  additional  104(e)  questionnaire
which was completed and submitted during 1992. This matter is still in discovery
and  therefore,  the Company and its  consultants  are unable to  determine  the
outcome or potential range of loss, if any.

The  Company is involved in certain  administrative  proceedings  arising in the
normal course of business. In the opinion of management, the Company's potential
exposure under the pending administrative proceedings is adequately provided for
in the accompanying financial statements.
                                      F-18
<PAGE>
(9)   GEOGRAPHIC SEGMENTS:

Sales by geographic  area and  identifiable  assets for the years ended December
31, 1996, 1995, and 1994 were as follows:
<TABLE>
<CAPTION>
                                      North
                                     America      Europe       Taiwan      Pacific Rim  Eliminations    Consolidated
                                    --------     ---------    ---------     --------     ----------       --------
                                                                    (in thousands)
<S>                                 <C>          <C>          <C>           <C>          <C>              <C>      
December 31, 1996
   Net sales                        $ 32,899     $  27,814    $      -      $     -      $       -        $  60,713
   Transfers to Europe                25,810            -            -            -         (25,810)             -
   Transfers to North America             -             -            -         1,494         (1,494)             -
                                    --------     ---------    ---------     --------     ----------       --------

   Total revenue                    $ 58,709     $  27,814    $      -      $  1,494     $  (27,304)      $  60,713
                                    ========     =========    =========     ========     ==========       =========
   Net income                       $ (4,005)    $      19    $      -      $     12     $      143       $  (3,831)
                                    ========     =========    =========     ========     ==========       =========
   Identifiable assets              $ 52,951     $   3,824    $      -      $  6,164     $     (370)      $  62,569
                                    ========     =========    =========     ========     ==========       =========

December 31, 1995:
   Net sales                        $ 24,235     $  67,350    $      -      $     -      $       -        $  91,585
   Transfers to Europe                60,361            -            -            -         (60,361)             -
   Transfers to North America             -             -            -         1,437         (1,437)             -
                                    --------     ---------    ---------     --------     ----------       --------

           Total revenue            $ 84,596     $  67,350    $      -      $  1,437     $  (61,798)      $  91,585
                                    ========     =========    =========     ========     ==========       =========

   Net income (loss)                $  5,093     $   3,353    $      -      $    (46)    $       17       $   8,417
                                    ========     =========    =========     ========     ==========       =========
   Identifiable assets              $ 50,779     $   8,491    $      -      $  7,789     $   (3,279)      $  63,780
                                    ========     =========    =========     ========     ===========      =========

December 31, 1994:
   Net sales                        $ 33,774     $  51,703    $      -      $     -      $       -        $  85,477
   Transfers to Europe                46,813            -            -            -         (46,813)             -
   Transfers to North America             -             -         1,750           -          (1,750)             -
                                    --------     ---------    ---------     --------     ----------       --------

   Total revenue                    $ 80,587     $  51,703    $   1,750     $     -      $  (48,563)      $  85,477
                                    ========     =========    =========     ========     ==========       =========
   Net income (loss)                $ 12,668     $    (457)   $     637     $     -      $     (302)      $  12,546
                                    ========     =========    =========     ========     ==========       =========
   Identifiable assets              $ 48,743     $   7,912    $       2     $  4,292     $   (4,669)      $  56,280
                                    ========     =========    =========     ========     ==========       =========
</TABLE>
                                      F-19
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
          SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
              FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
<TABLE>
<CAPTION>
                                           Balance at       Charged to        Charged to                           Balance
                                           Beginning        Costs and            Other                             at End
                                           of Period        Expenses           Accounts           Other           of Period
                                           ---------        --------           --------           -----           ---------
                                                                            (in thousands)
Allowance for doubtful
accounts and sales
returns and allowances:
-----------------------

<S>                                        <C>               <C>               <C>             <C>                 <C>   
Year ended December 31, 1996                  $603               14              32   (1)           --                $649

Year ended December 31, 1995                  $604              (36)             35   (1)           --                $603

Year ended December 31, 1994                  $399              248             (60)  (1)           17  (2)           $604


Inventory Reserve:
------------------

Year ended December 31, 1996                $2,767            5,939             142   (4)       (2,066) (3)         $6,782

Year ended December 31, 1995                $1,548            1,563             391   (4)         (735) (3)         $2,767

Year ended December 31, 1994                  $691            1,855              78   (4)       (1,076) (3)         $1,548
</TABLE>
-----------------------

(1)  Actual return activity
(2)  Accounts written off
(3)  Obsolete inventory written off
(4)  Inventory adjustments
                                       S-1