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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-K

|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1943    
|          
|           |  | For the fiscal year ended December 31,
    2002                                             
|          
|or        
|          
|o          |  | 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



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Applied Microsystems Corporation

(Exact name of registrant as specified in its
charter)




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|                                                                                                                                                                                                                         |  |                                            
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------------------------------------
|Washington                                                                                                                                                                                                               |  | 91-1074996                                 
|(State of incorporation)                                                                                                                                                                                                 |  | (I.R.S. Employer Identification
    Number)
|6244-185th Avenue NE, Building C,
    Suite 201, Redmond, Washington 98052
    (425)883-1606(Address, including zip code, of
    registrants principal executive offices and telephone
    number, including area code)



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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 þ          No o

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 this Form 10-K or any
amendment to this
Form 10-K.     þ

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Securities Exchange Act of
1934).     Yes o          No þ

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

Common stock: 7,597,303 shares outstanding
as of March 17, 2003.

The aggregate market value of the common stock
held by non-affiliates of the registrant, based on the closing
price on March 17, 2003, as reported on the OTC Bulletin
Board, was $633,630.1 The aggregate market value of
the common stock held by non-affiliates of the registrant, based
on the closing price on June 28, 2002, as reported on the
Nasdaq National Market, was $2,694,645.1

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this
Report, to the extent not set forth herein, is incorporated
herein by reference from the registrants definitive proxy
statement, which the registrant intends to file with the
Securities and Exchange Commission within 120 days after
the end of the fiscal year ended December 31, 2002.



---

1Excludes
shares held of record on that date by directors, executive
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.



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TABLE OF CONTENTS



|                                                 |                                                                                               |  |  |  |  |  |  | 
|------------------------------------------------ | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I                                          
|                                                 | Item 1. Business                                                                             
|                                                 | Item 2. Properties                                                                           
|                                                 | Item 3. Legal Proceedings                                                                    
|                                                 | Item 4. Submission of Matters to a Vote of Security Holders                                  
|PART II                                         
|                                                 | Item 5. Market for Registrants Common Equity and Related Stockholder Matters                
|                                                 | Item 6. Selected Consolidated Financial Data                                                 
|                                                 | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                                                 | Item 7A. Quantitative and Qualitative Disclosures about Market Risk                          
|                                                 | Item 8. Financial Statements and Supplementary Data                                          
|                                                 | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 
|PART III                                        
|                                                 | Item 10. Directors and Executive Officers of the Registrant                                  
|                                                 | Item 11. Executive Compensation                                                              
|                                                 | Item 12. Security Ownership of Certain Beneficial Owners and Management                      
|                                                 | Item 13. Certain Relationships and Related Transactions                                      
|PART IV                                         
|                                                 | Item 14. Controls and Procedures                                                             
|                                                 | Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K                    
|SIGNATURES                                      
|SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
|EXHIBIT INDEX                                   
|Exhibit 21                                      
|Exhibit 23                                      
|Exhibit 23.1                                    
|Exhibit 99.1                                    
|Exhibit 99.2                                    



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##### Table of Contents



TABLE OF CONTENTS

|         |  |                                                                                           |  |      |  | 
|-------- |  | ----------------------------------------------------------------------------------------- |  | ---- |  | 
|         |  |                                                                                           |  | Page
|         |  |                                                                                           |  |     
|Part I  
|Item 1.  |  | Business                                                                                  |  |      |  | 
|Item 2.  |  | Properties                                                                                |  |      |  | 
|Item 3.  |  | Legal Proceedings                                                                         |  |      |  | 
|Item 4.  |  | Submission of Matters to a Vote of Security
    Holders                                   |  |      |  | 
|Part II 
|Item 5.  |  | Market for Registrants Common Equity and
    Related Stockholder Matters                 |  |      |  | 
|Item 6.  |  | Selected Consolidated Financial Data                                                      |  |      |  | 
|Item 7.  |  | Managements Discussion and Analysis of
    Financial Condition and Results of Operations |  |      |  | 
|Item 7A. |  | Quantitative and Qualitative Disclosures about
    Market Risk                            |  |      |  | 
|Item 8.  |  | Financial Statements and Supplementary Data                                               |  |      |  | 
|Item 9.  |  | Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosure  |  |      |  | 
|Part III
|Item 10. |  | Directors and Executive Officers of the Registrant                                        |  |      |  | 
|Item 11. |  | Executive Compensation                                                                    |  |      |  | 
|Item 12. |  | Security Ownership of Certain Beneficial Owners
    and Management                        |  |      |  | 
|Item 13. |  | Certain Relationships and Related Transactions                                            |  |      |  | 
|Part IV 
|Item 14. |  | Controls and Procedures                                                                   |  |      |  | 
|Item 15. |  | Exhibits, Financial Statement Schedules, and
    Reports on Form 8-K                      |  |      |  | 

1



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PART I

This annual report on Form 10-K contains
forward-looking statements within the meaning of the federal
securities laws. These forward-looking statements include
without limitation statements regarding our expectations and
beliefs about the market and industry, our goals, plans, and
expectations regarding our plans to liquidate the Company, our
beliefs and expectations regarding our remaining corporate
obligations (including indemnification obligations arising from
the sale of our embedded systems development tools business and
assets in November 2002), our beliefs and expectations regarding
the timing and amount of any potential distribution to
shareholders, our beliefs regarding competition, our beliefs
regarding period-to-period results of operations, our
expectations regarding future financial results, our beliefs
regarding our results of operation and financial position, our
beliefs and expectations regarding liquidity and capital
resources, and our expectations regarding the impact of recent
accounting pronouncements.

These statements are subject to risks and
uncertainties that could cause actual results and events to
differ materially from those anticipated. These risks and
uncertainties include without limitation those identified in the
section of this annual report on Form 10-K entitled
Risk Factors That May Affect Future Results below.
Applied undertakes no obligation to update forward-looking
statements to reflect events or circumstances occurring after
the date of this annual report on Form 10-K.

As used in this annual report on Form 10-K,
unless the context otherwise requires, the terms we,
us, the Company, and Applied
refer to Applied Microsystems Corporation, a Washington
corporation, and its subsidiaries.






|        |         
|------- | --------
|Item 1. | Business

Overview

Since our inception in 1979, Applied Microsystems
Corporation historically created solutions to expedite the
development, test and deployment of business and safety-critical
embedded systems. We developed, marketed and supported a
comprehensive suite of software and hardware-enhanced
development, test, and verification tools for the development of
complex embedded microprocessor-based applications. Using these
tools, engineers develop, test, debug, emulate and verify
embedded software found in a wide variety of products, including
voice and data communications networks, console games, avionics
systems, automotive systems, medical devices, and consumer
electronics.

On November 1, 2002, we completed the sale
of our embedded systems development tools business and assets to
Metrowerks Corporation, a wholly owned subsidiary of Motorola,
Inc. The purchase price was $3.9 million, which included
payment for certain inventories and tangible assets, as well as
all intellectual property related to our embedded systems
development tools business. In addition, Metrowerks assumed
certain customer warranty and support obligations. We received
$3.4 million at closing, with the remaining $500,000
subject to a one-year holdback to secure certain indemnification
obligations. Certain other indemnification obligations relating
to our title to the assets sold, compliance with laws, and
certain matters relating to taxes continue until the expiration
of the statute of limitations applicable to claims with respect
to such matters.

With the sale of our historical
revenue-generating assets completed, we had planned to pursue
the development of new hardware and software products designed
to improve the way which services and other enterprise
applications are managed with enterprise data centers through
our Libra Networks division. Libra Networks was formed as a
result of our acquisition of REBA Technologies in May 2002.

As of November 1, 2002, we had cash
resources on hand that we anticipated would be sufficient to
finance the continuing product and business development
activities of Libra Networks until approximately the second
quarter of 2003, based on then-current fixed expense levels and
development budgets for Libra Networks. Prior to the second
quarter of 2003, however, we would need substantial additional
equity financing in order to continue and optimize our pursuit
of the Libra Networks business opportunity, particularly in
light of the fact that we would not expect the Libra Networks
business to produce any revenues in the near term, and expect
that it would operate at a loss for the foreseeable future.

2



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During the fourth quarter of 2002, we
aggressively pursued funding for our Libra Networks business,
and we contacted more than 30 potential funding sources.
Feedback from these potential funding sources produced
consistent themes, including concern over our capital structure
as a publicly held entity, concern over the timing and amount of
Libras projected funding needs, and varying levels of
interest in Libras overall market opportunity. We also
noted a softening in market projections for the adoption of
switch fabric technologies such as InfiniBandTM, on
which our Libra technology is based.

As a result, our board of directors concluded
that our continued pursuit of the Libra Networks business would
likely result in a lesser return to shareholders than a
voluntary liquidation and dissolution. Accordingly, on
December 16, 2002, we announced that our board of directors
had unanimously decided to recommend to shareholders that
Applied be liquidated. Liquidation of a corporation is a complex
process, and requires a shareholder vote and presents other
complexities, with significant uncertainties surrounding the
timing and amount of any distribution to shareholders.

Since December 16, 2002, we have taken steps
to reduce our expenses, to prepare our Libra Networks assets for
sale, and to prepare a proxy statement and related materials in
connection with submitting the proposal to liquidate and
dissolve Applied to our shareholders for vote at a meeting of
shareholders. We have reduced our workforce from
33 full-time personnel on December 16, 2002, to six
remaining administrative personnel and no remaining development
personnel. In an effort to further trim expenses, during the
fourth quarter of 2002, we entered into an agreement to
terminate our headquarters facilities lease no later than
December 31, 2002. We paid an early termination fee of
approximately $1 million to Teachers Insurance &
Annuity Association of America, the landlord under the lease, in
exchange for terminating any further obligations under the
lease. In December 2002, we entered into an agreement to
sublease approximately 7,200 square feet in Redmond,
Washington, and took possession of the premises later that
month. On February 27, 2003, we provided notice of our
intent to terminate the sublease in Redmond as of March 31,
2003. We then secured needed office facilities, consisting of
approximately 650 square feet, in the Redmond area on a
monthly rental basis.

If shareholders approve the liquidation of
Applied and the Plan of Liquidation and Dissolution (the
Plan of Dissolution), we will file articles of
dissolution with the Secretary of State of the State of
Washington promptly after the shareholder vote, and attempt to
convert our remaining assets, including our Libra Networks
assets, into cash and settle our liabilities as expeditiously as
possible. Some or all of our assets may be held in a contingency
reserve for the satisfaction of certain liabilities.

On September 16, 2002, our common stock was
transferred from the Nasdaq National Market to the Nasdaq
SmallCap Market. Our common stock was involuntarily delisted
from the Nasdaq SmallCap Market effective as of the opening of
business on January 3, 2003, as a result of our failure to
meet the minimum required bid price, market value of public
float, and shareholders equity requirement, and our common
stock has traded on the OTC Bulletin Board since January 3,
2003.

Applied is headquartered at 6244-185th Ave
NE, Building C, Suite 201, Redmond, Washington. We
file reports with the Securities and Exchange Commission
(SEC), including annual reports on Form 10-K,
quarterly reports on Form 10-Q and other reports from time
to time. The public may read and copy any materials we file with
the SEC at the SECs Public Reference Room at
450 Fifth Street, NW, Washington, DC 20549. The public may
obtain information on the operation of the Public Reference Room
by calling the SEC at 1-800-SEC-0330. We are an electronic
filer, and the SEC maintains an Internet site at
http://www.sec.gov that contains the reports, proxy and
information statements, and other information filed
electronically.

Background



| |               
| | --------------
| | Libra Networks

The goal of Libra Networks has been to design,
develop and bring to market a family of edge
computing devices, that reside at the edge of
a data center and manage traffic incoming from the public

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Internet, intranets or on-campus networks. The
principal design characteristics of the planned suite of Libra
products included:




| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Use of Network
    Processors since network
    speeds in modern data centers can reach multiple gigabits per
    second, we believe it is critical for edge computing devices to
    use network processors, which can handle the fastest network
    speeds while offering the programming versatility to handle
    multiple network protocols and adapt to changing standards such
    as web services. By contrast, we believe most edge computing
    devices available today rely on either Pentium-class processors,
    which lack the ability to keep up with high network speeds, or
    Application Specific Integrated Circuits (known as ASICs), which
    lack the programmability necessary to permit support of multiple
    network protocols and evolving standards.
|
| |  | Use of Web Services
    Standards we believe that
    enterprises will increasingly move to adopt web services
    standards (such as SOAP and WSDL), which have been embraced by
    most of the leading system software vendors such as Microsoft,
    IBM, BEA and Sun. We believe enterprises adopting these
    standards will require edge-computing devices that supply high
    performance traffic management based on the new web services
    standards, as distinguished from existing solutions in the
    server content switching market that we believe are for the most
    part based on HTTP and other early Internet standards.                                                                                                                                    
|
| |  | Use of Switch Fabric
    Technologies we believe
    that enterprise data centers will increasingly adopt switch
    fabric technologies to connect their edge devices, servers and
    data storage, in order to achieve higher throughput, lower
    latency, reduced server loads, simplified cabling and improved
    system and network management. One such switch fabric technology
    that is currently available is InfiniBand; others, such as iWarp
    based on Ethernet, are under development.                                                                                                                                                                                                                                                                          

Libra Networks has completed product
specifications and developed a preliminary proof-of-concept
demonstration for an edge device designed to act as the
load-balancing gateway between an InfiniBand-based server farm
and its external environment. This device is designed to handle
wire-speed InfiniBand routing of TCP/IP traffic, which would be
terminated and off-loaded at the device, as well as manage
load-balancing of client traffic across servers, utilizing
traditional demand-side load-balancing techniques as
well as an innovative supply-side load-balancing
capability that dynamically and intelligently provisions data
center applications and services to physical server processors
based upon the pattern of incoming traffic. This proprietary
supply-side load-balancing technology is the subject
of patent applications we acquired in the REBA transaction.

Although InfiniBand, the switch fabric
communication technology that is planned to be incorporated in
our initial Libra Networks product release, is the only new
switch fabric technology currently available for widespread
usage, its acceptance as a worldwide standard is highly
uncertain. In the second quarter of 2002, Microsoft and Intel
each announced that they would limit further investments in
InfiniBand-based products. Specifically, Intel announced that it
will stop developing host channel adapter chips for InfiniBand;
and Microsoft stated that it no longer plans to incorporate
InfiniBand into its next-generation server operating system, the
Windows.Net Server, although it would continue to assist
companies offering InfiniBand products that plug into Microsoft
products. These announcements have created doubt regarding the
feasibility and likelihood of InfiniBands acceptance as
the worldwide standard for server-to-server, and
network-to-server interconnect solutions. In addition, during
the fourth quarter of 2002, industry analysts published adverse
revisions to projections for market adoption of InfiniBand
architecture.

After considering the factors described above,
our board of directors determined that our continued pursuit of
the Libra Networks business could result in a lesser return to
shareholders than a voluntary liquidation and dissolution.
Accordingly we have taken steps to reduce our expenses and
prepare our Libra Networks assets for sale. We have terminated a
significant number of our staff, including Libra development
personnel and senior management who we believe would be critical
to the success of the Libra business. We have reduced our
workforce from 33 full-time personnel on December 16,
2003 to six remaining administrative personnel and no remaining
development staff as of March 15, 2003.

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To further reduce ongoing personnel expenditures,
only one of our four executive officers  our chief
financial officer, Rob Bateman  remains on our
ongoing payroll. Our president and chief executive officer,
Steve Verleye, continues to perform the duties of president and
chief executive officer on an unpaid and part-time basis.
Mr. Verleye also continues to serve as a member of our
board of directors.



| |                       
| | ----------------------
| | Embedded Systems Tools

Our embedded systems development tools business,
which was sold to Metrowerks in November 2002, consisted of
products that were designed to enhance customers
productivity by providing a set of solutions that span a
products lifecycle. We provided development tools for
customers using a variety of third-party operating systems and a
wide range of popular microprocessors. We also offered certain
custom engineering services to provide customers with
specialized development tools and design services.

Embedded systems generally include an embedded
microprocessor, program storage (e.g. in flash memory),
real-time operating system (RTOS) software, and
custom software to implement assigned applications. Embedded
systems are incorporated within electronic devices and are
dedicated to performing specific tasks quickly and reliably in
response to rapidly occurring external events. Manufacturers
worldwide use embedded systems to enhance the functionality and
performance, reduce the cost and size, and improve the
reliability of a broad variety of products. These manufacturers
are often faced with competitive markets that require them to
bring increasingly complex products to market faster and at
reduced costs. As the computing power of embedded
microprocessors has grown, and as unit prices for embedded
microprocessors have generally declined, manufacturers have been
able to incorporate improved features, speed and reliability
into their products. This additional sophistication has resulted
in significantly larger and more complicated application
software and increased 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
application software, which is typically written in a high-level
programming language. As the complexity and volume of such
software increases, so does the potential for programming
errors, the need to eliminate performance shortcomings, and the
difficulty of thoroughly testing the complete system.

Products

Prior to the sale of our embedded systems
development tools business, we developed, marketed and supported
a comprehensive suite of software and hardware-enhanced
development, test, and verification tools for the development of
complex embedded microprocessor-based applications. Our
development solutions were targeted principally for use by
software engineers in the development of embedded software and
associated products. We designed our products to support major
market segments utilizing 32 and 64-bit embedded
microprocessors, as well as products to meet the specific needs
of console game console developers (Microsofts
XboxTM and Nintendos GamecubeTM
video gaming systems, in particular).

Our former products generally enabled engineers
to perform debugging functions in high-level programming
languages and operate on personal computers or engineering
workstations. These tools also enabled engineers to observe
software interaction and functions with several commercially
available RTOS products and to read file format output from
compatible compilers.

The embedded systems development tools we
produced prior to November 2002 can be classified into three
broad categories: hardware-enhanced debugging tools, software
analysis tools, and game development systems.



| |                                      
| | -------------------------------------
| | Hardware-Enhanced Debugging
    Tools

We manufactured a wide range of hardware-enhanced
software tools for the design and debugging of embedded systems.
These in-circuit microprocessor and read-only memory
(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

5



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engineers for low-level testing of software
functions and by hardware engineers in system integration and
troubleshooting their designs.


These emulators perform the following basic
functions or subsets 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; to examine and modify both
    registers and memory; and to resume operation at the desired
    point after any alterations have been made to the system or
    software.
|
| |  | Visibility into the Configuration of the
    Microprocessor the ability
    to interrogate the microprocessor and to display for the user
    the current state and meanings of the various possible register
    configurations.                                                                                                                                                                                                                               
|
| |  | High-Level Language
    Debugging the ability to
    display source code, data and relevant RTOS information, and to
    control each of the development tools other basic
    functions through a high-level language interface to the target
    system under development.                                                                                                                                                                                   

Prior to the November 2002 sale of our embedded
systems development tools business, we offered a broad selection
of hardware-enhanced software design and debugging tools. The
tools are accessed through a high-level language debugger
interface that we developed, or licensed from third parties and
resold with the product.



| |                        
| | -----------------------
| | Software Analysis Tools

Our software analysis tools were designed
specifically to offer a broad range of optimization and testing
capabilities to software developers. These tools measure the
performance and reliability of software, as well as the adequacy
of the test process itself, in a minimally intrusive manner. The
measurements are then displayed in an intuitive format. Software
engineers use these products during the full range of system
development  beginning with initial software
development, extending to system integration, and then to final
system test and validation.

Software analysis tools included the following
modules:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Coverage
    Analysis 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.                                                         
|
| |  | Advanced Coverage
    Tools adds a finer degree
    of granularity for analyzing test execution to the Statement,
    Decision and Modified Condition Decision Coverage levels. For
    certain industries such as avionics, government regulations
    mandate test methodologies for each type of software application
    based on the criticality of that application. Advanced Coverage
    Tools show what conditions, 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; 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; 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 target 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 to address software
    performance or memory problems.                                                                                                                                                                                                                                                                 

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Certain software modules were sold separately or
with a separate hardware probe. Our software analysis tools
supported a range of popular microprocessors and RTOS offerings
for embedded applications.



| |                         
| | ------------------------
| | Game Development Systems

In 1999, we began developing tools, including
DVD-emulation technology, for Nintendos Gamecube video
gaming console, based on a development and manufacturing
agreement with Nintendo. In 2000, we announced an agreement with
Microsoft to develop and manufacture DVD-emulation technology
for inclusion in Microsofts Xbox Development Kit, the
development platform that allows game developers to optimize
games for Microsofts Xbox video gaming console. Both the
Gamecube and the Xbox were introduced to the U.S. markets
during the fourth quarter of 2001.

Our game development tools included a DVD
emulator, which replaced the game developers target DVD
drive with a hard disk, DVD mechanics emulation, and could also
provide specific DVD layout and mastering tools. Data that would
normally be read from the DVD are translated to files on a hard
disk on the game developers computers. The emulator lets
developers see their games run as if they were actually
accessing target DVDs and significantly reduces the need to burn
DVDs, which can be a time-consuming and expensive process.
Because the data can be accessed more easily from the
developers hard drive, the game development time can be
significantly reduced. We sold the game development system
technology, excluding any technology that was proprietary to our
customers, to Metrowerks in the asset sale that closed in
November 2002. In connection with the asset sale, Microsoft
elected to exercise its contractual rights under the agreement
with us to withdraw certain technology held in escrow.

Customers

We had no revenues in 2002 from our Libra
Networks business. Our embedded systems development sales were
concentrated primarily in the telecommunications industry and in
the video games industry. Sales to Microsoft for Xbox game
development tools represented 25% of 2002 revenues, compared to
30% of total 2001 revenues. Sales are generally made pursuant to
customer purchase orders.

Sales, Marketing and Customer
Support

Our Libra Networks business plan contemplates
selling hardware and software technology through system OEMs,
system integrators, VARs, resellers, and direct to large
accounts.

We distributed and supported our embedded systems
development tools primarily through a network of direct sales
and service offices located in the United States, Japan, and
Europe, through distributors in the rest of the world, as well
as through partnerships with selected companies 
including third-party developers of integrated development
environments.

Competition

Libra Networks competition is expected to
come from established server load balancing companies (such as
F5 Networks, Cisco, Foundry Networks, and Extreme Networks)
as well as new switch-fabric competitors (such as Topspin
Communications, InfiniCon Systems, and Voltaire). There may be
additional competitors who have not yet publicly announced their
development of content networking products. Most of our
potential competitors have significantly greater financial,
technical, distribution and other resources we do.

The market for our embedded software development
solutions has been fragmented and highly competitive for many
years, with providers offering technical solutions to address
the design, debugging, testing and service needs of embedded
software developers. In addition, many companies chose to
develop their own proprietary solutions as opposed to purchasing
development tools and services from outside vendors. This market
was also subject to rapid change, as technological developments
created new needs and rendered prior technical solutions
obsolete.

The principal competition for our
hardware-enhanced debugging tools came primarily from a division
of Wind River (through Wind Rivers acquisition of Embedded
Support Tools Corporation), Lauterbach

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Datentechnik GmbH, and Agilent Technologies,
Inc., as well as from various other domestic and international
providers of in-circuit emulators. To a lesser extent,
competition also came from domestic providers of embedded
microprocessor simulators, RTOS debugging software, logic
analyzers, ROM monitors and ROM emulators.


Competition for our software analysis tools came
primarily from Rational Software Corporation (through, in part,
its acquisition in 2001 of ATTOL Testware, a France-based
company that had focused on the testing of embedded systems);
LDRA Ltd., a U.K.-based company offering code analysis testing
tools; IPL, a U.K.-based company that provides software
development and test tools; Real-Time Innovations, a developer
of embedded software tools; and McCabe & Associates, a
company that offers software analysis tools. Competition also
came from providers of embedded debug software, emulators and
logic analyzers, which are generally able to perform only
portions of the software testing functions offered by our former
software analysis tools. We also historically experienced
competition from the engineering departments of major
manufacturers, which may choose to develop internal technical
solutions to their design, debugging or testing problems.

Competition for our game development solutions
had historically been from console manufacturers that offered
proprietary development tools. We faced competition from Hudson
Soft Company, a Japan-based company, for development tools aimed
at Nintendos Gamecube video gaming system.

Manufacturing

Prior to the November 2002 sale of our embedded
systems development tools business, we maintained manufacturing
operations primarily to support our hardware-enhanced
development solutions and game development tools. The
manufacturing operations consisted of the procurement and
inspection of parts and components, assembly, software
duplication, and testing of components and finished products.
Our products incorporated our proprietary software, as well as
software licensed from others. We conducted virtually all steps
of the assembly process, including board assembly, at our
facility in Redmond, Washington. We had a computerized
manufacturing inventory control system that integrated and
monitored purchasing, inventory control and production.

We inspected and tested our manufactured products
during the manufacturing process and tested finished products
using tests designed and developed internally based on the
custom requirements and functionality of the product. In
addition, our products underwent quality inspection and testing,
including burn-in procedures during the
manufacturing process to ensure the quality and reliability of
our products. We also required that all employees involved in
the assembly process have appropriate training. We maintained
our ISO 9002 certification since December 1995. We provided
standard warranty that our hardware, software and mechanical
parts would be free from defects in materials and workmanship
for periods generally ranging from three to twelve months,
depending on the product and location; such warranty
obligations, combined with customer support agreements, were
assumed by Metrowerks in the November 2002 asset sale.

As part of our agreement with Microsoft relating
to Xbox development tools, we continue to be responsible for
reimbursing Microsoft for certain costs in the event of an
epidemic failure of our products that were
incorporated into Microsofts Xbox Development Kit. As
further defined in the agreement with Microsoft, an epidemic
failure is defined as the occurrence of defects in greater than
4% of the products shipped to Microsoft in any particular
shipment, or in greater than 4% of the aggregate number of units
shipped to Microsoft within any 90-day period.

We are 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 formerly used in our manufacturing process. We are not
aware of any significant liability related to environmental
issues.

Research and Development

Our Libra Networks engineering and development
group included 13 full-time employees as of
December 31, 2002. As of March 15, 2003, we have no
engineering and development personnel. During 2002,

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research and development expenses were
$5.7 million, compared to $10.2 million in 2001 and
$13.1 million in 2000.


Proprietary Rights

Libra Networks intellectual property
includes patent applications acquired from our May 2002
acquisition of REBA Technologies. None of the patents have
issued, and there can be no assurance that they will ever issue
or provide adequate protection to the business contemplated by
Libra Networks. We announced on December 16, 2002, that our
board of directors had unanimously decided to recommend to
shareholders that Applied be liquidated, and we have since taken
steps to find a buyer for the Libra Networks intellectual
property; however, we currently do not have a buyer for these
assets.

We believe that we owned or had adequate rights
to utilize all material technologies relating to the embedded
systems development tools business and assets we sold to
Metrowerks and for which we continue to provide indemnification
under the terms of the asset sale agreement. We are not aware of
any indemnification claims that have been made to date or are
pending. The embedded systems development market has been
characterized by rapid technological change, with frequent
introductions of new products and technologies. As a result,
industry participants have found 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 products and processes within the traditional
embedded markets that we sold to Metrowerks could conflict with
patents that have been granted or may be granted to competitors
or others. Such competitors or others could bring legal actions
claiming damages. If we become involved in such
litigation  through our indemnification obligation to
Metrowerks  it could consume a substantial portion of
our remaining resources.

Employees

As of December 31, 2002, the Company
(including Libra Networks) had 26 employees, excluding
3 personnel who were in a transition role relating to the
sale of our embedded systems development tools assets and
business. Of the total, 13 were engaged in sales, general and
administrative and 13 were in research and development. 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.

Risk Factors That May Affect Future
Results

The Companys actual results may differ
materially from those anticipated due to a variety of factors,
including those set forth in the following risk factors and
elsewhere in this document. The Company will not update any
forward-looking statements due to new information, future events
or otherwise.

Risks Related to the Plan of
Dissolution



| |                                                                                                                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our shareholders do not approve the
    voluntary liquidation and dissolution of Applied, we will not
    have the resources to continue operations without seeking
    additional capital, which we believe will be very difficult to
    obtain, and our resources may diminish completely.

We have limited cash resources, and these
resources continue to diminish. We recorded a net loss of
$5.7 million and consumed $5.9 million of our cash in
operating activities during 2002. We expect that our cash
resources will continue to diminish. If our shareholders do not
approve the Plan of Dissolution, our board of directors will
determine an appropriate course of action, which could include
continuing to preserve our Libra Networks assets and technology
and continue to seek financing for our Libra Networks business
or a sale of our Libra Networks assets and technology, using a
minimum of our resources until our resources are completely
depleted. Considering our recent financial performance and the
difficulty we have had in obtaining financing, it is unlikely
that we would be able to obtain additional equity or debt
financing. If we were to be unable to obtain sufficient capital,
we would deplete our available resources and would be required
to discontinue operation of our business.

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| |                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------
| | We might not be able to sell certain of our
    assets or to receive reasonable value from the sale of our
    assets.

The value that shareholders ultimately realize as
a result of the sale of our assets and the liquidation of
Applied is dependent in part on the proceeds received from the
sale of the assets or other disposition of our operating assets.
Our assets include certain technology and intellectual property
for which we may not be able to find a buyer. Despite our
ongoing efforts to sell our Libra Networks assets and technology
and certain other intellectual property, we currently do not
have a buyer for these assets. We may be unable to sell certain
of our assets and may not realize any value from these assets.
In addition it may be difficult to obtain a favorable return
when selling our operating assets in connection with the
liquidation and dissolution of Applied. Because we are seeking
to consummate the liquidation of our operating assets in the
near to short term in order to minimize the losses associated
with operating Applied, we may not realize as much value for
these assets as we might have if we had been able to sell our
business as a going concern.

We do not plan to obtain a fairness opinion with
respect to the sale of our Libra Networks technology and assets;
therefore, we cannot assure shareholders that the price we may
negotiate for these assets is the best possible price we could
obtain. While we will attempt to obtain the best price in
connection with the sale of our Libra Networks technology and
assets, there can be no assurance that the value we realize from
the sale of these assets will reflect the potential future value
of these assets.



| |                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The timing of liquidating payments and
    total value shareholders receive upon liquidation is subject to
    many variables and risks, many of which will not be known at the
    time of the vote.

Shareholders may receive distributions from us or
the liquidating trust, as the case may be, the timing of which
will be at the discretion of management or the trustee or
trustees, unless it is determined that any such distribution
would be inconsistent with the purposes of the Plan of
Dissolution. The distribution of our assets to shareholders may
be delayed for a number of reasons, including the risk that one
or more of our creditors might seek an injunction against our
making the proposed distributions to shareholders under the
terms of the Plan of Dissolution. The value of what shareholders
receive will be a product of various factors and risks,
including the proceeds received from the sale or other
disposition of our operating assets, and the amount of
Applieds actual and potential liabilities. If our
liabilities prove to be higher than anticipated, additional
creditors appear, or legal action is brought against us by
creditors or others, it is possible that the planned
distribution to shareholders could be delayed or reduced, or
there could be nothing remaining available for distribution to
shareholders.



| |                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Shareholders could be liable under
    Washington law to return some or all of the cash they may
    receive from us if we do not provide for all of our liabilities
    and expenses.

Washington law provides that we can dispose of
any known claims against us by providing written notice to our
known creditors of the planned dissolution of Applied, and
paying or making adequate provision for the debts of the company
within the time allowed by law. However, an unpaid creditor or a
creditor that was not known to us can still, within two years of
our dissolution, bring a lawsuit against Applied and its former
shareholders for any amount unpaid. All shareholders who receive
proceeds from the liquidation may be liable to a creditor who
has a valid claim that exceeds the amount retained by the
company or the liquidating trust for the purpose of settling
claims, up to the amount they received in the liquidation.



| |                                                                                                                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may be required to pay up to
    $3.3 million to Metrowerks Corporation, a Texas corporation
    that is a wholly-owned subsidiary of Motorola, Inc., for
    potential breaches of our representations in the asset purchase
    agreement dated as of September 3, 2002.

Under the terms of the asset purchase agreement
that we entered into on September 3, 2002, we have an
obligation to indemnify Metrowerks for any losses from potential
breaches of our representations or warranties that are asserted
within 12 months after the closing date of the asset sale
or within the applicable statute of limitations period for
claims relating to our ownership of our assets, payment of our
taxes, and our compliance with applicable laws, if longer. Our
indemnification obligations are limited to an overall amount of

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$3.3 million. Although we currently are not
aware of any material breaches of our representations or
warranties, the payment of any such indemnification obligations
would decrease the amount of cash we would have available to
distribute to shareholders in the liquidation.


Risks Related to Applieds Continuing
Business Operations

If the Plan of Dissolution is not approved by our
shareholders, we would face the following risks and
uncertainties in connection with continuing to pursue our Libra
Networks business.



| |                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------
| | We do not have any immediate source of
    revenue and we expect to incur significant losses for an
    indefinite period of time.

Our Libra Networks business involves the
development of a new and as yet unreleased product line with no
market penetration in a highly competitive market sector
typified by rapid changes in technology and competitive
products. We do not expect our Libra Networks business to
produce any revenues in the near term, and if we were to
continue pursuing the Libra Networks business, we would expect
to operate at a loss until at least 2004. We cannot predict when
or to what extent Libra Networks might begin to produce
revenues, or whether it would ever reach profitability. If we
were unable to achieve significant levels of recurring revenue
from our Libra Networks business, our losses would likely
continue indefinitely. If this were to occur the market price of
our common stock could suffer as well as our viability as a
going concern.



| |                                                                                                                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Due to our lack of available resources, and
    to preserve available resources to satisfy our liabilities, we
    have terminated a significant number of our personnel and
    therefore have limited ability to pursue the Libra Networks
    business.

Due to our lack of available resources to fully
pursue the Libra Networks business plan, we have terminated a
significant number of our staff, including Libra development
personnel and senior management who would be critical to the
success of the Libra business. As of March 15, 2003, we had
six remaining administrative personnel, and no remaining
development staff. Libras success depends to a significant
degree on our ability to attract and retain highly skilled and
experienced technical, managerial, sales and marketing
personnel. There can be no assurance that we would be successful
in recruiting new personnel or in retaining existing personnel.
Our inability to attract additional qualified employees would
have a material adverse effect on our business, results of
operations and financial condition.



| |                                                                                                                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We do not have sufficient working capital
    to fund our Libra Networks business, and we believe it is likely
    that we would be unable to obtain additional capital. If we
    raise additional financing, shareholders may suffer significant
    dilution.

If the Plan of Dissolution is not approved, we
would need to seek a third party investment as soon as possible
in order to provide additional working capital for our Libra
Networks business. We have previously contacted more than
30 potential funding sources, but have received overall
negative feedback from these funding sources, including concern
over our capital structure as a publicly held entity, concern
over the timing and amount of our projected funding needs, and
the size and timing of our overall market opportunity.

We expect the funding climate to remain
difficult, and we cannot be certain that financing from third
parties will be available on acceptable terms to us or at all.
The extent and timing of our future capital requirements would
depend upon several factors, including the rate of market
acceptance of our products, the degree of competition for our
products, our ability to build and expand an efficient indirect
distribution system, and our level of expenditures for product
development, sales and marketing. If we are unable to raise
funds on acceptable terms, we may not be able to develop our
products and services, take advantage of future opportunities or
respond to competitive pressures or unanticipated requirements,
any of which would have a material adverse effect on our ability
to establish a viable business. Further, if we were to issue
equity securities, shareholders would experience severe dilution
of their ownership percentage, and the new equity securities may
have rights, preferences or privileges senior to those of our
common stock.

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| |                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The emergence of InfiniBand, the switch
    fabric communication technology that is planned to be
    incorporated in our initial Libra Networks product release, as a
    worldwide standard is uncertain.

Our initial Libra Networks products are being
developed using InfiniBand architecture. InfiniBand is currently
the only new Switch Fabric technology currently available for
widespread usage. In the second quarter of 2002, Microsoft and
Intel each announced that they will limit further investments in
InfiniBand-based products. Specifically, Intel announced that it
will stop developing host channel adapter chips for InfiniBand;
and Microsoft stated that it no longer plans to incorporate
InfiniBand into its next-generation server operating system, the
Windows.Net Server, although it will continue to assist
companies offering InfiniBand products that plug into Microsoft
products. These announcements have created doubt regarding the
feasibility and likelihood of InfiniBands acceptance as
the worldwide standard for server-to-server, and
network-to-server interconnect solutions. If InfiniBand is not
accepted as a standard in the marketplace, our planned products
would have to be redesigned to operate under a different
architecture, and delays in product releases and slower revenue
growth would be likely. Industry analysts have recently
published adverse revisions to their earlier projections for
market adoption of InfiniBand switch fabric technology, on which
Libra Networks contemplated products were initially to be
based.



| |                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We are dependent on a single line of
    business that currently has no products or revenues. We cannot
    predict our future results because our Libra Networks business
    has no operating history.

Our only remaining line of business is the
development of the Libra Networks products and technology. We
have not yet developed any products based on this technology and
consequently there are currently no revenues from this line of
business. Furthermore, we do not know whether any products will
be developed on this technology or the timing of such
developments if a product is created. Given the lack of
operating history in the Libra Networks business it is difficult
to predict our future results. The Libra Networks business is
characterized by rapid technological change, new product
development, a new and unproven business model, and evolving
industry standards. Shareholders should consider the risks and
uncertainties that we may encounter as a pre-revenue-stage
company in a new and rapidly evolving market. These
uncertainties include:



| |   |                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------
| |  | our ability to design and engineer products
    having the technological features planned for the Libra Networks
    product line;  
|
| |  | consumer demand for, and acceptance of, the Libra
    Networks business products;                                                   
|
| |  | our ability to establish relationships with OEMs,
    VARs, system integrators and other channel partners needed to
    drive sales;
|
| |  | our ability to demonstrate the benefits of our
    products and services to end user data center managers;                          
|
| |  | our unproven and evolving business model;                                                                                           
|
| |  | unfavorable economic conditions in the technology
    industry;                                                                     
|
| |  | decreased spending on technology due to adverse
    economic conditions; and                                                        
|
| |  | global economic conditions.                                                                                                         



| |                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our Libra Networks technology and products
    are not fully developed, are untested, and remain subject to
    significant uncertainty. Rapid technological change could render
    our products and services obsolete.

Our Libra Networks technology and products are in
the development stage and have not been completed or proven. The
market for products related to data management is characterized
by rapid technological innovation, sudden changes in user and
customer requirements and preferences, frequent new product and
service introductions and the emergence of new industry
standards and practices. Each of these characteristics could
render our Libra Networks products, intellectual property and
systems obsolete. The rapid evolution of our market requires
that we improve continually the performance, features and
reliability of our products and

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services, particularly in response to competitive
offerings. The successful development of our products is subject
to the risks that:




| |   |                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------
| |  | any or all of our proposed products are found to
    be ineffective for their intended purposes;                                
|
| |  | the proposed products or procedures are
    uneconomical to manufacture or market or do not achieve broad
    market acceptance;
|
| |  | third parties hold proprietary rights that
    preclude us from marketing them; or                                              
|
| |  | third parties market a superior or equivalent
    product.                                                                      

Significant undetected errors or delays in new
products or releases may affect market acceptance of our
products. There can be no assurance that, despite our testing,
errors would not be found in new products or releases after
commencement of commercial shipments, resulting in loss of
customers or failure to achieve market acceptance.

In addition, our Libra Networks technology and
products would need to be compatible with a broad array of
disparate technologies in order to be interoperable with other
products routinely used in corporate data centers such as
routers, switches, operating systems and systems management
software. This interoperability may depend on partnerships with
third parties such as Cisco, Dell, IBM, Sun, BEA, BMC and
Microsoft. We currently do not have any partnerships with such
third parties. Without such partnerships, we would likely not be
able to achieve market acceptance or demand for our products
within our target base of customers, because our products would
not operate with many of the applications they currently use.



| |                                                                                                                                                                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our Libra Networks business would have to
    rely on third parties to provide certain components and software
    for its products. If our vendors were to fail to deliver their
    products in a reliable, timely and cost-efficient manner, our
    business would suffer.

Our Libra Networks business would depend upon
relationships with third parties who may be sole source
providers of key, leading-edge hardware and software components
critical for some of the products being developed by our Libra
Networks business. If these providers of exclusive proprietary
technology do not produce these components or software modules
on a timely basis or if the components or software modules do
not meet our specifications or are otherwise flawed, we may have
to delay product delivery, recall or replace unacceptable
products. As a result, we could lose existing and potential
customers and any revenues that we may have at that time may
decline dramatically.



| |                                                                                          
| | -----------------------------------------------------------------------------------------
| | We may not be able to meet our product
    development objectives or market expectations.

Our Libra Networks product development efforts
are inherently difficult to manage and keep on schedule and
there can be no assurance that we would be able to meet our
development objectives or to meet market expectations. In
addition to development delays, we may experience substantial
cost overruns in completing development of our products. The
technological feasibility for some of the products that we
envision is not completely established. We may be unable, for
technological or other reasons, to develop and introduce
products in a timely manner in response to changing customer
requirements. Further, there can be no assurance that while we
were attempting to finish development of our products, a
competitor might not introduce similar products thus diminishing
our technological advantage, or a superior alternative to ours,
rendering our products and technologies partially or wholly
obsolete, or at least requiring substantial re-engineering in
order to become commercially acceptable. Our failure to maintain
our product development schedules, avoid cost overruns and
undetected errors or introduce a product that is superior to
competing products would have a materially adverse effect on our
business, financial condition and results of operations.



| |                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------
| | We may not be able to successfully compete
    in the highly competitive and rapidly evolving data center
    management market.

The market for products that enhance the speed,
capacity and efficiency of enterprise data centers is still
developing, and there can be no assurance that our products
would ever achieve market acceptance. Since we

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have no existing customers with respect to the
Libra Networks business, we would need to convince enterprise
corporate data center managers that have no history of buying
products from us to buy Libra Networks products, including
additional follow-on products or product updates. To the extent
we do not achieve growth, it would be difficult for us to
generate meaningful revenue or to achieve profitability.


The market for data center management products is
intensely competitive, evolving and subject to rapid
technological change. The competition for Libra Networks
planned suite of products would likely come from three types of
competitors:



| |   |                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | manufacturers of existing load-balancing
    switches, such as F5 Networks, Inc., Cisco Systems Inc.,
    Extreme Networks, Inc., and Foundry Networks, Inc.;
|
| |  | vendors of TCP/IP-to-InfiniBand gateways, such as
    Voltaire, Inc., and TopSpin Communications, Inc.; and                                                  
|
| |  | companies offering load-balancing capabilities
    for Web Services standards, such as Sarvega, Inc., DataPower
    Technology, Inc. and Forum Systems, Inc. 

Some of our current and potential competitors
have longer operating histories, significantly greater
financial, technical, marketing and other resources,
significantly greater name recognition and a substantially
larger installed base of customers than we do. We expect the
intensity of competition in this market to increase in the
future. Increased competition is likely to result in price
reductions, and may result in reduced or negative margins and
difficulty in gaining market share. Any of these effects could
seriously harm our business.



| |                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------
| | We may not be successful in developing or
    maintaining strong distribution channels for our Libra Networks
    products.

The success of the Libra Networks business
depends on developing strong OEM relationships with system
vendors who are selling servers and other network management
equipment and technologies to end-users. The Libra business plan
would rely primarily on OEM relationships to initially market
our Libra Networks products, although our OEM sales would be
expected to be augmented by a direct sales force working closely
with indirect channel partners such as value-added resellers and
other resellers and integrators. If we were not successful in
creating a strong national distribution channel in a timely
manner, we may not gain significant sales.



| |                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may not be able to protect intellectual
    property of our Libra Networks business against third-party
    infringements or claims of infringement.

Failure to protect our intellectual property
rights may result in a loss of our exclusivity or the right to
use our Libra Networks technology. We rely on patent, trade
secret, trademark and copyright law to protect our Libra
Networks intellectual property. Our patent position is subject
to complex factual or legal issues that may give rise to
uncertainty as to the validity, scope and enforceability of a
particular patent. Accordingly, there can be no assurance that
any patents will be issued pursuant to our current or future
patent applications or that patents issued pursuant to such
applications will not be invalidated, circumvented or
challenged. Moreover, there can be no assurance that the rights
granted under any such patents will provide competitive
advantages to us or be adequate to safeguard and maintain our
proprietary rights. In addition, effective patent, trademark,
copyright and trade secret protection may be unavailable,
limited or not applied for in certain foreign countries.

Although patent applications have been filed with
respect to certain aspects of our Libra Networks technology,
some of our Libra Networks intellectual property is not covered
by any patent or patent application and includes trade secrets
and other know-how that is not patentable. We also seek to
protect our proprietary intellectual property, including
intellectual property that may not be patented or patentable, in
part by confidentiality agreements and, if applicable,
inventors rights agreements with our current and future
strategic partners and employees. We cannot assure you that
these agreements will not be breached, that we

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will have adequate remedies for any breach or
that such persons or institutions will not assert rights to
intellectual property arising out of these relationships.


Some of our Libra Networks intellectual property
includes technologies and processes that may be similar to the
patented technologies and processes of third parties. If we do
not adequately assure our freedom to use our Libra Networks
technology, we may have to pay others for rights to use their
intellectual property, pay damages for infringement or
misappropriation or be enjoined from using such intellectual
property.



| |                                                                                          
| | -----------------------------------------------------------------------------------------
| | We would be dependent on third parties for
    manufacturing our Libra Networks products.

We have yet to develop a manufacturing plan for
Libra Networks products. However, we would expect to rely on one
or more third party manufacturers for our manufacturing needs.
We may be unable to engage a third party manufacturer on a
timely basis or on terms favorable to us which could limit our
ability to sell our products and generate revenues. Furthermore,
the failure of such third party manufacturers to deliver
products to us in a timely manner or in accordance with our
quality control standards could damage our reputation and could
adversely affect our operating results.



| |                                                                                                                                                                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our common stock currently trades on the
    OTC Bulletin Board; if shareholders approve our plan to dissolve
    and liquidate the Company, then it is likely that we will close
    our transfer books and restrict transfers of our common
    stock  shareholders would experience a lack of
    liquidity as a result.

Our common stock was transferred from the Nasdaq
National Market to the Nasdaq SmallCap Market effective as of
September 16, 2002. Our common stock was involuntarily
delisted from the Nasdaq SmallCap Market effective as of the
opening of business on January 3, 2003, as a result of our
failure to meet the minimum required bid price, market value of
public float, and shareholders equity requirement, and our
common stock has traded on the OTC Bulletin Board since
January 3, 2003. As part of our liquidation plan, we may
close our stock transfer books and the prices of our common
stock would cease to be quoted on the OTC Bulletin Board, and
shareholders would experience a lack of liquidity as a result.






|        |           
|------- | ----------
|Item 2. | Properties

On October 15, 2002, we entered into a Lease
Termination Agreement (the Termination Agreement),
by and between Applied and Teachers Insurance & Annuity
Association of America (TIAA). Pursuant to the
Termination Agreement, we paid an early termination fee of
approximately $1 million to TIAA in exchange for the
termination of any further obligations under the lease. As of
the date of the Termination Agreement, our remaining lease
obligation extended through 2007 and was in excess of
$6 million. The Termination Agreement required that we
vacate the leased premises no later than December 31, 2002.
We vacated the leased premises prior to December 31, 2002
under the terms of the Termination Agreement, and we have no
remaining lease obligation.

In December 2002, we signed an agreement to
sublease approximately 7,200 square feet in Redmond,
Washington, and took possession of the premises in that month.
Under the terms of the lease agreement, we may terminate the
lease by providing a 30-day notice. On February 27, 2003,
we provided notice of our intent to terminate the lease, and
plan to vacate the premises by March 31, 2003 and secure
needed office space on a monthly rental basis. We incurred no
termination fee as a result of our February 27, 2003 notice
of our intent to terminate the lease.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

From time to time, Applied is involved in legal
proceedings, none of which is currently considered material to
our business. However, any adverse outcome to future lawsuits
against Applied may result in a material adverse effect on our
financial condition.

15



---



##### Table of Contents








|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

A Special Meeting of Shareholders was held on
October 29, 2002. The following summarizes the results of
matters voted upon at the Special Meeting:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The shareholders voted 4,529,911 shares in
    the affirmative, 173,093 shares in the negative, and
    10,453 shares abstained relative to approval of the Asset
    Purchase Agreement dated as of September 3, 2002, by and
    between Metrowerks Corporation, a Texas corporation and wholly
    owned subsidiary of Motorola, Inc., a Delaware corporation, and
    Applied Microsystems Corporation, a Washington corporation, and
    to approve the proposed sale of Applieds embedded systems
    development tools business and assets to Metrowerks.




PART II






|        |                                                                          
|------- | -------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity
    and Related Stockholder Matters

Our common stock was involuntarily delisted from
the Nasdaq SmallCap Market effective as of the opening of
business on January 3, 2003. Our common stock currently
trades on the OTC Bulletin Board under the symbol
APMC.OB. As of March 17, 2003, there were
approximately 2,300 holders of our common stock, as estimated by
the number of record holders including holders represented by
brokers and other institutions.

The last reported sales price of our common stock
as quoted by the OTC Bulletin Board on March 17, 2003 was
$0.10 per share. The price per share in the following table
sets forth the range of low and high closing prices of the
Companys common stock as quoted on the Nasdaq National
Market for the period from January 1, 2001 through
September 15, 2002, and on the Nasdaq SmallCap Market for
the period from September 16, 2002 through
December 31, 2002:

|     |                |     |   |      |  |  |   |      | 
|---- | -------------- | --- | - | ---- |  |  | - | ---- | 
|     |                | Low |   | High
|     |                |     |   |     
|2001 |                |     |   |      |  |  |   |     
|     | First quarter  |     | $ | 2.13 |  |  | $ | 5.47 | 
|     | Second quarter |     |   | 2.06 |  |  |   | 5.35 | 
|     | Third quarter  |     |   | 1.13 |  |  |   | 5.16 | 
|     | Fourth quarter |     |   | 1.00 |  |  |   | 1.66 | 
|2002 |                |     |   |      |  |  |   |     
|     | First quarter  |     | $ | 1.01 |  |  | $ | 1.83 | 
|     | Second quarter |     |   | 0.46 |  |  |   | 1.35 | 
|     | Third quarter  |     |   | 0.15 |  |  |   | 0.49 | 
|     | Fourth quarter |     |   | 0.08 |  |  |   | 0.25 | 

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

16



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##### Table of Contents








|        |                                         
|------- | ----------------------------------------
|Item 6. | Selected Consolidated Financial
    Data

|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |        | 
|------------------------------------------------------------------------------------------------------------------------------ | ----------------------------------- | ---------------------------------------- | ------ | ----- |  | ---- | ------ | ------ |  | ---- | ------ | ------ |  | - | ------ | ------ |  | - | ------ | ------ | 
|                                                                                                                               |                                     |                                         
|                                                                                                                               |                                     | Year Ended December 31,                 
|                                                                                                                               |                                     |                                         
|                                                                                                                               |                                     | 2002                                     |        | 2001  |  | 2000 |        | 1999   |  | 1998
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |     
|                                                                                                                               |                                     |                                         
|                                                                                                                               |                                     | (In thousands, except per-share amounts)
|Statement of Operations Data:                                                                                                  |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Net sales                                                                                                                      |                                     | $                                        | 13,520 |       |  | $    | 28,870 |        |  | $    | 32,315 |        |  | $ | 33,241 |        |  | $ | 37,020 |       
|Cost of sales                                                                                                                  |                                     |                                          | 4,788  |       |  |      | 8,059  |        |  |      | 9,674  |        |  |   | 8,664  |        |  |   | 9,587  |       
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Gross profit                                                                                                                   |                                     |                                          | 8,732  |       |  |      | 20,811 |        |  |      | 22,641 |        |  |   | 24,577 |        |  |   | 27,433 |       
|Operating expenses:                                                                                                            |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|                                                                                                                               | Sales, general and administrative   |                                          |        | 8,481 |  |      |        | 13,600 |  |      |        | 17,094 |  |   |        | 18,929 |  |   |        | 18,104 | 
|                                                                                                                               | Research and development            |                                          |        | 5,745 |  |      |        | 10,204 |  |      |        | 13,101 |  |   |        | 11,435 |  |   |        | 10,438 | 
|                                                                                                                               | In-process research and development |                                          |        | 621   |  |      |        |       |  |      |        |       |  |   |        |       |  |   |        |       | 
|                                                                                                                               | Business restructuring              |                                          |        | 1,704 |  |      |        | 2,289  |  |      |        |       |  |   |        |       |  |   |        |       | 
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Total operating expenses                                                                                                       |                                     |                                          | 16,551 |       |  |      | 26,093 |        |  |      | 30,195 |        |  |   | 30,364 |        |  |   | 28,542 |       
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Loss from operations before other items                                                                                        |                                     |                                          | (7,819 | )     |  |      | (5,282 | )      |  |      | (7,554 | )      |  |   | (5,787 | )      |  |   | (1,109 | )     
|Gain on sale of embedded systems development
    tools business and assets                                                     |                                     |                                          | 3,583  |       |  |      |       |        |  |      |       |        |  |   |       |        |  |   |       |       
|Loss on sale, disposal, and impairment of
    long-lived assets held for sale                                                  |                                     |                                          | (901   | )     |  |      |       |        |  |      |       |        |  |   |       |        |  |   |       |       
|Loss on eliminating foreign currency translation
    adjustment from substantial liquidation of international
    subsidiaries |                                     |                                          | (593   | )     |  |      |       |        |  |      |       |        |  |   |       |        |  |   |       |       
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Loss from operations                                                                                                           |                                     |                                          | (5,730 | )     |  |      | (5,282 | )      |  |      | (7,554 | )      |  |   | (5,787 | )      |  |   | (1,109 | )     
|Interest income and other, net                                                                                                 |                                     |                                          | 58     |       |  |      | 261    |        |  |      | 659    |        |  |   | 706    |        |  |   | 783    |       
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Loss before income taxes and cumulative effect of
    change in accounting principle                                           |                                     |                                          | (5,672 | )     |  |      | (5,021 | )      |  |      | (6,895 | )      |  |   | (5,081 | )      |  |   | (326   | )     
|Income taxes                                                                                                                   |                                     |                                          |       |       |  |      |       |        |  |      |       |        |  |   |       |        |  |   | 19     |       
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Loss before cumulative effect of change in
    accounting principle                                                            |                                     |                                          | (5,672 | )     |  |      | (5,021 | )      |  |      | (6,895 | )      |  |   | (5,081 | )      |  |   | (345   | )     
|Cumulative effect of change in accounting
    principle                                                                        |                                     |                                          |       |       |  |      |       |        |  |      | (1,110 | )      |  |   |       |        |  |   |       |       
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Net loss                                                                                                                       |                                     | $                                        | (5,672 | )     |  | $    | (5,021 | )      |  | $    | (8,005 | )      |  | $ | (5,081 | )      |  | $ | (345   | )     
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Per-share amounts:                                                                                                             |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Basic and diluted loss per share before
    cumulative effect of change in accounting principle                                |                                     | $                                        | (0.76  | )     |  | $    | (0.71  | )      |  | $    | (1.00  | )      |  | $ | (0.76  | )      |  | $ | (0.05  | )     
|Cumulative effect of change in accounting
    principle                                                                        |                                     |                                          |       |       |  |      |       |        |  |      | (0.16  | )      |  |   |       |        |  |   |       |       
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Basic and diluted net loss per share                                                                                           |                                     | $                                        | (0.76  | )     |  | $    | (0.71  | )      |  | $    | (1.16  | )      |  | $ | (0.76  | )      |  | $ | (0.05  | )     
|                                                                                                                               |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Shares used in per-share calculation                                                                                           |                                     |                                          | 7,422  |       |  |      | 7,076  |        |  |      | 6,915  |        |  |   | 6,727  |        |  |   | 6,811  |       
|Pro forma amounts, assuming change in accounting
    principle applied retroactively:                                          |                                     |                                          |        |       |  |      |        |        |  |      |        |        |  |   |        |        |  |   |        |       
|Net loss                                                                                                                       |                                     |                                          | N/A    |       |  |      | N/A    |        |  | $    | (6,895 | )      |  | $ | (4,514 | )      |  | $ | (245   | )     
|Basic and diluted loss per share                                                                                               |                                     |                                          | N/A    |       |  |      | N/A    |        |  | $    | (1.00  | )      |  | $ | (0.67  | )      |  | $ | (0.04  | )     

17



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See Note 1 of Notes to Consolidated
Financial Statements for information on the change in
accounting principle.

|                                              |  |                |       |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|--------------------------------------------- |  | -------------- | ----- | ---- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ |  |  | - | ------ | 
|                                              |  |               
|                                              |  | December 31,  
|                                              |  |               
|                                              |  | 2002           |       | 2001 |  | 2000 |        | 1999 |  | 1998
|                                              |  |                |       |      |  |      |        |      |  |     
|                                              |  |               
|                                              |  | (In thousands)
|Balance Sheet Data:                           |  |                |       |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|Working capital                               |  | $              | 1,882 |      |  | $    | 5,762  |      |  | $    | 8,253  |  |  | $ | 16,311 |  |  | $ | 20,116 | 
|Total assets                                  |  |                | 5,219 |      |  |      | 15,024 |      |  |      | 21,453 |  |  |   | 28,042 |  |  |   | 33,290 | 
|Long-term liabilities, net of current portion |  |                |      |      |  |      | 894    |      |  |      |       |  |  |   |       |  |  |   |       | 
|Shareholders equity                          |  |                | 1,882 |      |  |      | 6,542  |      |  |      | 10,823 |  |  |   | 19,187 |  |  |   | 23,931 | 






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

Overview

Applied Microsystems Corporation historically
created solutions to expedite the development, test and
deployment of business and safety-critical embedded systems. We
developed, marketed and supported a comprehensive suite of
software and hardware-enhanced development, test, and
verification tools for the development of complex embedded
microprocessor-based applications. Using these tools, engineers
develop, test, debug, emulate and verify embedded software found
in a wide variety of products, including voice and data
communications networks, console games, avionics systems,
automotive systems, medical devices, and consumer electronics.

On November 1, 2002, we completed the sale
of our embedded systems development tools business and assets to
Metrowerks Corporation, a wholly owned subsidiary of Motorola,
Inc. The purchase price was $3.9 million, which included
payment for certain inventories and tangible assets, as well as
all intellectual property related to our embedded systems
development tools business. In addition, Metrowerks assumed
certain customer warranty and support obligations. We received
$3.4 million at closing, with the remaining $500,000
subject to a one-year holdback to secure certain indemnification
obligations. Certain other indemnification obligations relating
to our title to the assets sold, compliance with laws, and
certain matters relating to taxes continue until the expiration
of the statute of limitations applicable to claims with respect
to such matters.

With the sale of our historical
revenue-generating assets completed, we had planned to pursue
the development of new hardware and software products through
our Libra Networks division. Libra Networks was formed as a
result of our acquisition of REBA Technologies in May 2002. We
planned to focus our Libra Networks development on delivering
innovative technology that improves the way Web Services and
other enterprise applications are managed in enterprise data
centers.

During the fourth quarter of 2002 we aggressively
pursued funding for the Libra Networks business. Feedback from
various funding sources produced consistent themes, including
concern over Applieds capital structure as a publicly held
entity, concern over the timing and amount of Libra
Networks projected funding needs, and varying levels of
interest in Libra Networks overall market opportunity. We
also noted a softening in market projections for the adoption of
InfiniBand technology in the data center.

As a result, our board of directors concluded
that there was a low probability that Libra Networks could
achieve timely and sufficient funding to reasonably support its
business plan. Therefore, on December 16, 2002, we
announced that our board of directors had unanimously decided to
recommend to shareholders that Applied be liquidated.
Liquidation of a corporation is a complex process, and requires
a shareholder vote and presents other complexities, with
significant uncertainties surrounding the timing and amount of
any distribution to shareholders.

Since December 16, 2002, we have taken steps
to reduce our expenses, to prepare our Libra Networks assets for
sale, and to prepare a proxy statement and related materials in
connection with submitting the proposal to liquidate and
dissolve Applied to our shareholders for vote at a meeting of
shareholders. We have

18



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##### Table of Contents



reduced our workforce from 33 full-time
personnel on December 16, 2002, to six remaining
administrative personnel and no remaining development personnel.
In an effort to further trim expenses, in the fourth quarter of
2002, we entered into an agreement to terminate our headquarters
facilities lease no later than December 31, 2002. We paid
an early termination fee of approximately $1 million to
Teachers Insurance & Annuity Association of America,
the landlord under the lease, in exchange for termination of any
further obligations under the lease. In December 2002, we
entered into an agreement to sublease approximately
7,200 square feet in Redmond, Washington, and took
possession of the premises later than month. On
February 27, 2003, we provided notice of our intent to
terminate the sublease in Redmond as of March 31, 2003. We
then secured needed office facilities, consisting of
approximately 650 square feet, in the Redmond area on a
monthly rental basis.


If shareholders approve the liquidation of
Applied and the Plan of Liquidation and Dissolution (the
Plan of Dissolution), we will file articles of
dissolution with the Secretary of State of the State of
Washington promptly after the shareholder vote, and attempt to
convert our remaining assets, including our Libra Networks
assets, into cash and settle our liabilities as expeditiously as
possible. Some or all of our assets may be held in a contingency
reserve for the satisfaction of certain liabilities.

On September 16, 2002, our common stock was
transferred from the Nasdaq National Market to the Nasdaq
SmallCap Market. Our common stock was involuntarily delisted
from the Nasdaq SmallCap Market effective as of the opening of
business on January 3, 2003, as a result of our failure to
meet the minimum required bid price, market value of public
float, and shareholders equity requirement, and our common
stock has traded on the OTC Bulletin Board since January 3,
2003.

Critical Accounting Policies and
Estimates

This discussion and analysis of financial
condition and results of operations are based upon our
consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements
requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses,
and related disclosure of contingent assets and liabilities. On
an on-going basis, we evaluate our critical accounting policies
and estimates, including those related to accounting for the
sale of our embedded systems development tools assets and
business in November 2002, our plans announced December 16,
2002 to seek shareholder approval to pursue a corporate
liquidation, revenue recognition, inventories, accounting for
acquisitions such as the May 2002 REBA acquisition, and
restructuring activities. We base our estimates and our future
expectations on historical experience and on various other
assumptions that we believe to be reasonable under the
circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or
conditions.

We believe the following accounting policies are
the most critical to aid in fully understanding and evaluating
our more significant judgments and estimates used in the
preparation of our consolidated financial statements.

Sale of embedded systems development tools
assets and business.Effective
November 1, 2002, we completed the sale of our embedded
systems development tools business and assets to Metrowerks. We
accounted for the sale by removing sold assets and assumed
liabilities at their corresponding carrying amounts on the
closing date, recognizing the cash proceeds, recognizing the
$500,000 holdback receivable, recognizing the corresponding
transaction expenses (either as a reduction in previously
capitalized transaction expenses, or as a liability for
yet-to-be-paid items), and making other transaction-related
adjustments as deemed appropriate in the circumstances. As a
result, we recognized a net gain on the transaction.

Our policies with regard to accounting and
presentation are based on Statement of Financial Accounting
Standards (SFAS) No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets. The
long-lived corporate assets relating to the Companys
embedded systems development tools business meet the criteria of
long-lived assets to be disposed of by sale, as defined in
SFAS 144. Most such assets were sold prior

19



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##### Table of Contents



to the end of the year, either in the sale to
Metrowerks or through an auction held December 10, 2002 at
our former corporate headquarters facility.


Corporate
liquidation.On December 16,
2002, we announced that our board of directors had unanimously
decided to recommend to shareholders that Applied be liquidated.
Our critical accounting policies with regard to this announced
plan to seek liquidation are based on guidance from Emerging
Issues Task Force (EITF) 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring). Therefore, as of December 31, 2002,
we accrued certain costs relating to employee severance and
related benefits, as well as other expenses to terminate our
business activities. Ongoing expenses to operate the business
during the wind-down are treated as period expenses and were not
accrued as of December 31, 2002. In June 2002, the FASB
issued SFAS 146, Accounting for Exit or Disposal
Activities. SFAS 146 addresses issues regarding the
recognition, measurement, and reporting of costs that are
associated with exit and disposal activities, including
restructuring activities. SFAS 146 is effective for exit or
disposal activities that are initiated after December 31,
2002. Our current exit activities were initiated in 2002, and we
are applying the guidance of EITF 94-3.

We also determined that, under the provisions of
SFAS 144, many of our remaining fixed assets as of the end
of 2002 were impaired. We therefore recognized an impairment
loss and wrote down our fixed assets to fair value, in
accordance with SFAS 144.

Although we have announced our intent to seek
corporate liquidation, such liquidation requires that we obtain
shareholder approval, which is not assured. Therefore, our
consolidated financial statements for all periods presented have
been prepared in accordance with accounting principles generally
accepted in the United States of America, and not specifically
on the liquidation basis of accounting.

Revenue recognition.We historically earned revenue on the sale of hardware and
software products. We also earned revenue on the sale of
services, including hardware and software support, installation,
training, and professional engineering services. Revenue from
the sale or licensing of products was recognized when persuasive
evidence of an arrangement existed, delivery of the product had
occurred, the fee was fixed or determinable, and collectibility
was probable. If the fee due from a customer was not fixed or
determinable, revenue was recognized as payments became due from
a customer. If customers had inspection or acceptance rights
beyond standard warranty provisions, revenue was recognized when
formal notification of inspection or acceptance had been
received from the customer. Due to business customs in Japan and
our interpretation of Japanese law, product sales in Japan were
recognized when the customer notified us that it had inspected
and accepted the product. In the absence of receiving written
notification of inspection and acceptance, we recognized revenue
in Japan on receipt of payment by the customer as an indication
of acceptance. When products were sold with significant
installation services, all revenue was deferred until
installation was completed. Revenue from training and contract
engineering services was generally recognized as the services
were performed. Revenue from longer-term agreements to perform
development services was recognized under the
percentage-of-completion method, measured based on labor effort
or cost incurred to total estimated labor effort or cost
(assuming other revenue recognition criteria were met).

Inventories.We
write down our inventories for estimated obsolescence or
unmarketable inventories equal to the difference between cost
and the estimated net realizable value based on assumptions
about future demand and market conditions. Changes in those
underlying assumptions  including the impact of the
November 2002 asset sale  also resulted in additional
write-downs of inventories. While inventories have historically
been a material component of our financial statements, we had no
remaining inventories as of December 31, 2002 because all
inventories had been sold or otherwise disposed of prior to the
end of 2002.

Acquisitions.In May
2002, we announced our acquisition of REBA Technologies, Inc.
Applied does not have a history of acquiring companies;
therefore, the accounting policies relating to acquisitions
depend on the facts and circumstances of the specific
transaction. In this case, we assessed the proper allocation of
the purchase price in light of the circumstances and determined
that the entire purchase consideration be allocated to
in-process research and development, based primarily on the fact
that we acquired patent-pending technology (and we acquired no
other significant tangible or intangible assets).

20



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##### Table of Contents



Restructuring
activities.In the third quarter of
2001, we implemented a restructuring plan designed to reduce
operating costs. Again in the second quarter of 2002, we
implemented further cost reductions. These restructuring plans
included reductions in full-time employees worldwide across our
functional organizations; discontinuance or reallocation of
selected projects and activities not essential to our long-term
goals; abandonment of excess space at our headquarters; as well
as other cost reduction and control measures. We used estimates
to establish accruals in connection with the restructuring
plans, particularly with regard to our contractual lease
obligations for abandoned facilities, and the timing and market
rates that may be available if we successfully sublease the
excess space. In October 2002 we signed a lease termination
agreement with the landlord of our headquarters facility whereby
we paid an early termination fee of approximately
$1 million to the landlord in exchange for the termination
of any further obligations under the lease.

Results of Operations

|                                                                                                                               |                                     |                         |        |       |  |      |        |        |  |   |        |        | 
|------------------------------------------------------------------------------------------------------------------------------ | ----------------------------------- | ----------------------- | ------ | ----- |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|                                                                                                                               |                                     |                        
|                                                                                                                               |                                     | Year Ended December 31,
|                                                                                                                               |                                     |                        
|                                                                                                                               |                                     | 2002                    |        | 2001  |  | 2000
|                                                                                                                               |                                     |                         |        |       |  |     
|                                                                                                                               |                                     |                        
|                                                                                                                               |                                     | (In thousands)         
|Net sales                                                                                                                      |                                     | $                       | 13,520 |       |  | $    | 28,870 |        |  | $ | 32,315 |       
|Cost of sales                                                                                                                  |                                     |                         | 4,788  |       |  |      | 8,059  |        |  |   | 9,674  |       
|                                                                                                                               |                                     |                         |        |       |  |      |        |        |  |   |        |       
|Gross profit                                                                                                                   |                                     |                         | 8,732  |       |  |      | 20,811 |        |  |   | 22,641 |       
|Operating expenses:                                                                                                            |                                     |                         |        |       |  |      |        |        |  |   |        |       
|                                                                                                                               | Sales, general and administrative   |                         |        | 8,481 |  |      |        | 13,600 |  |   |        | 17,094 | 
|                                                                                                                               | Research and development            |                         |        | 5,745 |  |      |        | 10,204 |  |   |        | 13,101 | 
|                                                                                                                               | In-process research and development |                         |        | 621   |  |      |        |       |  |   |        |       | 
|                                                                                                                               | Business restructuring              |                         |        | 1,704 |  |      |        | 2,289  |  |   |        |       | 
|                                                                                                                               |                                     |                         |        |       |  |      |        |        |  |   |        |       
|Total operating expenses                                                                                                       |                                     |                         | 16,551 |       |  |      | 26,093 |        |  |   | 30,195 |       
|                                                                                                                               |                                     |                         |        |       |  |      |        |        |  |   |        |       
|Loss from operations before other items                                                                                        |                                     |                         | (7,819 | )     |  |      | (5,282 | )      |  |   | (7,554 | )     
|Gain on sale of embedded systems development
    tools business and assets                                                     |                                     |                         | 3,583  |       |  |      |       |        |  |   |       |       
|Loss on sale, disposal, and impairment of
    long-lived assets held for sale                                                  |                                     |                         | (901   | )     |  |      |       |        |  |   |       |       
|Loss on eliminating foreign currency translation
    adjustment from substantial liquidation of international
    subsidiaries |                                     |                         | (593   | )     |  |      |       |        |  |   |       |       
|                                                                                                                               |                                     |                         |        |       |  |      |        |        |  |   |        |       
|Loss from operations                                                                                                           |                                     |                         | (5,730 | )     |  |      | (5,282 | )      |  |   | (7,554 | )     
|Interest income and other, net                                                                                                 |                                     |                         | 58     |       |  |      | 261    |        |  |   | 659    |       
|                                                                                                                               |                                     |                         |        |       |  |      |        |        |  |   |        |       
|Loss before cumulative effect of change in
    accounting principle                                                            |                                     |                         | (5,672 | )     |  |      | (5,021 | )      |  |   | (6,895 | )     
|Cumulative effect of change in accounting
    principle                                                                        |                                     |                         |       |       |  |      |       |        |  |   | (1,110 | )     
|                                                                                                                               |                                     |                         |        |       |  |      |        |        |  |   |        |       
|Net loss                                                                                                                       |                                     | $                       | (5,672 | )     |  | $    | (5,021 | )      |  | $ | (8,005 | )     
|                                                                                                                               |                                     |                         |        |       |  |      |        |        |  |   |        |       

Net Sales.Our
revenues are derived from the embedded systems development tools
business that we sold in November 2002. Such revenues can be
classified into three broad categories: hardware-enhanced
debugging tools, software analysis tools, and game development
systems. The following table provides revenue information for
each of these categories.

|                                  |                 |                |       |        |  |      |        |        |  |   |        |        | 
|--------------------------------- | --------------- | -------------- | ----- | ------ |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|                                  |                 | 2002           |       | 2001   |  | 2000
|                                  |                 |                |       |        |  |     
|                                  |                 |               
|                                  |                 | (In thousands)
|Hardware-enhanced debugging tools |                 | $              | 5,153 |        |  | $    | 11,507 |        |  | $ | 21,912 |       
|Software analysis tools           |                 |                | 4,187 |        |  |      | 8,209  |        |  |   | 6,147  |       
|Game development systems          |                 |                | 4,180 |        |  |      | 9,154  |        |  |   | 4,256  |       
|                                  |                 |                |       |        |  |      |        |        |  |   |        |       
|                                  | Total net sales |                | $     | 13,520 |  |      | $      | 28,870 |  |   | $      | 32,315 | 
|                                  |                 |                |       |        |  |      |        |        |  |   |        |       

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Net sales decreased $15.3 million, or 53%,
in 2002, as compared to 2001. The decreases in hardware-enhanced
debugging tools revenues and software analysis tools revenues
were attributable primarily to continued lower demand from
telecommunications customers; lower volume of software licenses
sold through third-party developers of integrated development
environments; a continued low level of technology spending in
the major geographies in which we do business; and the effect of
our cost-control measures that forced us to choose development
projects among each of our product categories, thereby
eliminating some potential revenue-generating opportunities. The
overall decline in revenues was also attributable to the sale of
our embedded systems development tools assets and business on
November 1, 2002, and the related customer uncertainty
leading up to the sale.

Our game development systems revenues related to
agreements with Nintendo and Microsoft to provide game
development tools for Nintendos GamecubeTM and
Microsofts XboxTM video gaming systems. Game
development systems revenues were particularly strong in the
first half of 2001 due primarily to shipments to Microsoft in
anticipation of the November 2001 retail launch of the Xbox;
however, quarterly game development system revenues fluctuated
significantly in 2000, in the latter part of 2001, and
throughout 2002, depending on order cycles from Microsoft and
Nintendo. Order volumes in these periods were generally much
lower than in the first half of 2001.

Net sales decreased $3.4 million, or 11%, in
2001 as compared to 2000. The overall decrease in net sales in
2001 was attributable primarily to decreased sales of
hardware-enhanced debug, test, and performance solutions. The
decrease in these run control products was due
primarily to decreased demand from telecommunications customers,
overall lower average selling prices, slower-than-anticipated
unit volumes through distribution channels, and a general
decline in technology spending in the various geographies in
which we do business. The decrease in run control product
revenues was also attributable to our focus on developing
products and channels for software analysis tools as customers
moved from hardware development to software development. As a
result, we invested less in developing and supporting run
control products than in prior periods.

Software analysis revenues increased 34% in 2001,
as compared to 2000 results. This increase was due primarily to
our efforts to provide software development solutions that
provided value to our customers  including a focus on
safety and business-critical customer projects, the timing of
customer orders from a third-party developer of integrated
development environments, and increased professional services
contracts in 2001.

Our net sales include product support revenues,
which are included within the aforementioned major categories of
our products. These support revenues totaled approximately
$1.9 million in 2002, compared to $3.2 million in 2001
and $4.2 million in 2000. These declines were due primary
to lower hardware-enhanced debugging sales, for which support
contracts are often sold, as well as the sale of the embedded
systems development tools business in November 2002.

Sales outside of North America represented 28% of
net sales in 2002, compared to 28% in 2001 and 41% in 2000. In
U.S. dollars, international sales outside of North America
decreased 53% in 2002, as compared to 2001, and decreased 39% in
2001, as compared to 2000. These decreases were due primarily to
poor economic conditions in the international geographies in
which we do business, as well as our focus on telecommunications
customers. The telecommunications industry continued to
experience a worldwide downturn in 2002. Lower international
revenues in 2002 was also due to the sale of our embedded
systems development tools business in November 2002.

Our sales through our foreign subsidiaries were
generally denominated in local currencies; as a result,
fluctuations in currency exchange rates at times had a
significant effect on our reported net sales. Had the average
exchange rates in 2002 remained constant from 2001, the dollar
amount of overall net sales would have been materially unchanged
from the amounts reported. Had the average exchange rates in
2001 remained constant from 2000, the dollar amount of overall
net sales would have decreased 9% instead of the reported 11%,
due primarily to the U.S. dollar strengthening relative to
the Japanese yen during much of 2001.

Cost of Sales and Gross Profit.Gross profit was 65% of net sales in
2002, compared to 72% in 2001 and 70% in 2000. Cost of sales
includes materials, labor and overhead incurred in the
manufacturing of products as

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well as the cost of providing professional
services, performing non-recurring engineering, and estimated
warranty costs. We performed periodic assessments of required
reserves for potential inventory obsolescence, and corresponding
adjustments to such reserves were included within cost of sales.
The dollar amounts of cost of sales and gross profit fluctuated
based on a number of factors, including the volume of
corresponding net sales and vendor pricing pressures.


The gross profit percentage in 2002 was lower
than in 2001 due primarily to lower production volumes and
differences in the overall sales mix between the two periods.
The lower 2002 margin was also due to amounts paid to Metrowerks
relating to certain Xbox development tools orders. As part of
the November 2002 asset sale transaction, we requested that
certain customers and licensors of third-party technology assign
contractual rights to Metrowerks. We maintained a contractual
relationship with Microsoft whereby we provided development
tools for Microsofts Xbox video gaming system. In
connection with the asset sale, Microsoft elected to exercise
their contractual rights under the agreement with us to withdraw
certain technology held in escrow. Microsoft also accelerated
certain purchase requirements for development tools, and we
delivered such development tools in October 2002, prior to
closing the asset sale transaction. Because the order was
accelerated to occur prior to closing the transaction, Applied
and Metrowerks agreed to share the gross margin realized under
the sale of those specific development tools, and we paid
Metrowerks approximately $350,000 during the fourth quarter of
2002 as a one-time payment. This payment was charged to cost of
goods sold, and had the effect of decreasing the 2002 gross
profit percentage by 2%.

Our 2001 increase in gross profit percentage, as
compared to 2000, was attributable primarily to changes in
product mix  for example, software analysis revenues
increased in total and as a percentage of revenues from the
prior year, and such revenues generate a higher gross profit
percentage than the Companys hardware-based tools. Though
game development systems generally yield a lower gross profit
percentage, the increased throughput in the manufacturing
operations during the first half of 2001 attributable to game
development tools allowed for higher margins for
hardware-enhanced debugging tools as well.

Sales, General and Administrative Expenses.Sales, general, and administrative
expenses decreased $5.1 million, or 38%, in 2002, as
compared to 2001. The decrease was primarily the result of the
effects of continued cost-cutting (including lower personnel
levels than the prior year), lower overall commission expenses
in 2002 due to the lower revenue levels, and the sale of our
embedded systems development tools business in November 2002.

Sales, general, and administrative expenses
decreased $3.5 million, or 20%, in 2001, as compared to
2000. The decrease was due primarily to the adoption of our
cost-reduction plan in August 2001, as well as otherwise overall
lower personnel-related expenditures on lower headcount levels.
Sales of game development tools, which have lower sales-related
expenses than our other hardware and software products, also
contributed to lower expense levels in 2001, and we had lower
overall commission expenses in 2001 due to the decline in total
revenues. Because our cost reduction plan was implemented in the
second half of 2001, expenses for that year reflect only a
partial benefit of the cost reductions.

Research and Development Expenses.Research and development expenses
decreased $4.5 million, or 44%, in 2002, as compared to
2001. The decrease was primarily the result of the effects of
continued cost-cutting (including lower personnel levels than
the prior year) and the sale of our embedded systems development
tools business in November 2002.

Research and development expenses decreased
$2.9 million, or 22%, in 2001, as compared to 2000. This
decrease was primarily due to the adoption of a cost-reduction
plan in August 2001, as well as lower prototype expenditures in
2001 since much of the effort to develop game development
solutions was completed in 2000. In circumstances in which our
engineers provide services to customers under development
arrangements, the cost of engineers normally classified as
research and development are reclassified to cost of goods sold.
The overall reduction in 2001 research and development expenses
was partially offset by lower 2001 cost allocations to cost of
goods sold in comparison to the allocations in 2000 due
primarily to game development work completed in 2000.

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In-Process Research and Development.In May 2002, we announced that we had
completed the acquisition of REBA Technologies, Inc., and formed
Libra Networks, a division of Applied Microsystems, to pursue
development of the acquired technology. The acquisition
consideration consisted of an aggregate of approximately
350,000 shares of our common stock plus an aggregate
principal amount of $178,000 of promissory notes, due May 2004,
and bearing interest at the rate of 6% annually. We did not
acquire any personnel, tangible assets or known liabilities in
the transaction. As a result of the acquisition, we recognized
in-process research and development expenses of $621,000 in the
second quarter of 2002, representing the entire purchase price
(including transaction-related expenses).

Because Lary L. Evans was a director of Applied
and was the holder of approximately 86% of REBAs
outstanding shares, the negotiation of the terms of the
acquisition was handled by an independent committee of our board
of directors composed entirely of disinterested directors. This
committee engaged an independent valuation firm to provide a
basis for negotiations, and ultimately recommended that the
transaction be approved by our entire board of directors.
Mr. Evans resigned from the board of directors on
December 13, 2002, and has had no further involvement in
the operations of Applied.

At closing of the transaction, 50% of the merger
consideration was placed into an escrow for the purpose of
securing the indemnification obligations of the REBA
shareholders under the merger agreement. Those shares and notes
will remain in escrow for a period of three years from the
closing date and until all pending claims for indemnification,
if any, have been resolved.

Business Restructuring.In August 2001, we implemented a
restructuring plan designed to reduce operating costs. The
restructuring plan included an abandonment of excess space at
our headquarters; as well as other cost reduction and control
measures. During the second quarter of 2002, we reassessed the
potential exposure for losses for the abandoned space identified
in the August 2001 restructuring in light of revised estimates
of the timeframe and terms under which a sublease could be
negotiated. As a result, we recognized an additional charge of
$480,000 in the second quarter of 2002.

In May 2002, we announced further plans to reduce
expenses through a reduction in personnel and realignment of
business objectives. The cost reductions consisted primarily of
a reduction of approximately 45 full-time employees
worldwide across our functional organizations, as well as a
write-off of certain assets for which the book value was deemed
in excess of net realizable value under accounting rules. As a
result, we recognized $669,000 in restructuring charges during
the second quarter of 2002.

In the fourth quarter of 2002, after announcing
on December 16, 2002 that our board of directors had
unanimously decided to recommend to shareholders that Applied be
liquidated, we further recognized $906,000 in restructuring
charges associated with severance and benefits for the remaining
26 personnel. Also during the fourth quarter of 2002, we
entered into a Lease Termination Agreement (the
Termination Agreement), by and between Applied and
Teachers Insurance & Annuity Association of America
(TIAA). Pursuant to the Termination Agreement, we
paid an early termination fee of approximately $1 million
to TIAA in exchange for the termination of any further
obligations under the lease. As of the date of the Termination
Agreement, our remaining lease obligation extended through 2007
and was in excess of $6 million. The lease termination fee
was less than we had reserved for abandoned space in our accrued
restructuring reserve; therefore, we recognized a net benefit of
$351,000 in the restructuring charge in the fourth quarter of
2002 relating to the elimination of the reserve for abandoned
space.

Gain on Sale of Embedded Systems Development
Tools Business and Assets.On
November 1, 2002, we completed the sale of our embedded
systems development tools business and assets to Metrowerks
Corporation, a wholly owned subsidiary of Motorola, Inc. The
purchase price was $3.9 million, which included payment for
certain inventories and tangible assets, as well as all
intellectual property related to our embedded systems
development tools business. In addition, Metrowerks assumed
certain customer warranty and support obligations, and offered
employment to 26 Applied personnel. We received
$3.4 million at closing, with the remaining $500,000
subject to a one-year holdback to secure certain indemnification
obligations. Certain other indemnification obligations relating
to our title to the assets sold, compliance with laws, and
certain matters relating to taxes continue until the expiration
of the statute of limitations applicable to claims with respect
to such matters.

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To account for the sale, we recognized the cash
proceeds and the holdback receivable, removed sold assets and
liabilities from our records at their carrying amounts, and
recognized transaction-related expenses. As a result, we
recognized a gain on the sale in the fourth quarter of 2002.

Loss on Sale, Disposal, and Impairment of
Long-Lived Assets Held for Sale.Subsequent to the sale of our embedded systems development tools
business, we held an auction on December 10, 2002 at our
former Redmond, Washington facility, in which we sold virtually
all excess furniture, inventory, and equipment that we no longer
needed for the Libra Networks business (and in anticipation of
moving to a much smaller furnished facility before the end of
the year). We accounted for the auction by removing sold assets
at net book value, recognizing auction-related expenses, and
recognizing the net proceeds from the sale. We also otherwise
disposed of remaining inventory and those fixed assets that were
not deemed necessary for the Libra Networks business.

Loss on Eliminating Foreign Currency
Translation Adjustment from Substantial Liquidation of
International Subsidiaries.We are in
the process of liquidating our foreign subsidiaries in Japan,
The United Kingdom, France, and Germany. The operations of these
entities were significantly curtailed leading up to, and
immediately following, the sale of our embedded systems
development tools business. In accordance with accounting rules,
in the event of the substantial liquidation of a
foreign-controlled entity, any remaining foreign currency
translation adjustment should be reported as a gain or loss;
therefore, we eliminated the foreign currency translation
adjustment as of December 31, 2002 and charged the amount
as a loss in the fourth quarter of 2002.

Interest Income and Other, Net.Interest income and other, net,
decreased $203,000, or 78%, in 2002, as compared to 2001.
Interest income and other, net, decreased $398,000, or 60%, in
2001, as compared to 2002. These decreases were due primarily to
a decrease in cash available for short-term investments.

Cumulative Effect of Change in Accounting
Principle.Applied implemented
SAB 101 in the fourth quarter of 2000, effective
retroactive to January 1, 2000. SAB 101 provides
guidance related to revenue recognition policies based on
interpretations and practices followed by the SEC. As a result
of our assessment of these new guidelines, we changed our
revenue recognition practices for sales in Japan to reflect
revenues upon the earlier of customer inspection and acceptance
or, in the absence of notification of inspection and acceptance,
upon receipt of payment. We adopted SAB 101 under the
cumulative catch-up method of accounting, which is the manner
prescribed under applicable accounting and reporting rules.
Under these rules, the cumulative effect of a change in
accounting principle is recognized as an additional item on the
Companys statement of operations in the first quarter of
the year in which the change is made. Our adoption of this new
standard resulted in a $1.1 million cumulative adjustment
increasing our first quarter 2000 net loss. Revenues and
expenses in each of the 2000 quarters were likewise adjusted as
if the new accounting principle had been adopted since
January 1, 2000. See Note 1 of Notes to
Consolidated Financial Statements.

Income Taxes

As of December 31, 2002 we had net operating
loss carryforwards of approximately $22.7 million and
research and development credit carryforwards of approximately
$3.3 million for federal income tax purposes, both of which
expire in various amounts through 2022. Utilization of net
operating loss carryforwards may be subject to certain
limitations under Section 382 of the Internal Revenue Code.
If we obtain shareholder approval and complete the planned
corporate liquidation of Applied, we will be unable to utilize
our operating loss carryforwards and research and development
tax credits.

Deferred income taxes reflect the net tax effects
of temporary differences between the tax basis of assets and
liabilities and the corresponding financial statement amounts.
Due to the significant uncertainty of our ability to utilize our
net deferred tax assets, including our net operating losses and
research and development credits, a valuation allowance has been
established for financial reporting purposes equal to the amount
of the net deferred tax assets. See Note 8 of Notes to
Consolidated Financial Statements.

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Quarterly Results of Operations

Our results of operations have historically
fluctuated significantly from quarter to quarter. The sale of
our embedded systems development tools business and subsequent
announced plans to seek shareholder approval to liquidate
Applied are expected to significantly affect our future
quarterly operating results. For example, we no longer have
revenue-generating activities or manufacturing operations, and
we have significantly reduced the overall number of personnel in
light of our limited financial resources. Therefore, our
quarterly results of operations are not necessarily indicative
of results for any future period.

Liquidity and Capital Resources

As of December 31, 2002, we had
$3.9 million in cash, cash equivalents, and short-term
investments compared to $7.4 million as of
December 31, 2001. If shareholders approve our plan to
liquidate the Company, we would no longer require capital for
the financing of inventories and accounts receivable, sales and
marketing efforts, product development activities, and capital
equipment purchases. Rather, we would expect to use the
remaining cash to wind-down operations, satisfy our known and
unknown obligations and, if cash is available, distribute
remaining amounts to shareholders. As part of the agreement to
sell our embedded systems development tools business, we agreed
to indemnify Metrowerks for specified items  $500,000
of the agreed-upon purchase price was held back to secure
certain of these indemnification obligations, and this amount is
due to be received in November 2003. Certain other
indemnification obligations relating to our title to the assets
sold, compliance with laws, and certain matters relating to
taxes continue until the expiration of the statute of
limitations applicable to claims with respect to such matters.
These indemnification obligations, other known or unknown
obligations, the actual cost of meeting legal and regulatory
requirements in the United States and in other jurisdictions to
liquidate Applieds legal entities, and other factors are
expected to affect the timing and/or the amount of any
distribution to shareholders.

We used cash of $5.9 million for operating
activities in 2002, compared to using $3.6 million for
operating activities in 2001. Investing activities provided
$6.2 million in cash in 2002, including net cash proceeds
of $2.5 million from the sale of our embedded systems
development tools business and assets. We used cash to purchase
$118,000 in property and equipment in 2002, compared to
purchasing $180,000 in property and equipment in 2001 (excluding
an equipment purchase of $250,000 in 2001 financed under a
long-term capital lease).

The Company leases certain equipment and
international office space under noncancelable leases. We plan
to enter into negotiations to settle these obligations, but
there can be no assurance that we will be able to do so on terms
favorable to the Company, or at all, nor that we will have
sufficient funds to do so. Minimum future payments as of
December 31, 2002 are as follows:

|           |  |                |     |           |  |   |     | 
|---------- |  | -------------- | --- | --------- |  | - | --- | 
|           |  | Capital        |     | Operating
|           |  | Lease          |     | Leases   
|           |  |                |     |          
|           |  |               
|           |  | (In thousands)
|2003       |  | $              | 62  |           |  | $ | 129 | 
|2004       |  |                | 62  |           |  |   | 37  | 
|2005       |  |                | 62  |           |  |   | 16  | 
|2006       |  |                | 16  |           |  |   | 13  | 
|2007       |  |                |    |           |  |   |    | 
|Thereafter |  |                |    |           |  |   |    | 
|           |  |                |     |           |  |   |     | 
|           |  | $              | 202 |           |  | $ | 195 | 
|           |  |                |     |           |  |   |     | 

We received funds totaling $58,000 in 2002 from
the sale of our common stock to personnel through an employee
stock purchase plan and the exercise of employee stock options,
compared to receiving $497,000 in 2001. We do not anticipate
future funds from this source.

We believe that our existing working capital will
provide us with sufficient funds to effect an orderly
liquidation, if our shareholders approve a corporate
liquidation; however, the timing and amount of any

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distribution to shareholders is subject to
significant uncertainty. If we are unable to effect an orderly
liquidation, we could be required to seek protection under the
laws of bankruptcy. Our stock is currently trading on the OTC
Bulletin Board, and we do not believe we could successfully
raise additional funds under our corporate circumstances, either
through a debt or equity offering.


Accounting Pronouncements

In April 2002, the FASB issued SFAS 145,
Rescission of FASB Statements 4, 44, and 64, Amendment of
FASB Statement 13, and Technical Corrections. Among other
provisions, SFAS 145 rescinds SFAS 4, Reporting
Gains and Losses from Extinguishment of Debt. Accordingly,
gains or losses from extinguishment of debt should not be
reported as extraordinary items unless the extinguishment
qualifies as an extraordinary item under the criteria of
Accounting Principles Board Opinion 30, Reporting the
Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual
and Infrequently Occurring Events and Transactions. Gains
or losses from extinguishment of debt, which do not meet the
criteria of Accounting Principles Board Opinion 30, should
be reclassified to income from continuing operations in all
prior periods presented. The provisions of SFAS 145 will be
effective for fiscal years beginning after May 15, 2002.
Adoption of SFAS 145 is not expected to have a material
impact on the Companys financial statements because the
Company has not historically experienced debt extinguishments.

In June 2002, the FASB issued SFAS 146,
Accounting for Exit or Disposal Activities.
SFAS 146 addresses issues regarding the recognition,
measurement, and reporting of costs that are associated with
exit and disposal activities, including restructuring
activities. SFAS 146 is effective for exit or disposal
activities that are initiated after December 31, 2002. The
Companys current exit activities were initiated in 2002,
and the Company is applying the guidance of Emerging Issues Task
Force (EITF) 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a
Restructuring). SFAS 146 is not expected to have a
material impact on the Companys financial statements
because the Company does not expect to initiative future exit
activities.

In November 2002, FASB Interpretation 45,
Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of
Others (FIN 45), was issued. FIN 45
requires a guarantor entity, at the inception of a guarantee
covered by the measurement provisions of the interpretation, to
record a liability for the fair value of the obligation
undertaken in issuing the guarantee. Under prior standards,
companies generally did not record a liability when guaranteeing
obligations unless it became probable that they would have to
perform under the guarantee. FIN 45 applies prospectively
to guarantees the Company issues or modifies subsequent to
December 31, 2002, but has certain disclosure requirements
effective for interim and annual periods ending after
December 15, 2002. The Company does not anticipate
FIN 45 will have a material effect on its financial
statements.

In December 2002, the FASB issued SFAS 148,
Accounting for Stock-Based Compensation 
Transition and Disclosure. This standard amends
SFAS 123, Accounting for Stock-Based
Compensation, to provide alternative methods of transition
for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition,
this Statement amends the disclosures in both annual and interim
financial statements about the method of accounting for
stock-based employee compensation and the effect of the method
used on reported results. The amendments to SFAS 123 of
this Statement shall be effective for financial statements for
fiscal years ending after December 15, 2002. The initial
application of SFAS 148 is not expected to have a material
effect on the Companys consolidated financial statements.

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|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    about Market Risk

The Company is exposed to market risk related to
changes in interest rates, which could adversely affect the
value of the Companys short-term investments. Applied
maintains a short-term investment portfolio consisting of
interest-bearing securities with an average maturity of less
than one year. These securities are classified as
available-for-sale securities. These
interest-bearing securities are subject to interest rate risk
and will fall in value if market interest rates increase. If
market interest rates were to increase immediately and uniformly
by 10% from levels at December 31, 2002, the fair value of
the portfolio would decline by an immaterial amount. We do not
expect our operating results or cash flows to be affected to any
significant degree by a sudden change in market interest rates.

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|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

APPLIED MICROSYSTEMS CORPORATION

INDEX TO FINANCIAL STATEMENTS

|                                                                                                         |  |      |  | 
|-------------------------------------------------------------------------------------------------------- |  | ---- |  | 
|                                                                                                         |  | Page
|                                                                                                         |  |     
|Audited Annual Financial Statements:                                                                     |  |      |  | 
|Report of Independent Certified Public Accountants                                                       |  |      |  | 
|Report of Ernst & Young LLP, Independent
    Auditors                                                    |  |      |  | 
|Consolidated Balance Sheet as of
    December 31, 2002 and 2001                                          |  |      |  | 
|Consolidated Statements of Operations for the
    Years Ended December 31, 2002, 2001 and 2000           |  |      |  | 
|Consolidated Statements of Shareholders
    Equity for the Years Ended December 31, 2002, 2001 and 2000 |  |      |  | 
|Consolidated Statements of Cash Flows for the
    Years Ended December 31, 2002, 2001 and 2000           |  |      |  | 
|Notes to Consolidated Financial Statements                                                               |  |      |  | 

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REPORT OF INDEPENDENT CERTIFIED PUBLIC
ACCOUNTANTS

Board of Directors

Applied Microsystems Corporation


We have audited the accompanying consolidated
balance sheet of Applied Microsystems Corporation as of
December 31, 2002, and the related statements of
operations, shareholders equity, and cash flows for the
year then ended. These financial statements are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements based on our audit.

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

In our opinion, the financial statements referred
to above present fairly, in all material respects, the
consolidated balance sheet of Applied Microsystems Corporation
as of December 31, 2002, and the results of its operations
and its cash flows for the year then ended, in conformity with
accounting principles generally accepted in the United States of
America.

The accompanying financial statements have been
prepared assuming that the Company will continue as a going
concern. As shown in the financial statements, the Company
incurred a net loss of $5,672,000 during the year ended
December 31, 2002 and the board of directors had
unanimously decided to recommend to the shareholders that the
Company be liquidated. These factors, among others, as discussed
in Note 1 to the financial statements, raise substantial
doubt about the Companys ability to continue as a going
concern. Managements plans in regard to these matters are
also described in Note 1. The financial statements do not
include any adjustments that might result from the outcome of
this uncertainty.

We have also audited Schedule II for the
year ended December 31, 2002. In our opinion, the schedule,
when considered in relation to the basic financial statements
taken as a whole, presents fairly, in all material respects, the
information therein.

Seattle, Washington

February 20, 2003


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REPORT OF ERNST & YOUNG LLP,
INDEPENDENT AUDITORS

Shareholders and Board of Directors

Applied Microsystems Corporation


We have audited the accompanying consolidated
balance sheet of Applied Microsystems Corporation as of
December 31, 2001, and the related consolidated statements
of operations, shareholders equity, and cash flows for
each of the two years in the period ended December 31,
2001. Our audits also included the financial statement schedule
for the two years in the period ended December 31, 2001
listed in the Index at Item 15(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
auditing standards generally accepted in the United States.
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 financial statements referred
to above present fairly, in all material respects, the
consolidated financial position of Applied Microsystems
Corporation at December 31, 2001, and the consolidated
results of its operations and its cash flows for each of the two
years in the period ended December 31, 2001, in conformity
with accounting principles generally accepted in the United
States. 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.

As discussed in Note 1 to the financial
statements, in 2000 the Company changed its method of accounting
for revenue recognition in accordance with guidance provided in
SEC Staff Accounting Bulletin No. 101, Revenue
Recognition in Financial Statements.



| |                  
| | -----------------
| | ERNST & YOUNG LLP

Seattle, Washington

February 1, 2002


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APPLIED MICROSYSTEMS CORPORATION

CONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                           |                                                |                |         |       |  |   |         |       | 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------- | -------------- | ------- | ----- |  | - | ------- | ----- | 
|                                                                                                                                                                           |                                                |               
|                                                                                                                                                                           |                                                | December 31,  
|                                                                                                                                                                           |                                                |               
|                                                                                                                                                                           |                                                | 2002           |         | 2001 
|                                                                                                                                                                           |                                                |                |         |      
|                                                                                                                                                                           |                                                |               
|                                                                                                                                                                           |                                                | (In thousands)
|ASSETS                                                                                                                                                                    
|Current assets:                                                                                                                                                            |                                                |                |         |       |  |   |         |      
|                                                                                                                                                                           | Cash and cash equivalents                      |                | $       | 3,600 |  |   | $       | 2,971 | 
|                                                                                                                                                                           | Securities available-for-sale                  |                |         | 299   |  |   |         | 3,997 | 
|                                                                                                                                                                           | Restricted investment                          |                |         |      |  |   |         | 400   | 
|                                                                                                                                                                           | Accounts receivable, net                       |                |         | 280   |  |   |         | 3,594 | 
|                                                                                                                                                                           | Note receivable                                |                |         | 500   |  |   |         |      | 
|                                                                                                                                                                           | Inventories                                    |                |         |      |  |   |         | 1,959 | 
|                                                                                                                                                                           | Prepaid and other current assets               |                |         | 449   |  |   |         | 429   | 
|                                                                                                                                                                           | Property and equipment held for sale           |                |         | 91    |  |   |         |      | 
|                                                                                                                                                                           |                                                |                |         |       |  |   |         |      
|Total current assets                                                                                                                                                       |                                                |                | 5,219   |       |  |   | 13,350  |      
|Property and equipment, net                                                                                                                                                |                                                |                |        |       |  |   | 1,358   |      
|Other assets                                                                                                                                                               |                                                |                |        |       |  |   | 316     |      
|                                                                                                                                                                           |                                                |                |         |       |  |   |         |      
|Total assets                                                                                                                                                               |                                                | $              | 5,219   |       |  | $ | 15,024  |      
|                                                                                                                                                                           |                                                |                |         |       |  |   |         |      
|                                                                                                                                                                          
|LIABILITIES AND SHAREHOLDERS
    EQUITY                                                                                                                                  
|Current liabilities:                                                                                                                                                       |                                                |                |         |       |  |   |         |      
|                                                                                                                                                                           | Accounts payable                               |                | $       | 744   |  |   | $       | 1,704 | 
|                                                                                                                                                                           | Accrued payroll                                |                |         | 1,143 |  |   |         | 1,178 | 
|                                                                                                                                                                           | Other accrued expenses                         |                |         | 765   |  |   |         | 1,453 | 
|                                                                                                                                                                           | Deferred revenue                               |                |         | 325   |  |   |         | 3,253 | 
|                                                                                                                                                                           | Capital lease obligation                       |                |         | 175   |  |   |         |      | 
|                                                                                                                                                                           | Notes payable                                  |                |         | 185   |  |   |         |      | 
|                                                                                                                                                                           |                                                |                |         |       |  |   |         |      
|Total current liabilities                                                                                                                                                  |                                                |                | 3,337   |       |  |   | 7,588   |      
|                                                                                                                                                                           | Capital lease obligation, less current portion |                |         |      |  |   |         | 175   | 
|                                                                                                                                                                           | Accrued cost of business restructuring         |                |         |      |  |   |         | 719   | 
|                                                                                                                                                                           |                                                |                |         |       |  |   |         |      
|Total long-term liabilities                                                                                                                                                |                                                |                |        |       |  |   | 894     |      
|Commitments and contingencies                                                                                                                                              |                                                |                |        |       |  |   |        |      
|Shareholders equity:                                                                                                                                                      |                                                |                |         |       |  |   |         |      
|Preferred stock, $0.01 par value;
    5,000,000 shares authorized; none issued and outstanding                                                                             |                                                |                |        |       |  |   |        |      
|Common stock, $0.01 par value;
    25,000,000 shares authorized; 7,597,000 and
    7,149,000 shares issued and outstanding at
    December 31, 2002 and 2001, respectively |                                                |                | 27,233  |       |  |   | 26,857  |      
|Accumulated other comprehensive loss                                                                                                                                       |                                                |                |        |       |  |   | (636    | )    
|Accumulated deficit                                                                                                                                                        |                                                |                | (25,351 | )     |  |   | (19,679 | )    
|                                                                                                                                                                           |                                                |                |         |       |  |   |         |      
|Total shareholders equity                                                                                                                                                 |                                                |                | 1,882   |       |  |   | 6,542   |      
|                                                                                                                                                                           |                                                |                |         |       |  |   |         |      
|Total liabilities and shareholders equity                                                                                                                                 |                                                | $              | 5,219   |       |  | $ | 15,024  |      
|                                                                                                                                                                           |                                                |                |         |       |  |   |         |      

See accompanying notes.

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APPLIED MICROSYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |        | 
|------------------------------------------------------------------------------------------------------------------------------ | ----------------------------------- | ------------------------- | ------ | ----- |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|                                                                                                                               |                                     |                          
|                                                                                                                               |                                     | Year Ended December 31,  
|                                                                                                                               |                                     |                          
|                                                                                                                               |                                     | 2002                      |        | 2001  |  | 2000
|                                                                                                                               |                                     |                           |        |       |  |     
|                                                                                                                               |                                     |                          
|                                                                                                                               |                                     | (In thousands,           
|                                                                                                                               |                                     | except per-share amounts)
|Net sales                                                                                                                      |                                     | $                         | 13,520 |       |  | $    | 28,870 |        |  | $ | 32,315 |       
|Cost of sales                                                                                                                  |                                     |                           | 4,788  |       |  |      | 8,059  |        |  |   | 9,674  |       
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Gross profit                                                                                                                   |                                     |                           | 8,732  |       |  |      | 20,811 |        |  |   | 22,641 |       
|Operating expenses:                                                                                                            |                                     |                           |        |       |  |      |        |        |  |   |        |       
|                                                                                                                               | Sales, general and administrative   |                           |        | 8,481 |  |      |        | 13,600 |  |   |        | 17,094 | 
|                                                                                                                               | Research and development            |                           |        | 5,745 |  |      |        | 10,204 |  |   |        | 13,101 | 
|                                                                                                                               | In-process research and development |                           |        | 621   |  |      |        |       |  |   |        |       | 
|                                                                                                                               | Business restructuring              |                           |        | 1,704 |  |      |        | 2,289  |  |   |        |       | 
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Total operating expenses                                                                                                       |                                     |                           | 16,551 |       |  |      | 26,093 |        |  |   | 30,195 |       
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Loss from operations before other items                                                                                        |                                     |                           | (7,819 | )     |  |      | (5,282 | )      |  |   | (7,554 | )     
|Gain on sale of embedded systems development
    tools business and assets                                                     |                                     |                           | 3,583  |       |  |      |       |        |  |   |       |       
|Loss on sale, disposal, and impairment of
    long-lived assets held for sale                                                  |                                     |                           | (901   | )     |  |      |       |        |  |   |       |       
|Loss on eliminating foreign currency translation
    adjustment from substantial liquidation of international
    subsidiaries |                                     |                           | (593   | )     |  |      |       |        |  |   |       |       
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Loss from operations                                                                                                           |                                     |                           | (5,730 | )     |  |      | (5,282 | )      |  |   | (7,554 | )     
|Interest income and other, net                                                                                                 |                                     |                           | 58     |       |  |      | 261    |        |  |   | 659    |       
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Loss before cumulative effect of change in
    accounting principle                                                            |                                     |                           | (5,672 | )     |  |      | (5,021 | )      |  |   | (6,895 | )     
|Cumulative effect of change in accounting
    principle                                                                        |                                     |                           |       |       |  |      |       |        |  |   | (1,110 | )     
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Net loss                                                                                                                       |                                     | $                         | (5,672 | )     |  | $    | (5,021 | )      |  | $ | (8,005 | )     
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Per-share amounts:                                                                                                             |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Basic and diluted loss per share before
    cumulative effect of change in accounting principle                                |                                     | $                         | (0.76  | )     |  | $    | (0.71  | )      |  | $ | (1.00  | )     
|Cumulative effect of change in accounting
    principle                                                                        |                                     |                           |       |       |  |      |       |        |  |   | (0.16  | )     
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Basic and diluted net loss per share                                                                                           |                                     | $                         | (0.76  | )     |  | $    | (0.71  | )      |  | $ | (1.16  | )     
|                                                                                                                               |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Shares used in per-share calculation                                                                                           |                                     |                           | 7,422  |       |  |      | 7,076  |        |  |   | 6,915  |       
|Pro forma amounts, assuming change in accounting
    principle applied retroactively:                                          |                                     |                           |        |       |  |      |        |        |  |   |        |       
|Net loss                                                                                                                       |                                     |                           | N/A    |       |  |      | N/A    |        |  | $ | (6,895 | )     
|Basic and diluted net loss per share                                                                                           |                                     |                           | N/A    |       |  |      | N/A    |        |  | $ | (1.00  | )     

See accompanying notes.

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APPLIED MICROSYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY

|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |        |        |  
|---------------------------- | ------------------------------------------------------------------------------------------------------------------------------ | ------------------ | ----- | ----------- |  | ------------- | ------ | ------------- |  | ------ | ------- | ------ | - | - | ---- | ---- | - | - | ------ | ------ | ------ | -
|                             |                                                                                                                                |                    |       |             |  | Accumulated   |        |              
|                             |                                                                                                                                | Common Stock       |       |             |  | Other         |        | Total        
|                             |                                                                                                                                |                    |       | Accumulated |  | Comprehensive |        | Shareholders
|                             |                                                                                                                                | Shares             |       | Amount      |  | Deficit       |        | Income (Loss) |  | Equity
|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |       
|                             |                                                                                                                                |                   
|                             |                                                                                                                                | (In thousands)    
|Balance at January 1, 2000   |                                                                                                                                |                    | 6,830 |             |  | $             | 25,792 |               |  | $      | (6,653  | )      |   | $ | 48   |      |   | $ | 19,187 |       
|                             | Stock options exercised                                                                                                        |                    |       | 109         |  |               |        | 426           |  |        |         |       |   |   |      |     |   |   |        | 426    |       
|                             | Sale of common stock to employees                                                                                              |                    |       | 20          |  |               |        | 142           |  |        |         |       |   |   |      |     |   |   |        | 142    |       
|                             | Net loss                                                                                                                       |                    |       |            |  |               |        |              |  |        |         | (8,005 | ) |   |      |     |   |   |        | (8,005 | )     
|                             | Foreign currency translation adjustment                                                                                        |                    |       |            |  |               |        |              |  |        |         |       |   |   |      | (927 | ) |   |        | (927   | )     
|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |       
|                             |                                                                                                                                | Comprehensive loss |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |        | (8,932 | )
|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |       
|Balance at December 31, 2000 |                                                                                                                                |                    | 6,959 |             |  |               | 26,360 |               |  |        | (14,658 | )      |   |   | (879 | )    |   |   | 10,823 |       
|                             | Stock options exercised                                                                                                        |                    |       | 114         |  |               |        | 210           |  |        |         |       |   |   |      |     |   |   |        | 210    |       
|                             | Sale of common stock to employees                                                                                              |                    |       | 76          |  |               |        | 287           |  |        |         |       |   |   |      |     |   |   |        | 287    |       
|                             | Net loss                                                                                                                       |                    |       |            |  |               |        |              |  |        |         | (5,021 | ) |   |      |     |   |   |        | (5,021 | )     
|                             | Foreign currency translation adjustment                                                                                        |                    |       |            |  |               |        |              |  |        |         |       |   |   |      | 243  |   |   |        | 243    |       
|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |       
|                             |                                                                                                                                | Comprehensive loss |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |        | (4,778 | )
|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |       
|Balance at December 31, 2001 |                                                                                                                                |                    | 7,149 |             |  |               | 26,857 |               |  |        | (19,679 | )      |   |   | (636 | )    |   |   | 6,542  |       
|                             | Stock options exercised                                                                                                        |                    |       | 43          |  |               |        | 2             |  |        |         |       |   |   |      |     |   |   |        | 2      |       
|                             | Sale of common stock to employees                                                                                              |                    |       | 55          |  |               |        | 56            |  |        |         |       |   |   |      |     |   |   |        | 56     |       
|                             | Common stock issued in                                                                                                         |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |        |       
|                             | REBA acquisition                                                                                                               |                    |       | 350         |  |               |        | 318           |  |        |         |       |   |   |      |     |   |   |        | 318    |       
|                             | Loss on eliminating foreign currency translation
    adjustment from substantial liquidation of international
    subsidiaries |                    |       |            |  |               |        |              |  |        |         |       |   |   |      | 593  |   |   |        | 593    |       
|                             | Net loss                                                                                                                       |                    |       |            |  |               |        |              |  |        |         | (5,672 | ) |   |      |     |   |   |        | (5,672 | )     
|                             | Foreign currency translation adjustment                                                                                        |                    |       |            |  |               |        |              |  |        |         |       |   |   |      | 43   |   |   |        | 43     |       
|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |       
|                             |                                                                                                                                | Comprehensive loss |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |        | (5,629 | )
|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |       
|Balance at December 31, 2002 |                                                                                                                                |                    | 7,597 |             |  | $             | 27,233 |               |  | $      | (25,351 | )      |   | $ |     |      |   | $ | 1,882  |       
|                             |                                                                                                                                |                    |       |             |  |               |        |               |  |        |         |        |   |   |      |      |   |   |        |       

See accompanying notes.

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APPLIED MICROSYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                     |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |       |      |  
|------------------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------ | -------------------------------------------------------------------------- | ------ | ------ | ------ | ---- | ------ | ----- | ------ | - | ------ | ----- | ---- | -
|                                                                                     |                                                                                                                                |                                                                           
|                                                                                     |                                                                                                                                | Year Ended December 31,                                                   
|                                                                                     |                                                                                                                                |                                                                           
|                                                                                     |                                                                                                                                | 2002                                                                       |        | 2001   |        | 2000
|                                                                                     |                                                                                                                                |                                                                            |        |        |        |     
|                                                                                     |                                                                                                                                |                                                                           
|                                                                                     |                                                                                                                                | (In thousands)                                                            
|Operating activities                                                                 |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|Net loss                                                                             |                                                                                                                                | $                                                                          | (5,672 | )      |        | $    | (5,021 | )     |        | $ | (8,005 | )    
|Adjustments to reconcile net loss to net cash
    used in operating activities:      |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|                                                                                     | Gain on sale of embedded systems development
    tools business and assets                                                     |                                                                            |        | (3,583 | )      |      |        |      |        |   |        |      |     
|                                                                                     | Loss on sale, disposal, and impairment of
    long-lived assets held for sale                                                  |                                                                            |        | 901    |        |      |        | 176   |        |   |        |      |     
|                                                                                     | Loss on eliminating foreign currency translation
    adjustment from substantial liquidation of international
    subsidiaries |                                                                            |        | 593    |        |      |        |      |        |   |        |      |     
|                                                                                     | In-process research and development                                                                                            |                                                                            |        | 621    |        |      |        |      |        |   |        |      |     
|                                                                                     | Transaction expenses for in-process research and
    development                                                               |                                                                            |        | (117   | )      |      |        |      |        |   |        |      |     
|                                                                                     | Cumulative effect of change in accounting
    principle                                                                        |                                                                            |        |       |        |      |        |      |        |   |        | 1,110 |     
|                                                                                     | Depreciation and amortization                                                                                                  |                                                                            |        | 707    |        |      |        | 1,019 |        |   |        | 1,053 |     
|                                                                                     | Net change in operating accounts:                                                                                              |                                                                            |        |        |        |      |        |       |        |   |        |       |     
|                                                                                     |                                                                                                                                | Accounts receivable                                                        |        |        | 3,315  |      |        |       | 1,912  |   |        |       | (204 | )
|                                                                                     |                                                                                                                                | Inventories                                                                |        |        | 801    |      |        |       | 604    |   |        |       | (23  | )
|                                                                                     |                                                                                                                                | Prepaid and other assets                                                   |        |        | 197    |      |        |       | (83    | ) |        |       | 160  |  
|                                                                                     |                                                                                                                                | Accounts payable, accrued expenses, and accrued
    business restructuring |        |        | (2,005 | )    |        |       | (799   | ) |        |       | 796  |  
|                                                                                     |                                                                                                                                | Deferred revenue                                                           |        |        | (1,659 | )    |        |       | (1,419 | ) |        |       | (276 | )
|                                                                                     |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|Net cash used in operating activities                                                |                                                                                                                                |                                                                            | (5,901 | )      |        |      | (3,611 | )     |        |   | (5,389 | )    
|Investing activities                                                                 |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|Purchases of securities available-for-sale                                           |                                                                                                                                |                                                                            | (2,275 | )      |        |      | (8,013 | )     |        |   | (5,322 | )    
|Maturities of securities available-for-sale                                          |                                                                                                                                |                                                                            | 5,973  |        |        |      | 6,542  |       |        |   | 13,460 |      
|Net proceeds from sale of embedded systems
    development tools business and assets |                                                                                                                                |                                                                            | 2,489  |        |        |      |       |       |        |   |       |      
|Net proceeds from sale and disposal of long-lived
    assets held for sale           |                                                                                                                                |                                                                            | 84     |        |        |      |       |       |        |   |       |      
|Additions to property and equipment                                                  |                                                                                                                                |                                                                            | (118   | )      |        |      | (180   | )     |        |   | (753   | )    
|                                                                                     |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|Net cash provided by (used in) investing
    activities                              |                                                                                                                                |                                                                            | 6,153  |        |        |      | (1,651 | )     |        |   | 7,385  |      
|Financing activities                                                                 |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|Sale of common stock to employees                                                    |                                                                                                                                |                                                                            | 56     |        |        |      | 287    |       |        |   | 142    |      
|Stock options exercised                                                              |                                                                                                                                |                                                                            | 2      |        |        |      | 210    |       |        |   | 426    |      
|Cash released (restricted) to secure letter
    of credit                            |                                                                                                                                |                                                                            | 400    |        |        |      |       |       |        |   | (400   | )    
|Payments on capital lease obligation                                                 |                                                                                                                                |                                                                            | (45    | )      |        |      | (32    | )     |        |   |       |      
|                                                                                     |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|Net cash provided by financing activities                                            |                                                                                                                                |                                                                            | 413    |        |        |      | 465    |       |        |   | 168    |      
|Effects of foreign currency exchange rate changes                                    |                                                                                                                                |                                                                            | (36    | )      |        |      | 212    |       |        |   | (290   | )    
|                                                                                     |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|Net increase (decrease) in cash and cash
    equivalents                             |                                                                                                                                |                                                                            | 629    |        |        |      | (4,585 | )     |        |   | 1,874  |      
|Cash and cash equivalents at beginning of year                                       |                                                                                                                                |                                                                            | 2,971  |        |        |      | 7,556  |       |        |   | 5,682  |      
|                                                                                     |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      
|Cash and cash equivalents at end of year                                             |                                                                                                                                | $                                                                          | 3,600  |        |        | $    | 2,971  |       |        | $ | 7,556  |      
|                                                                                     |                                                                                                                                |                                                                            |        |        |        |      |        |       |        |   |        |      

Supplemental disclosure of non-cash
activities:

In 2001, the Company obtained equipment under a
five-year capital lease obligation of $250,000.


See accompanying notes.

35



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS



|   |                                                                           
|-- | --------------------------------------------------------------------------
|1. | Description of Business and Summary of
    Significant Accounting Policies



| |         
| | --------
| | Business

Applied Microsystems Corporation
(Applied or the Company) historically
created solutions to expedite the development, test and
deployment of business and safety-critical embedded systems.
Applied developed, marketed and supported a comprehensive suite
of software and hardware-enhanced development, test, and
verification tools for the development of complex embedded
microprocessor-based applications. Using these tools, engineers
develop, test, debug, emulate and verify embedded software found
in a wide variety of products, including voice and data
communications networks, console games, avionics systems,
automotive systems, medical devices, and consumer electronics.

Effective November 1, 2002, the Company sold
its embedded systems development tools business and assets to
Metrowerks Corporation, a wholly owned subsidiary of Motorola,
Inc. The Company had planned to pursue the development of new
hardware and software products through Applieds Libra
Networks division. Libra Networks was formed as a result of the
Companys acquisition of REBA Technologies in May 2002, and
Libra is focused on delivering innovative technology that
improves the way Web Services and other enterprise applications
are managed in enterprise data centers.

During the fourth quarter of 2002 the Company
aggressively pursued funding for the Libra Networks business;
however, funding was not secured. Applieds board of
directors concluded that there was a low probability that Libra
could achieve timely and sufficient funding to reasonably
support Libras business plan. Therefore, on
December 16, 2002, the Company announced that the board of
directors had unanimously decided to recommend to shareholders
that Applied be liquidated. The Libra Networks business is
operated using the same infrastructure as Applied Microsystems;
therefore, Libras operations are included within the
Companys statements of operations.



| |                      
| | ---------------------
| | Basis of Presentation

Although the Company has announced its intent to
seek corporate liquidation, such liquidation requires
shareholder approval, which is not assured. Therefore, the
Companys consolidated financial statements for all periods
presented have been prepared on a going concern basis in
accordance with accounting principles generally accepted in the
United States of America. However, under Applieds current
business circumstances, management considers the financial
statement presentation to be materially consistent with a
liquidation basis.

If Applieds shareholders do not approve the
Companys plan to liquidate, the board of directors will
determine an appropriate course of action, which could include
continuing to preserve the Libra Networks assets and technology
and continuing to seek financing for the Libra Networks business
or a sale of the Libra Networks assets and technology, using a
minimum of resources until the Companys resources are
completely depleted. Considering the Companys recent
financial performance and the difficulty it has had in obtaining
financing, it is unlikely that Applied would be able to obtain
additional equity or debt financing. If the Company were to be
unable to obtain sufficient capital, it would deplete its
available resources and would be required to discontinue
operation of its business.



| |                            
| | ---------------------------
| | Principles of Consolidation

The consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries. All
significant intercompany accounts and transactions are
eliminated in consolidation.

36



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |                 
| | ----------------
| | Cash Equivalents

The Company considers all highly liquid
investments purchased with a remaining maturity of three months
or less at the date of purchase to be cash equivalents. Cash
equivalents are carried at cost, which approximates market value.



| |                              
| | -----------------------------
| | Securities Available-for-Sale

Applieds investment portfolio is classified
as available-for-sale; as such, securities are stated at fair
value based on quoted market prices. Interest earned on
securities available-for-sale is included in interest income.
The amortized cost of investments 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 are also included in interest
income and other, but were insignificant for all periods
presented. The cost of securities sold is calculated using the
specific identification method.



| |                    
| | -------------------
| | Accounts Receivable

Because the Company sold its revenue-generating
business, the remaining accounts receivable at December 31,
2002 primarily represent amounts due from sales activities prior
to the November 1, 2002 transaction date. The Company
extended credit based on evaluation of customers financial
condition and, generally, collateral was not required. Certain
accounts receivable balances  consisting primarily of
amounts due from international distribution channels 
have been reserved for as uncollectible as of December 31,
2002 and charged to bad debt expense, based on managements
judgment and the Companys lack of ongoing business
relationships with these distributors. Historically, the Company
determined its allowance for doubtful accounts by considering a
number of factors, including the length of time trade accounts
receivable were past due, the Companys previous loss
history, a customers ability to pay its obligations to the
Company, and the condition of the general economy and the
embedded systems development tools industry as a whole. The
Company writes off accounts receivable when they become
uncollectible, and payments subsequently received on such
receivables are credited to the allowance for doubtful accounts.



| |                                        
| | ---------------------------------------
| | Fair Value of Financial
    Instruments

The Companys financial instruments consist
of cash and cash equivalents, securities available-for-sale,
accounts and note receivable, accounts and notes payable, and a
capital lease obligation. The recorded value of cash and cash
equivalents, securities available-for-sale, accounts and note
receivable, and accounts payable approximates their fair value
due to their short maturities. The recorded value of the notes
payable and capital lease obligation approximates fair value
based on their short expected maturities as the Company pursues
shareholder approval for a corporate liquidation.



| |               
| | --------------
| | Concentrations

Applieds financial instruments that are
exposed to concentrations of credit risk consist primarily of
cash, cash equivalents, securities available-for-sale, and
accounts receivable. The Companys investment policy limits
Applieds exposure to concentration of credit risk by
limiting the amounts that may be invested in similar investment
categories. The Companys $500,000 note receivable as of
December 31, 2002 is due in November 2003 from Metrowerks,
and represents a holdback from the embedded systems development
tools business and asset sale. The holdback secures certain
Applied indemnification obligations that expire in November
2003. The Companys cash balances are in excess of amounts
insured by the Federal Deposit Insurance Corporation.

37



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |            
| | -----------
| | Inventories

While inventories have historically been a
material component of the Companys financial statements,
Applied had no remaining inventories as of December 31,
2002 because all inventories had been sold or otherwise disposed
of prior to the end of 2002. Historically, inventories have been
stated at the lower of cost (first-in, first-out basis) or
market. Inventory costs included shipping and handling expenses
incurred for the purchase of raw materials.



| |                                                 
| | ------------------------------------------------
| | Property and Equipment and Long-Lived
    Assets

Property and equipment are carried at the lower
of cost or fair value. Applied evaluates the recoverability of
its long-lived assets in accordance with the provisions of
Statement of Financial Accounting Standards (SFAS)
144, Accounting for the Impairment or Disposal of
Long-Lived Assets. SFAS 144 requires recognition of
impairment of long-lived assets in the event the net book value
of such assets exceeds the future undiscounted cash flows
attributable to such assets. Accordingly, the Company evaluates
asset recoverability at each balance sheet date or when an event
occurs that may impair recoverability of the asset. Under the
provisions of SFAS 144, the Companys remaining
long-term assets as of the end of 2002 were impaired. The
Company therefore recognized an impairment loss of approximately
$428,000, which is included within the $901,000 loss on sale,
disposal, and impairment of long-lived assets held for sale, and
wrote down the long-term assets to estimated fair value, with
fair value determined primarily through reference to sales of
similar items in third-party transactions. Such remaining assets
consist primarily of equipment under a capitalized lease with a
recorded value of $50,000 and computer equipment. As of
December 31, 2002, the equipment under a capitalized lease
is classified as a current asset under property and equipment
held for sale, has no accumulated amortization due to the
write-down to estimated fair value, and is no longer
depreciated. The remaining computer equipment is likewise
classified as a current asset under property and equipment held
for sale as of December 31, 2002 due to the Companys
plans to seek shareholder approval for liquidating the Company.



| |                    
| | -------------------
| | Acquired Technology

Costs to acquire technology are capitalized to
the extent the products are technologically feasible. Such
amounts are included in other assets on the balance sheet. The
Company has historically amortized these costs over periods
ranging from 5 to 7 years to match the anticipated revenue
stream for the products incorporating the acquired technology.
As of December 31, 2002 there was no acquired technology
remaining on the balance sheet; as of December 31, 2001,
the Company had recorded acquired technology with a net book
value of $128,000, and a corresponding accumulated amortization
balance of $322,000. Amortization expense was $128,000 in 2002,
compared to amortization expense of $97,000 in 2001 and $45,000
in 2000.



| |                                   
| | ----------------------------------
| | Research and Development
    Costs

Research and development costs are expensed as
incurred. Financial accounting standards require the
capitalization of certain software development costs after
technological feasibility of the software is established. In the
development of the Companys new products and enhancements
to existing products, the technological feasibility of the
software is not established until substantially all product
development is complete, including the development of a working
model.



| |                                                                                  
| | ---------------------------------------------------------------------------------
| | Revenue Recognition and Cumulative Effect
    of a Change in Accounting Principle

The Company historically earned revenue on the
sale of hardware and software products. The Company also earned
revenue on the sale of services, including hardware and software
support, installation, training, and professional engineering
services. Revenue from the sale or licensing of products was
recognized when persuasive evidence of an arrangement existed,
delivery of the product had occurred, the fee was fixed or

38



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

determinable, and collectibility was probable. If
the fee due from a customer was not fixed or determinable,
revenue was recognized as payments became due from a customer.
If customers had inspection or acceptance rights beyond standard
warranty provisions, revenue was recognized when formal
notification of inspection or acceptance had been received from
the customer. Due to business customs in Japan and the
Companys interpretation of Japanese law, product sales in
Japan were recognized when the customer notified the Company
that it had inspected and accepted the product. In the absence
of receiving written notification of inspection and acceptance,
Applied recognized revenue in Japan on receipt of payment by the
customer as an indication of acceptance. When products were sold
with significant installation services, all revenue was deferred
until installation was completed. Revenue from training and
contract engineering services was generally recognized as the
services were performed. Revenue from longer-term agreements to
perform development services was recognized under the
percentage-of-completion method, measured based on labor effort
or cost incurred to total estimated labor effort or cost
(assuming other revenue recognition criteria were met).
Adjustments to the Companys trade accounts receivable
balance that results from unused and expired customer credit
memos and related items are recognized as revenue in the period
in which such credits are no longer available for customer use
or are otherwise deemed expired.

The Company previously recognized revenue in
Japan at the time of shipment. Effective January 1, 2000,
the Company changed its method of accounting for product sales
in Japan to recognize such revenue at the earlier of when it has
been notified by the customer that it has inspected and accepted
the product or upon receipt of payment. The Company believes the
change in accounting principle is consistent with the guidance
provided in SEC Staff Accounting Bulletin No. 101
(SAB 101), Revenue Recognition in
Financial Statements. In accordance with SAB 101, the
Company recorded a non-cash charge of $1,110,000 (or
$0.16 per share, basic and diluted), to reflect the
cumulative effect of the change as of the beginning of 2000. The
decrease to net loss before the cumulative effect of the change
in accounting principle as a result of the adoption of
SAB 101 was $886,000 (or $0.13 per share, basic and
diluted) for the year ended December 31, 2000. Deferred
revenue at January 1, 2000 included $1,406,000 related to
goods that were shipped and previously recognized as revenue but
did not meet the new revenue recognition policy. All of these
deferred revenues were recognized during the year ended
December 31, 2000.

The cumulative effect of the change in accounting
principle includes product revenue and cost of sales that were
subsequently recognized when customers inspected and accepted
the products. The pro forma amounts shown on the statements of
operations are presented as if the new revenue recognition
policy had been applied retroactively for the periods presented.



| |                     
| | --------------------
| | Advertising Expenses

Advertising costs are expensed as incurred. The
Company incurred $50,000 in advertising expenses in 2002,
compared to $52,000 in 2001 and $134,000 in 2000. The Company
also incurred expenses related to attendance at trade shows and
other promotional activities.



| |                 
| | ----------------
| | Interest Expense

The Company incurred $45,000 in interest expense
in 2002, compared to $20,000 in 2001 and $6,000 in 2000.



| |                   
| | ------------------
| | Foreign Currencies

Assets and liabilities of foreign subsidiaries
are translated to U.S. dollars at the exchange rates on the
balance sheet date. Revenues and expenses of foreign
subsidiaries are translated at the average rates of exchange
prevailing during the year. The cumulative translation
adjustments resulting from this process have historically been
accumulated in other comprehensive income (loss). As a result of
the Companys sale of its embedded systems development
tools business and assets in November 2002, and the subsequent
announce-

39



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

ment that Applied is seeking shareholder approval
to liquidate, the Companys international operations were
substantially closed by the end of the year. The Company
therefore recognized a charge of $593,000 in the fourth quarter
of 2002 relating to the write-off of foreign currency
translation adjustments that had accumulated for these
subsidiaries.

The Company may enter into foreign currency
forward contracts to hedge foreign currency transactions,
primarily intercompany transactions resulting from sales to
foreign subsidiaries. No such contracts were outstanding at any
time during 2002, 2001, or 2000.



| |                                     
| | ------------------------------------
| | Basic and Diluted Loss per
    Share

Basic loss per share excludes the dilutive
effects of stock options, and is computed using the
weighted-average number of common shares outstanding during the
period. Diluted loss per share would be computed using the
weighted-average number of common shares and dilutive common
stock equivalent shares outstanding during the period. Because
Applieds stock options are not dilutive (due to net
losses) there is no difference between basic net loss per share
and diluted net loss per share. As of December 31, 2002,
2001, and 2000, options to purchase 55,000, 1,491,000, and
1,405,000 shares of common stock, respectively, were
excluded from the calculation of loss per share because their
effect was antidilutive.



| |                         
| | ------------------------
| | Stock-Based Compensation

Applied has elected to follow the intrinsic value
method prescribed by Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to
Employees, and related Interpretations in accounting for
its stock options. Because the exercise price of the
Companys common stock options equals the market price of
the underlying stock on the date of grant, no corresponding
compensation expense has been recognized. (See Note 9 for
SFAS 123, Accounting for Stock-Based
Compensation, pro forma disclosures.)

The following table illustrates the effect on net
loss and loss per share if the Company had applied the fair
value recognition provisions of SFAS 123 using the
assumptions described in Note 9, to its stock-based awards.

|                                                                                    |  |                        |        |      |  |      |        |   |  |   |        |  
|----------------------------------------------------------------------------------- |  | ---------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                                                    |  | 2002                   |        | 2001 |  | 2000
|                                                                                    |  |                        |        |      |  |     
|                                                                                    |  |                       
|                                                                                    |  | (In thousands,        
|                                                                                    |  | except per-share data)
|Net loss, as reported                                                               |  | $                      | (5,672 | )    |  | $    | (5,021 | ) |  | $ | (8,005 | )
|Total stock-based compensation expense determined
    under fair-value-based method |  |                        | (1,176 | )    |  |      | (1,685 | ) |  |   | (1,958 | )
|                                                                                    |  |                        |        |      |  |      |        |   |  |   |        |  
|Pro forma net loss                                                                  |  | $                      | (6,848 | )    |  | $    | (6,706 | ) |  | $ | (9,963 | )
|                                                                                    |  |                        |        |      |  |      |        |   |  |   |        |  
|Net loss per share as reported                                                      |  | $                      | (0.76  | )    |  | $    | (0.71  | ) |  | $ | (1.16  | )
|                                                                                    |  |                        |        |      |  |      |        |   |  |   |        |  
|Pro forma net loss per share                                                        |  | $                      | (0.92  | )    |  | $    | (0.95  | ) |  | $ | (1.44  | )
|                                                                                    |  |                        |        |      |  |      |        |   |  |   |        |  



| |                          
| | -------------------------
| | Accounting Pronouncements

In April 2002, the FASB issued SFAS 145,
Rescission of FASB Statements 4, 44, and 64,
Amendment of FASB Statement 13, and Technical
Corrections. Among other provisions, SFAS 145
rescinds SFAS 4, Reporting Gains and Losses from
Extinguishment of Debt. Accordingly, gains or losses from
extinguishment of debt should not be reported as extraordinary
items unless the extinguishment qualifies as an extraordinary
item under the criteria of Accounting Principles Board
Opinion 30, Reporting the Results of
Operations  Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions. Gains or
losses from extinguishment of debt, which do not meet the
criteria of Accounting Principles Board Opinion 30, should
be reclassified to income from continuing

40



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

operations in all prior periods presented. The
provisions of SFAS 145 will be effective for fiscal years
beginning after May 15, 2002. Adoption of SFAS 145 is
not expected to have a material impact on the Companys
financial statements because the Company has not historically
experienced debt extinguishments.

In June 2002, the FASB issued SFAS 146,
Accounting for Exit or Disposal Activities.
SFAS 146 addresses issues regarding the recognition,
measurement, and reporting of costs that are associated with
exit and disposal activities, including restructuring
activities. SFAS 146 is effective for exit or disposal
activities that are initiated after December 31, 2002. The
Companys current exit activities were initiated in 2002,
and the Company is applying the guidance of Emerging Issues Task
Force (EITF) 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a
Restructuring). SFAS 146 is not expected to have a
material impact on the Companys financial statements
because the Company does not expect to initiative future exit
activities as a result of the Companys liquidation plan.

In November 2002, FASB Interpretation 45,
Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of
Others (FIN 45), was issued. FIN 45
requires a guarantor entity, at the inception of a guarantee
covered by the measurement provisions of the interpretation, to
record a liability for the fair value of the obligation
undertaken in issuing the guarantee. Under prior standards,
companies generally did not record a liability when guaranteeing
obligations unless it became probable that they would have to
perform under the guarantee. FIN 45 applies prospectively
to guarantees the Company issues or modifies subsequent to
December 31, 2002, but has certain disclosure requirements
effective for interim and annual periods ending after
December 15, 2002. The Company does not anticipate
FIN 45 will have a material effect on its financial
statements.

In December 2002, the FASB issued SFAS 148,
Accounting for Stock-Based Compensation 
Transition and Disclosure. This standard amends
SFAS 123, Accounting for Stock-Based
Compensation, to provide alternative methods of transition
for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition,
this Statement amends the disclosures in both annual and interim
financial statements about the method of accounting for
stock-based employee compensation and the effect of the method
used on reported results. The amendments to SFAS 123 of
this Statement shall be effective for financial statements for
fiscal years ending after December 15, 2002. The initial
application of SFAS 148 is not expected to have a material
effect on the Companys consolidated financial statements.



| |                 
| | ----------------
| | Use of Estimates

The preparation of financial statements in
conformity with generally accepted accounting principles
generally accepted in the United States of America 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.



| |                  
| | -----------------
| | Reclassifications

Certain prior-year amounts have been reclassified
to conform to the current-year presentation.



|   |                                                                   
|-- | ------------------------------------------------------------------
|2. | Sale of Embedded Systems Development Tools
    Business and Assets

Effective November 1, 2002, the Company sold
its embedded systems development tools business and assets to
Metrowerks Corporation, a wholly owned subsidiary of Motorola,
Inc. The purchase price was $3.9 million, which included
payment for certain inventories and tangible assets, as well as
all intellectual property related to the Companys embedded
systems development tools business. In addition, Metrowerks
assumed certain customer warranty and support obligations. The
Company received $3.4 million at closing,

41



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

with the remaining $500,000 subject to a one-year
holdback to secure certain indemnification obligations. Certain
other indemnification obligations relating to title to the
assets sold, compliance with laws, and certain matters relating
to taxes continue until the expiration of the statute of
limitations applicable to claims with respect to such matters.

As of the November 1, 2002 transaction date,
the carrying amount of assets and liabilities included in the
sale transaction were as follows (in thousands):

|                                                |                                  |   |       |     | 
|----------------------------------------------- | -------------------------------- | - | ----- | --- | 
|Assets                                          |                                  |   |       |    
|                                                | Inventories                      |   | $     | 910 | 
|                                                | Prepaid and other current assets |   |       | 54  | 
|                                                | Fixed assets                     |   |       | 84  | 
|                                                |                                  |   |       |    
|                                                |                                  | $ | 1,048 |    
|                                                |                                  |   |       |    
|Liabilities  deferred revenue and
    warranty |                                  | $ | 1,433 |    
|                                                |                                  |   |       |    

The gain in the Companys sale of its
embedded systems development tools business and is summarized as
follows (in thousands):

|                                            |                |   |       |       | 
|------------------------------------------- | -------------- | - | ----- | ----- | 
|Cash received at closing                    |                | $ | 3,352 |      
|Holdback note receivable                    |                |   | 500   |      
|Liabilities assumed by purchaser            |                |   | 1,433 |      
|                                            |                |   |       |      
|                                            | Total proceeds |   |       | 5,285 | 
|Carrying value of assets sold               |                |   | 1,048 |      
|Transaction and other accrued expenses, net |                |   | 654   |      
|                                            |                |   |       |      
|                                            | Gain on sale   |   | $     | 3,583 | 
|                                            |                |   |       |      



|   |                              
|-- | -----------------------------
|3. | Securities Available-for-Sale

Securities available-for-sale consist of the
following:

|                                                        |  |                   |     |            |  |            |   |            |  |   |   |  |  |   |     | 
|------------------------------------------------------- |  | ----------------- | --- | ---------- |  | ---------- | - | ---------- |  | - | - |  |  | - | --- | 
|                                                        |  |                  
|                                                        |  | December 31, 2002
|                                                        |  |                  
|                                                        |  |                   |     | Gross      |  | Gross      |   |           
|                                                        |  | Amortized         |     | Unrealized |  | Unrealized |   |           
|                                                        |  | Cost              |     | Gains      |  | Losses     |   | Fair Value
|                                                        |  |                   |     |            |  |            |   |           
|                                                        |  |                  
|                                                        |  | (In thousands)   
|U.S. Treasury and other U.S. Government
    obligations |  | $                 | 299 |            |  | $          |  |            |  | $ |  |  |  | $ | 299 | 
|                                                        |  |                   |     |            |  |            |   |            |  |   |   |  |  |   |     | 

|                                                        |  |                   |       |            |  |            |    |            |  |   |   |  |  |   |       | 
|------------------------------------------------------- |  | ----------------- | ----- | ---------- |  | ---------- | -- | ---------- |  | - | - |  |  | - | ----- | 
|                                                        |  |                  
|                                                        |  | December 31, 2001
|                                                        |  |                  
|                                                        |  |                   |       | Gross      |  | Gross      |    |           
|                                                        |  | Amortized         |       | Unrealized |  | Unrealized |    |           
|                                                        |  | Cost              |       | Gains      |  | Losses     |    | Fair Value
|                                                        |  |                   |       |            |  |            |    |           
|                                                        |  |                  
|                                                        |  | (In thousands)   
|U.S. Treasury and other U.S. Government
    obligations |  | $                 | 2,987 |            |  | $          | 12 |            |  | $ |  |  |  | $ | 2,999 | 
|Corporate debt securities                               |  |                   | 998   |            |  |            |   |            |  |   |  |  |  |   | 998   | 
|                                                        |  |                   |       |            |  |            |    |            |  |   |   |  |  |   |       | 
|                                                        |  | $                 | 3,985 |            |  | $          | 12 |            |  | $ |  |  |  | $ | 3,997 | 
|                                                        |  |                   |       |            |  |            |    |            |  |   |   |  |  |   |       | 

42



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

As of December 31, 2002, all of the
Companys securities available-for-sale had contractual
maturities of less than one year. Expected maturities may differ
from contractual maturities because issuers may have the right
to prepay obligations.



|   |                          
|-- | -------------------------
|4. | Balance Sheet Information

Detailed balance sheet data is as follows:

|                       |                                                                                      |                                           |     |        |       |   |       |        |       |  
|---------------------- | ------------------------------------------------------------------------------------ | ----------------------------------------- | --- | ------ | ----- | - | ----- | ------ | ----- | -
|                       |                                                                                      |                                          
|                       |                                                                                      | December 31,                             
|                       |                                                                                      |                                          
|                       |                                                                                      | 2002                                      |     | 2001  
|                       |                                                                                      |                                           |     |       
|                       |                                                                                      |                                          
|                       |                                                                                      | (In thousands)                           
|Accounts receivable    |                                                                                      |                                           |     |        |       |   |       |       
|                       | Receivables                                                                          |                                           | $   | 641    |       |   | $     | 3,646  |      
|                       | Allowance for sales returns and doubtful accounts                                    |                                           |     | (361   | )     |   |       | (52    | )    
|                       |                                                                                      |                                           |     |        |       |   |       |       
|                       |                                                                                      | $                                         | 280 |        |       | $ | 3,594 |       
|                       |                                                                                      |                                           |     |        |       |   |       |       
|                       | Allowance for sales returns and doubtful accounts
    activity
    Beginning balance |                                           | $   | (52    | )     |   | $     | (56    | )    
|                       |                                                                                      | Bad debt expense/estimated sales returns  |     |        | (401  | ) |       |        | (56   | )
|                       |                                                                                      | Accounts written off/actual sales returns |     |        | 94    |   |       |        | 62    |  
|                       |                                                                                      | Recoveries                                |     |        | (2    | ) |       |        | (2    | )
|                       |                                                                                      |                                           |     |        |       |   |       |       
|                       |                                                                                      | Ending balance                            |     | $      | (361  | ) |       | $      | (52   | )
|                       |                                                                                      |                                           |     |        |       |   |       |       
|Inventories            |                                                                                      |                                           |     |        |       |   |       |       
|                       | Finished goods                                                                       |                                           | $   |       |       |   | $     | 999    |      
|                       | Work in process                                                                      |                                           |     |       |       |   |       | 55     |      
|                       | Purchased parts                                                                      |                                           |     |       |       |   |       | 905    |      
|                       |                                                                                      |                                           |     |        |       |   |       |       
|                       |                                                                                      | $                                         |    |        |       | $ | 1,959 |       
|                       |                                                                                      |                                           |     |        |       |   |       |       
|Property and equipment |                                                                                      |                                           |     |        |       |   |       |       
|                       | Machinery and equipment                                                              |                                           | $   | 1,512  |       |   | $     | 2,243  |      
|                       | Office furniture                                                                     |                                           |     | 720    |       |   |       | 1,985  |      
|                       |                                                                                      |                                           |     |        |       |   |       |       
|                       |                                                                                      | Total property and equipment              |     |        | 2,232 |   |       |        | 4,228 |  
|                       | Accumulated depreciation                                                             |                                           |     | (2,141 | )     |   |       | (2,870 | )    
|                       |                                                                                      |                                           |     |        |       |   |       |       
|                       |                                                                                      | $                                         | 91  |        |       | $ | 1,358 |       
|                       |                                                                                      |                                           |     |        |       |   |       |       



|   |                              
|-- | -----------------------------
|5. | Commitments and Contingencies

The Company has historically maintained long-term
facilities leases that included a corporate headquarters in
Redmond, Washington. On October 15, 2002, the Company
entered into a Lease Termination Agreement (the
Termination Agreement), by and between Applied and
Teachers Insurance & Annuity Association of America
(TIAA), the landlord under the Companys prior
headquarters facilities lease. Pursuant to the Termination
Agreement, Applied paid an early termination fee of
approximately $1 million to TIAA in exchange for the
termination of any further obligations under the lease. As of
the date of the Termination Agreement, the Companys
remaining lease obligation extended through 2007 and was in
excess of $6 million. The Company vacated the leased
premises prior to December 31, 2002 under the terms of the
Termination Agreement, and the Company has no remaining lease
obligation. In December 2002, Applied signed an agreement to
sublease approximately 7,200 square feet in Redmond,
Washington, and took

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APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

possession of the premises in that month. Under
the terms of the lease agreement, the Company may terminate the
lease by providing a 30-day notice. On February 27, 2003,
Applied provided notice of its intent to terminate the lease,
and the Company plans to vacate the premises by March 31,
2003. The Company has secured needed office space, consisting of
approximately 650 square feet, in the Redmond area on a
monthly rental basis. The Company incurred no termination fee as
a result of the February 27, 2003 notice of its intent to
terminate the lease.

The Company leases certain equipment and
international office space under noncancelable leases. Minimum
future payments as of December 31, 2002 are as follows:

|                                               |  |                |     |           |  |   |     | 
|---------------------------------------------- |  | -------------- | --- | --------- |  | - | --- | 
|                                               |  | Capital        |     | Operating
|                                               |  | Lease          |     | Leases   
|                                               |  |                |     |          
|                                               |  |               
|                                               |  | (In thousands)
|2003                                           |  | $              | 62  |           |  | $ | 129 | 
|2004                                           |  |                | 62  |           |  |   | 37  | 
|2005                                           |  |                | 62  |           |  |   | 16  | 
|2006                                           |  |                | 16  |           |  |   | 13  | 
|2007                                           |  |                |    |           |  |   |    | 
|Thereafter                                     |  |                |    |           |  |   |    | 
|                                               |  |                |     |           |  |   |     | 
|                                               |  |                | 202 |           |  | $ | 195 | 
|                                               |  |                |     |           |  |   |     | 
|Less amount representing interest              |  |                | 27  |           |  |   |     | 
|                                               |  |                |     |           |  |   |     | 
|Present value of capital lease obligation      |  |                | 175 |           |  |   |     | 
|Current portion                                |  |                | 175 |           |  |   |     | 
|                                               |  |                |     |           |  |   |     | 
|Capital lease obligation, less current portion |  | $              |    |           |  |   |     | 
|                                               |  |                |     |           |  |   |     | 

Total rent expense in 2002 was $1,523,000
(excluding the amount paid for the Termination Agreement), as
compared to rent expense of $1,619,000 in 2001 and $1,430,000 in
2000. The capital lease obligation is classified as a current
liability due to Applieds intent to liquidate the Company
and settle its remaining obligations.

The Company maintained an irrevocable letter of
credit in favor of TIAA under the prior headquarters lease. To
secure the letter of credit, the Company had pledged a $400,000
certificate of deposit with a bank, which amount was subject to
withdrawal restrictions until the related lease was terminated
in the fourth quarter of 2002. The Company therefore had no
remaining cash restriction as of December 31, 2002; the
certificate of deposit is classified as a restricted investment
on the balance sheet at December 31, 2001.

As part of the sale of its embedded systems
development tools business, the Company requested that certain
customers and licensors of third-party technology assign
contractual rights to Metrowerks. Applied maintained a
contractual relationship with Microsoft whereby Applied provided
development tools for Microsofts XboxTM video
gaming system. In connection with the asset sale, Microsoft
elected to exercise its contractual rights under the agreement
with Applied to withdraw certain technology held in escrow.
Applied continues to be responsible for reimbursing Microsoft
for certain costs in the event of an epidemic
failure of Applieds products that were incorporated
into Microsofts Xbox Development Kit.

Under the terms of the sale of its embedded
systems development tools business, the Company has an
obligation to indemnify Metrowerks for any losses from potential
breaches of representations or warranties that are asserted
within 12 months after the closing date of the asset sale
or within the applicable statute of limitations period for
claims relating to ownership of assets, payment of taxes, and
compliance with applicable laws, if longer. The Companys
indemnification obligations are limited to an overall amount of
$3.3 million.

44



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|   |                                  
|-- | ---------------------------------
|6. | Business Restructuring Activities

In August 2001, in response to economic
uncertainty and reduced revenue streams, Applied implemented a
restructuring plan designed to reduce operating costs. The
restructuring plan included a reduction of approximately
90 full-time employees worldwide across the Companys
functional organizations, or 39% of the workforce;
discontinuance or reallocation of selected projects and
activities not essential to the Companys long-term goals;
abandonment of excess space at the Companys headquarters;
as well as other cost reduction and control measures. The charge
for abandoned facilities related to amounts accrued for
estimated losses on lease commitments for facilities that
Applied had abandoned in connection with the August 2001
restructuring. As a result of adopting the restructuring plan,
Applied recorded a restructuring charge of $2.3 million in
the third quarter of 2001.

The restructuring charges and related activity
for the year ended December 31, 2001 are as follows:

|                               |  |                |   |               |  |              |       |              |  |   |       |  |  |   |       | 
|------------------------------ |  | -------------- | - | ------------- |  | ------------ | ----- | ------------ |  | - | ----- |  |  | - | ----- | 
|                               |  | Accrued        |   |               |  |              |       | Accrued     
|                               |  | Balance at     |   |               |  | Amounts Paid |       | Balance at  
|                               |  | December 31,   |   | Restructuring |  | or Charged   |       | December 31,
|                               |  | 2000           |   | Charges       |  | Off, Net     |       | 2001        
|                               |  |                |   |               |  |              |       |             
|                               |  |               
|                               |  | (In thousands)
|Severance and related expenses |  | $              |  |               |  | $            | 1,001 |              |  | $ | 937   |  |  | $ | 64    | 
|Asset write-offs               |  |                |  |               |  |              | 134   |              |  |   | 134   |  |  |   |      | 
|Abandoned facilities           |  |                |  |               |  |              | 1,154 |              |  |   | 60    |  |  |   | 1,094 | 
|                               |  |                |   |               |  |              |       |              |  |   |       |  |  |   |       | 
|                               |  | $              |  |               |  | $            | 2,289 |              |  | $ | 1,131 |  |  | $ | 1,158 | 
|                               |  |                |   |               |  |              |       |              |  |   |       |  |  |   |       | 

As of December 31, 2001, a portion of the
accrued restructuring liabilities in the amount of $719,000,
representing lease commitments which were not planned to be
settled in the following 12 months, was classified as long
term on the Companys balance sheet. The remaining accrued
restructuring liabilities were classified as current liabilities
as of December 31, 2001, and consisted of accounts payable
of $3,000, accrued payroll of $12,000 and other accrued expenses
of $424,000.

In May 2002, the Company announced further plans
to reduce expenses through a reduction in personnel and
realignment of business objectives. The cost reductions
consisted primarily of a reduction of approximately
45 full-time employees worldwide across the Companys
functional organizations, as well as a write-off of certain
assets for which the book value was deemed in excess of net
realizable value under accounting rules. As a result, the
Company recognized a charge of $602,000 for severance and
related expenses and $67,000 for asset write-offs in the second
quarter of 2002. The Company also reassessed the potential
exposure for losses for the abandoned space identified in the
August 2001 restructuring in light of revised estimates of the
timeframe and terms under which a sublease could be negotiated.
As a result, the Company recognized an additional charge of
$480,000 in the second quarter of 2002.

In the fourth quarter of 2002, after announcing
on December 16, 2002 that the Companys board of
directors had unanimously decided to recommend to shareholders
that Applied be liquidated, Applied further recognized $906,000
in restructuring charges associated with severance and benefits
for the remaining 26 personnel. Also during the fourth
quarter of 2002, the Company entered into an agreement to
terminate its headquarters facility lease by paying a lease
termination fee of approximately $1.0 million. The lease
termination fee was less than the Company had reserved for
abandoned space in the accrued restructuring reserve; therefore,
Applied recognized a net benefit of $351,000 in the
restructuring charge in the fourth quarter of 2002 relating to
the elimination of the reserve for abandoned space.

45



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The restructuring charges and related activity
for the year ended December 31, 2002 are as follows:

|                               |  |                |       |            |  |              |       |              |  |              |       |  |  |   |     |   |  |   |     | 
|------------------------------ |  | -------------- | ----- | ---------- |  | ------------ | ----- | ------------ |  | ------------ | ----- |  |  | - | --- | - |  | - | --- | 
|                               |  | Accrued        |       |            |  |              |       |              |  | Accrued     
|                               |  | Balance at     |       |            |  | Amounts Paid |       |              |  | Balance at  
|                               |  | December 31,   |       | Additional |  | or Charged   |       | Amounts      |  | December 31,
|                               |  | 2001           |       | Charges    |  | Off, Net     |       | Reclassified |  | 2002        
|                               |  |                |       |            |  |              |       |              |  |             
|                               |  |               
|                               |  | (In thousands)
|Severance and related expenses |  | $              | 64    |            |  | $            | 1,508 |              |  | $            | 819   |  |  | $ | 30  |   |  | $ | 783 | 
|Asset write-offs               |  |                |      |            |  |              | 67    |              |  |              | 67    |  |  |   |    |   |  |   |    | 
|Abandoned facilities           |  |                | 1,094 |            |  |              | 129   |              |  |              | 1,097 |  |  |   | (30 | ) |  |   | 96  | 
|                               |  |                |       |            |  |              |       |              |  |              |       |  |  |   |     |   |  |   |     | 
|                               |  | $              | 1,158 |            |  | $            | 1,704 |              |  | $            | 1,983 |  |  | $ |    |   |  | $ | 879 | 
|                               |  |                |       |            |  |              |       |              |  |              |       |  |  |   |     |   |  |   |     | 

As of December 31, 2002, the accrued
restructuring liabilities consisted of accrued payroll of
$775,000, accounts payable of $96,000, and other accrued
expenses of $8,000.



|   |                                           
|-- | ------------------------------------------
|7. | Acquisition of REBA Technologies,
    Inc.

In May 2002, the Company announced that it had
completed the acquisition of REBA Technologies, Inc.
(REBA). REBAs patent-pending technology is
focused on enhancing the operation of server farms for
enterprises, application service providers and network service
providers. The acquisition consideration consisted of an
aggregate of approximately 350,000 shares of the
Companys common stock, valued at $315,000, plus an
aggregate principal amount of $178,000 of promissory notes, due
May 2004, and bearing interest at the rate of 6% annually. The
Company did not acquire any personnel, tangible assets or known
liabilities in the transaction. As a result of the acquisition,
the Company recognized in-process research and development
expenses of $621,000 in the second quarter of 2002, representing
the entire purchase price (including transaction-related
expenses).

Because Lary L. Evans was a director of the
Company and was the holder of approximately 86% of REBAs
outstanding shares, the negotiation of the terms of the
acquisition was handled by an independent committee of the
Companys board of directors composed of disinterested
directors. This committee engaged an independent valuation firm
to provide a basis for negotiations, and ultimately recommended
that the transaction be approved by the Companys entire
board of directors. Mr. Evans resigned from the board of
directors on December 13, 2002, and has had no further
involvement in the operations of the Company.

At closing of the transaction, 50% of the merger
consideration was placed into an escrow for the purpose of
securing the indemnification obligations of the REBA
shareholders under the merger agreement. Those shares and notes
will remain in escrow for a period of three years from the
closing date and until all pending claims for indemnification,
if any, have been resolved. In a liquidation of Applied
Microsystems, the Company would seek to sell the remaining
corporate assets, including the intellectual property acquired
in the REBA transaction. The sale of such intellectual property
would, of necessity, also address the terms of the escrow
agreement, including payment of merger consideration held in
escrow.

46



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|   |             
|-- | ------------
|8. | Income Taxes

Due to net operating losses, the Companys
provision for income taxes was zero in each of the three years
ended December 31, 2002. The provision for income taxes
differs from the amount computed using the statutory federal
income tax rate as follows:

|                                           |  |                         |        |      |  |      |        |   |  |   |        |  
|------------------------------------------ |  | ----------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                           |  |                        
|                                           |  | Year Ended December 31,
|                                           |  |                        
|                                           |  | 2002                    |        | 2001 |  | 2000
|                                           |  |                         |        |      |  |     
|                                           |  |                        
|                                           |  | (In thousands)         
|Tax benefit at U.S. statutory rate         |  | $                       | (1,929 | )    |  | $    | (1,707 | ) |  | $ | (2,722 | )
|Foreign losses with no tax benefit         |  |                         | 498    |      |  |      | 241    |   |  |   |       |  
|Tax credits                                |  |                         | (173   | )    |  |      | (538   | ) |  |   | (723   | )
|Change in deferred tax valuation allowance |  |                         | 1,328  |      |  |      | 1,836  |   |  |   | 3,580  |  
|In-process research and development        |  |                         | 211    |      |  |      |       |   |  |   |       |  
|Other                                      |  |                         | 65     |      |  |      | 168    |   |  |   | (135   | )
|                                           |  |                         |        |      |  |      |        |   |  |   |        |  
|                                           |  | $                       |       |      |  | $    |       |   |  | $ |       |  
|                                           |  |                         |        |      |  |      |        |   |  |   |        |  

Deferred income taxes reflect the net tax effects
of temporary differences between the tax basis of assets and
liabilities and the corresponding financial statement amounts.
Significant components of the Companys deferred income
taxes are as follows:

|                          |                                                  |                |         |       |  |   |         |       |  
|------------------------- | ------------------------------------------------ | -------------- | ------- | ----- |  | - | ------- | ----- | -
|                          |                                                  |               
|                          |                                                  | December 31,  
|                          |                                                  |               
|                          |                                                  | 2002           |         | 2001 
|                          |                                                  |                |         |      
|                          |                                                  |               
|                          |                                                  | (In thousands)
|Deferred tax assets:      |                                                  |                |         |       |  |   |         |      
|                          | Reserves for sales returns and doubtful accounts |                | $       | 137   |  |   | $       | 40    |  
|                          | Accrued and other expenses                       |                |         | 309   |  |   |         | 555   |  
|                          | Inventories and other                            |                |         |      |  |   |         | 453   |  
|                          | Foreign currency translation                     |                |         |      |  |   |         | 147   |  
|                          | Difference in basis of property and equipment    |                |         | 191   |  |   |         |      |  
|                          | Net operating loss carryforwards                 |                |         | 7,712 |  |   |         | 6,150 |  
|                          | Tax credit carryforwards                         |                |         | 3,347 |  |   |         | 3,175 |  
|                          |                                                  |                |         |       |  |   |         |      
|                          |                                                  |                | 11,696  |       |  |   | 10,520  |      
|Deferred tax liabilities: |                                                  |                |         |       |  |   |         |      
|                          | Difference in basis of property and equipment    |                |         |      |  |   |         | (152  | )
|                          |                                                  |                |         |       |  |   |         |      
|                          |                                                  |                |        |       |  |   | (152    | )    
|                          |                                                  |                |         |       |  |   |         |      
|Net deferred tax asset    |                                                  |                | 11,696  |       |  |   | 10,368  |      
|Valuation allowance       |                                                  |                | (11,696 | )     |  |   | (10,368 | )    
|                          |                                                  |                |         |       |  |   |         |      
|Net deferred taxes        |                                                  | $              |        |       |  | $ |        |      
|                          |                                                  |                |         |       |  |   |         |      

Due to the uncertainty of the Companys
ability to generate sufficient taxable income to realize its
deferred tax assets, a valuation allowance has been established
for financial reporting purposes equal to the amount of the net
deferred tax assets. The valuation allowance increased
$1.3 million in 2002, and increased $1.8 million in
2001.

As of December 31, 2002, the Company had net
operating loss carryforwards for federal tax purposes of
approximately $22.7 million available to offset future
taxable income. To the extent that net operating losses,

47



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

when realized, relate to stock option deductions,
the resulting benefits would be credited to shareholders
equity. The Company also had research and development credits of
approximately $3.3 million that 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 2003 to
2022. Utilization of net operating loss carryforwards may be
subject to certain limitations under Section 382 of the
Internal Revenue Code. If the Company obtains shareholder
approval and completes the planned corporate liquidation of
Applied, it will be unable to utilize the operating loss
carryforwards and research and development tax credits.



|   |                     
|-- | --------------------
|9. | Shareholders Equity



| |              
| | -------------
| | Stock Options

The Company has the following
shareholder-approved stock option plans that provide for option
grants to employees, directors, and others: the Applied
Microsystems Corporation 1992 Performance Stock Plan (the
1992 Plan), the Applied Microsystems 2001 Stock
Option Plan (the 2001 Plan), and the Applied
Microsystems Corporation Director Stock Option Plan (the
Director Plan). The exercise price of options
granted under these plans has been at fair market value on the
date of grant. Options are not transferable, and expire no later
than ten years following the grant date.

Prior to February 2000, options granted under the
1992 Plan generally were immediately exercisable, but then
subject to the Companys right to repurchase any shares of
common stock received upon exercise in the event that the
optionees employment with the Company should terminate.
Such repurchase rights generally lapsed at a rate of
25% per year from the date of grant. For presentation
purposes, outstanding but unexercised options that could be
exercised subject to repurchase rights are treated as unvested.
Beginning in February 2000, options granted under the 1992
plan  as well as options granted under the 2001 Plan
since adopted  are not exercisable immediately, have
no Company repurchase rights, and generally vest in 3 to
4 years.

In April 1999, the Company issued a nonqualified
stock option to its then new President and Chief Executive
Officer from a specific-purpose stock option plan. The option
was granted at an exercise price equal to fair market value on
the day of grant for the purchase of 215,000 shares of the
Companys common stock, and was immediately exercisable;
however, the Company retained repurchase rights similar to
options issued under the 1992 Plan during that period of time.

As a result of the Companys sale of its
embedded systems development tools business and assets in
November 2002, all vesting for stock options under the 1992
Plan, the 2001 Plan, and the specific-purpose stock option plan
was accelerated. Because all such unvested options had exercise
prices substantially above the trading price of the
Companys common stock, no options were exercised as a
result of the accelerated vesting, and all such options were
subsequently terminated. The only options that remain
outstanding as of December 31, 2002 are those granted under
the Director Plan. Options granted under the Director Plan vest
one year following grant date.

48



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

A summary of the Companys stock option
activity and related information is as follows:

|                                 |           |                         |       |                |   |         |      |                |  |         |       |                |   |   |      |      |  |  |       |      |   |   |      |      | 
|-------------------------------- | --------- | ----------------------- | ----- | -------------- | - | ------- | ---- | -------------- |  | ------- | ----- | -------------- | - | - | ---- | ---- |  |  | ----- | ---- | - | - | ---- | ---- | 
|                                 |           |                        
|                                 |           | Year Ended December 31,
|                                 |           |                        
|                                 |           |                         |       |                |   |        
|                                 |           | 2002                    |       | 2001           |   | 2000   
|                                 |           |                         |       |                |   |        
|                                 |           |                         |       | Weighted-      |   |         |      | Weighted-      |  |         |       | Weighted-     
|                                 |           | Options                 |       | Average        |   | Options |      | Average        |  | Options |       | Average       
|                                 |           | (000)                   |       | Exercise Price |   | (000)   |      | Exercise Price |  | (000)   |       | Exercise Price
|                                 |           |                         |       |                |   |         |      |                |  |         |       |               
|Outstanding at beginning of year |           |                         | 1,491 |                |   | $       | 3.21 |                |  |         | 1,405 |                |   | $ | 4.05 |      |  |  | 1,381 |      |   | $ | 3.49 |     
|                                 | Granted   |                         |       | 155            |   |         |      | 1.00           |  |         |       | 678            |   |   |      | 2.50 |  |  |       | 448  |   |   |      | 6.34 | 
|                                 | Expired   |                         |       | (1,548         | ) |         |      | 3.00           |  |         |       | (478           | ) |   |      | 5.02 |  |  |       | (315 | ) |   |      | 4.89 | 
|                                 | Exercised |                         |       | (43            | ) |         |      | 0.05           |  |         |       | (114           | ) |   |      | 1.85 |  |  |       | (109 | ) |   |      | 3.89 | 
|                                 |           |                         |       |                |   |         |      |                |  |         |       |                |   |   |      |      |  |  |       |      |   |   |      |     
|Outstanding at end of year       |           |                         | 55    |                |   | $       | 5.35 |                |  |         | 1,491 |                |   | $ | 3.21 |      |  |  | 1,405 |      |   | $ | 4.05 |     
|                                 |           |                         |       |                |   |         |      |                |  |         |       |                |   |   |      |      |  |  |       |      |   |   |      |     
|Vested options                   |           |                         | 45    |                |   | $       | 6.33 |                |  |         | 572   |                |   | $ | 3.73 |      |  |  | 541   |      |   | $ | 3.10 |     
|                                 |           |                         |       |                |   |         |      |                |  |         |       |                |   |   |      |      |  |  |       |      |   |   |      |     

Using the Black-Scholes multiple option pricing
model, the weighted average fair value of options granted during
2002 was $0.60, compared to $1.95 in 2001 and $5.00 in 2000. As
of December 31, 2002, 1,627,749 options were available for
grant.

The following table summarizes information
related to outstanding and vested options at December 31,
2002:

|                         |  |             |    |          |  |           |       |        |  |          |     |  |  |  |    |  |  |   |       | 
|------------------------ |  | ----------- | -- | -------- |  | --------- | ----- | ------ |  | -------- | --- |  |  |  | -- |  |  | - | ----- | 
|                         |  |             |    |         
|                         |  | Outstanding |    | Vested  
|                         |  |             |    |         
|                         |  |             |    | Weighted |  | Weighted  |       |        |  | Weighted
|                         |  |             |    | Average  |  | Average   |       |        |  | Average 
|                         |  | Shares      |    | Exercise |  | Remaining |       | Shares |  | Exercise
|Range of Exercise Prices |  | (000)       |    | Price    |  | Term      |       | (000)  |  | Price   
|                         |  |             |    |          |  |           |       |        |  |         
|$0.02- 2.00              |  |             | 10 |          |  | $         | 0.95  |        |  |          | 9.4 |  |  |  |   |  |  | $ |      | 
|2.01- 4.00               |  |             | 20 |          |  |           | 3.73  |        |  |          | 7.9 |  |  |  | 20 |  |  |   | 3.73  | 
|4.01- 7.00               |  |             | 20 |          |  |           | 6.14  |        |  |          | 6.1 |  |  |  | 20 |  |  |   | 6.14  | 
|7.01-17.50               |  |             | 5  |          |  |           | 17.50 |        |  |          | 3.4 |  |  |  | 5  |  |  |   | 17.50 | 
|                         |  |             |    |          |  |           |       |        |  |          |     |  |  |  |    |  |  |   |       | 
|                         |  |             | 55 |          |  |           | 5.35  |        |  |          | 7.1 |  |  |  | 45 |  |  |   | 6.33  | 
|                         |  |             |    |          |  |           |       |        |  |          |     |  |  |  |    |  |  |   |       | 

Pro forma information regarding net loss and net
loss per share is required by SFAS 123 and has been
determined as if the Company had accounted for its stock options
under the fair value method of SFAS 123. The fair value for
these options was estimated at the date of grant using a
Black-Scholes multiple option pricing model with the following
weighted-average assumptions:

|                             |  |           |  |           |  |          
|---------------------------- |  | --------- |  | --------- |  | ---------
|                             |  | 2002      |  | 2001      |  | 2000     
|                             |  |           |  |           |  |          
|Annualized volatility factor |  | 1.250     |  | 1.133     |  | 1.102    
|Risk-free interest rate      |  | 2.4%      |  | 4.4%      |  | 6.2%     
|Expected life of options     |  | 1.7 years |  | 4.2 years |  | 4.5 years
|Expected dividend rate       |  | nil       |  | nil       |  | nil      

The Black-Scholes option value model was
developed for use in estimating the fair value of traded options
that have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price
volatility. Because the Companys stock options have
characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions
can materially affect the fair value estimate, in
managements opinion, the existing models do not
necessarily provide a reliable single measure of the fair value
of its stock options.

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APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

For purposes of pro forma disclosures, the
estimated fair value of the options is amortized to expense over
the options vesting period. The Companys pro forma
information follows:

|                               |  |                        |        |      |  |      |        |   |  |   |        |  
|------------------------------ |  | ---------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                               |  | 2002                   |        | 2001 |  | 2000
|                               |  |                        |        |      |  |     
|                               |  |                       
|                               |  | (In thousands,        
|                               |  | except per-share data)
|Net loss, as reported          |  | $                      | (5,672 | )    |  | $    | (5,021 | ) |  | $ | (8,005 | )
|Pro forma net loss             |  |                        | (6,848 | )    |  |      | (6,706 | ) |  |   | (9,963 | )
|Net loss per share as reported |  |                        | (0.76  | )    |  |      | (0.71  | ) |  |   | (1.16  | )
|Pro forma net loss per share   |  |                        | (0.92  | )    |  |      | (0.95  | ) |  |   | (1.44  | )



| |                        
| | -----------------------
| | Shareholder Rights Plan

In 1998, the Company adopted a Shareholder 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 an
exercise 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.



|    |                  
|--- | -----------------
|10. | Employee Benefits

The Company has a retirement plan covering
substantially all U.S. employees that provides for
voluntary salary deferral contributions on a pre-tax basis in
accordance with Section 401(k) of the Internal Revenue
Code. The Company may provide matching contributions based on a
defined formula, or may make discretionary contributions. During
2002, the Company made no contributions, as compared to
contributions of $115,000 in 2001 and $234,000 in 2000.

The Company also has an employee stock purchase
plan (the ESPP) through which the Company is
authorized to issue up to 500,000 shares of common stock.
The ESPP permits eligible personnel to purchase the
Companys common stock at the lesser of 85% of fair market
value on certain prescribed dates, as defined in the ESPP,
through payroll deductions of up to 15% of their compensation,
provided that no employee may purchase common stock worth more
than $25,000 in any calendar year. At December 31, 2002,
163,520 shares were available under the plan.

11.     Product,
Geographic, and Related Information

All Company revenue was derived from a single
line of business  the design, manufacture, and
distribution of development and test hardware and software tools
for embedded product manufacturers  which business
was sold effective November 1, 2002. Sales of game
development products and services to Microsoft Corporation
accounted for 25% of net sales in 2002 and 30% in 2001; no
customer accounted for

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APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

more than 10% of net sales in 2000. The following
table provides information concerning products and services
offered:

|                   |                                                |                         |        |        |  |      |        |        |  |   |        |        | 
|------------------ | ---------------------------------------------- | ----------------------- | ------ | ------ |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|                   |                                                |                        
|                   |                                                | Year Ended December 31,
|                   |                                                |                        
|                   |                                                | 2002                    |        | 2001   |  | 2000
|                   |                                                |                         |        |        |  |     
|                   |                                                |                        
|                   |                                                | (In thousands)         
|Net sales          |                                                |                         |        |        |  |      |        |        |  |   |        |       
|                   | Hardware and software debug and analysis tools |                         | $      | 7,148  |  |      | $      | 14,519 |  |   | $      | 22,685 | 
|                   | Game development tools                         |                         |        | 4,100  |  |      |        | 8,325  |  |   |        | 2,839  | 
|                   |                                                |                         |        |        |  |      |        |        |  |   |        |       
|                   | Total product sales                            |                         |        | 11,248 |  |      |        | 22,844 |  |   |        | 25,524 | 
|                   | Services                                       |                         |        | 2,272  |  |      |        | 6,026  |  |   |        | 6,791  | 
|                   |                                                |                         |        |        |  |      |        |        |  |   |        |       
|                   |                                                | $                       | 13,520 |        |  | $    | 28,870 |        |  | $ | 32,315 |       
|                   |                                                |                         |        |        |  |      |        |        |  |   |        |       
|Cost of goods sold |                                                |                         |        |        |  |      |        |        |  |   |        |       
|                   | Products                                       |                         |        | 4,379  |  |      |        | 6,810  |  |   |        | 7,827  | 
|                   | Services                                       |                         |        | 409    |  |      |        | 1,249  |  |   |        | 1,847  | 
|                   |                                                |                         |        |        |  |      |        |        |  |   |        |       
|                   |                                                | $                       | 4,788  |        |  | $    | 8,059  |        |  | $ | 9,674  |       
|                   |                                                |                         |        |        |  |      |        |        |  |   |        |       

Certain operating information 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. The operating information relates
primarily to the Companys embedded systems development
tools business, which was sold effective November 1, 2002.

|                                       |                                                                                    |                         |        |        |   |      |        |        |   |   |        |        |  
|-------------------------------------- | ---------------------------------------------------------------------------------- | ----------------------- | ------ | ------ | - | ---- | ------ | ------ | - | - | ------ | ------ | -
|                                       |                                                                                    |                        
|                                       |                                                                                    | Year Ended December 31,
|                                       |                                                                                    |                        
|                                       |                                                                                    | 2002                    |        | 2001   |   | 2000
|                                       |                                                                                    |                         |        |        |   |     
|                                       |                                                                                    |                        
|                                       |                                                                                    | (In thousands)         
|Net sales                              |                                                                                    |                         |        |        |   |      |        |        |   |   |        |       
|                                       | United States                                                                      |                         | $      | 10,454 |   |      | $      | 22,090 |   |   | $      | 20,659 |  
|                                       | Japan                                                                              |                         |        | 2,022  |   |      |        | 4,747  |   |   |        | 8,111  |  
|                                       | Europe                                                                             |                         |        | 1,044  |   |      |        | 2,033  |   |   |        | 3,545  |  
|                                       |                                                                                    |                         |        |        |   |      |        |        |   |   |        |       
|                                       |                                                                                    | $                       | 13,520 |        |   | $    | 28,870 |        |   | $ | 32,315 |       
|                                       |                                                                                    |                         |        |        |   |      |        |        |   |   |        |       
|Export sales to unaffiliated customers |                                                                                    | $                       | 739    |        |   | $    | 1,270  |        |   | $ | 1,611  |       
|                                       |                                                                                    |                         |        |        |   |      |        |        |   |   |        |       
|Loss before income taxes               |                                                                                    |                         |        |        |   |      |        |        |   |   |        |       
|                                       | United States                                                                      |                         | $      | (3,904 | ) |      | $      | (4,266 | ) |   | $      | (6,675 | )
|                                       | Japan                                                                              |                         |        | (4,203 | ) |      |        | (923   | ) |   |        | 63     |  
|                                       | Europe                                                                             |                         |        | (648   | ) |      |        | (845   | ) |   |        | (818   | )
|                                       | Corporate eliminations and cumulative effect of
    change in accounting principle |                         |        | 3,083  |   |      |        | 1,013  |   |   |        | (575   | )
|                                       |                                                                                    |                         |        |        |   |      |        |        |   |   |        |       
|                                       |                                                                                    | $                       | (5,672 | )      |   | $    | (5,021 | )      |   | $ | (8,005 | )     
|                                       |                                                                                    |                         |        |        |   |      |        |        |   |   |        |       

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APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

|                            |               |                |    |      |  |   |       |       | 
|--------------------------- | ------------- | -------------- | -- | ---- |  | - | ----- | ----- | 
|                            |               |               
|                            |               | December 31,  
|                            |               |               
|                            |               | 2002           |    | 2001
|                            |               |                |    |     
|                            |               |               
|                            |               | (In thousands)
|Long-lived assets           |               |                |    |      |  |   |       |      
|Property and equipment, net |               |                |    |      |  |   |       |      
|                            | United States |                | $  | 91   |  |   | $     | 1,292 | 
|                            | Japan         |                |    |     |  |   |       | 15    | 
|                            | Europe        |                |    |     |  |   |       | 51    | 
|                            |               |                |    |      |  |   |       |      
|                            |               | $              | 91 |      |  | $ | 1,358 |      
|                            |               |                |    |      |  |   |       |      
|Other assets, net           |               |                |    |      |  |   |       |      
|                            | United States |                | $  |     |  |   | $     | 185   | 
|                            | Japan         |                |    |     |  |   |       | 113   | 
|                            | Europe        |                |    |     |  |   |       | 18    | 
|                            |               |                |    |      |  |   |       |      
|                            |               | $              |   |      |  | $ | 316   |      
|                            |               |                |    |      |  |   |       |      

The Companys net assets in defined
geographic areas were as follows:

|              |  |                |       |      |  |   |       |  
|------------- |  | -------------- | ----- | ---- |  | - | ----- | -
|              |  |               
|              |  | December 31,  
|              |  |               
|              |  | 2002           |       | 2001
|              |  |                |       |     
|              |  |               
|              |  | (In thousands)
|United States |  | $              | 1,432 |      |  | $ | 5,688 |  
|Japan         |  |                | 415   |      |  |   | 862   |  
|Europe        |  |                | 35    |      |  |   | (8    | )
|              |  |                |       |      |  |   |       |  
|              |  | $              | 1,882 |      |  | $ | 6,542 |  
|              |  |                |       |      |  |   |       |  



|    |                                                
|--- | -----------------------------------------------
|12. | Quarterly Financial Information
    (unaudited)

Summarized quarterly financial information is as
follows:

|                                                           |  |                                       |        |         |  |          |        |         |  |   |        |   |  |   |       | 
|---------------------------------------------------------- |  | ------------------------------------- | ------ | ------- |  | -------- | ------ | ------- |  | - | ------ | - |  | - | ----- | 
|                                                           |  |                                      
|                                                           |  | Quarters Ended in 2002               
|                                                           |  |                                      
|                                                           |  | March 31                              |        | June 30 |  | Sept. 30 |        | Dec. 31
|                                                           |  |                                       |        |         |  |          |        |        
|                                                           |  |                                      
|                                                           |  | (In thousands, except per-share data)
|Net sales                                                  |  | $                                     | 4,865  |         |  | $        | 3,271  |         |  | $ | 2,781  |   |  | $ | 2,603 | 
|Gross profit                                               |  |                                       | 3,070  |         |  |          | 2,330  |         |  |   | 1,873  |   |  |   | 1,459 | 
|Net income (loss)                                          |  |                                       | (1,212 | )       |  |          | (3,423 | )       |  |   | (1,045 | ) |  |   | 8     | 
|Basic and diluted net income (loss) per share              |  | $                                     | (0.17  | )       |  | $        | (0.47  | )       |  | $ | (0.14  | ) |  | $ | 0.00  | 
|Shares used in basic and diluted per-share
    calculation |  |                                       | 7,171  |         |  |          | 7,338  |         |  |   | 7,553  |   |  |   | 7,597 | 

Net loss for the quarter ended June 30, 2002
includes the effect of the Companys acquisition of REBA
Technologies, and a charge of $621,000 for in-process research
and development (see Note 7). Net income for the quarter
ended December 31, 2002 includes a $3.6 million gain
on sale of the Companys embedded

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APPLIED MICROSYSTEMS CORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

systems development tools business (see
Note 2). The Companys 2002 quarterly results were
also impacted by business restructuring activities (see
Note 6).

|                                             |  |                                       |        |         |  |          |       |         |  |   |        |   |  |   |       |  
|-------------------------------------------- |  | ------------------------------------- | ------ | ------- |  | -------- | ----- | ------- |  | - | ------ | - |  | - | ----- | -
|                                             |  |                                      
|                                             |  | Quarters Ended in 2001               
|                                             |  |                                      
|                                             |  | March 31                              |        | June 30 |  | Sept. 30 |       | Dec. 31
|                                             |  |                                       |        |         |  |          |       |        
|                                             |  |                                      
|                                             |  | (In thousands, except per-share data)
|Net sales                                    |  | $                                     | 10,114 |         |  | $        | 8,840 |         |  | $ | 4,605  |   |  | $ | 5,311 |  
|Gross profit                                 |  |                                       | 7,307  |         |  |          | 6,324 |         |  |   | 3,424  |   |  |   | 3,756 |  
|Net income (loss)                            |  |                                       | 260    |         |  |          | (892  | )       |  |   | (3,968 | ) |  |   | (421  | )
|Basic net income (loss) per share            |  | $                                     | 0.04   |         |  | $        | (0.13 | )       |  | $ | (0.56  | ) |  | $ | (0.06 | )
|Diluted net income (loss) per share          |  | $                                     | 0.04   |         |  | $        | (0.13 | )       |  | $ | (0.56  | ) |  | $ | (0.06 | )
|Shares used in basic per-share calculation   |  |                                       | 6,990  |         |  |          | 7,055 |         |  |   | 7,113  |   |  |   | 7,143 |  
|Shares used in diluted per-share calculation |  |                                       | 7,277  |         |  |          | 7,055 |         |  |   | 7,113  |   |  |   | 7,143 |  

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|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

On June 21, 2002 we filed a current report
on Form 8-K announcing that on June 14, 2002, we
dismissed Ernst & Young LLP as our independent
accountants. We also disclosed that on June 20, 2002, the
Company engaged Grant Thornton LLP as our new independent
accountants for the year ended December 31, 2002.

The reports of Ernst & Young LLP on the
Companys financial statements for the past two years did
not contain an adverse opinion or disclaimer of opinion and were
not qualified or modified as to uncertainty, audit scope, or
accounting principles, except that the Independent
Auditors Report on the consolidated financial statements
of the Company for the year ended December 31, 2000
contained an explanatory paragraph regarding the Companys
change in its method of accounting for revenue recognition in
accordance with guidance provided in SEC Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial
Statements.

In connection with the audits of our financial
statements for each of the two years ended December 31,
2001 and 2000, and in the subsequent interim period, there were
no disagreements with Ernst & Young LLP on any matters
of accounting principles or practices, financial statement
disclosure, or auditing scope and procedure which, if not
resolved to the satisfaction of Ernst & Young LLP would
have caused Ernst & Young LLP to make reference to the
matter in their report.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

The information called for by this Item is
incorporated by reference from the registrants definitive
proxy statement to be filed pursuant to Regulation 14A
under the Securities Exchange Act of 1934, as amended, no later
than 120 days from the registrants 2002 fiscal year
end.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information called for by this Item is
incorporated by reference from the registrants definitive
proxy statement to be filed pursuant to Regulation 14A
under the Securities Exchange Act of 1934, as amended, no later
than 120 days from the registrants 2002 fiscal year
end.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

The information called for by this Item is
incorporated by reference from the registrants definitive
proxy statement to be filed pursuant to Regulation 14A
under the Securities Exchange Act of 1934, as amended, no later
than 120 days from the registrants 2002 fiscal year
end.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information called for by this Item is
incorporated by reference from the registrants definitive
proxy statement to be filed pursuant to Regulation 14A
under the Securities Exchange Act of 1934, as amended, no later
than 120 days from the registrants 2002 fiscal year
end.




PART IV






|         |                        
|-------- | -----------------------
|Item 14. | Controls and Procedures

(a) Under the supervision and with the
participation of our management, including our principal
executive officer and principal financial officer, we conducted
an evaluation of our disclosure controls and procedures, as such
term is defined under Rule 13a-14(c) promulgated under the
Securities Exchange Act of 1934, as amended (the Exchange
Act), within 90 days of the filing date of this
report. Based on their evaluation, our principal executive
officer and principal accounting officer concluded that our
disclosure controls and procedures are effective.

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##### Table of Contents



(b) There have been no significant changes
(including corrective actions with regard to significant
deficiencies or material weaknesses) in our internal controls or
in other factors that could significantly affect these controls
subsequent to the date of the evaluation referenced in
paragraph (a) above.






|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules,
    and Reports on Form 8-K

(a) Index to list of documents filed as
part of this report

(1) Financial
Statements See Index to
Financial Statements at Item 8 of this report.

(2) Financial Statement
Schedules



| |                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Report of Grant Thornton LLP, Independent
    Auditors, on Financial Statement Schedule Schedule II:
    Valuation and Qualifying Accounts                                     
|
| | All other schedules have been omitted because
    they were not applicable or were not required under the
    applicable regulations of the Securities and Exchange Commission.

(3) Exhibits

|        |    |             |  |                                                                                                                                                                                                                                                                             
|------- | -- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 3  | .1(1)       |  | Restated Articles of Incorporation of the Company                                                                                                                                                                                                                           
|        | 3  | .2(1)       |  | Restated Bylaws of the Company                                                                                                                                                                                                                                              
|        | 10 | .3(1)       |  | 1992 Performance Stock Plan, as amended to
    date                                                                                                                                                                                                                         
|        | 10 | .4 (1)      |  | 1995 Directors Stock Option Plan, as amended to
    date                                                                                                                                                                                                                    
|        | 10 | .8 (1)      |  | Third Amended and Restated Investment Agreement
    dated as of September 15, 1995                                                                                                                                                                                          
|        | 10 | .18(2)      |  | Employment Agreement by and between Stephen J.
    Verleye and the Company, dated April 1, 1999                                                                                                                                                                             
|        | 10 | .20(3)      |  | Shareholder Rights Plan, dated December 10,
    1998, between the Company and ChaseMellon Shareholder Services,
    L.L.C.                                                                                                                                                  
|        | 10 | .21(4)      |  | First Amendment to the Shareholder Rights Plan,
    effective December 10, 1998, between the Company and Mellon
    Investor Services LLC (formerly ChaseMellon Shareholder Services
    L.L.C.) dated May 23, 2000                                                         
|        | 10 | .22(5)      |  | 2001 Stock Option Plan                                                                                                                                                                                                                                                      
|        | 10 | .23(6)      |  | Form of Change of Control Agreement for vice
    president officers, adopted by the Board of Directors
    April 23, 2001                                                                                                                                                   
|        | 10 | .24(7)      |  | Microsoft Xbox Component Purchase Agreement                                                                                                                                                                                                                                 
|        | 10 | .25(8)      |  | 1996 Employee Stock Purchase Plan, as amended and
    restated to date                                                                                                                                                                                                      
|        | 10 | .26(9)      |  | Agreement and Plan of Reorganization By and Among
    Applied Microsystems Corporation, Libra Networks, Inc., and
    Sellers dated May 22, 2002                                                                                                                            
|        | 10 | .27(9)      |  | Escrow Agreement relating to the Agreement and
    Plan of Reorganization By and Among Applied Microsystems
    Corporation, Libra Networks, Inc., and Sellers dated
    May 22, 2002                                                                                       
|        | 10 | .28(10)     |  | Asset Purchase Agreement by and between
    Metrowerks Corporation, a Texas corporation and wholly owned
    subsidiary of Motorola, Inc. on the one hand, and Applied
    Microsystems Corporation, a Washington Corporation on the other
    hand, dated September 3, 2002

55



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##### Table of Contents



|        |    |             |  |                                                        
|------- | -- | ----------- |  | -------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 10 | .29(11)     |  | Lease Termination Agreement, dated
    October 15, 2002
|        | 21 |             |  | Subsidiaries of the Registrant                         
|        | 23 |             |  | Consent of Grant Thornton LLP, Independent
    Auditors
|        | 23 | .1          |  | Consent of Ernst & Young LLP,
    Independent Auditors 
|        | 99 | .1          |  | Certification of Chief Executive Officer               
|        | 99 | .2          |  | Certification of Chief Financial Officer               



---



| |     |                                                                                                                                                                                                                             
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to the Companys
    Registration Statement on Form S-1 filed with the
    Securities and Exchange Commission on September 15, 1995
    (File No. 333-97002)                                      
|
| | (2) | Filed as an exhibit to Form 10-Q for the
    quarters ended June 30, 1999 and September 30, 1999,
    and incorporated herein by reference.                                                                                 
|
| | (3) | Incorporated by reference to the Companys
    registration statement on Form 8-A filed with the
    Securities and Exchange Commission on December 15, 1998.                                                               
|
| | (4) | Incorporated by reference to the Companys
    Current Report on Form 8-K filed with the Securities and
    Exchange Commission on May 23, 2001.                                                                            
|
| | (5) | Incorporated by reference to the Companys
    definitive Proxy Statement for the Companys Annual Meeting
    of Shareholders held on May 22, 2001 filed with the
    Securities and Exchange Commission on April 16, 2001.
|
| | (6) | Filed as an exhibit to Form 10-Q for the
    quarter ended June 30, 2001, and incorporated herein by
    reference.                                                                                                         
|
| | (7) | Filed as an exhibit to the Companys Annual
    Report on Form 10-K for the year ended December 31,
    2001, and incorporated herein by reference.                                                                         
|
| | (8) | Incorporated by reference to the Companys
    definitive Proxy Statement for the Companys Annual Meeting
    of Shareholders held on May 23, 2000 filed with the
    Securities and Exchange Commission on April 14, 2000.
|
| | (9) | Incorporated by reference to the Companys
    Current Report on Form 8-K filed with the Securities and
    Exchange Commission on May 24, 2002.                                                                            



|     |                                                                                                                                                      
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Companys
    Current Report on Form 8-K filed with the Securities and
    Exchange Commission on September 4, 2002.
|    
|(11) | Incorporated by reference to the Companys
    Current Report on Form 8-K filed with the Securities and
    Exchange Commission on October 21, 2002. 

(b) Reports on Form 8-K



| |                                                                                                                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We filed a report on Form 8-K with the
    Securities and Exchange Commission on December 18, 2002,
    regarding our board of directors unanimous decision to
    recommend to shareholders that the Company be liquidated.                                                
|
| | We filed a report on Form 8-K with the
    Securities and Exchange Commission on December 31, 2002,
    regarding our receipt of a Nasdaq SmallCap Market delisting
    notification.                                                                                        
|
| | We filed a report on Form 8-K with the
    Securities and Exchange Commission on March 4, 2003,
    regarding information on our tentative liquidation timeframe and
    recent measures taken by the Company to reduce its expenses
    pending liquidation and dissolution.

56



---



##### Table of Contents






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 28, 2003.



| |                                 
| | --------------------------------
| | APPLIED MICROSYSTEMS CORPORATION



| |    |                      
| | -- | ---------------------
| | By | /s/ ROBERT C. BATEMAN

| |                                                 
| | ------------------------------------------------
| |                                                 
| | Robert C. Bateman                               
| | Vice President, Chief Financial
    Officer,    
| | Corporate Secretary, and Treasurer              
| | (Principal Financial and Accounting
    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/ STEPHEN J. VERLEYEStephen J. Verleye     |  | President, Chief Executive Officer
    and Director
    (Principal Executive Officer)                                                    |  | March 28, 2003
|                                            
|/s/ ROBERT C. BATEMANRobert C. Bateman       |  | Vice President,
    Chief Financial Officer,
    Corporate Secretary, and Treasurer
    (Principal Financial
    and Accounting Officer) |  | March 28, 2003
|                                            
|/s/ CHARLES H. HOUSECharles H. House         |  | Chairman of the Board                                                                                                                    |  | March 28, 2003
|                                            
|/s/ ELWOOD D. HOWSE, JR.Elwood D. Howse, Jr. |  | Director                                                                                                                                 |  | March 28, 2003

57



---



##### Table of Contents



SECTION 302(a) CERTIFICATIONS

I, Robert C. Bateman, certify that:



|   |                                                                                                                                                                                                                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. | I have reviewed this annual report on
    Form 10-K of Applied Microsystems Corporation;                                                                                                                                                                                                                                                    
|  
|2. | Based on my knowledge, this annual report does
    not contain any untrue statement of a material fact or omit to
    state a material fact necessary to make the statements made, in
    light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|  
|3. | Based on my knowledge, the financial statements,
    and other financial information included in this annual report,
    fairly present in all material respects the financial condition,
    results of operations and cash flows of the registrant as of,
    and for, the periods presented in this annual report;                       
|  
|4. | The registrants other certifying officer
    and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and we have:                                                                                                        



| |    |                                                                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | designed such disclosure controls and procedures
    to ensure that material information relating to the registrant,
    including its consolidated subsidiaries, is made known to us by
    others within those entities, particularly during the period in
    which this annual report is being prepared;
|
| | b) | evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) | presented in this annual report our conclusions
    about the effectiveness of the disclosure controls and
    procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



|   |                                                                                                                                                                                                                                                               
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|5. | The registrants other certifying officer
    and I have disclosed, based on our most recent evaluation, to
    the registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent functions):



| |    |                                                                                                                                                                                                                                                                                                                   
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) | any fraud, whether or not material, that involves
    management or other employees who have a significant role in the
    registrants internal controls; and                                                                                                                                                    



|   |                                                                                                                                                                                                                                                                                                                                                                                                              
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|6. | The registrants other certifying officer
    and I have indicated in this annual report whether or not there
    were significant changes in internal controls or in other
    factors that could significantly affect internal controls
    subsequent to the date of our most recent evaluation, including
    any corrective actions with regard to significant deficiencies
    and material weaknesses.

Date: March 28, 2003



| |                                             
| | --------------------------------------------
| | /s/ ROBERT C. BATEMAN                       
| |                                             
| | Robert C. Bateman                           
| | Vice President, Chief Financial
    Officer,
| | Secretary, and Treasurer                    

58



---



##### Table of Contents



I, Stephen J. Verleye, certify that:



|   |                                                                                                                                                                                                                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. | I have reviewed this annual report on
    Form 10-K of Applied Microsystems Corporation;                                                                                                                                                                                                                                                    
|  
|2. | Based on my knowledge, this annual report does
    not contain any untrue statement of a material fact or omit to
    state a material fact necessary to make the statements made, in
    light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|  
|3. | Based on my knowledge, the financial statements,
    and other financial information included in this annual report,
    fairly present in all material respects the financial condition,
    results of operations and cash flows of the registrant as of,
    and for, the periods presented in this annual report;                       
|  
|4. | The registrants other certifying officer
    and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and we have:                                                                                                        



| |    |                                                                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | designed such disclosure controls and procedures
    to ensure that material information relating to the registrant,
    including its consolidated subsidiaries, is made known to us by
    others within those entities, particularly during the period in
    which this annual report is being prepared;
|
| | b) | evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) | presented in this annual report our conclusions
    about the effectiveness of the disclosure controls and
    procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



|   |                                                                                                                                                                                                                                                                
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|5. | The registrants other certifying officers
    and I have disclosed, based on our most recent evaluation, to
    the registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent functions):



| |    |                                                                                                                                                                                                                                                                                                                   
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) | any fraud, whether or not material, that involves
    management or other employees who have a significant role in the
    registrants internal controls; and                                                                                                                                                    



|   |                                                                                                                                                                                                                                                                                                                                                                                                               
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|6. | The registrants other certifying officers
    and I have indicated in this annual report whether or not there
    were significant changes in internal controls or in other
    factors that could significantly affect internal controls
    subsequent to the date of our most recent evaluation, including
    any corrective actions with regard to significant deficiencies
    and material weaknesses.

Date: March 28, 2003



| |                                          
| | -----------------------------------------
| | /s/ STEPHEN J. VERLEYE                   
| |                                          
| | Stephen J. Verleye                       
| | President and Chief Executive
    Officer

59



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##### Table of Contents






SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

APPLIED MICROSYSTEMS CORPORATION

Years Ended December 31, 2002, 2001 and
2000

|                              |                                                   |            |  |            |  |            |  |             |  |            |  |        |     |  |  |         |      |  |  |         | 
|----------------------------- | ------------------------------------------------- | ---------- |  | ---------- |  | ---------- |  | ----------- |  | ---------- |  | ------ | --- |  |  | ------- | ---- |  |  | ------- | 
|                              |                                                   |            |  |            |  |            |  |            
|COL A.                        |                                                   | COL B.     |  | COL C.     |  | COL D.     |  | COL E.     
|                              |                                                   |            |  |            |  |            |  |            
|                              |                                                   |            |  |            |  |            |  |            
|                              |                                                   |            |  | Additions  |  |            |  |            
|                              |                                                   |            |  |            |  |            |  |            
|                              |                                                   |            |  |            |  | (2)        |  |             |  |           
|                              |                                                   |            |  | (1)        |  | Charged to |  |             |  |           
|                              |                                                   | Balance at |  | Charged to |  | Other      |  |             |  | Balance at
|                              |                                                   | Beginning  |  | Costs and  |  | Accounts:  |  | Deductions: |  | End of    
|Description                   |                                                   | of Period  |  | Expenses   |  | Describe   |  | Describe    |  | Period    
|                              |                                                   |            |  |            |  |            |  |             |  |           
|Year ended December 31, 2002: |                                                   |            |  |            |  |            |  |             |  |            |  |        |     |  |  |         |      |  |  |        
|Deducted from asset accounts: |                                                   |            |  |            |  |            |  |             |  |            |  |        |     |  |  |         |      |  |  |        
|                              | Allowance for sales returns and doubtful accounts |            |  | 52,000     |  |            |  | 380,000     |  |            |  | 21,000 | (B) |  |  | (92,000 | )(A) |  |  | 361,000 | 
|Year ended December 31, 2001: |                                                   |            |  |            |  |            |  |             |  |            |  |        |     |  |  |         |      |  |  |        
|Deducted from asset accounts: |                                                   |            |  |            |  |            |  |             |  |            |  |        |     |  |  |         |      |  |  |        
|                              | Allowance for sales returns and doubtful accounts |            |  | 56,000     |  |            |  | 1,000       |  |            |  | 55,000 | (B) |  |  | (60,000 | )(A) |  |  | 52,000  | 
|Year ended December 31, 2000: |                                                   |            |  |            |  |            |  |             |  |            |  |        |     |  |  |         |      |  |  |        
|Deducted from asset accounts: |                                                   |            |  |            |  |            |  |             |  |            |  |        |     |  |  |         |      |  |  |        
|                              | Allowance for sales returns and doubtful accounts |            |  | 92,000     |  |            |  |            |  |            |  | 34,000 | (B) |  |  | (70,000 | )(A) |  |  | 56,000  | 



---



|    |  |                                                                                    
|--- |  | -----------------------------------------------------------------------------------
|(A) |  | Uncollectible accounts written off, net of
    recoveries, and actual sales returns
|   
|(B) |  | Estimated future sales returns charged to revenue                                  

60



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##### Table of Contents






EXHIBIT INDEX

|        |    |             |  |                                                                                                                                                                                                                                                                             
|------- | -- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 3  | .1(1)       |  | Restated Articles of Incorporation of the Company                                                                                                                                                                                                                           
|        | 3  | .2(1)       |  | Restated Bylaws of the Company                                                                                                                                                                                                                                              
|        | 10 | .3(1)       |  | 1992 Performance Stock Plan, as amended to
    date                                                                                                                                                                                                                         
|        | 10 | .4 (1)      |  | 1995 Directors Stock Option Plan, as amended to
    date                                                                                                                                                                                                                    
|        | 10 | .8 (1)      |  | Third Amended and Restated Investment Agreement
    dated as of September 15, 1995                                                                                                                                                                                          
|        | 10 | .18(2)      |  | Employment Agreement by and between Stephen J.
    Verleye and the Company, dated April 1, 1999                                                                                                                                                                             
|        | 10 | .20(3)      |  | Shareholder Rights Plan, dated December 10,
    1998, between the Company and ChaseMellon Shareholder Services,
    L.L.C.                                                                                                                                                  
|        | 10 | .21(4)      |  | First Amendment to the Shareholder Rights Plan,
    effective December 10, 1998, between the Company and Mellon
    Investor Services LLC (formerly ChaseMellon Shareholder Services
    L.L.C.) dated May 23, 2000                                                         
|        | 10 | .22(5)      |  | 2001 Stock Option Plan                                                                                                                                                                                                                                                      
|        | 10 | .23(6)      |  | Form of Change of Control Agreement for vice
    president officers, adopted by the Board of Directors
    April 23, 2001                                                                                                                                                   
|        | 10 | .24(7)      |  | Microsoft Xbox Component Purchase Agreement                                                                                                                                                                                                                                 
|        | 10 | .25(8)      |  | 1996 Employee Stock Purchase Plan, as amended and
    restated to date                                                                                                                                                                                                      
|        | 10 | .26(9)      |  | Agreement and Plan of Reorganization By and Among
    Applied Microsystems Corporation, Libra Networks, Inc., and
    Sellers dated May 22, 2002                                                                                                                            
|        | 10 | .27(9)      |  | Escrow Agreement relating to the Agreement and
    Plan of Reorganization By and Among Applied Microsystems
    Corporation, Libra Networks, Inc., and Sellers dated
    May 22, 2002                                                                                       
|        | 10 | .28(10)     |  | Asset Purchase Agreement by and between
    Metrowerks Corporation, a Texas corporation and wholly owned
    subsidiary of Motorola, Inc. on the one hand, and Applied
    Microsystems Corporation, a Washington Corporation on the other
    hand, dated September 3, 2002
|        | 10 | .29(11)     |  | Lease Termination Agreement, dated
    October 15, 2002                                                                                                                                                                                                                     
|        | 21 |             |  | Subsidiaries of the Registrant                                                                                                                                                                                                                                              
|        | 23 |             |  | Consent of Grant Thornton LLP, Independent
    Auditors                                                                                                                                                                                                                     
|        | 23 | .1          |  | Consent of Ernst & Young LLP,
    Independent Auditors                                                                                                                                                                                                                      
|        | 99 | .1          |  | Certification of Chief Executive Officer                                                                                                                                                                                                                                    
|        | 99 | .2          |  | Certification of Chief Financial Officer                                                                                                                                                                                                                                    



---



| |     |                                                                                                                                                                                                                             
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to the Companys
    Registration Statement on Form S-1 filed with the
    Securities and Exchange Commission on September 15, 1995
    (File No. 333-97002)                                      
|
| | (2) | Filed as an exhibit to Form 10-Q for the
    quarters ended June 30, 1999 and September 30, 1999,
    and incorporated herein by reference.                                                                                 
|
| | (3) | Incorporated by reference to the Companys
    registration statement on Form 8-A filed with the
    Securities and Exchange Commission on December 15, 1998.                                                               
|
| | (4) | Incorporated by reference to the Companys
    Current Report on Form 8-K filed with the Securities and
    Exchange Commission on May 23, 2001.                                                                            
|
| | (5) | Incorporated by reference to the Companys
    definitive Proxy Statement for the Companys Annual Meeting
    of Shareholders held on May 22, 2001 filed with the
    Securities and Exchange Commission on April 16, 2001.
|
| | (6) | Filed as an exhibit to Form 10-Q for the
    quarter ended June 30, 2001, and incorporated herein by
    reference.                                                                                                         



---



##### Table of Contents





| |     |                                                                                                                                                                                                                             
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (7) | Filed as an exhibit to the Companys Annual
    Report on Form 10-K for the year ended December 31,
    2001, and incorporated herein by reference.                                                                         
|
| | (8) | Incorporated by reference to the Companys
    definitive Proxy Statement for the Companys Annual Meeting
    of Shareholders held on May 23, 2000 filed with the
    Securities and Exchange Commission on April 14, 2000.
|
| | (9) | Incorporated by reference to the Companys
    Current Report on Form 8-K filed with the Securities and
    Exchange Commission on May 24, 2002.                                                                            



|     |                                                                                                                                                      
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Companys
    Current Report on Form 8-K filed with the Securities and
    Exchange Commission on September 4, 2002.
|    
|(11) | Incorporated by reference to the Companys
    Current Report on Form 8-K filed with the Securities and
    Exchange Commission on October 21, 2002.