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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                    FORM 10-K


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

(Mark One)
[ X ]    Annual report pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934.
                   For the fiscal year ended December 31, 1998

                                       or

[    ]   Transition report pursuant to section 13  or 15(d) of the Securities
         Exchange Act of 1934.
                 For the transition period from ______ to ______

                         COMMISSION FILE NUMBER 0-26778


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

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


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

          WASHINGTON                                      91-1074996
(State of incorporation)                 (I.R.S. Employer Identification Number)

             5020 148TH AVENUE N.E. , REDMOND, WASHINGTON 98052-5172 
                                (425) 882-2000
(Address, including zip code, of Registrant's principal executive offices and
telephone number, including area code)


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

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

          Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of the Form 10-K or any
amendment to this form 10-K. (1)

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

Common stock: 6,680,688 shares outstanding as of March 19, 1999

         The aggregate market value of the Common Stock held by non-affiliates
of the registrant, based on the closing price on March 19, 1999, as reported on
NASDAQ, was $10,786,791. (1)

       (1) Excludes shares held of record on that date by directors, officers
and greater than 10% shareholders of the registrant. Exclusion of such shares
should not be construed to indicate that any such person directly or indirectly
possesses the power to direct or cause the direction of the management of the
policies of the registrant.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Portions of the registrant's Proxy Statement relating to the
registrant's 1999 Annual Meeting of Stockholders to be held on May 25, 1999, are
incorporated by reference into Part III of this Report.

         This report including exhibits consists of 50 pages. The exhibit index
appears on page 46.


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                                TABLE OF CONTENTS

<TABLE>
<CAPTION>

                                                                                                               PAGE


PART I.

<S>          <C>                                                                                              <C>
ITEM 1.       Business............................................................................................1

ITEM 2.       Properties.........................................................................................11

ITEM 3.       Legal Proceedings..................................................................................11

ITEM 4.       Submission of Matters to a Vote of Security Holders................................................11

ITEM 4A.      Executive Officers of the Registrant...............................................................11


PART II.

ITEM 5.       Market for Registrant's Common Equity and Related Stockholder Matters..............................13

ITEM 6.       Selected Financial Data............................................................................14

ITEM 7.       Management's Discussion and Analysis of Financial Condition and Results of
              Operations.........................................................................................14

ITEM 7A.      Qualitative and Quantitative Disclosures about Market Risk.........................................21

ITEM 8.       Financial Statements and Supplementary Data........................................................22

ITEM 9.       Changes in and Disagreements with Accountants on Accounting and Financial
              Disclosure.........................................................................................42


PART III.

ITEM 10.      Directors and Executive Officers of the Registrant.................................................42

ITEM 11.      Executive Compensation.............................................................................42

ITEM 12.      Security Ownership of Certain Beneficial Owners and Management.....................................42

ITEM 13.      Certain Relationships and Related Transactions.....................................................42


PART IV.

ITEM 14.      Exhibits, Financial Statement Schedules, and Reports on Form 8-K...................................43
</TABLE>



                                       -i-


<PAGE>




                                     PART I


ITEM 1.           BUSINESS

OVERVIEW

         Applied Microsystems Corporation is a leader and innovator in embedded
systems solutions. Applied develops, markets and supports a comprehensive suite
of software and hardware enhanced development and test tools and engineering
services for the development of complex embedded microprocessor based
applications. Embedded systems are used extensively in industries such as
avionics, internetworking, telecommunications, computer peripherals, office
products, medical instrumentation and industrial process control, as well as in
consumer markets such as the automotive and entertainment industries. Embedded
systems are found in a wide variety of products, including automotive braking
systems, hospital patient monitors, airplane flight control systems, modems and
facsimile machines, set-top boxes, cellular telephones, automated teller
machines and video games.

         Applied's solutions enhance manufacturers' productivity which 
improves their product's "time-to-market". Applied does this by providing a 
set of solutions that are useful throughout a product's lifecycle. Applied's 
debug solutions assist customers with the development of software and the 
integration of software and hardware in creating the embedded product. These 
tools include low-cost solutions, such as CodeTAP-Registered Trademark- and 
NetROM-TM- tools, and full-featured tools such as our patented, compact 
SuperTAP-TM- emulator. Applied's CodeTEST-Registered Trademark- optimization 
and test solutions give customers a way to enhance the performance and 
quality of their designs. Rapid Evaluation and Development Solutions 
integrate all the main components of a productive development environment: 
software tools, board support packages and intellectual property, operating 
on a reference hardware platform for quick prototyping. Applied's consulting 
services group provides customers with solutions to fit their unique 
development environment, toolchain and real time operating systems as well as 
actual design services.

         Applied distributes its solutions through a network of direct sales and
service offices located in the United States, Japan, and Europe, and
distributors throughout the rest of the world. A sampling of Applied's customers
include Alcatel, Ascend, Boeing, Cabletron, Canon, Cisco, DSC Communications,
Eastman Kodak, Fujitsu, General Instruments, Hewlett Packard, Hitachi,
Honeywell, IBM, International Games Technology, Lucent, Matsushita, Mitsubishi,
Motorola, NEC, Newbridge, Nortel, NTT, OKI Electric, Panasonic, Qualcomm, Ricoh,
Rockwell, Samsung, Siemens, Storage Technology, Tellabs, Toshiba, and Xerox.

         Applied was incorporated in Washington in 1979 and is headquartered at
5020 148th Avenue. NE, Redmond, Washington. The Company is ISO 9002 certified.
For more information, visit Applied's home page on the World Wide Web:
http://www.amc.com.


BACKGROUND

         Manufacturers worldwide are making increasing use of embedded systems
to enhance the functionality and performance, reduce the cost and size, and
improve the reliability of a broad variety of products. Embedded systems are
incorporated within electronic devices and are dedicated to performing specific
tasks quickly and reliably in response to rapidly occurring external events.
Embedded systems generally include an embedded microprocessor (often referred to
as a microcontroller or MCU), a read-only memory ("ROM"), real-time operating
system ("RTOS") software and custom software to implement assigned applications.
Embedded systems are used extensively in industries such as avionics,



                                      -1-
<PAGE>

internetworking, telecommunications, computer peripherals, office products,
medical instrumentation and industrial process control, as well as in consumer
markets such as the automotive and entertainment industries. For example,
cellular telephone switching systems use embedded systems to coordinate the
routing and connection of thousands of simultaneous calls as users move from
cell to cell. Use of embedded systems is now widespread among manufacturers of a
wide variety of products, including automotive braking systems, hospital patient
monitors, airplane flight control systems, modems and facsimile machines,
set-top boxes, cellular telephones, automated teller machines and video games.

         Manufacturers are faced with an expanding competitive market that
requires them to bring ever increasing complex products to market faster and at
reduced costs. As the computing power of embedded microprocessors has grown and
moved toward 32-bit architectures, and as unit prices for embedded
microprocessors have declined, manufacturers have been able to incorporate
vastly improved features, speed and reliability into their products at
relatively low incremental cost. This additional sophistication has resulted in
significantly larger and more complicated applications software and increased
the challenges associated with delivering a product on schedule.

         The development of embedded systems using today's high-speed
microprocessors requires the design, debugging and testing of substantial
amounts of complex custom applications software ("embedded software"), which is
typically written in a high-level programming language such as C or C++. As the
complexity and volume of such software increases, the need to eliminate
performance shortcomings, the potential for programming errors, and the
difficulty of thoroughly testing the complete system all increase dramatically.
As embedded systems are used increasingly in medical diagnostic equipment,
avionics systems, communications and other applications where software errors
may have serious consequences, the need for careful debugging and testing of
embedded software increases.

         In their efforts to remain competitive, manufacturers are increasingly
faced with the demands of two fundamental but conflicting pressures. As they
incorporate increasing numbers of 32-bit embedded microprocessors into their
products, these manufacturers must hire more software engineers, develop more
embedded software, and intensify their debugging and testing efforts, all of
which tend to lengthen product development cycles or increase development costs.
At the same time, competitive demands for technologically superior products
without corresponding cost increases and decreasing electronics product life
cycles create pressures to minimize development costs and time-to-market.
Applied's solutions are designed to help electronics manufacturers respond
successfully to both of these conflicting demands.

PRODUCTS

         Applied provides design, debugging and testing tools and services for
use principally by software engineers in the development of embedded software
and associated products. Applied designs its products to support major industry
segments over a broad range of 16- and 32-bit embedded microprocessors primarily
manufactured by AMD, ARM, Intel, Hitachi, MIPS and Motorola. The Company's
products are designed to address three distinct requirements of embedded
software developers: software design and debugging, optimization and testing,
and services.

         The Company's products generally enable engineers to perform debugging
functions in high-level programming languages, such as C or C++, and operate on
IBM-compatible personal computers or engineering workstations produced by
Hewlett-Packard or Sun Microsystems. The Company's tools also enable engineers
to observe software interaction and functions with several commercially
available RTOS products (including certain of those produced by Integrated
Systems, Mentor Graphics, Microsoft and Wind River Systems) and to read file
format output from compatible compilers (including certain of those produced by
Borland, GNU, Intel, Metrowerks and Microsoft).



                                      -2-
<PAGE>


SOFTWARE DESIGN AND DEBUGGING TOOLS

         The Company manufactures a wide range of hardware-enhanced software
tools for the design and debugging of embedded software. These in-circuit
microprocessor and ROM emulators are utilized primarily by software engineers
during the highly iterative software development and system integration phases
of the embedded systems development process. To a lesser extent, they are also
used by software engineers for low-level testing of software functions and by
hardware engineers in system integration and troubleshooting their designs.

         The Company's emulators perform four basic functions or subset thereof
depending on product configuration:

           -   DOWNLOAD AND RUN CONTROL--the ability to load the developer's
               software program into the system under development, to specify
               predetermined events or problems that may occur in the course of
               software execution, to stop system operation upon such an
               occurrence and to resume operation at the desired point after any
               alterations have been made to the system or software.

          -    EXECUTION TRACE--the ability to detect, observe and provide an
               execution history of detailed software instructions and flow by
               collecting this data in a minimally intrusive manner in the
               probe's random access memory, a capability particularly important
               in identifying bugs or timing problems, or in reconstructing the
               events leading up to a system failure.

          -    OVERLAY MEMORY--the ability to replace the system's memory
               with memory residing in the emulator where embedded software can
               be debugged and modified easily before it is permanently "burned
               into" the system's ROM.

          -    HIGH-LEVEL LANGUAGE DEBUGGING--the ability to display source
               code, data and relevant RTOS information, and to control each of
               the tool's other basic functions through a high-level language
               interface to the system under development.

         Applied offers a broad selection of hardware-enhanced software design
and debugging tools with a variety of features and prices. The tools are
accessed through a high level language debugger human interface licensed from
CAD UL, Mentor Graphics, Metrowerks, or Paradigm and generally resold with the
product. The market segments for these tools are broken down into low cost,
feature focused products and high end, high cost products.

         The low cost, feature focused products consist of CodeTAP and SuperTAP
tools that are pocket sized and provide basic to full featured capabilities; and
NetROM which provides low cost target ethernet access and memory substitution.
These tools support the latest generation of microprocessors primarily from
Motorola (Power PC and CPU 32), Intel (Pentium and x86), Hitachi (SH), AMD (Elan
and x86), ARM and MIPS. This segment represents the largest revenue category for
Applied in 1998. Prices for these class of tools range from $3,000 to $20,000,
depending on the model and configuration.

         The high end, high cost products consist of the EL Series and CodeICE
emulators that represent previous generation technology and have a form factor
similar to a desktop personal computer. These products are full featured and
support older families of microprocessors from Motorola (680X0 series) and Intel
(80960 series). Based upon a shift in designs to newer microprocessors, demand
for these products has been in decline. Prices for these class of tools range
from $15,000 to $35,000, depending on the model and configuration.


                                      -3-
<PAGE>

         Applied believes it will be necessary to develop additional products in
1999 to support existing and future microprocessors, as well as to continue to
enhance and broaden its user-interface technology with third parties. The
process of developing such additional products is subject to the challenges and
uncertainties normally associated with product development, and there can be no
assurance that the Company will be able to complete these development efforts
successfully or in a timely manner.

SOFTWARE TESTING TOOLS

         The Company produces a line of software testing tools called CodeTEST,
which are designed specifically to offer a broad range of optimization and
testing capabilities to developers of embedded software. These tools are
designed to measure the performance and reliability of embedded software, as
well as the adequacy of the test process itself, in a minimally intrusive
manner, and to present these measurements in a format designed to be understood
easily by software engineers. These products are expected to be utilized by
software engineers during the software development, system integration, and
system test and validation phases of embedded systems development.

         CodeTEST software testing tools are designed to perform five basic
functions:

          -    COVERAGE ANALYSIS - Basic Block Coverage: the ability to
               measure the percentage of a software program's routines actually
               exercised by certain tests, to identify redundancies among tests,
               to identify the optimal set of tests to maximize the percentage
               of code tested in the shortest test period, and to determine the
               point at which the cost of continued testing is likely to exceed
               the benefits to be derived.

          -    CODETEST-ACT, ADVANCED COVERAGE TOOLS - adds a finer degree of
               granularity for analyzing test execution to the Statement,
               Decision and Modified Condition Decision Coverage (MCDC) levels.
               For mandated industries like avionics, the FAA specifies test
               methodologies for each type of software application based on the
               criticality of that application. MCDC shows what conditions, as
               well as, what decision paths and code statements have been
               tested.

          -    PERFORMANCE ANALYSIS - the ability to measure the time that a
               software program takes to perform a particular function and the
               degree of embedded microprocessor utilization, and to identify
               any hindrances to high-speed processing so that system reaction
               times and compliance with performance specifications can be
               optimized.

          -    MEMORY ALLOCATION ANALYSIS - the ability to monitor the use of
               memory during software execution, and to identify likely "memory
               leaks" and other memory allocation errors, in order to improve
               programming reliability and aid in minimizing the size and cost
               of the embedded system's memory.

          -    SOFTWARE EXECUTION TRACE - the ability to observe software
               functions from the source code level to the task level at any
               point in execution history, in order to address software
               performance or memory problems.

         The CodeTEST line includes six software modules sold separately
(Performance, Basic Block Coverage, MCDC, Decision Coverage, Memory Analysis,
Software Trace), and a separate hardware probe designed for use with a specific
embedded microprocessor. CodeTEST supports the most popular 32bit
microprocessors including Motorola (680X0, Power PC and CPU 32), Intel (80960,
Pentium and x86), Hitachi (SH), AMD (29000, Elan and x86) and MIPS, as well as
the VME Bus. Applied plans to support additional embedded microprocessors with
additional releases during 1999, but there can be no assurance as to the success
or timeliness of such development efforts. Prices for the Company's software
testing tools range from $11,000 to $50,000, depending on the software modules
purchased.


                                      -4-
<PAGE>

         In 1997, Applied entered into an OEM agreement with a third party
developer of real time operating systems for integration of certain CodeTest
modules within their integrated development environment. In 1998, Applied
released and began shipping a software only version of two CodeTEST modules,
basic block coverage and memory analysis, through this third party. The modules
run on the embedded target within the third parties integrated development
environment. Applied plans on expanding software only CodeTEST with additional
module releases and distribution channels during 1999.

RAPID EVALUATION AND DEVELOPMENT SOLUTION

         In 1998, Applied began developing technology to assist manufacturers
with their "time to market" challenge through the rapid evaluation and
development of product prototypes. Applied has assembled through internal
development, licensing and procurement, a set of solutions that includes
software and hardware tools, intellectual property, and hardware platforms and
displays for multiple microprocessor families. The manufacturer has the option
to license the intellectual property for use in their resulting product based
upon a run time license fee.

         The initial focus for the solution set is supporting 
Microsoft-Registered Trademark- Windows-Registered Trademark- CE operating 
system based upon an agreement entered into with Microsoft in the Spring of 
1998. The first products were introduced in October, 1998 as the 
Foundation-CE-TM- Embedded Development Suite. The solution includes a system 
development kit with a single board computer, packaged with a pre-installed 
and fully configured version of Windows CE; target porting kit , including 
board support source code and hardware schematics; Microsoft Windows CE 
embedded tool kit (ETK) for C++ 5.0; and consulting and support services. 
Product became available for shipment in the first quarter of 1999 for Power 
PC and X86 and will be available in the second quarter for Hitachi SH3.

         Applied believes that continual investment will be necessary in the
future to expand the intellectual property, software and hardware tools,
operating system and microprocessor coverage. The process of developing such
additional products is subject to the challenges and uncertainties normally
associated with product development, and there can be no assurance that the
Company will be able to complete these development efforts successfully or in a
timely manner.

CONSULTING SERVICES

         Applied offers manufacturers consulting services focused on assisting
with technical and resource issues surrounding embedded product development. The
level of services include onsite training and installation, customization of
Applied's products, design review, product development and full turnkey design
with limited production. The efforts are coordinated through a consulting
services group at Applied's headquarters and are supported either through
internal engineering personnel and/or outside sub-contractors.

CUSTOMERS

         The Company's sales are presently concentrated primarily in the
internetworking, telecommunications and computer peripherals segments of the
electronics industry. In addition, sales to leasing and rental companies serving
customers in Japan are a significant portion of net sales. During 1998 and 1997,
sales to Orix Rentec, a leasing and rental company in Japan, accounted for 9.6%
and 9.1% of net sales, respectively. The Company expects that a substantial
portion of its net sales will continue to be concentrated among a relatively
limited number of customers for the foreseeable future. Sales are generally made
pursuant to purchase orders.



                                      -5-
<PAGE>


SALES, MARKETING AND CUSTOMER SUPPORT

         The Company markets its products and services primarily through its
domestic and international direct sales organization. As of December 31, 1998,
the Company had 78 sales and support employees worldwide, including 44 field
sales engineers, inside sales specialists and field application engineers
located at the Company's headquarters and in direct or home sales offices
throughout North America, and in the Company's wholly-owned subsidiaries in
Japan, Germany, France and the United Kingdom. Due to the highly technical
nature of its products, the Company believes that an important aspect of its
direct sales strategy is the technical support and training provided to
customers, and that a high level of customer service and support is critical to
customer adoption and successful utilization of design, debugging and testing
technology. The Company's field application engineers offer ongoing support and
product demonstration, and assist customers to incorporate the Company's design,
debugging and testing tools into their design process.

         International sales represented 44.0%, 49.4% and 47.6% of the Company's
net sales in 1998, 1997 and 1996, respectively. Sales through the Company's
subsidiary in Japan accounted for 28.8%, 33.6% and 33.3% of the Company's net
sales in 1998, 1997 and 1996, respectively. The Company also has international
distribution agreements covering 24 countries. Sales to the Company's
international distributors in 1998, 1997 and 1996 accounted for approximately
6.4%, 8.3% and 11.0%, respectively, of the Company's net sales. Generally, the
Company's agreements with its international distributors have a term of 12
months and are exclusive on a country-by-country basis.

         The sale of software development tools in foreign countries involves
risks associated with currency exchange rate fluctuations and restrictions,
export-import regulations, customs matters, longer payment cycles, foreign
collection problems, and military, political and transportation risks. The
Company's sales through its foreign subsidiaries are generally denominated in
foreign currencies. As a result, fluctuations in currency exchange rates can
have a significant effect on the Company's sales, even in the absence of an
increase or decrease of unit sales to foreign customers. For example, the
Company estimates that currency fluctuations affecting sales by the Company's
foreign subsidiaries, especially in Japan, accounted for a 2.3% decrease, a 3.7%
decrease and a 7.0% decrease in the dollar value of the Company's net sales
value in 1998, 1997 and 1996, respectively. In addition, foreign sales involve
uncertainties arising from local business practices and cultural considerations,
and risks associated with international trade tensions. Sales of the Company's
products in Japan, in particular, are subject to the risks associated with trade
tensions between the United States and Japan, which could adversely affect the
volume of U.S.-manufactured microprocessors purchased by Japanese embedded
systems developers, thus reducing the need for the Company's products in Japan.
The Company expects that international sales, in particular sales in Japan, will
continue to account for a significant portion of the Company's net sales in the
future.

         The Company participates in cooperative marketing activities with other
embedded systems development tools providers such as Enea Data, CadUL, Mentor
Graphics, Metrowerks, Paradigm, Microware, Signus Systems, Integrated Systems
and Wind River Systems and embedded microprocessor manufacturers, such as Intel,
AMD, Motorola, MTI, IBM, IDT, Toshiba, Philips, NEC, Sony, LSI Logic and ARM.
These relationships enable the Company to further leverage its technical
capabilities, customer relationships and international sales and support
infrastructure. The Company believes that developing and maintaining these
relationships is important to its ability to achieve broad market penetration.
The Company's marketing efforts also include attending trade shows, publishing
articles and advertising in trade magazines and journals, direct mail and
product demonstrations. The Company also maintains a home page on the World Wide
Web at http://www.amc.com.

         The time between order and delivery of the Company's products is often
quite short. The number of orders, as well as the size of individual orders, can
vary substantially from month to month. Because 



                                      -6-
<PAGE>

of the short period between order receipt and shipment of products, the Company
typically does not have a meaningful backlog of unfilled orders and believes a
backlog is neither significant to an understanding of its business nor
representative of potential revenue for any future period.

COMPETITION

         The market for tools used in the development of embedded software is
fragmented, highly competitive and characterized by relatively low barriers to
entry, with over 50 providers offering technical solutions to address the
design, debugging, testing and service needs of embedded software developers.
This market is also subject to rapid change, as technological developments
create new needs and render prior technical solutions obsolete. The Company's
ability to compete successfully in this market will depend on its ability to
develop and introduce new products and features that address the increasingly
sophisticated needs of its customers, to respond to technological advances,
emerging industry standards and practices and competitive developments, and to
implement relationships and acquisitions that enable it to broaden its product
offerings.

         The principal competition for the Company's hardware-enhanced software
design and debugging tools comes primarily from Hewlett-Packard, from various
other domestic and international providers of in-circuit emulators, many of
which focus primarily on developing products to support either Intel or Motorola
microprocessors, and, to a lesser extent, from domestic providers of embedded
microprocessor simulators, RTOS debugging software, logic analyzers, ROM
monitors and ROM emulators. Competition for its CodeTEST product line will come
principally from domestic providers of embedded debug software, emulators and
logic analyzers, which are generally able to perform only portions of the
software testing functions offered by CodeTEST tools. The Company has also
historically experienced competition from the engineering departments of major
manufacturers, which occasionally develop internal technical solutions to their
design, debugging or testing problems.

         Competition among providers of embedded software design, debugging,
testing and services focuses on a variety of factors, including the availability
of tools that are compatible with the customer's chosen embedded microprocessor,
engineering workstation and other software development equipment; performance
characteristics and features such as high-speed processing, real-time visibility
and control, high-level programming language and ease-of-use; product
reliability; price/performance characteristics; customer service and worldwide
support; and product availability and delivery time. The Company believes that
the relative importance of each of these factors to a prospective customer
varies for each development project depending upon the complexity of the
embedded system design, the microprocessor to be used, the project development
schedule and the software engineer's budget and experience level. The Company
believes its products are most competitive in situations involving high-speed,
complex 16- thru 64-bit microprocessor designs.

         The Company anticipates that the embedded systems development market is
likely to experience consolidation as providers of various embedded software
development tools strive to broaden their product offerings. The Company expects
competition to increase from both established and emerging companies. The
Company believes that much of its competition is now, and will increasingly be,
from larger companies having substantially greater technical, financial and
marketing resources, as well as larger customer bases and greater name
recognition, than the Company. To compete effectively, the Company may find it
necessary to enter into alliances with other providers, or to acquire other
technologies or product lines, in order to broaden its product offerings. Some
of the Company's competitors bundle their design and debugging solutions with
sales of other embedded systems development products, and the Company
anticipates that such competitive tactics may increase as competitors broaden
their product offerings. Major semiconductor manufacturers have increasingly
been incorporating features into their newer embedded microprocessors which
facilitate visibility into and control over internal software debugging
functions. This trend may further lower technological barriers 



                                      -7-
<PAGE>

to entry and encourage new or lower-cost competition, and could render the
Company's technologies or products wholly or partially unnecessary or obsolete.
Increased competition could result in price reductions, reduced margins or loss
of market share, any of which could materially adversely affect the Company's
business, financial condition and results of operations. If the Company is
unable to compete successfully against current and future competitors, its
business, financial condition and results of operations will be materially
adversely affected.

MANUFACTURING

         The Company's manufacturing operations consist of the procurement and
inspection of parts and components, assembly, software duplication, and
extensive testing of components and finished products. The Company's products
incorporate the Company's proprietary software, as well as software licensed
from others. The Company conducts virtually all steps of the assembly process,
including board assembly, at its facility in Redmond, Washington. The Company
has a computerized manufacturing inventory control system which integrates and
monitors purchasing, inventory control and production.

         The Company thoroughly inspects and tests its products during the
manufacturing process and tests finished products using tests designed and
developed internally based on the custom requirements and functionality of the
product. In addition, the Company's products undergo thorough quality inspection
and testing, including "burn-in" procedures throughout the manufacturing process
to ensure the quality and reliability of the Company's products. The Company
also requires that all employees involved in the assembly process undergo
thorough training. The Company was ISO 9002 certified in December, 1995. The
Company warrants that its hardware, software and mechanical parts will be free
from defects in materials and workmanship for 90 days domestically and from 90
days to one year internationally depending on the product and location.

         The Company pursues a strategy of using the latest high-performance
hardware components in the manufacture of its software development tools. A
number of these product components, such as microprocessors, ASICs, standard
integrated circuits, memory chips, connectors and cables, are available only
from a single source or a limited number of distributors. The Company has
entered into agreements with a number of its vendors that include provisions
requiring the vendor to maintain specified levels of key parts and components.
In addition, due to high demand and limits on production, it is typical for a
number of key components to be on "allocation" at any given time. There can be
no assurance that the Company will be able in the future to obtain key
components in a timely manner, in sufficient quantities, or on favorable price
terms. The Company has a limited ability to avoid or offset future price
increases by suppliers of key components. If the Company were in the future to
experience significant delays, interruptions or reductions in its supply of key
components, or unfavorable price terms, its business, financial condition and
results of operations could be materially adversely affected.

         Although the Company's customers occasionally forecast projected
purchase requirements in advance of shipment dates, more frequently customers
order on an as-needed basis and products are often shipped within a few weeks
after an order is received. As a result, the Company's ability to plan
production and inventory levels is limited. The need for immediate delivery by
many customers, as well as the numerous products and configurations sold by the
Company, requires the Company to maintain a relatively high level of parts in
inventory.

         The Company is subject to a variety of federal, state and local
governmental regulations related to the storage, use, discharge and disposal of
toxic, volatile or otherwise hazardous chemicals used in its manufacturing
process. There can be no assurance that changes in environmental regulations
will not impose the need for additional capital equipment or other requirements.
Any failure by the Company to control the use of, or adequately to restrict the
discharge of, hazardous substances under present or future 



                                      -8-
<PAGE>

regulations could subject the Company to liability. The Company does not believe
such liability would have a material adverse effect on the Company's business,
financial condition and results of operations.

RESEARCH AND DEVELOPMENT

         Applied has made and intends to continue making substantial investments
in the development of new technologies and products. Because of the competitive
importance of offering tools that are compatible with the particular
microprocessors and other equipment to be used in developing embedded systems,
tool providers are under continuing pressure to support major new families of
embedded microprocessors, as well as advances in other development software and
hardware. Applied believes that its future growth and financial performance will
depend heavily on its ability to enhance its existing products, develop and
introduce new products and features that address the increasingly sophisticated
needs of its customers, and respond to technological advances, emerging industry
standards and practices and competitive developments. Applied's engineering and
development group includes 83 full-time employees. During 1998, 1997 and 1996,
research and development expenses were $10.4 million, $8.5 million and $8.0
million.

PROPRIETARY RIGHTS

         The Company's success will depend in part on its ability to protect its
technology and to preserve its trade secrets. Although the Company relies
primarily upon continuing technological innovations, trade secrets and know-how
to develop and maintain its competitive position, it also relies on a
combination of patent, copyright and trademark laws, confidentiality procedures
and contractual provisions to protect its proprietary rights. The Company has
limited patent protection, and there can be no assurance that any patents will
provide a competitive advantage or will afford protection against competitors
with similar technology, or will not be successfully challenged or circumvented
by competitors. There can be no assurance that the trade secrecy and other
measures taken by the Company will be adequate to prevent or deter
misappropriation of its technology, or that competitors will not be able
independently to develop technologies having similar functions or performance
characteristics. In addition, the laws of some foreign countries do not protect
the Company's proprietary rights to the same extent as do the laws of the United
States. There can be no assurance that the Company will have an adequate legal
remedy to prevent or seek redress for future unauthorized misappropriations of
the Company's technology. The Company has been issued two U.S. patents and a
Japanese patent covering certain technology incorporated in the Company's
CodeTAP and SuperTAP products. A corresponding European patent application has
been published for purposes of opposition, and a competitor has filed an
opposition which is presently under review. If the opposition is dismissed, the
European patent will be registered in France, Germany and the United Kingdom.
The U.S. patents will expire in 2010 and the foreign patents will expire in
2011.

         The embedded systems development market is characterized by rapid
technological change, with frequent introductions of new products and
technologies. As a result, industry participants often find it necessary to
develop products and features similar to those introduced by others, increasing
the risk that their products and processes may give rise to claims that they
infringe the patents of others. Accordingly, the Company's current and future
products and processes, or uses thereof, may conflict with patents that have
been granted or may be granted to competitors or others. Such competitors or
others could bring legal actions against the Company or its customers, claiming
damages and seeking to enjoin manufacturing, marketing or use of the affected
product or processes. Similarly, the Company may in the future find it necessary
to commence litigation in order to enforce and protect its proprietary rights.
If the Company becomes involved in such litigation, it could consume a
substantial portion of the Company's resources and result in a significant
diversion of management attention. If the outcome of any such litigation were
adverse to the Company or its customers, the Company's business, financial
condition and results of operations could be materially and adversely affected.
In addition to any 



                                      -9-
<PAGE>

potential liability for damages, the Company or its customers could be enjoined
from continuing to manufacture or market the affected product or use the
affected process, and could be required to obtain a license to continue to
manufacture or market the affected product or use the affected process. There
can be no assurance that the Company or its customers would prevail in any such
action or that any license required under any such patent would be made
available on acceptable terms, if at all .

         Third parties have in the past made patent infringement claims against
the Company. In certain cases, the Company has resolved these claims by
obtaining a license to the technology. The Company has also asserted claims of
infringement of its trade secrets and certain of its patents against various
competitors and in has brought suits to protect trade secrets and enforce patent
rights relating to its CodeTAP product. In those instances, the competitors have
settled by paying damages for past infringement and obtaining a license to the
patented technology or have discontinued production of the infringing product.
There can be no assurance as to the outcome of any pending or future claims,
litigation or proceedings involving the Company's proprietary rights.

         Although the Company believes that it currently owns or has adequate
rights to utilize all material technologies relating to its existing products,
as it continues to develop new products and features it anticipates that it may
find it desirable or necessary to obtain other nonexclusive or exclusive
licenses from third parties entitling it to use certain technologies or software
solutions. There can be no assurance that such licenses would be available to
the Company on acceptable terms, if at all. The Company currently has licenses
to several software programs, which are used in its design, debugging and
testing products. Termination of any such agreement, or failure to renew any
such agreement upon its expiration with respect to products the Company intended
to continue to market, would require product redesign and could significantly
increase the cost to the Company of manufacturing such products and have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company's loss of or inability to obtain necessary or
desirable licenses from third parties could have a material adverse effect on
the Company's business, financial condition and results of operations.

EMPLOYEES

         As of December 31, 1998, the Company had 262 employees, of whom 233
were based in the United States and 29 were based overseas. Of the total, 140
were engaged in Sales, General and Administrative, 83 were in research and
development and 39 were in manufacturing. None of the Company's employees is
represented by a labor union. The Company has not experienced any work stoppages
and considers its relations with its employees to be good.

                                      -10-
<PAGE>


ITEM 2.           PROPERTIES

         The Company's principal administrative, sales, marketing, research and
development and manufacturing facility is located in an approximately 59,000
square-foot building in Redmond, Washington that is leased through May 31, 2001.
The Company also leases nine other domestic sales and support offices in the
United States and five international sales offices in Japan, France, Germany and
the United Kingdom. The Company believes that its facilities are adequate to
satisfy its projected requirements, including its requirements for production
capacity into 1999 and that additional space will be available as needed.


ITEM 3.           LEGAL  PROCEEDINGS

         From time to time, Applied is involved in legal proceedings, none of
which is material.


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

         None.

ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT

         The executive officers of the Company are elected annually at the
meeting of the Board of Directors held in conjunction with the annual meeting of
stockholders. The following are the current executive officers of the Company:

<TABLE>
<CAPTION>

            NAME                          AGE                               POSITION
            ----                          ---                               --------

<S>                                       <C>       <C>                                           
Robert L. Deinhammer                      53        Chairman of the Board
Stephen J. Verleye                        43        President, Chief Executive Officer and Director
Douglas A. Fullaway                       47        Executive Vice President
A. James Beach                            42        Vice President, Secretary, Treasurer and Chief
                                                    Financial Officer
Larry Ritter                              40        Vice President and Division General Manager
John Stressing                            54        Vice President World Wide Sales
</TABLE>

         ROBERT L. DEINHAMMER joined the Company in July 1992 and served as a 
director since then. He assumed the role of Chairman of the Board in April 
1999. From July 1992 through March 1999, he served as the Company's President 
and Chief Executive Officer.  Before joining the Company, he served as an 
independent consultant from January 1991 to July 1992, and held senior 
management positions at several high-technology companies, including President 
and Chief Operating Officer of ADAC Laboratories from May 1985 to December 
1990. From April 1984 to May 1985, Mr. Deinhammer served as President and 
Chief Operating Officer of Silicon General, after serving as Vice President 
and General Manager of one of its operating divisions from April 1979 to March 
1984.

         STEPHEN J. VERLEYE will join the Company in April 1999 as its 
President, Chief Executive Officer and Director. Prior to joining the Company, 
Mr. Verleye spent six years at RadiSys Corp. first as its Vice President of 
Marketing, and subsequently served as the Company's Vice President of Business 
Development. In May 1996 he was appointed Vice President and General 
Manager, Commercial Equipment Division and in October 1998 he was appointed 
joint responsibility of the merged Automation Equipment Division. From 1986 to 
1993, Mr. Verleye held various marketing management roles at Sequent Computer 
Systems, Inc., the most recent being Director of Product Marketing. From 1977 
to 1986, Mr. Verleye held various sales and marketing roles at Intel.

         DOUGLAS A. FULLAWAY has served as the Company's Executive Vice
President since July 1998 and has served as the Company's Vice President
Worldwide Sales, since January 1995, after serving as Vice President,
International Sales from November 1993 to December 1994. Prior to joining the
Company, Mr. Fullaway held positions of increasing management responsibility at
Mentor Graphics Corporation from January 1984 to October 1993, including Pacific
Rim General Manager from August 1987 to August 1989, European Operations Manager
from August 1985 to August 1987 and Manufacturing Manager from January 1984 to
August 1985. From 1980 to 1983, he was employed by Tektronix Inc. in a variety
of operational positions.



                                      -11-
<PAGE>




         A. JAMES BEACH has served as the Company's Vice President and Chief
Financial Officer since October 1992, and was elected Secretary and Treasurer in
November 1992. Before joining the Company, Mr. Beach spent eight years at
Microcosm Inc., where he served as Vice President of Finance & Administration
from June 1984 to October 1988 and as President and General Manager from October
1988 to May 1992. Microcosm Inc. was acquired by Microtek International Inc. in
April 1990. From April 1981 to June 1984, he served as a senior auditor with the
Technology and Emerging Business Practice at the accounting and consulting firm
of Deloitte & Touche.

         LARRY RITTER joined the Company as Director of Marketing in January
1995 and has served as the Company's Vice President and Division General Manager
since February 1996. Before joining the Company, Mr. Ritter spent 15 years at
Hewlett Packard where he served as Product Marketing Manager at the Colorado
Springs Division from June 1992 to January 1995, and in various positions of
increasing marketing and sales responsibility prior to June 1992.

         JOHN STRESSING joined the Company as Vice President of World Wide Sales
in June 1998. Before joining the Company, Mr. Stressing spent 5 years at IKOS
Systems where he served first as European Director, then as Vice President of
International Sales before becoming Vice President of Worldwide Sales from
August 1995 to May 1998. Prior to joining IKOS, he ran his own consulting firm,
Premier Consultants, from January 1989 to October 1993. From 1985 to 1989 Mr.
Stressing was European Director for Zycad and from 1981 to 1985 was a sales
representative for Teradyne Incorporated. From 1968 to 1981, held various
positions of increasing development and management responsibility at British
Aerospace.



                                      -12-
<PAGE>




                                     PART II

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

         Applied Microsystems' common stock has been traded on the NASDAQ
National Market System under the symbol APMC. The Company estimates that at
March 19, 1999, there were approximately 3,000 beneficial owners of the common
stock of the Company.

         The closing price of the Company's common stock as reported by the
NASDAQ National Market on March 19, 1999 was $3.00 per share. The price per
share in the following table sets forth the low and high closing prices in the
NASDAQ National Market for the quarter indicated below:

<TABLE>
<CAPTION>
                                                                                LOW              HIGH
                                                                                ---              ----
<S>                                                                            <C>               <C>
1996
               First Quarter............................................       7 3/4            12 3/4
               Second Quarter...........................................         9              20 3/4
               Third Quarter............................................       11 1/4           23 7/8
               Fourth Quarter...........................................         9              23 3/4

1997
               First Quarter............................................       4 7/8              16
               Second Quarter...........................................       3 7/8            10 1/2
               Third Quarter............................................         8              12 7/8
               Fourth Quarter...........................................         5              12 5/8
1998
               First Quarter............................................       4 1/2             8 7/8
               Second Quarter...........................................      3 13/16            7 5/8
               Third Quarter............................................       2 5/8             4 5/8
               Fourth Quarter...........................................       2 1/8             4 3/4
</TABLE>


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

         Proceeds from the Company's initial public offering were $13.0 million
net of costs. Since the offering, the Company has used $4.0 million to purchase
capital equipment, $2.5 million to pay off bank debt, $.5 million to purchase a
product line and the remaining proceeds of $6.0 million have been invested in
short term commercial and government paper and money market funds.



                                      -13-
<PAGE>


ITEM 6            SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                     YEAR ENDED DECEMBER 31,
                                                ------------------------------------------------------------------
 (in thousands, except for earnings per share)          1998        1997          1996          1995         1994
                                                        ----        ----          ----          ----         ----
STATEMENT OF INCOME DATA:
<S>                                                 <C>          <C>           <C>           <C>          <C>    
Net sales.....................................       $37,020     $39,124       $38,662       $31,039      $25,663
Cost of sales.................................         9,587      10,532        10,793         9,530        8,903
                                                    ---------    -------       -------       -------      -------
Gross profit..................................        27,433      28,592        27,869        21,509       16,760
Operating expenses:
      Sales, general and administrative.......        18,104      18,542        15,142        13,321       11,715
      Research and development................        10,438       8,468         7,988         6,275        4,482
                                                    ---------    -------       -------       -------      -------
      Total operating expenses................        28,542      27,010        23,130        19,596       16,197
                                                    ---------    -------       -------       -------      -------
Income from operations........................        (1,109)      1,582         4,739         1,913          563
Interest expense and other income.............           783         669           559          (154)        (465)
                                                    ---------    -------       -------       -------      -------
Income (loss) before income taxes.............          (326)      2,251         5,298         1,759           98
Provision for income taxes....................            19         349         1,582           305           68
                                                    ---------    -------       -------       -------      -------
Net income (loss).............................          (345)      1,902         3,716         1,454           30
                                                    ---------    -------       -------       -------      -------
                                                    ---------    -------       -------       -------      -------
Diluted income (loss) per share ..............        ($0.05)      $0.26         $0.52         $0.27      $  0.01
Average number of common and equivalent
      shares outstanding......................         6,811       7,297         7,097         5,329        3,502
</TABLE>


<TABLE>
<CAPTION>

                                                                          DECEMBER 31,
                                                ------------------------------------------------------------------
                (in thousands)                          1998        1997          1996          1995         1994
                                                        ----        ----          ----          ----         ----
BALANCE SHEET DATA:
<S>                                                  <C>         <C>           <C>           <C>           <C>   
Working capital...............................       $20,116     $20,547       $19,415       $15,756       $1,800
Total assets..................................        33,290      32,582        30,824        26,846       14,011
Long-term debt, net of current................             -           -            15            68          385
Shareholders' equity..........................        23,931      24,291        22,607        18,654        4,286
</TABLE>


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

         The following discussion and analysis should be read in conjunction
with "Selected Consolidated Financial Data" and the Company's Consolidated
Financial Statements and Notes thereto included elsewhere in this document.

OVERVIEW

         From its inception in 1979 until 1994, the Company has focused on
designing, manufacturing and marketing tools used in the debugging of embedded
software. The Company's product line initially consisted primarily of
chassis-style in-circuit emulators, highly technical tools utilized at that time
by hardware engineers. In the late 1980s, customer demand focused increasingly
on tools with greater speed, software sophistication, ease-of-use and
price/performance value. By 1991, the Company's sales and profitability began to
decline due to various factors, including a poorly targeted product development
strategy, slowness in responding to changing customer requirements and
increasing competition.

         Beginning in mid-1992, the Company assembled a new management team that
devised and began implementing a new business strategy. As a part of this new
strategy, management effected a restructuring of the Company, which included
significant headcount reductions and a refocusing of its product line by
concentrating marketing and engineering activity on new hardware-enhanced
software tools for use with a broad range of Intel and Motorola 16- and 32-bit
embedded microprocessors, employing advanced hardware designs to reduce size and
cost, and emphasizing ease-of-use by software engineers. Following this
restructuring, the Company reengineered its pocket-sized CodeTAP emulator in
late 1993; introduced its compact and more affordable CodeICE emulator in 1994;
and began shipping CodeTEST software testing tools focused on embedded test in
late 1995. In 1996, the Company released SuperTAP, which brings full featured
emulation into a CodeTAP form factor. In 1997, the Company



                                      -14-
<PAGE>

released CodeTEST(R)-ACT, an enhanced suite of MCDC software test and analysis
tools for C language applications, and CodeTRACE(TM), a source-level trace
analysis tool. The Company's strategy has resulted in lower average selling
prices and increased unit volumes.

         The Company's sales through its foreign subsidiaries are generally
denominated in foreign currencies, and as a result fluctuations in currency
exchange rates can have a significant effect on the Company's reported net
sales. The effect of currency exchange rate fluctuations on the Company's net
sales is dependent in part upon the Company's pricing policies. The Company is,
however, unable to predict currency exchange rate fluctuations and anticipates
that such fluctuations will continue to affect its net sales to varying degrees
in the future. The Company expects international sales, especially in Japan, to
continue to account for a significant percentage of its net sales.

         To enhance its competitive position, it will be necessary for the
Company to continue developing its technology base and broadening its product
offerings to address additional needs within the embedded software development
process. These objectives may require expansion of the Company's internal
product development efforts or acquisitions of or investments in complementary
businesses, products or technologies in related market segments.

         The Company believes that the growth rates reflected in results of
operations for prior periods should not be relied upon as an indication of
growth rates for future periods. The Company also believes that competition is
likely to increase, which could result in loss of market share, price reductions
or reduced margins, any of which could have a material adverse effect on the
Company's business, financial condition and results of operations.

RESULTS OF OPERATIONS

         The following table sets forth, for the periods indicated, certain
items from the Company's Consolidated Statements of Income, expressed as a
percentage of sales.

<TABLE>
<CAPTION>

                                                                        YEAR ENDED DECEMBER 31,
                                              --------------------------------------------------------------------
                                                               1998                   1997                   1996
                                                               ----                   ----                   ----
<S>                                                           <C>                    <C>                    <C>   
Net sales...................................                  100.0%                 100.0%                 100.0%
Cost of sales...............................                   25.9                   26.9                   27.9
                                                              -----                  -----                  -----
Gross profit................................                   74.1                   73.1                   72.1
Operating expenses:
      Sales, general and administrative.....                   48.9                   47.4                   39.2
      Research and development..............                   28.2                   21.6                   20.7
                                                              -----                  -----                  -----
      Total operating expenses..............                   77.1                   69.0                   59.9
                                                              -----                  -----                  -----
Operating income (loss).....................                   (3.0)                   4.1                   12.2
Interest expense and other income...........                    2.1                    1.7                    1.5
                                                              -----                  -----                  -----
Income (loss) before income taxes...........                   (0.9)                   5.8                   13.7
Income taxes................................                    0.0                    0.9                    4.1
                                                              -----                  -----                  -----
Net income (loss)...........................                   (0.9%)                  4.9%                   9.6%
                                                              -----                  -----                  -----
</TABLE>

NET SALES

         Net sales decreased by 5.4% to $37.0 million in 1998 from $39.1 million
in 1997 and increased by 1.2% in 1997 from $38.7 million in 1996. The decrease
in 1998 over 1997 was primarily attributable to a decline in unit sales of high
end debug products and to a lesser extent currency exchange rate fluctuations
affecting the dollar value of international sales which were partially offset by
an increase in unit growth and average selling price of low cost debug tools and
to a lesser extent patent license royalties and consulting services. Net sales
increased slightly in 1997 over 1996 which was primarily attributable to the
unit growth and average selling price in sales of low cost debug tools and to a
lesser extent increase in units sales of CodeTEST tools and an increase in
support contract revenues which were partially offset by a decline in unit sales
of higher priced debug tools and to a lesser extent currency 



                                      -15-
<PAGE>

exchange rate fluctuations affecting the dollar value of international sales.
The Company's net sales are presently derived predominantly from sales of
software design, debugging and testing tools. The Company's net sales also
include product support revenues, which represented 12.6%, 11.9% and 8.3% of net
sales in 1998, 1997 and 1996, respectively, as well as increased patent license
royalties and fees from consulting services. The Company generally recognizes
revenues from product sales upon shipment, and recognizes product support
revenues ratably over the life of each maintenance contract, typically 12
months, and consulting revenues as performed. See Note 1 of Notes to
Consolidated Financial Statements.
  
         International sales represented 44.0%, 49.4% and 47.6% of total net
sales in 1998, 1997 and 1996, respectively. International sales outside of North
America in U.S. dollars decreased by 15.7% in 1998 over 1997, and increased by
4.9% in 1997 over 1996. The decrease in 1998 over 1997 is attributable to a
reduction in units sales and average selling price directly related to the Asian
financial crisis, particularly in Japan and Korea, partially offset by an
increase in unit sales in Europe. The increase in 1997 over 1996 is attributable
to increased unit sales primarily in Asia, which is due primarily to increased
sales and marketing efforts. The Company estimates that unfavorable currency
rate fluctuations affecting the dollar value of sales by the Company's foreign
subsidiaries, especially in Japan, resulted in a 2.3% reduction in the dollar
value of the Company's net sales in 1998 based upon the change from the average
1997 rate and a 3.7% reduction in the dollar value of 1997 based upon the change
in the average 1996 rate.

GROSS PROFIT

         Cost of sales included materials, labor and overhead incurred in the
manufacturing of products as well as the cost of providing consulting services
and maintenance. Gross profit margins as a percentage of net sales were 74.1%,
73.1% and 72.1% in 1998, 1997 and 1996, respectively. The increase in 1998 over
1997 was primarily attributable to an increase in the percentage of net sales of
newer low cost debug products that have lower material costs as a percentage of
sales price and to a lesser extent an increase in royalties and software
licenses which were partially offset by lower production over which to spread
fixed manufacturing overhead costs and, to a lesser extent, due to declines in
sales revenue due to unfavorable currency exchange rate fluctuations. The
increase in 1997 over 1996 was primarily attributable to an increase in the
percentage of net sales attributable to newer low cost debug and CodeTEST
products that have lower material costs as a percentage of sales price and to a
lesser extent an increase in higher margin support contract revenue and
favorable cost reductions on certain hardware components which were partially
offset by declines in sales revenue due to unfavorable currency exchange rate
fluctuations and an increase in factory overhead. The Company expects its gross
profit to fluctuate based upon its product mix, geographic mix, product and
patent licenses and variances in volume and related absorption of factory
overhead costs. Accordingly, there can be no assurance that the Company will be
able to sustain its recent gross margins.

SALES, GENERAL AND ADMINISTRATIVE

         Sales, general and administrative expenses were $18.1 million or 48.9%
of net sales, $18.5 million, or 47.4% of net sales and $15.1 million, or 39.2%
of net sales, in 1998, 1997 and 1996, respectively. The dollar amount slightly
decreased in 1998 over 1997 was due to a reduction in foreign currency exchange
losses and reduction in general operating expenses partially offset by increased
headcount and compensation related expenses and promotional costs in connection
with the company's expansion of its sales and marketing efforts. The percentage
between comparable periods was basically the same due to the continued budgeted
investment in sales and marketing and lower than anticipated revenues. The
dollar amount increase in 1997 over 1996 was primarily attributable to increased
compensation-related expenses resulting principally from increased headcount and
compensation related expenses, and to a lesser extent, increases in operating
expenses, promotional costs and foreign exchange 



                                      -16-
<PAGE>

losses. The percentage increase between comparable periods was primarily
attributable to lower than anticipated revenues for the year as compared to the
increase in budgeted costs. The Company expects its sales and marketing
expenditures to continue to increase in absolute dollars in the future as it
introduces and markets new products, and continues to expand its sales, general
and administrative organization.

         Foreign exchange gains and losses are included in sales, general and
administrative expenses. In order to mitigate certain intercompany risks
associated with exchange rate fluctuations, the Company, does from time to time,
hedge a portion of its foreign exchange risk in Japan as it relates to the trade
debt the Company's Japanese subsidiary owes to the Company. Although the Company
generally plans to continue to engage in exchange rate hedging activities with
respect to certain exchange rate risks, there can be no assurance that it will
do so or that any such activities will successfully protect the Company against
such risks.

RESEARCH AND DEVELOPMENT

         Research and development expenses were $10.4 million or 28.2% of net
sales, $8.5 million, or 21.6% of net sales and $8.0 million, or 20.7% of net
sales, in 1998, 1997 and 1996, respectively. The dollar amount increase in 1998
over 1997 was primarily attributable to an increase in contract labor, headcount
and compensation related expenses which was partially offset by a reduction in
prototype expenses. The dollar amount increase in 1997 over 1996 was primarily
attributable to a decrease in external development funding received from third
parties that offsets expenses and to an increase in hardware prototype related
costs. The Company intends to continue to make substantial investments in
product development, including development of software design, debugging and
test tools for additional embedded microprocessors as well as continued advanced
development in future directions. As a result, the Company anticipates that net
research and development expenses are likely to increase for the foreseeable
future.

INCOME TAXES

         The Company's income tax provision for 1998, 1997 and 1996 reflect
utilization of Net Operating Loss (NOL) and General Business Credit
carryforwards. As of December 31, 1998 the Company had remaining NOL
carryforwards of $3.5 million and research and development credit carryforwards
of $1.7 million, both of which will expire in various amounts through 2018. The
utilization of these amounts in the future is subject to an annual limit of
approximately $392,000 under the Internal Revenue Code. As a result of these
limitations, the Company anticipates that in the future its effective tax rate
will approach the statutory rate in future years. A full valuation allowance has
been established for net deferred tax assets due to the uncertainty whether they
will be realized. See Note 7 of Notes to Consolidated Financial Statements.

QUARTERLY RESULTS OF OPERATIONS

         The Company's results of operations have in the past fluctuated
substantially from quarter to quarter, and the Company expects such fluctuations
to continue as a result of a variety of factors. Product and price competition,
research and development requirements, the volume and timing of customer
development projects and orders, introductions of new embedded microprocessors,
announcements or introductions of new products or technologies by the Company or
its competitors, foreign currency exchange rates, investments in marketing and
distribution, price increases by suppliers, parts shortages, conditions in the
embedded systems market and the electronics industry in general, and national
and global economic conditions may be expected to cause significant variations
in the Company's quarterly operating results. As a result, the results of
operations for any quarter are not necessarily indicative of 



                                      -17
<PAGE>

results for any future period. Moreover, a significant portion of the Company's
net sales in each quarter generally results from shipments during the last few
weeks of the quarter.

LIQUIDITY AND CAPITAL RESOURCES

         The Company requires capital principally for the financing of
inventory, capital equipment and accounts receivable, and for investment in
product development activities and new technologies. To date, the Company has
financed its operations primarily through cash flow from operations, bank
borrowings and private placements of equity securities. In November 1995, the
Company completed its initial public offering pursuant to which it sold
1,500,000 shares of common stock and received net proceeds of approximately $13
million. During 1998, the Company generated $1.8 million of cash from
operations; utilized $1.3 million of cash for equipment purchases; and utilized
$15,000 of cash for net debt reduction. As of December 31, 1998, the Company had
working capital of $20.1 million, including $17.1 million of cash and cash
equivalents.

         The Company has revolving credit facilities aggregating $7.0 million
from a commercial bank. There were no outstanding balances under these
facilities as of December 31, 1998. The credit facilities bear interest at the
bank's floating prime rate and are unsecured. The loan documents also contain
customary negative covenants. The credit facilities expire in May 1999 and the
Company anticipates renegotiating a new line at comparable terms.

         The Company currently has no specific commitments with regard to
capital expenditures, but expects to spend an aggregate of approximately $1.5
million in 1999 for new capital equipment. The Company anticipates that its
annual capital expenditures will increase gradually in the future as a function
of replacement cycles and anticipated growth of the Company's business. The
Company's capital needs may be further affected by its plans to broaden product
offerings through a combination of internal development, third party
relationships and acquisitions of other business products or technologies.

         The Company believes that its current cash and cash equivalent balances
at year end together with funds from operations and borrowings, will provide the
Company with sufficient funds to finance its operations for at least the next 12
months. The Company's future capital requirements will, however, depend on a
number of factors, including costs associated with product development efforts,
the success of the commercial introduction of the Company's products and the
acquisition of complementary businesses, products or technologies. To the extent
additional capital is required, the Company may sell additional equity, debt or
convertible securities, or obtain additional credit facilities.

IMPACT OF YEAR 2000

         The Company is taking steps to evaluate and minimize the risk presented
by the potential impact of the Year 2000 issue. The Company formed a committee
to conduct an assessment of the Company's preparedness for the Year 2000, as
well as the preparedness of third parties relevant to the Company's business.
The assessment consists of five phases: Awareness, which consists of making
Company personnel, and those at third parties, aware of the Year 2000 issue;
Inventory, which consists of identifying the Company's operations or systems
which are Year 2000 sensitive; Analysis, which consists of determining whether
sensitive areas will in fact be adversely impacted by Year 2000 issues;
Remediation, which consists of addressing potential Year 2000 issues; and
Contingency Planning, which consists of developing strategies for those areas
where remediation may not be effective or practicable. In conducting its
assessment, the committee evaluated the Company's internal information systems,
the engineering and product development software, the Company's hardware, and
general facilities infrastructure. The assessment has been completed for the
Company's information system and general facilities infrastructure. The Company
has completed the awareness, inventory and analysis phases with 



                                      -18-
<PAGE>

respect to other systems. Based on results of these analyses , the Company
believes the remediation phase will be completed prior to March 31, 1999. The
Company anticipates that it will complete its contingency planning within 2
months after completing the other phases of its assessment.

         The Company's business operations information system was upgraded in
the standard course of systems maintenance early in 1998. The current version
has been certified by Oracle to be Year 2000 compliant. The Company is currently
in the analysis phase with respect to its assessments of its own product. The
Company believes it will have completed the analysis and remediation by March,
1999.

         The Company estimates that it has expended approximately $100,000 in
assessing and re-mediating internal Year 2000 issues, in addition to those
upgrades that have been made as part standard system maintenance. The Company
does not believe that its assessment and remediation activities have resulted in
any material delay or deferral of systems maintenance or upgrades. The Company
believes the additional aggregate costs of its internal assessment and upgrade,
other than those implemented in the course of normal maintenance and equipment
upgrades, will not exceed $150,000, to be expended over the next two to three
quarters.

         The Company cannot predict yet the effect of the Year 2000 problem on
its suppliers or the resulting effect on the Company. The Company has not yet
developed a contingency plan to operate in the event that critical systems of
vendors, suppliers, or other third parties are not Year 2000 compliant and have
a material adverse effect on the Company. The Company expects to develop such
contingency plan by April 30, 1999. If any of the Company's critical systems are
not in fact Year 2000 compliant, or if preventive and/or corrective actions by
those entities with whom the Company does business are not made in a timely
matter, the Year 2000 issue could have a material adverse effect on the
Company's business, financial condition, and results of operations.

OUTLOOK: ISSUES AND UNCERTAINTIES

         The Company does not provide forecasts of future financial performance
or sales volumes, although this Annual Report contains certain other
forward-looking statements that involve risks and uncertainties. The Company
may, in discussions of its future plans, objectives and expected performance in
periodic reports filed by the Company with the Securities and Exchange
Commission (or documents incorporated by reference therein) and in written and
oral presentations made by the Company, include forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 or Section 21E
of the Securities Exchange Act of 1934, as amended. Such forward-looking
statements are based on assumptions which the Company believes are reasonable,
but are by their nature inherently uncertain. In all cases, there can be no
assurance that such assumptions will prove correct or that projected events will
occur. Actual results could differ materially from those projected depending on
a variety of factors, including, but not limited to, the issues discussed below.
While Company management is optimistic about the Company's long-term prospects,
the following issues and uncertainties, among others, should be considered in
evaluating its growth outlook and for forward-looking statements.

         RAPIDLY CHANGING TECHNOLOGY AND PRODUCT DEVELOPMENT UNCERTAINTIES. The
introduction of products embodying new technologies and the emergence of new
industry standards and practices can render existing products obsolete and
unmarketable. The Company's future business, financial condition and results of
operations will depend upon its ability to anticipate market demand for specific
embedded microprocessors, develop new products and features that address the
increasingly sophisticated needs of its customers, and respond to technological
advances and emerging industry standards and practices.

         MANUFACTURING UNCERTAINTIES. A number of the Company's components are
manufactured by a single source or distributed through a limited number of
outlets. There can be no assurance that the 


                                      -19-
<PAGE>

Company will be able in the future to obtain key components in a timely manner,
in sufficient quantities, or on favorable price terms.

         PRODUCT SHIP SCHEDULES. Delays in new-product releases could impact
revenue growth rates and cause the Company's customer base to become
dissatisfied and erode.

         PRICES. Prices the Company can obtain for its products may decrease
from historical levels, depending on competitive market or cost factors which
could have an adverse effect on revenues and gross margin.

         COST OF SALES. Although cost of sales as a percentage of net sales
decreased in 1997 and 1998, it varies with channel mix and product mix within
channels. Such mix factors may increase cost of sales as a percentage of
revenues in future periods.

         SEMICONDUCTOR MANUFACTURERS. A substantial decline in the number of
design starts for 16-bit or 32-bit embedded microprocessors produced by Intel,
AMD or Motorola or delays by such manufacturers in the release of embedded
microprocessors for which the Company has developed tools could have an adverse
effect on the Company's revenues.

         INDUSTRY FOCUS. The Company's sales are concentrated primarily in the
internetworking, telecommunications and computer peripherals markets and any
negative events affecting the electronics industry or these markets in
particular could have an adverse effect on revenues.

         COMPETITION. The Company expects competition to increase from
established and emerging companies. Sales and marketing and research and
development costs may increase in dollar amounts and as a percentage of sales in
order for the Company to successfully compete.

         KEY PERSONNEL. The Company believes that its future success will depend
largely upon its ability to retain and attract key personnel and skilled
employees.

         MANAGEMENT OF GROWTH. The Company plans to continue to invest in
product lines and sales and marketing. The Company's growth plans will present
management, competitive and other challenges to the Company's managers and
employees.

         INTELLECTUAL PROPERTY. The Company's success will depend in part on its
ability to protect its technology and preserve its trade secrets.

         PRODUCT LIABILITY. The use of the Company's tools in the development of
embedded systems that are incorporated in products used by or affecting the
general public, or that otherwise pose a risk of serious consequences if they do
not perform flawlessly under critical conditions, could expose the Company to
significant product liability claims.

         GLOBAL ECONOMIC CONDITIONS. Almost half of the Company's business
occurs outside of North America. Economic crisis in any of these regions could
have a material adverse effect on the Company's business.

         FOREIGN EXCHANGE. A large percentage of the Company's sales, costs of
sales and marketing is transacted in local currencies. As a result, the
Company's international results of operations are subject to foreign exchange
rate fluctuations.


                                      -20-
<PAGE>

         LITIGATION. The Company may become subject to litigation regarding
intellectual property rights, patents, and copyrights. If an adverse judgment
were entered against the Company, such a proceeding could adversely affect the
Company's financial condition and results of operation.


ITEM 7A..QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

         The Company develops products in the United State and sells in North
America, Asia and Europe. As a result, financial results could be affected by
factors such as changes in foreign currency exchange rates or weak economic
conditions in foreign markets. Since sales are currently priced in U.S. Dollars
and translated to local currency amounts, a strengthening of the dollar could
make the Company's products less competitive in foreign markets. Interest income
is sensitive to changes in the general level of U.S. interest rates,
particularly since the majority of Company investments are in short-term
instruments. Due to the nature of these short-term investments, the Company has
concluded that there is no material market risk exposure.



                                      -21-
<PAGE>


ITEM 8            FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                        APPLIED MICROSYSTEMS CORPORATION

                          INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
AUDITED ANNUAL FINANCIAL STATEMENTS:                                                                           PAGE
                                                                                                               ----
<S>                                                                                                            <C>
Report of Ernst & Young LLP, Independent Auditors................................................................23

Balance Sheets as of December 31, 1998 and 1997..................................................................24

Statements of Operations for the Years Ended December 31, 1998, 1997 and 1996....................................25

Statements of  Stockholders' Equity for the Years Ended December 31, 1998,  1997 and 1996........................26

Statements of Cash Flows for the Years Ended December 31, 1998, 1997 and 1996....................................27

Notes to Financial Statements....................................................................................28
</TABLE>



                                      -22-
<PAGE>



                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS



Shareholders and Board of Directors
Applied Microsystems Corporation

         We have audited the accompanying consolidated balance sheets of Applied
Microsystems Corporation as of December 31, 1998 and 1997, and the related
consolidated statements of operations, shareholders' equity, and cash flows for
each of the three years in the period ended December 31, 1998. Our audits also
included the financial statement schedule listed in the Index at Item 14(a).
These financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.

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

         In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Applied Microsystems Corporation at December 31, 1998 and 1997, and the
consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.


                                                               ERNST & YOUNG LLP



Seattle, Washington
February 2, 1999


                                      -23-
<PAGE>






                        APPLIED MICROSYSTEMS CORPORATION

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                          DECEMBER 31,
                                                                                   1998                  1997
                                                                             ------------------    ------------------
                                                                                         (in thousands)

                                  ASSETS
<S>                                                                          <C>                   <C>    
Current assets:

Cash and cash equivalents..................................................            $ 6,041               $ 6,336
Short term investments.....................................................             11,101                10,345
Accounts receivable, net of allowance for sales returns and doubtful
accounts of $649 and $611, respectively....................................              8,483                 7,741
Inventories................................................................              3,332                 3,465
Prepaid and other current assets...........................................                518                   951
                                                                             ------------------    ------------------
Total current assets.......................................................             29,475                28,838

Property and equipment, net................................................              2,918                 2,900
Other assets...............................................................                897                   844
                                                                             ------------------    ------------------
Total assets...............................................................            $33,290               $32,582
                                                                             ------------------    ------------------
                                                                             ------------------    ------------------

                   LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Accounts payable...........................................................             $3,283                $2,804
Accrued payroll............................................................              1,840                 1,684
Other accrued expenses.....................................................              1,129                   991
Deferred revenue...........................................................              3,107                 2,797
Current portion of long-term obligations...................................            ----                       15
                                                                             ------------------    ------------------
Total current liabilities..................................................              9,359                 8,291

Shareholders' equity:
Preferred stock, par value $.01
     Authorized - 5,000,000 shares                                                     ----                    ----
Common stock, par value $.01
     Authorized - 25,000,000 shares
     Issued - 6,681,000 shares (6,827,000 shares in 1997)                               25,383                26,387
Cumulative translation adjustment..........................................                120                 (869)
Accumulated deficit........................................................            (1,572)               (1,227)
                                                                             ------------------    ------------------
Total shareholders' equity.................................................             23,931                24,291
                                                                             ------------------    ------------------
Total liabilities and shareholders' equity.................................           $ 33,290              $ 32,582
                                                                             ------------------    ------------------
                                                                             ------------------    ------------------
</TABLE>

                             See accompanying notes.



                                      -24-
<PAGE>







                        APPLIED MICROSYSTEMS CORPORATION

                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                          YEAR ENDED DECEMBER 31,
                                                       --------------------------------------------------------------
                                                             1998                  1997                  1996
                                                       ------------------    ------------------    ------------------
                                                                 (in thousands, except per share amounts)

<S>                                                    <C>                   <C>                   <C>     
Net sales............................................           $ 37,020              $ 39,124              $ 38,662
Cost of sales........................................              9,587                10,532                10,793
                                                       ------------------    ------------------    ------------------
Gross profit.........................................             27,433                28,592                27,869

Operating expenses:
Sales, general and administrative....................             18,104                18,542                15,142
Research and development.............................             10,438                 8,468                 7,988
                                                       ------------------    ------------------    ------------------
Total operating expenses.............................             28,542                27,010                23,130
                                                       ------------------    ------------------    ------------------
Income (loss)  from operations.......................             (1,109)                1,582                 4,739

Interest income and other............................                784                   682                   601
Interest expense.....................................                 (1)                  (13)                  (42)
                                                       ------------------    ------------------    ------------------
Income (loss) before income taxes....................               (326)                2,251                 5,298
Income taxes.........................................                 19                   349                 1,582
                                                       ------------------    ------------------    ------------------
                                                       ------------------    ------------------    ------------------
Net income (loss)....................................              ($345)               $1,902                $3,716
                                                       ------------------    ------------------    ------------------
                                                       ------------------    ------------------    ------------------

Basic income (loss) per share........................             ($0.05)                $0.28                 $0.57
Shares used in basic per share calculation...........              6,811                 6,769                 6,545

Diluted income (loss) per share......................             ($0.05)                $0.26                 $0.52
Shares used in diluted per share calculation.........              6,811                 7,297                 7,097
</TABLE>

                             See accompanying notes.




                                      -25-
<PAGE>







                        APPLIED MICROSYSTEMS CORPORATION

                 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>

                                                                                      ACCUMULATED
                                                                                         OTHER            TOTAL
                                            COMMON STOCK             ACCUMULATED     COMPREHENSIVE    SHAREHOLDERS
                                      SHARES           AMOUNT          DEFICIT       INCOME (LOSS)       EQUITY
                                      ------           ------          -------       -------------       ------
                                                                    (in thousands)

<S>                               <C>              <C>              <C>             <C>              <C>    
Balance at December 31, 1995           6,468            $25,655        ($6,845)           ($156)          $18,654
    Issuance of common stock
    upon exercise of  common
    stock warrants..............          35              ----          ----             ----             ----
    Stock options exercised.....         115                 23         ----             ----              23
    Income tax benefit from
    stock plans.................       ----                 204         ----             ----             204
    Sale of common stock to
    employees...................          16                186         ----             ----             186
    Comprehensive income:
      Net Income................       ----               ----           3,716           ----           3,716
      Foreign currency
       translation adjustment...       ----               ----          ----               (176)         (176)
                                                                                                     ----------------
    Comprehensive income........                                                                        3,540
                                  ---------------- ---------------- --------------- ---------------- ----------------
Balance at December 31, 1996           6,634             26,068         (3,129)            (332)       22,607
    Issuance of common stock
    upon exercise of common
    stock warrants..............          59              ----          ----             ----             ----
    Stock options exercised.....          88                 17         ----             ----              17
    Income tax benefit from
    stock plans.................       ----                  55         ----             ----              55
    Sale of common stock to
    employees...................          46                247         ----             ----             247
    Comprehensive income:
      Net Income................       ----               ----           1,902           ----           1,902
      Foreign currency
       translation adjustment...       ----               ----          ----               (537)         (537)
                                                                                                     ----------------
    Comprehensive income........                                                                        1,365
                                  ---------------- ---------------- --------------- ---------------- ----------------
Balance at December 31, 1997           6,827             26,387         (1,227)            (869)       24,291
    Stock options exercised.....         126                 12           ----           ----              12
    Sale of common stock to
    employees...................          55                194           ----           ----             194
    Stock repurchase............        (327)            (1,210)          ----           ----          (1,210)
    Comprehensive income:
      Net Loss..................       ----               ----           (345)           ----            (345)
      Foreign currency
       translation adjustment...       ----               ----            ----              989           989
                                                                                                     ----------------
    Comprehensive income........                                                                          644
                                  ---------------- ---------------- --------------- ---------------- ----------------
                                  ---------------- ---------------- --------------- ---------------- ----------------
Balance at December 31, 1998           6,681            $25,383       ($1,572)             $120       $23,931
                                  ---------------- ---------------- --------------- ---------------- ----------------
                                  ---------------- ---------------- --------------- ---------------- ----------------
</TABLE>

                             See accompanying notes.




                                      -26-
<PAGE>





                        APPLIED MICROSYSTEMS CORPORATION

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>

                                                                          YEAR ENDED DECEMBER 31,
                                                       --------------------------------------------------------------
                                                             1998                  1997                  1996
                                                       ------------------    ------------------    ------------------
                                                                              (in thousands)
<S>                                                    <C>                   <C>                   <C>   
Cash flows from operating activities:
Net income (loss)....................................              ($345)               $1,902                $3,716
Adjustments to reconcile net income (loss) to net
     cash provided by operating activities:
     Depreciation and amortization...................              1,219                 1,148                 1,116
Changes in operating assets and liabilities:
     Accounts receivable.............................               (742)                2,520                (2,751)
     Inventories.....................................                133                  (268)                  (52)
     Prepaid expenses and other current assets.......                433                    69                  (566)
     Other assets....................................               (13)                  (217)                  (96)
     Accounts payable and accrued expenses...........                773                    82                  (566)
     Deferred revenue................................                310                   101                   862
                                                       ------------------    ------------------    ------------------
         Net cash provided by operating activities...              1,768                 5,337                 1,663

Cash flows from investing activities:
     Purchase of short-term investments..............               (756)               (4,414)               (5,931)
     Property and equipment additions................             (1,277)               (1,469)               (1,261)
                                                       ------------------    ------------------    ------------------
         Net cash used in investing activities.......             (2,033)               (5,883)               (7,192)

Cash flows from financing activities:
     Sale of common stock to employees..............`                194                   247                   186
     Stock options exercised.........................                 12                    17                    23
     Stock repurchase................................             (1,210)                  ----                  ----
     Repayment of long-term obligations..............                (15)                  (53)                  (67)
                                                       ------------------    ------------------    ------------------
         Net cash provided by (used in) financing
         activities..................................             (1,019)                  211                   142

Effects of foreign exchange rate changes on cash.....                989                  (537)                 (176)
                                                       ------------------    ------------------    ------------------
Decrease in cash and cash equivalents................               (295)                 (872)               (5,563)
Cash and cash equivalents at beginning of year.......              6,336                 7,208                12,771
                                                       ------------------    ------------------    ------------------
                                                       ------------------    ------------------    ------------------
Cash and cash equivalents at end of year.............             $6,041                $6,336                $7,208
                                                       ------------------    ------------------    ------------------
                                                       ------------------    ------------------    ------------------

Supplemental disclosures of cash paid:
     Interest........................................                 $1                   $13                   $42
     Income Taxes....................................               $128                  $642                $1,320

Supplemental disclosures of non-cash activities:
     Tax benefit realized from
     non-qualifying dispositions of stock                            ----                  $55                  $204
     options.........................................
</TABLE>


                             See accompanying notes.





                                      -27-
<PAGE>



                        APPLIED MICROSYSTEMS CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.       THE COMPANY AND SIGNIFICANT ACCOUNTING POLICIES

         Applied Microsystems Corporation (the Company) is a leader and
innovator in embedded systems solutions. Applied develops, markets and supports
a comprehensive suite of software and hardware enhanced development and test
tools and engineering services for the development of complex embedded
microprocessor based applications. The Company markets its products and services
primarily through its domestic and international direct sales organizations in
the United States, Japan, the United Kingdom, Germany, and France, and is
supplemented with distributors throughout the rest of the world

         PRINCIPLES OF CONSOLIDATION

         The consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries, Applied Microsystems Corporation
Limited (AML), Applied Microsystems Japan Limited (AMJ), Applied Microsystems
Gmbh (AMG), Applied Microsystems SARL (AMF) and Applied Microsystems Foreign
Sales Corporation (FSC). All significant intercompany accounts and transactions
are eliminated in consolidation.

         INVENTORIES

         Inventories, including demonstration equipment, are stated at the lower
of cost (first-in, first-out basis) or market.

         CASH EQUIVALENTS

         The Company considers all highly liquid investments purchased with an
initial maturity of three months or less to be cash equivalents.

         SECURITIES AVAILABLE FOR SALE

         Securities available for sale consist primarily of investment-grade
corporate obligations, all of which mature in 1999. Management currently
classifies the Company's entire investment portfolio as available for sale. The
portfolio is stated at fair value based on quoted market prices. Interest earned
on securities available for sale is included in interest income. The cost of
debt securities in this category is adjusted for amortization of premiums and
accretion of discounts to maturity. Such amortization and accretion are included
in interest income. Realized gains and losses and declines in value judged to be
other than temporary on securities available for sale (none in 1998, 1997 or
1996) are also included in interest income. The cost of securities sold is
calculated using the specific identification method.

         FINANCIAL INSTRUMENTS

         The Company's financial instruments consist of cash and cash
equivalents, accounts receivable and payable, and long-and short-term
borrowings. The fair value of these instruments approximates their recorded
value.



                                      -28-
<PAGE>





                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

         PROPERTY AND EQUIPMENT

         Property and equipment are carried at cost. The Company provides for
depreciation and amortization using the straight-line method for financial
reporting purposes and accelerated methods for income tax purposes. Depreciation
expense includes amounts amortized for assets recorded under capital leases.

         The estimated useful lives of equipment for financial reporting
purposes are as follows:

<TABLE>
<CAPTION>
                  <S>                                                               <C>    
                  Machinery and equipment............................................3 to 5 years
                  Office furniture and equipment....................................5 to 15 years
</TABLE>

         LONG-LIVED ASSETS

         The Company's policy to recognize impairment losses relating to
long-lived assets is based on several factors, including, but not limited to,
management's plans for future operations, recent operating results and projected
cash flows.

         REVENUE RECOGNITION

         The Company adopted Statement of Position 97-2, "Software Revenue
Recognition" effective January 1, 1998, as it relates to revenue recognition on
the Company's software product sales. Generally, revenues from sales of products
are recognized when products are shipped unless the Company has obligations
remaining under a sales or licensing agreement, in which case revenue is
deferred until all obligations are satisfied. Revenues from sales of maintenance
contracts are deferred and recognized ratably over the contract period. Revenues
from maintenance contracts in 1998, 1997, and 1996 were $4,671,000, $4,644,000,
and $3,158,000, respectively. Revenues from consulting services are recognized
as performed.

         In December 1998, the AICPA issued SOP 98-9, "Modification of SOP 97-2,
Software Revenue Recognition", with respect to certain transactions. SOP 98-9
amends SOP 97-2 and SOP 98-4 extending the deferral of the application of
certain provisions of SOP 97-2 amended by SOP 98-4 through fiscal years
beginning on or before March 15, 1999. All other provisions of SOP 98-9 are
effective for transactions entered into in fiscal years beginning after March
15, 1999. We have not yet determined the effect of the final adoption of SOP
98-9 on our financial condition or results of operations.

         USE OF ESTIMATES

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



                                      -29-
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


         RESEARCH AND DEVELOPMENT COSTS

         Research and development costs are expensed as incurred. The Company's
policy is to capitalize software development from the time "technological
feasibility" has been reached in accordance with SFAS No. 86, "Accounting for
the Costs of Computer Software to be Sold, Leased or Otherwise Marketed".
Technological feasibility is reached upon completion of a working model. No such
costs have been capitalized because the impact on the accompanying consolidated
financial statements would be immaterial.

         ACQUIRED TECHNOLOGY

         Costs to acquire technology are capitalized to the extent the products
are technologically feasible. Costs of acquired technology capitalized are
included in other assets in the balance sheet. The Company's policy is to
amortize these costs to match the associated revenue stream for the products
containing the acquired technology. As of December 31, 1998 and 1997, amounts
capitalized, net of accumulated amortization of $139,000 and $139,000, were
$553,000 and $561,000, respectively. Amortization expense was $150,000, $92,000
and $47,000 for the years ended December 31, 1998, 1997 and 1996, respectively.

         FOREIGN CURRENCIES

         The functional currencies of each of the Company's subsidiaries outside
the United States is that country's local currency. The related gains and losses
resulting from the translation of the subsidiaries' financial statements are
credited or charged to shareholders' equity in the cumulative translation
adjustments account. Realized and unrealized gains and losses on foreign
currency transactions are included in other income and expense.

         The Company has a program in place to manage foreign currency risk. As
part of that program, the Company has entered into foreign currency forward
contracts to hedge anticipated foreign currency transactions, primarily
intercompany accounts resulting from sales to international subsidiaries. The
forward contracts typically mature within three months. Gains and losses on
contracts that are designated and effective as hedges of such transactions are
deferred and recognized in income in the same period as the hedged transactions.
At December 31, 1998, no contracts were outstanding.

         INCOME TAXES

         The provisions for income taxes include federal, state and foreign
taxes currently payable and the change in its deferred tax assets and
liabilities. Deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and liabilities
and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to reverse.

         CONCENTRATION OF CREDIT RISK

         Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of cash equivalents, short-term
investments and trade accounts receivable. By policy, the Company places its
investments only in high credit quality financial securities and limits the
amounts invested in any one institution or in any type of instrument. The
Company's trade accounts receivable 



                                      -30-
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


are geographically dispersed and include customers in many different industries.
The Company performs ongoing credit evaluations of its customers' financial
condition and limits its exposure to losses from bad debts by limiting the
amount of credit extended whenever deemed necessary and generally does not
require collateral. The Company sells certain trade account receivable in Japan
with recourse in the ordinary course of business. At December 31, 1998, accounts
receivable included $32,000 sold with recourse.

         EARNINGS (LOSS) PER SHARE

         Basic earnings per share excludes any dilutive effects of stock
options. Basic earnings per share is computed using the weighted-average number
of common shares outstanding during the period. Diluted earnings per share is
computed using the weighted-average number of common shares and common stock
equivalent shares outstanding during the period. Common stock equivalent shares
are excluded from the computation if their effect is antidilutive.

         STOCK-BASED COMPENSATION

         As allowed by SFAS No. 123, "Accounting for Stock Based Compensation",
the Company applies APB No. Opinion 25, "Accounting for Stock Issued to
Employees", and related interpretations in accounting for its stock option plans
and, accordingly, compensation expense, if any, is generally determined based on
the difference between the exercise price of stock options or awards and the
related fair market value of the common stock. Note 9 to the Consolidated
Financial Statements contains a summary of the pro forma effects to reported net
income and earnings per share if the Company had elected to recognize
compensation expense based on the fair value of the options granted at grant
date as prescribed by SFAS No. 123.

         SEGMENTS AND RELATED INFORMATION

         As of December 31, 1998, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information". SFAS No. 131
establishes new standards for the way that public enterprises report information
about operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial report issued subsequent to adoption. SFAS No. 131 also establishes
new standards for related disclosures about products and services, geographic
areas and major customers. The adoption of the Statement did not effect the
Company's consolidated results of operations, financial position or cash flow.
All prior period amounts have been presented to conform with SFAS No. 131.

         RECLASSIFICATIONS

         Certain prior year amounts have been reclassified to conform to the
current year presentation. Such reclassifications have no effect on previously
reported results of operations.

         RECENT ACCOUNTING PRONOUNCEMENTS

         In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". SFAS No.133 requires all derivatives to be
recorded on the balance sheet at fair value and establishes "special accounting"
for fair value hedges, cash flow hedges, and hedges of foreign 



                                      -31-
<PAGE>


                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


currency exposures of net investment in foreign operations. The Statement is
effective for years beginning after June 15, 1999, but companies can early adopt
as of the beginning of any fiscal quarter that begins after June 1998. The
adoption of SFAS No. 133 is not expected to have a significant impact on the
Company's consolidated results of operations, financial position or cash flow.

2.       SECURITIES AVAILABLE FOR SALE

         Securities available for sale consist of the following as of December
31:

<TABLE>
<CAPTION>

                                                                       1998
                                         -----------------------------------------------------------------
                                                              GROSS            GROSS
                                           AMORTIZED       UNREALIZED       UNREALIZED
                                              COST            GAINS           LOSSES         FAIR VALUE
                                         --------------- ---------------- ---------------- ---------------
                                                                  (in thousands)
<S>                                      <C>             <C>              <C>              <C>   
U.S. Treasury securities and other 
     U.S Government obligations.......           $8,135               $8             $----         $8,143
Corporate debt securities..............           2,958              ----             ----         $2,958
                                         --------------- ---------------- ---------------- ---------------
                                         --------------- ---------------- ---------------- ---------------
                                                $11,093               $8               $0         $11,101
                                         --------------- ---------------- ---------------- ---------------
                                         --------------- ---------------- ---------------- ---------------
</TABLE>


<TABLE>
<CAPTION>
                                                                       1997
                                         -----------------------------------------------------------------
                                                              GROSS            GROSS
                                           AMORTIZED       UNREALIZED       UNREALIZED
                                              COST            GAINS           LOSSES         FAIR VALUE
                                         --------------- ---------------- ---------------- ---------------
                                                                  (in thousands)
<S>                                      <C>             <C>              <C>              <C>   
U.S. Treasury securities and other 
     U.S Government obligations........
                                                 $2,956               $0             $----         $2,956
Corporate debt securities..............           7,387                2              ----         $7,389
                                         --------------- ---------------- ---------------- ---------------
                                         --------------- ---------------- ---------------- ---------------
                                                $10,343               $2               $0         $10,345
                                         --------------- ---------------- ---------------- ---------------
                                         --------------- ---------------- ---------------- ---------------
</TABLE>


         As of December 31, 1998, the securities available for sale have
contractual maturities of less than one year. Expected maturities will differ
from contractual maturities because the issuers of the securities may have the
right to prepay obligations without prepayment penalties.

3.       INVENTORIES

         Inventories consist of:

<TABLE>
<CAPTION>

                                                                             DECEMBER 31,
                                                                     ------------------------------
                                                                         1998             1997
                                                                     -------------    -------------
                                                                            (in thousands)

<S>                                                                  <C>              <C>   
Finished goods.....................................................        $1,501           $1,303
Work in process....................................................            28              157
Purchased parts....................................................         1,803            2,005
                                                                     -------------    -------------
                                                                     -------------    -------------
                                                                           $3,332           $3,465
                                                                     -------------    -------------
                                                                     -------------    -------------
</TABLE>



                                      -32-
<PAGE>


                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



4.       PROPERTY AND EQUIPMENT

         Property and equipment consist of:

<TABLE>
<CAPTION>

                                                                             DECEMBER 31,
                                                                     ------------------------------
                                                                         1998             1997
                                                                     -------------    -------------
                                                                            (in thousands)

<S>                                                                  <C>              <C>   
Machinery and equipment............................................        $3,529           $3,973
Office furniture and equipment.....................................         2,802            2,465
Leased equipment...................................................           ----             410
                                                                     -------------    -------------
                                                                            6,331            6,848
Less accumulated depreciation and amortization.....................         3,413            3,948
                                                                     -------------    -------------
                                                                     -------------    -------------
                                                                           $2,918           $2,900
                                                                     -------------    -------------
                                                                     -------------    -------------
</TABLE>

5.       REVOLVING LINE OF CREDIT AGREEMENTS

         In May 1998, the Company negotiated a revolving line of credit
agreement with a commercial bank aggregating $7.0 million, which expires in May
1999. Borrowings pursuant to this agreement bear interest at the bank's prime
lending rate. The agreement provides the Company an option to amortize $2.0
million of the available line over a five year term. The line of credit
agreement is unsecured, except for the term loan option, and includes certain
financial covenants. There were no amounts outstanding under the line of credit
at December 31, 1998 or 1997.

6.       COMMITMENTS AND CONTINGENCIES

         The Company leases office space and equipment under noncancelable
operating lease. Certain leases contain renewal options. Future minimum payments
under these leases at December 31, 1998 are as follows:

<TABLE>
<CAPTION>
<S>                                                            <C>   
1999........................................................               $1,260
2000........................................................                1,221
2001........................................................                  527
2002........................................................                  119
2003........................................................                   91
Thereafter..................................................                  397
                                                              --------------------
                                                              --------------------
                                                                           $3,615
                                                              --------------------
                                                              --------------------
</TABLE>


         Total rent expense for the years ended December 31, 1998, 1997 and 1996
was $1,393,000, $1,378,000, and $1,278,000, respectively.

         The Company is subject to various pending and threatened legal actions
that arise in the normal course of business. In the opinion of management,
liabilities arising from these claims, if any, will not have a material effect
on the consolidated financial statements of the Company.



                                      -33-
<PAGE>


                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


7.       INCOME TAXES

         The provision for incomes taxes in 1998, 1997 and 1996 is as follows:

<TABLE>
<CAPTION>
                                                                      YEAR ENDED DECEMBER 31,
                                                        -----------------------------------------------------
                                                             1998              1997               1996
                                                        ----------------  ----------------   ----------------
                                                                          (in thousands)
<S>                                                     <C>               <C>                <C>   
Federal................................................      ($ 9)             $179               $1,402
Foreign................................................        28               105                   90
State..................................................       --                 65                   90
                                                        ----------------  ----------------   ----------------
                                                              $19              $349               $1,582
                                                        ----------------  ----------------   ----------------
                                                        ----------------  ----------------   ----------------
</TABLE>

         SFAS No. 109, "Accounting for Income Taxes", requires recognition of
deferred tax assets and liabilities for the expected future tax consequences of
events that have been included in the financial statements or tax returns.
Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes and operating loss and tax
credit carryforwards. The tax effects of significant items comprising the
Company's deferred taxes were as follows:

<TABLE>
<CAPTION>

                                                                               YEAR ENDED DECEMBER 31,
                                                                          -----------------------------------
                                                                                1998              1997
                                                                          -----------------  ----------------
                                                                                    (in thousands)
<S>                                                                       <C>                <C>  
Deferred tax assets:
     Accrued and other expenses..........................................      $ 339              $ 166
     Inventories.........................................................        709                568
     Net operating loss carryforwards....................................      1,220                791
     Tax credit carryforwards............................................      1,746              1,208
                                                                          -----------------  ----------------
     Total deferred tax assets...........................................      4,014              2,733
Deferred tax liabilities:
     Depreciation........................................................        --                  11
     Foreign Currency....................................................        467              --
     Intangible and other assets.........................................        233                219
                                                                          -----------------  ----------------
     Total deferred tax liabilities......................................        700                230
Valuation allowance......................................................     (3,314)            (2,503)
                                                                          -----------------  ----------------
Net deferred taxes.......................................................      $   0              $   0
                                                                          -----------------  ----------------
                                                                          -----------------  ----------------
</TABLE>

         As of December 31, 1998, the Company has net operating loss
carryforwards for federal tax purposes of approximately $3,486,000 available to
offset future taxable income. The Company also has research and development
credits of approximately $1,746,000, which may be carried forward, subject to
certain limitations, to offset future tax liabilities. The net operating loss
and research and development tax credit carryforwards expire in various amounts
from 1999 to 2018. Sections 382 and 383 of the Internal Revenue Code of 1986, as
amended, set forth annual limits for the utilization of tax net operating loss
and credit carryforwards in the event of a significant change in ownership. The
issuance of preferred stock in 1992 resulted in such "ownership change."
Accordingly, utilization of the net operating loss carryforwards is limited to
approximately $392,000 per year.


                                      -34-
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


         A full valuation allowance has been established for the net deferred
tax assets due to the uncertainly whether or not they will be realized. The
valuation allowance for deferred tax assets increased approximately $811,000 and
$280,000 during 1998 and 1997, respectively.

         A reconciliation from the U.S. statutory rate to the effective tax rate
is as follows:


<TABLE>
<CAPTION>
                                                                      YEAR ENDED DECEMBER 31,
                                                        -----------------------------------------------------
                                                             1998              1997               1996
                                                        ----------------  ----------------   ----------------
                                                                          (in thousands)

<S>                                                     <C>                <C>               <C>   
Tax at U.S. statutory rate of 34%......................     $ (114)            $ 788              $1,854
Utilization of net operating loss and tax credit
     carryforwards.....................................       --                (137)               (532)
Benefit of foreign sales corporation...................       --                (122)                (98)
Alternative minimum tax................................       --                  57               --
Foreign taxes..........................................         28               105                  90
State taxes, net of federal effect.....................          7                42                  59
Foreign losses  with no tax benefit....................        132               404                 212
Loss on deemed liquidation of subsidiaries.............       --                (845)              --
Other..................................................        (34)               57                  (3)
                                                        ----------------  ----------------   ----------------
                                                            $   19             $ 349              $1,582
                                                        ----------------  ----------------   ----------------
                                                        ----------------  ----------------   ----------------
</TABLE>


         Effective as of April 1, 1997, the Company elected, pursuant to newly
issued Treasury Regulations, to treat its wholly-owned subsidiaries in the
United Kingdom, Germany and France as branches for U.S. tax purposes. The effect
of such election was a deemed liquidation of each subsidiary allowing its tax
attributes to be utilized by the Company, thereby reducing the 1997 tax
provision by $845,000.

In 1997 and 1996, income tax benefits of $55,000 and $204,000, respectively,
were allocated to stockholders equity. Such benefits were attributable to
employee stock option transactions.



                                      -35-
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


8.       INCOME PER SHARE

         The following table sets forth the computation of basic and diluted
income per share:

<TABLE>
<CAPTION>
                                                                                YEAR ENDED DECEMBER 31,
                                                                   --------------------------------------------------
(in thousands, except per share amount)                                 1998             1997             1996
                                                                   ---------------- ---------------- ----------------
<S>                                                                <C>              <C>              <C>   
Numerator:
    Numerator for basic and diluted income per share -
      net income (loss)..........................................      ($345)           $1,902           $3,716
                                                                   ---------------- ---------------- ----------------
                                                                   ---------------- ---------------- ----------------
Denominator:
    Denominator for basic income per share - weighted
      average common shares......................................       6,811            6,769            6,545
    Effect of dilutive securities:
    Stock options and warrants based on the treasury
      stock method using average market price....................        --                528              552
                                                                   ---------------- ---------------- ----------------
    Denominator for diluted income per share.....................       6,811            7,297            7,097
                                                                   ---------------- ---------------- ----------------
                                                                   ---------------- ---------------- ----------------
Basic income (loss) per share....................................      ($0.05)           $0.28            $0.57
                                                                   ---------------- ---------------- ----------------
                                                                   ---------------- ---------------- ----------------
Diluted income (loss) per share..................................      ($0.05)           $0.26            $0.52
                                                                   ---------------- ---------------- ----------------
                                                                   ---------------- ---------------- ----------------
</TABLE>

9.       SHAREHOLDERS' EQUITY

         STOCK OPTIONS

         Stock option plans (the Plans) have been established that authorize the
issuance of options for 2,575,317 shares of common stock to selected directors,
officers, employees, and consultants of the Company. As of December 31, 1998
options for 1,091,268 shares are outstanding and exercisable, of which options
for 816,070 shares are unvested. Options for 282,250 shares are available to be
granted.

         The Plans provide for granting incentive stock options, nonincentive
stock options, and stock appreciation rights. The Plans vest substantial
authority in the compensation committee of the Board of Directors to determine
the terms of each option. Shares issued as a result of exercise of options are
subject to repurchase rights by the Company in the event that the optionee's
employment with the Company should terminate; most rights lapse at a rate of 25%
per year from the date of grant. Options are not transferable and terminate
following the optionholder's cessation of employment. Options issued to date
have been at fair value at date of grant.

         On September 11, 1995, the Company's shareholders adopted the Director
Stock Option Plan which authorized the issuance of options for 45,000 shares of
common stock. The Plan authorized the annual issuance of options for 2,500
shares of common stock per outside director upon the exercise of stock options
that may be granted pursuant to this plan. As of December 31, 1998, options for
22,500 shares are outstanding and exercisable and options for 7,500 shares
contain repurchase rights.



                                      -36-
<PAGE>


                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


         A summary of stock option transactions for all plans for the years
ended December 31 follows:


<TABLE>
<CAPTION>
                                       1998                          1997                           1996
                           ----------------------------- ------------------------------ -----------------------------
                           OPTIONS   WEIGHTED-AVERAGE     OPTIONS   WEIGHTED-AVERAGE     OPTIONS   WEIGHTED-AVERAGE
                            (000)     EXERCISE PRICE       (000)     EXERCISE PRICE       (000)     EXERCISE PRICE
                            -----     --------------       -----     --------------       -----     --------------
<S>                        <C>        <C>                <C>         <C>                <C>         <C>       
Outstanding-beginning of
year......................   864          $ 3.13            729          $ 5.99             541         $    .31
Granted...................   525          $ 4.45            631          $ 4.62             326         $  13.18
Forfeited.................  (150)         $ 5.34           (407)        $ 11.19             (25)        $   3.06
Exercised.................  (125)          $ .10            (89)          $ .20            (113)        $    .20
                           ---------                     ----------                     ----------

Outstanding-end of year...
                            1,114         $ 3.79            864          $ 3.13            729          $   5.99
                           ---------                     ----------                     ----------
                           ---------                     ----------                     ----------

Vested options............   290          $ 2.34            262           $ .67            287          $    .14
                           ---------                     ----------                     ----------
                           ---------                     ----------                     ----------

Weighted-average fair
value of options granted
during the year...........  $ 3.39                        $ 3.19                         $10.14
</TABLE>

         The following table summarizes information related to outstanding and
exercisable options at December 31, 1998:

<TABLE>
<CAPTION>

                                          OUTSTANDING AND EXERCISABLE                         VESTED OPTIONS
                             -------------------------------------------------------  --------------------------------
                                             WEIGHTED AVERAGE     WEIGHTED AVERAGE                       WEIGHTED
                                                 EXERCISE            REMAINING                            AVERAGE
 RANGE OF EXERCISE PRICES       SHARES             PRICE          CONTRACTUAL LIFE       SHARES       EXERCISE PRICE
                                 (000)                                                    (000)
---------------------------- --------------  ------------------  -------------------  --------------  ----------------
<S>                          <C>             <C>                 <C>                  <C>             <C>  
      $  .02 - 2.00              170              $   .26               4.9                167            $   .24
      $ 2.38 - 4.18              570              $  4.01               8.5                107            $  4.13
      $ 4.56 - 7.00              366              $  7.94               9.1                  8            $  6.98
      $12.25 - 17.50               8              $ 16.75               7.4                  8            $ 17.09
                                             ------------------  -------------------                  ----------------

                             --------------                                           --------------
      $ .02 - 17.50             1,114            $ 3.79                8.1                290            $ 2.34
                             --------------                                           --------------
                             --------------                                           --------------
</TABLE>

         Had compensation expense for the Company's stock option plans been
determined based upon the fair value at the grant date for awards under these
plans consistent with the methodology prescribed under FSAS No. 123, the
Company's net income and earnings per share would have been as follows:


<TABLE>
<CAPTION>
  (in thousands, except per share amount)                      1998                 1997                 1996
                                                        -------------------  -------------------  --------------------
<S>                                                     <C>                  <C>                  <C>   
Net income (loss) - as reported.....................           ($345)              $1,902               $3,716
Net income (loss) - pro forma .......................        ($1,016)              $1,411               $3,282
Diluted net income (loss) per share as reported......        ($  .05)               $ .26               $  .52
Diluted net income (loss) per share pro-forma........        ($  .15)               $ .19               $  .46
</TABLE>

         Compensation expense not recognized in providing pro forma disclosures
may not be representative of the effects on pro forma net income for future
years because the above amounts include only the amortization for the fair value
of grants made in fiscal years 1998, 1997, and 1996.




                                      -37-
<PAGE>



                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


         The fair value of each option is estimated on the date of grant using
the Black-Scholes multiple-option approach pricing model with the following
weighted average assumptions:


<TABLE>
<CAPTION>
                                                               1998                 1997                 1996
                                                        -------------------  -------------------  --------------------
<S>                                                     <C>                  <C>                  <C>  
Annualized volatility................................         94.7%                93.9%                 89.6%
Risk-free interest rate..............................          5.0%                 6.0%                  6.4%
Expected life........................................       5.4 years            4.0 years             5.8 years
Expected dividend rate...............................          nil                  nil                   nil
</TABLE>

         STOCK WARRANTS

         During 1991, the Company granted a stock purchase warrant for 60,680
shares of common stock at $4.12 per share expiring after five years which were
issued to a shareholder in consideration for a one-year personal guarantee of a
$500,000 bank loan obtained by the Company. During 1996 all of the outstanding
warrants were exercised on a net basis resulting in issuance of 35,679 shares of
common stock.

         In 1992, in connection with an equity financing, the Company granted
stock purchase warrants for 114,563 shares of Series I preferred stock at $4.12
per share expiring after five years. In connection with the initial public
offering, these outstanding preferred stock warrants converted to common stock
warrants. During 1997 all of the remaining outstanding warrants were exercised
on a net basis resulting in issuance of 58,941 shares of common stock.

         EMPLOYEE STOCK PURCHASE PLAN

         On May 22, 1996, the Company's shareholders approved the 1996 Employee
Stock Purchase Plan (ESPP) and reserved a total of 250,000 shares of common
stock for issuance. The purpose of the ESPP is to provide eligible employees of
the Company with a means of acquiring common stock of the Company through
payroll deductions. The purchase price of such stock under the ESPP cannot be
less than 85% of the lower of the fair market value on the specified purchase
date or the beginning of the offering period. During 1998, 1997 and 1996,
55,193, 45,844 and 16,165 shares were sold through the ESPP, respectively.

         COMMON STOCK RESERVED

         Common stock reserved for future issuance at December 31, 1998 is as
follows:

<TABLE>

<S>                                                                  <C>    
Employee Stock Purchase Plan.......................................       132,798
Common stock options...............................................     1,418,793
                                                                     -------------
                                                                     -------------
                                                                        1,551,591
                                                                     -------------
                                                                     -------------
</TABLE>



                                      -38-
<PAGE>


                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


         SHAREHOLDER RIGHTS PLAN

         In 1998, the Company adopted a Rights Plan, declaring a dividend of one
preferred share purchase right ("Right") for each outstanding share of the
Company's common stock. The Rights become exercisable upon the earlier of a
person or group announcing (1) an acquisition of 15% or more of the common stock
of the Company or (2) the commencement of a tender or exchange offer that would
result in such person acquiring ownership of 15% or more of the common stock of
the Company. Each Right entitles the holder to purchase 1/100th of a preferred
share at a current price of $30. Upon a triggering event, each holder of a Right
shall be entitled to purchase common stock that has a market value equal to 
two times the exercise price of the Right. The Company is entitled to redeem 
the Rights at $0.01 each under specified circumstances.

         STOCK REPURCHASE PLAN

         In 1998, the Board of Directors authorized the Company to repurchase up
to 500,000 shares of its common stock using existing cash, from time-to-time at
market prices, and as market and business conditions warrant, in open market,
negotiated, or block transactions. The repurchase program seeks to offset
dilution associated with stock options issued under the Company's stock
incentive programs and for general corporate purposes. The Company has
repurchased 326,000 shares for $1,210,000.

10.      EMPLOYEE BENEFIT PLAN

         The Company maintains a Profit Sharing Plan (the Plan) under section
401K of the Internal Revenue Code. All U.S. based employees are eligible to
participate in the Plan at the start of each calendar quarter. Contributions by
the company are based on a matching formula as defined in the Plan. The Company
may also make discretionary contributions. During 1998, 1997 and 1996, the
Company made contributions of $192,000, $162,000 and $133,000, respectively.



                                      -39-
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)




11.      SEGMENT AND RELATED INFORMATION

         The Company is engaged in one line of business: the design,
manufacture, and distribution of development and test hardware and software
tools for embedded product manufacturers. Certain financial information of
operations by geographic area is provided in the table below based on the
location of the Company's facilities. Sales are not recognized for financial
statement purposes until there has been a sale to an unaffiliated customer.

<TABLE>
<CAPTION>

                                                                      YEAR ENDED DECEMBER 31,
                                                        -----------------------------------------------------
                                                             1998              1997               1996
                                                        ----------------  ----------------  -----------------
                                                                          (in thousands)
<S>                                                     <C>               <C>               <C>    
GEOGRAPHIC AREA DATA:
Net Sales:
United States..........................................     $22,325           $22,247           $22,615
Japan..................................................      10,664            13,132            12,842
Europe.................................................       4,031             3,745            3,205
                                                        ----------------  ----------------  -----------------
Consolidated net sales.................................     $37,020          $39,124           $38,662
                                                        ----------------  ----------------  -----------------

Export Sales to unaffiliated customers.................     $ 1,597          $ 2,446           $ 2,367
                                                        ----------------  ----------------  -----------------
                                                        ----------------  ----------------  -----------------

Income (loss) before income taxes:
United States..........................................     $ 1,139           $ 4,121          $ 5,900
Japan..................................................          34               107              266
Europe.................................................     (1,037)              (623)            (214)
Corporate eliminations.................................       (462)            (1,354)            (654)
                                                        ----------------  ----------------  -----------------
Consolidated income (loss) before income tax...........      ($326)            $2,251           $5,298
                                                        ----------------  ----------------  -----------------
                                                        ----------------  ----------------  -----------------

Long-lived assets:

Property, plant and equipment, net
United States..........................................     $2,797            $2,778            $2,286
Japan..................................................         50                53                61
Europe.................................................         71                69                94
                                                        ----------------  ----------------  -----------------
Consolidated assets....................................     $2,918            $2,900            $2,441
                                                        ----------------  ----------------  -----------------
                                                        ----------------  ----------------  -----------------

Other Assets, net
United States..........................................       $723              $682              $558
Japan..................................................        131               114               154
Europe.................................................         43                48                53
                                                        ----------------  ----------------  -----------------
Consolidated assets....................................       $897              $844              $765
                                                        ----------------  ----------------  -----------------
                                                        ----------------  ----------------  -----------------
</TABLE>




                                      -40-
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


12.      QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

Summarized quarterly financial information for 1998 and 1997 is as follows:

<TABLE>
<CAPTION>

                                                                       1998
                                       ---------------------------------------------------------------------
For the quarters ended:                    MAR. 31          JUNE 30           SEPT. 30          DEC. 31
                                           -------          -------           --------          -------
  (In thousands, except per share
data)
<S>                                        <C>               <C>               <C>               <C>   
    Net sales........................      $8,251            $9,157            $9,957           $9,655
    Gross profit.....................       5,938             6,832             7,432            7,230
    Net Income (loss)..............          (559)               58               113               43

    Diluted income (loss) per
    share............................      ($0.08)            $0.01             $0.02            $0.01
    Shares used in diluted per
    share calculation................       6,878             7,113             6,983            6,832
    Market price per share:
        High.........................       $8.88             $7.63             $4.63            $4.75
        Low..........................        4.50              3.81              2.63             2.13
</TABLE>


<TABLE>
<CAPTION>
                                                                       1997
                                       ---------------------------------------------------------------------
For the quarters ended:                    MAR. 31          JUNE 30           SEPT. 30          DEC. 31
                                           -------          -------           --------          -------
  (In thousands, except per share
data)
<S>                                         <C>              <C>               <C>               <C>   
    Net sales........................       $8,902           $10,009           $10,758           $9,455
    Gross profit.....................        6,446             7,310             7,897            6,939
    Net Income.....................             42               647             1,012              201

    Diluted income per share.........        $0.01             $0.09             $0.14            $0.03
    Shares used in diluted per
    share calculation................        7,101             7,259             7,393            7,397
    Market price per share:
        High.........................       $16.00            $10.50            $12.88           $12.63
        Low..........................         4.88              3.88              8.00             5.00
</TABLE>




                                      -41-
<PAGE>





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

                None.


                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         The information required by this Item is contained in part in the
sections captioned "Board of Directors -- Nominees for Director" and "Voting
Securities and Principal Holders -- Exchange Act Compliance" in the Proxy
Statement for the Company's Annual Meeting of Stockholders scheduled to be held
on May 25, 1999, and such information is incorporated herein by reference.

         The remaining information required by this Item is set forth as Item 4A
in Part I of this report under the caption "Executive Officers of the
Registrant."

ITEM 11. EXECUTIVE COMPENSATION

         The information required by this Item is incorporated by reference to
the information contained in the section captioned "Compensation and Benefits"
of the Proxy Statement for the Company's Annual Meeting of Stockholders
scheduled to be held on May 25, 1999.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information required by this Item is incorporated by reference to
the information contained in the sections captioned "Voting Securities and
Principal Holders" and "Compensation and Benefits--Certain Transactions" of the
Proxy Statement for the Company's Annual Meeting of Stockholders scheduled to be
held on May 25, 1999.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The information required by this Item is incorporated by reference to
the information contained in the section captioned "Compensation and
Benefits--Certain Transactions" of the Proxy Statement for the Company's Annual
Meeting of Stockholders scheduled to be held on May 25, 1999.




                                      -42-
<PAGE>




                                     PART IV

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


The following documents are filed as part of this report:

(A)(1)   FINANCIAL STATEMENTS - See Index to Financial Statements at Item 8 of 
this report.

(A)(2)   FINANCIAL STATEMENT SCHEDULES

         Schedule II:      Valuation and Qualifying Accounts

         Schedules not listed above have been omitted because the information
         required to be set forth therein is not applicable or is included in
         the Consolidated Financial Statements or notes thereto.

(A)(3)   EXHIBITS

         The following exhibits are filed with this report:

Exhibit No. 3:  Articles of Incorporation and Bylaws

         3.1      Second Restated Articles of Incorporation of Registrant
         3.2      Restated Bylaws of Registrant

Exhibit No. 10:  Material Contracts

         EXECUTIVE COMPENSATION PLANS AND AGREEMENTS

         10.2     1990 Stock Benefit Plan
         10.3     1992 Performance Stock Plan
         10.4     1995 Directors Stock Option Plan

         OTHER MATERIAL CONTRACTS




                                      -43-
<PAGE>

         10.7     Lease Agreement between W.R.C.  Properties,  Inc. and the 
                  Registrant dated February 27, 1989; and Amendments to Lease
                  Agreement dated November 7, 1990, May 11, 1992, August 18,
                  1993 and March 31, 1994
         10.8     Third Amended and Restated Investment Agreement dated as of 
                  September 15, 1995
         10.10    Tools  Development and Bond-Out License  Agreement  between 
                  the Registrant and Intel Corporation dated September 30, 1993,
                  as amended April 13, 1994 10.11 Bond-Out License Agreement
                  between the Registrant and Intel Corporation dated September
                  16, 1994 10.12 Source License and Distribution Agreement
                  between the Registrant and Microtec Research, Inc. dated
                  August 1, 1994
         10.15    Processor feature Technology License Agreement between the
                  Registrant and Intel Corporation dated September 21, 1995

         10.16    Business Loan Agreement between the Registrant and U.S. Bank
                  of Washington, N.A. dated February 9, 1996; Alternative Rate
                  Options Promissory Note dated February 9, 1996.

Exhibit No. 21:  Subsidiaries of Registrant

Exhibit No. 23:  Consent of Ernst & Young LLP, Independent Auditors.


(B)      REPORTS ON FORM 8-K

                  The Company filed a report on Form 8-K December 11, 1998
         declaring a dividend distribution of one preferred share purchase right
         (each a "Right") for each outstanding share of Common Stock of the
         Company payable to the holders of record of the Common Shares on
         December 21, 1998. The Rights dividend was declared by the Board of
         Directors in connection with its adoption of the Shareholder Rights
         Plan, dated December 10, 1998 between the Company and Chasemellon
         Shareholder Services, L.L.C., which was incorporated by reference from
         Exhibit 1 to the Company's Registration Statement on Form 8-A12G, dated
         December 15, 1998.



                                      -44-
<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, in the City of
Seattle, State of Washington, on March 31, 1999.

                                            APPLIED MICROSYSTEMS CORPORATION


                                            By /s/ A. JAMES BEACH
                                               ------------------
                                                A. James Beach
                                                CHIEF FINANCIAL OFFICER

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

SIGNATURE                   TITLE                                DATE

/s/ Robert L. Deinhammer    President, Chief Executive           March 31, 1999
------------------------    Officer and Director
Robert L. Deinhammer        (Principal Executive Officer)
 
/s/ A. James Beach          Vice President, Chief                March 31, 1999
-------------------         Financial Officer, Secretary
A. James Beach              and Treasurer (Principal
                            Financial and Accounting
                            Officer)

/s/ Anthony Miadich         Chairman of the Board                March 31, 1999
--------------------
Anthony Miadich

/s/ Charles H. House        Director                             March 31, 1999
--------------------
Charles H. House

/s/ Elwood D. Howse, Jr.    Director                             March 31, 1999
------------------------
Elwood D. Howse, Jr.

/s/ Paul N. Risinger        Director                             March 31, 1999
--------------------
Paul N. Risinger



                                      -45-
<PAGE>


                                  EXHIBIT INDEX

<TABLE>
<CAPTION>

     EXHIBIT NO.                                     DESCRIPTION

<S>                    <C>                                                             
 3.1                   Restated Articles of Incorporation of Registrant (incorporated by
                       reference from Exhibit 3.1 to the Registrant's Registration Statement
                       on Form S-1 filed with the Securities and Exchange Commission on
                       September 15, 1995 (File No. 33-97002)................................

 3.2                   Restated Bylaws of Registrant (incorporated by reference from Exhibit
                       3.2 to the Registrant's Registration Statement on Form S-1 filed with
                       the Securities and Exchange Commission on September 15, 1995 (File No.
                       33-97002).............................................................

10.2                   1990 Stock Benefit Plan (incorporated by reference from Exhibit 10.5
                       to the Registrant's Registration Statement on Form S-1 filed with the
                       Securities and Exchange Commission on September 15, 1995 (File No.
                       33-97002).............................................................

10.3                   1992 Performance Stock Plan (incorporated by reference from Exhibit
                       10.6 to the Registrant's Registration Statement on Form S-1 filed with
                       the Securities and Exchange Commission on September 15, 1995 (File No.
                       33-97002).............................................................

10.4                   1995 Directors Stock Option Plan (incorporated by reference from
                       Exhibit 10.7 to the Registrant's Registration Statement on Form S-1
                       filed with the Securities and Exchange Commission on September 15,
                       1995 (File No. 33-97002)..............................................

</TABLE>


                                      -46-
<PAGE>

<TABLE>
<CAPTION>
<S>                    <C>                                                             

10.7                   Lease Agreement between W.R.C. Properties, Inc. and the Registrant
                       dated February 27, 1989; and Amendments to Lease Agreement dated
                       November 7, 1990, May 11, 1992, August 18, 1993 and March 31, 1994
                       (incorporated by reference from Exhibit 10.4 to the Registrant's
                       Registration Statement on Form S-1 filed with the Securities and
                       Exchange Commission on September 15, 1995 (File No. 33-97002).........

10.8                   Third Amended and Restated Investment Agreement dated as of September
                       15, 1995 (incorporated by reference from Exhibit 10.8 to the
                       Registrant's Registration Statement on Form S-1 filed with the
                       Securities and Exchange Commission on September 15, 1995 (File No.
                       33-97002).............................................................

**10.9                 License Agreement between the Registrant and Intel Corporation dated
                       March 30, 1990 (incorporated by reference from Exhibit 10.9 to the
                       Registrant's Registration Statement on Form S-1 filed with the
                       Securities and Exchange Commission on September 15, 1995 (File No.
                       33-97002).............................................................

**10.10                Tools Development and Bond-Out License Agreement between the
                       Registrant and Intel Corporation dated September 30, 1993, as amended
                       April 13, 1994 (incorporated by reference from Exhibit 10.10 to the
                       Registrant's Registration Statement on Form S-1 filed with the
                       Securities and Exchange Commission on September 15, 1995 (File No.
                       33-97002).............................................................


**10.11                Bond-Out License Agreement between the Registrant and Intel
                       Corporation dated September 16, 1994 (incorporated by reference from
                       Exhibit 10.11 to the Registrant's Registration Statement on Form S-1
                       filed with the Securities and Exchange Commission on September 15,
                       1995 (File No. 33-97002)..............................................
</TABLE>




                                      -47-
<PAGE>


<TABLE>
<CAPTION>
<S>                    <C>                                                             
**10.12                Source License and Distribution Agreement between the Registrant and
                       Microtec Research, Inc. dated August 1, 1994 (incorporated by
                       reference from Exhibit 10.12 to the Registrant's Registration
                       Statement on Form S-1 filed with the Securities and Exchange
                       Commission on September 15, 1995 (File No. 33-97002)..................

**10.15                Processor feature Technology License Agreement between the Registrant
                       and Intel Corporation dated September 21, 1995 (incorporated by
                       reference from Exhibit 10.15 to the Registrant's Registration
                       Statement on Form S-1 filed with the Securities and Exchange
                       Commission on September 15, 1995 (File No. 33-97002)).................

10.16                  Business Loan Agreement between the Registrant and U.S. Bank of
                       Washington, N.A. dated February 9, 1996; Alternative Rate Options
                       Promissory Note dated February 9, 1996 (incorporated by reference from
                       Exhibit 10.16 to the Company's annual report on form 10K for year
                       ended December 31, 1995)..............................................

21                     Subsidiaries of the Registrant (incorporated by reference from Exhibit
                       21.1 to the Registrant's Registration Statement on Form S-1 filed with
                       the Securities and Exchange Commission on September 15, 1995 (File No.
                       33-97002).............................................................

23                     Consent of Ernst & Young LLP, Independent Auditors....................
</TABLE>
          
---------

** Confidential treatment has been granted for portions of this exhibit.



                                      -48-
<PAGE>



                 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS

                        APPLIED MICROSYSTEMS CORPORATION

                  YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------
                COL A.                     COL B.                  COL C.                  COL D.           COL E.
----------------------------------------------------------------------------------------------------------------------
                                                                 ADDITIONS
                                                     ---------------------------------
                                                            (1)              (2)
              DESCRIPTION                BALANCE AT      CHARGED TO      CHARGED TO      DEDUCTIONS:        BALANCE
                                         BEGINNING         COSTS            OTHER         DESCRIBE          END OF
                                         OF PERIOD          AND           ACCOUNTS:                         PERIOD
                                                          EXPENSES        DESCRIBE
----------------------------------------------------------------------------------------------------------------------

Year ended December 31, 1998: 
Deducted from asset accounts:
<S>                                     <C>             <C>             <C>              <C>              <C>    
   Allowance for doubtful accounts           $84,000         $12,000               --       ($15,000) (A)     $81,000
   Allowance for sales returns              $527,000              --          142,000 (B)   (101,000) (C)    $568,000
                                        -------------   -------------   --------------  --------------    ------------

   Totals                                   $611,000         $12,000         $142,000      ($116,000)        $649,000
                                        -------------   -------------   --------------  --------------    ------------
                                        -------------   -------------   --------------  --------------    ------------

Year ended December 31, 1997: 
Deducted from asset accounts:
   Allowance for doubtful accounts           $52,000         $32,000               --              --         $84,000
   Allowance for sales returns              $212,000              --          670,000 (B)   (355,000) (C)    $527,000
                                        -------------   -------------   --------------  --------------    ------------
   Totals                                   $264,000         $32,000         $670,000      ($355,000)        $611,000
                                        -------------   -------------   --------------  --------------    ------------
                                        -------------   -------------   --------------  --------------    ------------

Year ended December 31, 1996: 
Deducted from asset accounts:
   Allowance for doubtful accounts           $55,000        ($3,000)               --              --         $52,000
   Allowance for sales returns              $113,000              --          507,000 (B)   (408,000) (C)    $212,000
                                        -------------   -------------   --------------  --------------    ------------
   Totals                                   $168,000        ($3,000)         $507,000      ($408,000)        $264,000
                                        -------------   -------------   --------------  --------------    ------------
                                        -------------   -------------   --------------  --------------    ------------
</TABLE>

(A) Uncollectible accounts written off, net of recoveries 
(B) Estimated future sales returns charged to revenue 
(C) Actual Sales Returns



                                      -49-