<PAGE>   1

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

[X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
                                       OR
[ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
                  FOR THE TRANSITION PERIOD FROM           TO

                          COMMISSION FILE NO. 0-26814

                             DATAWORKS CORPORATION
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S>                                               <C>
                   CALIFORNIA                                        3-0209937
        (STATE OR OTHER JURISDICTION OF                           (I.R.S. EMPLOYER
         INCORPORATION OR ORGANIZATION)                         IDENTIFICATION NO.)

         5910 PACIFIC CENTER BOULEVARD
                   SUITE 300
             SAN DIEGO, CALIFORNIA                                     92121
    (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                         (ZIP CODE)
</TABLE>

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (619) 546-9600

          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
                                      NONE
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                                  COMMON STOCK
                                (TITLE OF CLASS)

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

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

     The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of March 2, 1998 was $278,636,614.*

     The number of shares outstanding of the Registrant's Common Stock was
14,191,964 as of March 2, 1998.

                      DOCUMENTS INCORPORATED BY REFERENCE

     Registrant's Definitive Proxy Statement to be filed with the Securities and
Exchange Commission (the "Commission") pursuant to Regulation 14A in connection
with the 1998 Annual Meeting of Shareholders to be held on June 18, 1998 (the
"1998 Annual Meeting") is incorporated herein by reference into Part III of this
Report.

     Certain Exhibits filed with the Registrant's Registration Statement on Form
SB-2 (Registration No. 33-97022 LA), as amended, the Registrant's Registration
Statement on Form S-4 (Registration No. 333-11741) and Interactive Group, Inc.'s
Registration Statement on Form S-1 (No. 33-90816), as amended, are incorporated
herein by reference with Part IV of this Report.
---------------
* Excludes the Common Stock held by executive officers, directors and
  shareholders whose beneficial ownership exceeds 5% of the Common Stock
  outstanding at March 2, 1998. Exclusion of such shares should not be construed
  to indicate that any such person possesses the power, direct or indirect, to
  direct or cause the direction of the management or policies of the Registrant
  or that such person is controlled by or under common control with the
  Registrant.
================================================================================
<PAGE>   2

     This Annual Report on Form 10-K contains certain forward-looking statements
that involve risks and uncertainties. The actual future results for DataWorks
Corporation ("DataWorks" or the "Company") may differ materially from those
discussed here. Additional information concerning factors that could cause or
contribute to such differences can be found in this Annual Report on Form 10-K
in Part I, Item 1 under the caption "Certain Risk Factors Related to the
Company's Business," Part II, Item 7 entitled "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and elsewhere
throughout this Annual Report.

                                     PART I

ITEM 1.  BUSINESS

     DataWorks develops, markets, implements and supports open systems,
client/server-based Enterprise Resource Planning ("ERP") software for mid-range
discrete manufacturing companies with annual revenues between $3 million and $1
billion. The Company's products and services facilitate enterprise-wide
management of resources and information and allow mid-range manufacturers to
reduce order fulfillment cycle times, improve operating efficiencies and measure
critical company performance against defined plan objectives. DataWorks'
products enable its customers to manage make-to-stock and make-to-order
production methods, as well as multiple hybrid or "mixed mode" production
methods, within a single manufacturing site or across multiple sites. The
Company's products also help customers adapt to growth, changing levels of
operations, and business process re-engineering, which is becoming commonplace
among manufacturing concerns.

     The business needs and resource requirements of mid-range manufacturers
tend to be considerably different than those of larger companies. Companies in
this market typically have small information systems ("IS") departments, budget
constraints and limited experience with the advanced technologies inherent in
ERP systems. DataWorks segments the mid-range manufacturing market into three
distinct sectors: the lower tier segment (companies with annual revenues of $3
million to $25 million), the mid-tier segment ($25 million to $200 million) and
the upper tier segment ($200 million to $1 billion). The Company's family of ERP
solutions is designed to provide a product migration path to address the
changing needs of growing companies in the mid-range manufacturing market.

     The Company's principal product is Avante, an open system
client/server-based product family that is targeted at mid-tier manufacturers.
By mid 1999, the Avante product will offer the combined functionality of the
individual application suites of ManFact, DataFlo and InfoFlo (acquired through
the Company's recent acquisition of Interactive Group, Inc. ["Interactive"]) in
one integrated solution. The Company broadened its product line to serve the
lower tier segment of the mid-range market with Vista and Vantage. Vista and
Vantage are easy-to-use Windows-based products, which the Company acquired
through its acquisition of DCD Corporation ("DCD"). The Company also has under
development its Impresa for Backoffice system (previously referred to as ECS) ,
an object oriented, multi-tier client/server-based product that is designed for
the upper tier segment of the mid-range market. The Company intends to commence
customer shipments of the initial phase of Impresa for Backoffice in late 1998.
To address primarily the unique requirements of the aerospace and defense
contractors in the mid-range market, especially those with maintenance, repair
and overhaul ("MRO") functionality needs, DataWorks has significantly enhanced
its commitment to this sector with the availability of Impresa for MRO
(previously called JIT and obtained by the Company in its acquisition of
Interactive). Impresa for MRO is a product built on a total Oracle technology
framework.

     The Company has designed its product family to be affordable and to
incorporate a broad range of applications, depth of functionality, ease of use
and an ability to be rapidly and economically deployed. The Company's products
are comprised of modules that provide and integrate feature-rich applications
and that can be configured to comprehensively support a customer's business.
DataWorks provides turnkey solutions by integrating its application software
products with third party hardware, operating systems, databases and other
software products. The Company offers a suite of development tools and a full
complement of services to help its customers maximize the benefits of the
Company's software products and efficiently implement the Company's ERP
solutions. These services include initial system implementation, consultation,
customer

                                        1
<PAGE>   3

support desk and maintenance activities, technical and programming services, and
periodic enhancement releases of software products.

     In September 1997, the Company acquired Interactive in a stock-for-stock
transaction that was accounted for as a pooling-of-interests. The financial
results of Interactive have been included in the financial results of the
Company included in this Annual Report. The Company believes its acquisition of
Interactive offers major advantages in three key areas -- significantly enhanced
international operations, including international channels, six offices in
Europe as well as a substantial distributor in Germany; more comprehensive
mid-tier product offerings; and substantial critical mass which makes DataWorks
one of the largest mid-range ERP providers in the world.

INDUSTRY BACKGROUND

     Manufacturers worldwide are attempting to re-engineer their businesses as
they react to increasing global competitive pressures, demanding vendor-customer
relationships and rapidly changing market requirements. In implementing these
re-engineering efforts, manufacturing companies in the mid-range sector are
increasingly orienting their operations to respond to customer needs by
shortening product development and delivery cycles, enhancing product quality
and providing products configured to meet customer requirements. To achieve
these objectives, manufacturers must increase the efficiency of their
operations, within the limits of budgetary constraints, by increasing the
productivity of personnel and the efficient management of assets throughout
their enterprises. Manufacturing companies also require the flexibility to
modify and expand operations in response to market demand. All of these factors
contribute to the need for information systems that offer enterprise-wide
availability and integrated use of a broad range of accurate and current
information that enables manufacturers to respond more quickly to their
customers and to manage their organizations more efficiently. The IS needs of
manufacturers depend to some degree on the nature of their manufacturing
processes, which may include make-to-stock, in which parts are assembled into
finished products based on a standard bill order; make-to-order, in which parts
are assembled into a finished product based on unique customer specifications;
and configure-to-order, in which the final assembly of parts can be configured
to create many different model and style variations based on customer orders.
Firms using configure-to-order production methods are referred to as one form of
mixed mode manufacturers because they assemble products using elements of both
make-to-stock and make-to-order. Mixed mode manufacturing can create significant
market advantages for companies embracing this latest production process
approach but is extremely difficult to realize economic gains without responsive
information systems.

     Since the early 1970s, there has been a steady evolution of manufacturing
software systems available from third party software developers or developed
internally by the manufacturers themselves. Initially, Material Requirements
Planning ("MRP") systems were introduced to allow manufacturers to manage the
flow of materials at various stages of the manufacturing process. These MRP
systems were superseded in the 1980s by a more expansive Manufacturing Resource
Planning ("MRP II") approach that incorporates labor and equipment capacity
planning for the production process as part of a materials planning methodology.
More recently, in response to the evolving needs of manufacturing companies,
there has been a significant shift away from the traditional MRP II
planning-oriented systems in favor of more comprehensive ERP systems that
provide actual enterprise-wide management of resources, integration of more
sophisticated forecasting and reporting models and the capability to measure
quality levels and delivery cycle responsiveness. ERP systems based on open
systems, client/server platforms offer further advantages to manufacturers by
providing access to information throughout the manufacturing enterprise on a
timely basis, providing a wider distribution of applications and databases and
permitting the integration of a diverse array of new software components and
technologies as they become available. Effectively designed ERP systems are also
scalable to permit deployment of localized information systems resources within
departments and individual business units or across an enterprise, as well as to
provide adequate support for organizational growth.

     Despite its virtues, open systems, client/server-oriented ERP solutions
have not historically been readily available to manufacturers in the mid-range
sector. There are several key contributing factors that have traditionally
precluded mid-size companies from reaping the full benefits of the new
technologies which have been made available to larger manufacturing firms in
recent years. In complex, diverse manufacturing

                                        2
<PAGE>   4

environments, many ERP systems require a significant IS staff, either internal
to the organization or contracted at substantial expense from outside the
company, and a high level of expertise to establish the proper design and
configuration of a client/server system that meets a company's specific needs.
Implementation of these systems has often been lengthy and costly. In addition,
large global ERP suppliers have continued to price their products beyond the
financial capabilities of the typical mid-size firm.

     In order to achieve their business process re-engineering ("BPR")
objectives, mid-range manufacturers need the benefits of open systems,
client/server ERP solutions that are affordable and can be quickly implemented
with minimal disruption to business and maintained with a limited IS staff.
These ERP systems must also provide sufficient depth of functionality and
flexibility to enable manufacturers to respond to varying customer needs and
offer scalability for growth in operations. The demand for a new generation of
turnkey ERP solutions that address the needs of the mid-range manufacturing
market is significant and growing.

     Large (multi-billion dollar) manufacturing enterprises increasingly are
seeking the efficiencies and competitive advantages of electronically tying
together in a supply chain sources of raw materials, component products, and
certain outsourced manufacturing processes. Many of the "feeder" suppliers of
these products and services to the large manufacturing enterprise are companies
in the mid-range manufacturing market. These mid-range companies require systems
to address their market diversity, scalability, and localized information
systems requirements, along with committed ERP vendor development resources, to
electronically link these systems into a wide area network for electronic supply
chain management.

THE DATAWORKS SOLUTION

     DataWorks offers open, client/server-based ERP software systems that enable
discrete manufacturing companies to re-engineer their businesses to compete more
effectively, while responding to the specific needs and limitations of the
mid-range market. The Company's current and planned products are designed to
meet the ERP needs of all tiers of mid-range manufacturing companies. As
companies in the lower and mid-tiers growth, their enterprise-wide management
requirements change, and DataWorks provides an efficient migration path to more
complex ERP solutions. The Company believes that mid-sized manufacturers in its
targeted industry segments represent a significantly higher growth sector than
the general manufacturing community at large. The principal elements of the
Company's ERP solutions are as follows:

     - OPEN SYSTEMS AND ADVANCED RDBMS ARCHITECTURE

     The Company's family of products addresses the dynamic environment faced by
mid-sized manufacturers through a commitment to open systems architecture.
DataWorks' software products operate on most major client/server hardware
platforms and operating systems, including Microsoft NT and UNIX, wide area
networks ("WANs"), local area networks ("LANs") and prominent user interfaces,
including Microsoft Windows, Apple Macintosh and ASCII. The Company uses
advanced relational database management systems ("RDBMS") that are best suited
for the particular application required by mid-range manufacturers, including
Ardent Software, Inc., (formerly UniData, Inc. and VMark Software, Inc.),
Microsoft Foxpro and Progress Software Corporation ("Progress").

     - BREADTH AND DEPTH OF PRODUCTS AND APPLICATIONS

     The Company's products are intended to address the application needs of
customers throughout the mid-range market. By utilizing certain core
technologies throughout its product line, the Company enables a customer to
migrate from product to product to address the changing needs of the customer's
enterprise. The Company's products are comprised of modules that provide and
integrate feature-rich applications in the areas of (i) Business Planning and
Engineering, (ii) Sales, Distribution and Customer Service, (iii) Production and
Material Operations and (iv) Finance and Administration. New application modules
are introduced periodically and are compatible with the current in-field
software release. In addition, the Company's development and implementation
support tools provide an interface to an increasing number of third party
application products that can be seamlessly integrated into the Company's ERP
products through application programming interface ("API") technology.

                                        3
<PAGE>   5

     - RAPID DEPLOYMENT

     By offering rapid product deployment and migration among its product lines,
the Company seeks to minimize the business interruption to companies that
typically results from the introduction of a new or expanded ERP system, thereby
enabling such companies to more quickly realize the benefits of a new or
expanded ERP system. DataWorks utilizes a highly responsive implementation
planning process and focused consulting and training services to design ERP
solutions that are "right sized" to satisfy the functionality and rapid
deployment needs of diverse customers while remaining within the varied but
generally limited budgets of such customers. For example, by utilizing these
deployment tools and procedures, the Company is able to complete the
enterprise-wide deployment of Avante in three to nine months. Vista, the
Company's least expensive ERP system, is virtually self-installable through
self-contained tutorials and training tools familiar to most personal computer
users, and Vantage can be deployed within three to six months. The Company
anticipates deployment of the Impresa for Backoffice system will take
significantly longer than that of Avante, but is being designed so that it can
be effectively accomplished without significantly disrupting the customer's
operations.

     - FLEXIBILITY/ADAPTABILITY/SCALABILITY

     A critical element to achieving initial user acceptance of a new system and
facilitating rapid implementation is the ability to adapt the Company's standard
software to conform more closely to the particular needs of users. The Company's
products permit ready adaptation of the DataWorks systems to meet initial needs
during the implementation phase and respond to a customer's unique system
refinements and ongoing changes in production and operational processes once the
system is fully in service. The Company's customers can start with a small
number of local concurrent users and expand to many hundreds of concurrent users
across LANs and WANs over several years utilizing the same ERP solution from the
Company. In addition to accommodating new modules and potential significant
growth of users without sacrificing performance, the scalability of the
Company's ERP solutions and the ability to migrate within the Company's product
family allow mid-range manufacturers to change levels of operations and expand
application functionality to accommodate growth.

     - SUPERIOR PRICE/PERFORMANCE

     The Company seeks to achieve superior price and performance by providing
its mid-range manufacturing customers with the "right sized" system and
associated functionality to meet their ERP needs while satisfying their
budgetary constraints. The Company's ERP systems emphasize standard application
modules that require minimum customization, advanced yet cost-effective RDBMS
and other technologies and highly user-oriented fourth generation language
("4GL") development environments. Furthermore, the Company has standardized the
implementation process and supported it with the Company's proprietary software
tools, resulting in cost effective and rapid initial deployment of its ERP
products.

THE DATAWORKS STRATEGY

     The Company's objective is to be the leading provider of business
information solutions and related products and services to mid-range
manufacturers within selected markets. The Company's strategy to achieve this
objective incorporates the following elements:

     - PROVIDE COMPLETE SOLUTIONS AND PRODUCT MIGRATION PATH

     The Company offers products in each tier of the mid-range manufacturing
market to address a broad range of customer needs and provide a product
migration path to address the changing needs of growing companies. The Company
offers products for both make-to-order and repetitive manufacturers, and seeks
to support new manufacturing processes such as demand-flow production and agile
manufacturing. The Company complements its product offerings with a full suite
of implementation and consulting services, education, training and software
tools to assist customers in deriving the maximum benefit from the Company's
products. By providing comprehensive solutions, the Company is able to work more
closely with

                                        4
<PAGE>   6

customers, sell additional modules or products, and provide additional support
services in an ongoing course of business.

     - FOCUSED MARKET STRATEGY

     The Company targets mid-range manufacturing companies with annual revenues
between $3 million and $1 billion and historically has focused its efforts on
discrete, rather than process, manufacturers. In the mid-tier of the mid-range
market, sales of the Company's Avante product solutions have targeted eight
primary "highly engineered product" manufacturing sectors: industrial equipment;
computer/office equipment; consumer electronics; instrumentation and controls;
medical/dental products; transportation/aerospace products; capital equipment;
and contract manufactures. This approach has enabled DataWorks to better
understand the needs of its customers and to use that knowledge to tailor
products and services to those needs. The Company plans to continue to rely on
its experience and reputation in these select markets to enhance its competitive
position. The Company intends to leverage its expertise in these eight sectors
to market and sell its Impresa for Backoffice system currently under development
to customers in the upper tier of the mid-range market. The Company further
plans to leverage its expertise to enhance sales of its Vista and Vantage
products, which are currently focused on a wide range of manufacturers in the
lower tier, to emerging growth oriented discrete manufacturers in those eight
primary manufacturing sectors.

     - MAINTAIN TECHNOLOGY LEADERSHIP

     DataWorks believes it is a technology leader in the mid-range manufacturing
market, as it was one of the first companies to offer ERP client/server
solutions for mid-range manufacturers and to introduce full ERP solutions on
Microsoft NT. The Company's products are designed to utilize the most effective
open systems technologies such as client/server architectures, RDBMS, graphical
user interface's ("GUI") and Workflow tools for the mid-range market. The
Company incorporates common technology across its product line in order to
leverage its development resources and ensure compatibility among products. The
Company seeks to develop new modules and incorporate new functionality into its
products such as Internet integration, business objects, decision support,
manufacturing execution systems ("MES") support, and Object EDI, a cross-
product universal transaction processing protocol.

     - ACHIEVE HIGH LEVELS OF CUSTOMER SATISFACTION

     DataWorks is committed to consistently achieving high levels of customer
satisfaction with the Company's ERP systems. The Company focuses on delivering
high-quality products that address specific application needs, are easy to
implement and enable increased productivity. The Company also designs its
applications and development tools to permit end-users to easily customize
systems to fit their specific needs, which enhances end-user productivity and
overall satisfaction with the DataWorks products and services.

     - COMPREHENSIVE SALES AND MARKETING PROCESS

     The Company has developed a sophisticated sales and marketing system
designed to enhance its new customer success rate. The Company utilizes a
multi-phased sales approach consisting of telemarketing sales for initial
qualification, account representatives, systems engineers and the active
involvement of senior management. The Company's prospecting system enables
account representatives to appropriately qualify prospective customers and track
active prospects in significant detail through three stages of sales cycle
management, and provides valuable management information to measure performance
of its sales force and monitor ongoing sales efforts. The Company intends to
leverage its sophisticated sales and marketing system to increase DataWorks'
presence in the lower-tier and international markets in an effort to enhance
sales and increase new customer success rates. The Company believes its sales
processes and prospect management system provide it with a significant
competitive advantage.

                                        5
<PAGE>   7

PRODUCTS

     The business needs and resource requirements of mid-sized manufacturers
tend to be considerably different than those of larger companies. Customers in
this market generally have small IS departments, budget constraints and limited
experience with the advanced technologies inherent in ERP systems. DataWorks has
designed its product family to be affordable and to incorporate a broad range of
applications, depth of functionality, ease of use and an ability to be deployed
rapidly. The Company has products or is developing products with features
intended to address the particular needs of each of the lower tier, mid-tier and
upper tier segments of the mid-range market.

     The following chart describes the Company's principal existing and planned
ERP solutions and typical customer profiles relating to each of them:

<TABLE>
<CAPTION>
                                       LOWER TIER SEGMENT     MID-TIER SEGMENT        UPPER TIER SEGMENT
                                       ------------------    ------------------    -------------------------
                                             VISTA                                      IMPRESA FOR MRO
             PRODUCTS                       VANTAGE                AVANTE          IMPRESA FOR BACKOFFICE(1)
             --------                  ------------------    ------------------    -------------------------
<S>                                    <C>                   <C>                   <C>
Customer Revenues..................    $3 -- $25 million     $25 -- $200           $200 million -- $1
                                                             million               billion
Type of Manufacturing Operations...    - Entry level         - Make to order       - MRO Functionality
                                       - Basic job shop/     - Mixed mode          - Multi-plant/Global
                                         Make-to-order       - Repetitive            supply chain/
                                                                                   - Distributed system
IS Infrastructure..................    Minimal               Limited               Significant
Price Range........................    $10,000 -- $150,000   $125,000 -- $750,000  $500,000 -- $3 million(1)
Deployment Period..................    1 -- 4 months         3 -- 9 months         (1)
</TABLE>

---------------
(1) Impresa for Backoffice is currently under development and, although the
    Company intends to commence customer shipments of the product in late 1998,
    there can be no assurance that the Company will commence such shipments on a
    timely basis, or at all, or if timely shipped, that the Impresa for
    Backoffice system will achieve market acceptance. As Impresa for Backoffice
    is currently under development, data on average deployment period and sales
    cycle is unavailable and the indicated price range is estimated. See
    "Business -- Products -- Upper Tier: Impresa for Backoffice."

LOWER TIER: VISTA AND VANTAGE

     DataWorks offers Vista and Vantage for its customers with annual revenues
typically between $3 million and $25 million. These products are better suited
for the lower tier segment of mid-range manufacturers who, as compared to
customers who use Avante, have less developed IS infrastructures and lower IS
budgets, require shorter deployment periods, and often seek established,
user-friendly products.

     Vista is an easy-to-use, Windows-based ERP software package that provides a
cost-effective solution for job shops with up to $5 million in revenues. Vista
fully integrates 15 core business modules and features single level bills of
material capabilities. Vista incorporates the DesignWare feature which permits
users to, among other things, define their own screens, add fields, change
colors, hide fields, change grid sizes and drag choices from menus to the
desktop.

     Vantage is an easy-to-use, Windows-based ERP software package with flexible
order-handling capabilities to support a mix of custom and standard part orders
and multilevel assemblies and comprises 18 fully integrated business modules.
Vantage is optimized for the rapid deployment, minimal support and
price/performance requirements of custom and mixed-mode manufacturers in the $5
million to $25 million revenue range.

     Vista and Vantage, like Avante, are comprised of groups of modules that can
be differently configured to comprehensively support a customer's business
processes. The following chart describes the Vista and

                                        6
<PAGE>   8

Vantage modules, and the discussion below points out certain key characteristics
of the Vista and Vantage modules:

<TABLE>
<CAPTION>
                              VISTA AND VANTAGE APPLICATION MODULE GROUPS
--------------------------------------------------------------------------------------------------------
                               SALES, DISTRIBUTION
      BUSINESS PLANNING            AND CUSTOMER        PRODUCTION AND MATERIAL          FINANCE AND
       AND ENGINEERING               SERVICE                  OPERATIONS              ADMINISTRATION
-----------------------------  --------------------  ----------------------------  ---------------------
<S>                            <C>                   <C>                           <C>
- Bills of Material            - Estimating          - Inventory Management        - Accounts Payable
- Scheduling                   - Order Entry         - Job Control                 - Accounts Receivable
- Shop Vision                  - Quoting             - Purchasing/Receiving        - General Ledger
- Global Finite Rescheduling   - EDI                 - Shop Floor Data Collection  - Payroll
                               - Shipping/Receiving  - Purchasing RFQ              - Report Writer
                                                     - Document Management
</TABLE>

     Business Planning and Engineering Group.  In Vista and Vantage, the
Business Planning and Engineering module allows the production manager to
control the sales and shop priorities through a visual scheduling manager.
Indented bills of material support provide the ability to retain product
information for repeat orders, and "what if" scheduling provides the ability to
simulate the impact of new orders and schedule changes.

     Sales, Distribution and Customer Service Group.  Estimating, quoting and
sales order processing are tightly integrated in the products, supporting the
requirement for rapid cost estimating and order commitment. Order-to-job linking
provides rapid access to production status and delivery information. EDI
applications allow for electronic distribution of sales orders, change orders
and invoices.

     Production and Material Operations Group.  Priorities established in
scheduling are realized in manufacturing job processing. These controls present
real-time status reporting based on data collection inputs and provide
just-in-time material purchasing and availability. Visual job "wizards" and
document management allow paperless management and instant graphical review of
job history, job status and inventory.

     Finance and Administration Group.  Vista's and Vantage's Finance and
Administration Group enables associated product costs and revenues to be
recorded to the General Ledger module as subsidiary ledgers of the Accounts
Payable, Accounts Receivable, Payroll and Shop Floor Data Collection modules.

     Prices of Vista and Vantage applications are based on the specific product
line, the modules purchased and the number of concurrent users. The average
sales prices of Vista and Vantage are $12,000 and $65,000, respectively. As of
December 31, 1997, these two products, cumulatively, were licensed to more than
1,500 customers.

MID-TIER: AVANTE

     DataWorks historically has focused its marketing, product development and
services resources on "highly engineered product" companies with annual revenues
typically between $25 million and $200 million in eight principal industries:
industrial equipment; computer/office equipment; consumer electronics;
instrumentation and controls; medical/dental products; transportation/aerospace
products; capital equipment; and contract manufacturers. Avante provides three
principal application software suites that address the needs of its customers in
this mid-tier. One of Avante's application suites is directed toward
manufacturers generally making high-volume products, often utilizing
repetitive/just-in-time techniques, that are either make-to-stock or
configure-to-order, and which may have some smaller make-to-order requirements.
In a second application suite, Avante supports customers who have mixed-mode
manufacturing techniques. Avante's third application suite is oriented toward
make-to-order or engineer-to-order manufacturers that typically have diverse
project management and project costing requirements, as well as a smaller
element of make-to-stock requirements. Avante includes application components
developed internally by DataWorks and some acquired with the acquisitions of
Madic-Compufact Corporation ("MCC") in June 1994 and Interactive in September
1997.

     The Avante system is comprised of groups of modules that comprehensively
support a manufacturing company's business process. These modules provide and
integrate feature-rich applications, are built upon a common set of design and
development standards and tools, and share a common database architecture.
Avante is highly modular in nature and can be scaled from small to large
configurations on a variety of

                                        7
<PAGE>   9

platforms supporting the Microsoft NT and UNIX operating systems. This
enterprise-wide system can be implemented in a variety of multi-currency,
multi-company and multi-plant environments networked through client and
host-based configurations.

     The following chart describes the Avante modules, and the discussion below
points out certain key characteristics of Avante modules:

<TABLE>
<CAPTION>
                                     AVANTE APPLICATION MODULE GROUPS
-----------------------------------------------------------------------------------------------------------
 BUSINESS PLANNING AND      SALES, DISTRIBUTION AND       PRODUCTION AND MATERIAL          FINANCE AND
      ENGINEERING              CUSTOMER SERVICE                  OPERATIONS              ADMINISTRATION
-----------------------  -----------------------------  ----------------------------  ---------------------
<S>                      <C>                            <C>                           <C>
- Capacity               - Customer Service             - Inventory Management        - Accounts Payable
  Requirements Planning  - Electronic Data Interchange  - Lot/Serial Control          - Accounts Receivable
- Engineering Change     - Estimating                   - MES                         - Budgeting
  Control                - Field Service                - Multi-Plant Control         - Cost Accounting
- Forecasting            - Quoting                      - Production Activity         - Currency and VAT
- Master Production      - Sales Order                    Management                    - Executive
  Scheduling             - Shipping/Returned Material   - Project Management            Information System
- Material Requirements                                 - Purchasing/Receiving        - Fixed Assets
  Planning                                              - Quality Control             - General Ledger
- Product Configurator                                  - Repetitive Manufacturing    - Payroll
- Product Definition                                    - Shop Floor Data Collection  - Personnel
                                                        - Work Order Control
</TABLE>

     Business Planning and Engineering Group.  The Business Planning and
Engineering Group enables manufacturing companies to create high-level business
plans from current and historical sales, production and purchasing data. These
plans are used to generate specific product and product family forecasts, as
well as capacity models that flow into final and sub-assembly manufacturing,
scheduling and purchase plans. Engineering and configuration management define
material and routing structures to planning and production and provide
visibility to anticipate and coordinate product changes.

     Sales, Distribution and Customer Service Group.  The Sales, Distribution
and Customer Service Group allows a manufacturer to estimate, quote and take
orders for standard, configured and custom, "one-of-a-kind" products. The sales
made are integrated with the Business Planning and Engineering modules providing
actual versus plan reporting. Shipments, order status and invoicing can be
transmitted directly to the customer via electronic data interchange ("EDI").
Return material, field service and Help Desk applications are available on line
to customer service providing detail service analysis and call tracking.

     Production and Material Operations Group.  The Production and Material
Operations Group provides a means to record, track and measure production,
material, labor, quality and cost flows throughout the manufacturing and
purchasing processes. Inventory tracking is provided by company, plant,
warehouse and location with full traceability. Traditional work order, as well
as rate and cell-based just-in-time production is supported and fully integrated
with detailed shop floor and quality control reporting. Blanket and contract
orders, EDI and detailed supplier analysis reporting is provided in the
purchasing application.

     Finance and Administration Group.  The Finance and Administration Group
flows from the operational modules included in the groups described above. All
associated costs and revenues are captured to the General Ledger module as
subsidiary ledgers of the Accounts Payable, Accounts Receivable, Payroll,
Inventory Management, Shop Floor Data Collection, Shipping/Returned Material and
Cost Accounting modules. The costing systems support both actual and standard
cost methodologies with additional capabilities for unlimited cost simulation,
modeling and reporting. The Financial modules support both distributed and
consolidated processing in a multi-company environment and provide complete
foreign currency and tax capabilities.

     The average price of DataWorks' Avante ERP system (exclusive of hardware)
sold to new customer sites in DataWorks' target market increased to
approximately $325,000 in 1997 from approximately $251,000 in 1996. As of
December 31, 1997, the Avante product was licensed to more than 1,000 customers
at more than 1,200 customer sites.

UPPER TIER: IMPRESA PRODUCT FAMILY

     Impresa for MRO (previously called JIT and obtained by the Company in its
acquisition of Interactive) is a software system consisting of standardized
modules and a family of additional integration modules.

                                        8
<PAGE>   10

Impresa for MRO is designed primarily for MRO and contract manufacturing,
including a fully integrated suite of software supporting supply chain
management, repair and overhaul, manufacturing, quality, financial and project
management applications which are designed to support an enterprise's business
processes in an industrial company. Impresa for MRO is typically sold to large
organizations in need of a fully integrated enterprise-wide system that can
accommodate multiple geographic sites, including international operations.

     Impresa for MRO is a complete set of Oracle-based client/server
applications which operates in a flexible UNIX operating environment and is
designed to manufacturing, accounting and human engineering standards. The major
components of Impresa for MRO's architecture are (i) client/server enterprise
resource planning within an open systems UNIX platform; (ii) a three-tiered
model (Presentation Clients, Application and Database Servers); (iii) use of the
Oracle 4GL toolset and Developer/2000 which provides easy site extension,
personalization and deployment of applications on the Internet and Intranet; and
(iv) use of the Oracle version 7 database. The Impresa for MRO software
application modules can be grouped into the functions of supply chain
management, operations, system applications, financial applications, engineering
and integration.

     The Impresa for Backoffice system, which the Company has under development,
has been designed to address the ERP needs of the upper tier of the mid-range
manufacturing market. This upper tier consists of companies with annual revenues
ranging from $200 million to $1 billion. These organizations typically have
substantial IS staff because supporting a variety of both standard and custom
applications in a dynamic, multi-national corporation requires a significant
investment in information services. These enterprises are better able to invest
in the tools and technology necessary to support a complex, fully distributed
client/server computing environment and to provide the depth of staff and
technological expertise to maintain a more "customized" application set.

     DataWorks believes its Impresa for Backoffice system will provide valuable
depth to its product family and will enable the Company to provide a product for
the upper tier that is complementary to its mid-tier product, Avante. Generally,
DataWorks believes that products currently offered by ERP vendors serving
Fortune 1000 firms that might potentially compete with the Company in the upper
tier of the mid-range manufacturing market are complex and expensive, and
usually require a multi-year "custom implementation" process. The Company
believes the Impresa for Backoffice system can be competitive with the products
currently offered by large ERP system vendors by offering superior technology, a
more open solution, competitive pricing and shorter, less costly deployment
periods. The Company intends that the Impresa for Backoffice system, in addition
to providing DataWorks with a product solution for the upper tier of the mid-
range market, will also provide a migration path for the Company's current
customers using Avante or an earlier derivative product that may outgrow those
ERP systems and require the features of the Impresa for Backoffice system.

     The Impresa for Backoffice system is a second generation client/server
application for manufacturing, planning, inventory, engineering, distribution,
service and finance. While the Avante system provides a tightly coupled 4GL tool
set and database architecture, Impresa for Backoffice is built on tools and
database architectures from established market leaders, such as Microsoft, IBM,
Oracle and Sybase, to promote flexibility and technology independence. The
Company believes that the flexible and independent Impresa for Backoffice system
architecture can be managed with the significant IS resources of typical upper
tier manufacturers. Impresa for Backoffice employs an object oriented,
three-tier client/server architecture, in which the business logic, database and
presentation layers can be allocated independently across multiple processors
(servers or clients). This distributed model allows large corporations to deploy
a series of smaller, departmental or company servers to replace their existing
mainframe computers. DataWorks' Impresa for Backoffice system has been designed
to be database independent, initially supporting the Microsoft SQL Server and
Oracle databases.

     The Company currently anticipates commencing customer shipments of its
initial phase of Impresa for Backoffice system in late 1998. However, there can
be no assurance that the Company will commence such shipments in 1998, or at
all. Furthermore, the Company has limited experience in selling products to
customers in the upper tier of the mid-range manufacturing market and
anticipates that selling products to such customers will result in a longer
sales cycle and will require a different strategy than that employed by the

                                        9
<PAGE>   11

Company in selling products to customers in the mid-tier market. For example, as
part of its upper tier marketing strategy, the Company is exploring potential
relationships with third party integrators to facilitate implementation of the
Impresa for Backoffice system. There can be no assurance that any such
relationships will be formed or, if formed, will prove beneficial to the
Company. Accordingly, even if customer shipments of the Impresa for Backoffice
system are timely commenced, there can be no assurance that the Company will be
successful in effectively marketing the Impresa for Backoffice system or that
the Impresa for Backoffice system will achieve market acceptance.

CORE FEATURES AND TECHNOLOGIES

     The Company provides certain core technologies for the mid-range market
across its entire product line, and offers certain development and
implementation support tools to facilitate customization and deployment of the
Company's products.

PORTABILITY AND SCALABILITY

     DataWorks provides its products on all major versions of Microsoft NT and
UNIX operating systems. These environments enable the Company's products to have
extensive portability and scalability.

DEVELOPMENT TOOLS

     DataWorks has enabled each of its products with a sophisticated 4GL
development environment that allows the Company's software to be tailored to the
unique needs of users while ensuring the integrity of the database and
applications. DataWorks' products support a Windows-based GUI providing
consistent, familiar desktop interfaces and connectivity to a wide variety of
third party products. Traditional screens and reports are managed as templates
and forms to provide flexible user views into the database.

     The database and development environments of products designed for the
lower tier of the mid-range market are tightly integrated to minimize cost and
support requirements. Vista provides VB Forms, a powerful form design tool that
supports user-definable screen generation. Vantage is written in the Progress
4GL and database, which provides a powerful, graphical development tool set. To
serve the mid-tier, DataWorks' Avante tools is an object based development tool
utilizing a graphical development environment. Through Avante tools, DataWorks
is able to support products across multiple operating systems from a single
object code library. The Impresa for Backoffice system is being designed for the
upper tier to support Powersoft's Powerbuilder 5.0 and Optima enterprise
development suite as the foundation of the Company's client/server
infrastructure ("CSI") development tool product. CSI's "object libraries" are
designed to support the complex development and deployment requirements of a
global enterprise, and are intended to ensure a consistent look and feel to all
functions of the Impresa for Backoffice system.

RDBMS

     DataWorks' products are designed to run on databases that are best suited
for the particular applications required by customers, including Microsoft
Foxpro and SQL Server, Progress, UniData, VMark uniVerse, Oracle and Sybase.
SQL, ODBC and sophisticated file transfer capabilities provide immediate access
to foreign databases and other host applications. DataWorks has chosen these
relational databases in order to maximize the throughput of its customers'
transactions, to provide realistic models of business data and to maximize price
and performance under the budget constraints of its customers in each tier of
the mid-range market.

SMARTLINKS

     DataWorks' SmartLinks interface to third party applications provides a
standard parameterized interface mechanism between the Avante product and
associated data and modules within selected third party applications. Links have
been established to a broad range of third party applications, such as Microsoft
Office and Autodesk AutoCad, for computer aided design, scanned images, database
graphics, word processing,

                                       10
<PAGE>   12

spreadsheets, multimedia, sales contact management, forecasting and project
planning. The Company plans to expand the SmartLinks capabilities to its other
products.

DEPLOYMENT TOOLS

     DataWorks' SmartTools data conversion system is a means for new customers,
implementation consultants or existing customers to convert data from either
legacy systems or third party applications, and process that data through the
business rules of the Company's ERP systems. SmartTools can greatly shorten the
time needed to build conversion routines and significantly increases conversion
accuracy. SmartTools electronically takes conversion data from the legacy system
and simulates the data being entered through a keyboard or generated
programmatically by the DataWorks system.

THIRD PARTY PRODUCTS

DATABASES

     DataWorks separately licenses database products to its customers. Microsoft
Foxpro and Progress support the Vista and Vantage product lines, respectively,
and the UniData and VMark uniVerse databases support the Avante product. Impresa
for Backoffice has been designed as a database independent application, and
initially will support the Oracle, Sybase and Microsoft SQL Server databases.

CLIENT TOOLS

     The Company's products support PC-based GUIs that manage application
presentation, desktop tools and network communications, and facilitate the
client workstation. DataWorks incorporates client GUI and development tools such
as Microsoft Visual Foxpro, Progress, Borland Delphi and Sybase Powerbuilder.

HARDWARE

     As part of its turnkey solutions, at the request of a customer DataWorks
can provide complete third party computer hardware systems and related computer
peripherals. In such situations hardware is either shipped directly from the
third party vendor or DataWorks resells the products. The Company does not
typically carry hardware inventory in either case. DataWorks implements its ERP
systems on a number of hardware platforms, including Hewlett-Packard Company
("Hewlett-Packard"), IBM, Data General, Digital Equipment Corporation ("DEC")
and Intel Pentium and other x86-based systems. Configurations may be host-
based, server-oriented, or full client/server with highly networked solutions,
in which DataWorks may participate in providing network hardware solutions.
Additionally, DataWorks offers peripherals, factory data collection equipment
and communications equipment for resale to its customers.

NETWORKS

     DataWorks supports a wide variety of network communication protocols as
part of its turnkey product support. DataWorks has support agreements with
regional and national communications suppliers and network suppliers to
facilitate the design and implementation of these environments.

SERVICE AND SUPPORT

     DataWorks offers a full complement of services that allow its customers to
maximize the benefits of DataWorks' software products, including project
management, consulting, implementation, education and multi-media training,
professional programming, system integration and support, video conferencing,
maintenance and customer service. DataWorks' services are not typically included
in the price of its software. Maintenance support is billed annually in advance,
while implementation, consulting and programming services are billed monthly as
incurred.

                                       11
<PAGE>   13

IMPLEMENTATION SUPPORT PROGRAM

     DataWorks offers its customers an Implementation Support Program ("ISP")
with their initial system order or significant upgrade to an existing system
installation. ISP provides a variety of project management and consulting
services to assist in rapid implementation and deployment of DataWorks' business
solutions. Services offered include a variety of site-specific technical and
consulting services to assist in all phases of the implementation process.
DataWorks may also provide assistance in integrating its products with the
customer's other software, such as automated systems and devices for factory
automation and shop floor data collection. In addition, DataWorks offers "first
call" support that allows customers to call DataWorks with service inquiries. As
part of the implementation of its software, DataWorks employs a pilot program
that allows certain of its customers to simulate running their businesses with
the new software prior to full-scale "live" implementation of the new system.
The entire implementation process, and specifically the pilot programs, are
greatly aided by DataWorks' SmartTools product. Pilot program simulations for
more complex businesses are conducted in an integrated series of hands-on
classroom exercises that emphasize system controls and procedures, using a
database generated by SmartTools that accurately represents the customer's
business. By simulating a number of relevant business scenarios, the pilot
program gives key users valuable experience with DataWorks' software, generates
involvement in and commitment to the new system and provides a means to track
the progress of the implementation of the system before actual full-scale use.

CUSTOMER SUPPORT PROGRAM

     DataWorks offers its customers a Comprehensive Support Program ("CSP"). The
cost of CSP is based on a percentage of list price of the DataWorks software
purchased and is generally billed annually in advance. Through CSP, DataWorks
provides product enhancements and updates that maintain the customers' software
and documentation to the then-current standard release level licensed and
supported by DataWorks. CSP also includes hotline telephone support during
extended business hours for questions regarding software use. This support is
available to customers up to 24 hours per day, seven days per week, as a
separately priced option.

EDUCATION AND TRAINING

     DataWorks offers education and training services that provide customers
with a formalized program to ensure that applications are implemented and
utilized in an efficient and cost-effective manner. Customers are also offered a
variety of software installation, technical support and user training services,
both on-site and in DataWorks' regional training centers. Customized education
and training programs are also available to meet customers' specific development
needs.

PROFESSIONAL CONSULTING SERVICES

     DataWorks provides an array of on-site and classroom implementation and
training services that are tailored to the complexity of each of the Company's
ERP systems. Each new customer site is assigned an Account Manager who
coordinates DataWorks' activities with the customer. These activities include
project management, hardware/software installation scheduling, classroom
education scheduling, on-site training, conversion planning and pilot simulation
supervision. Windows-based project management software maintains a detailed
project plan, resource list, and schedule of events for each phase of the
implementation. Designed to meet the return on investment objectives of the
customer, the project plan is the customer's key feedback and monitoring
mechanism for managing the success of the implementation. The Account Manager
and an assigned team are responsible for guiding the new customer from initial
installation through successful operation of the system in a live environment.
The Account Manager is also the initial point of contact to introduce other
DataWorks resources to the customer. The implementation of Vista typically only
requires such services on a limited basis.

PROFESSIONAL PROGRAMMING SERVICES

     DataWorks provides professional programming services, including custom
applications analysis, design, development, training and deployment for most of
its ERP solutions. Custom software projects may range

                                       12
<PAGE>   14

from simple report development to designing and programming complete
applications and integrating legacy systems. Throughout the project, software
and design reviews are provided to the customer as defined in the project
specification. Upon project completion, custom software is delivered under
revision control to a test database where compliance testing is conducted by the
customer. The revision control tools within Avante allow testing, deployment and
management of new enhancements without affecting current software releases. All
software enhancements of Avante, regardless of scope, are created using the
Object Preview development environment and conform to DataWorks' published
guidelines for standards and conventions.

PRODUCT DEVELOPMENT

     DataWorks' product development efforts are focused on enhancement of its
existing products and introduction of its Impresa for Backoffice system. At
December 31, 1997, DataWorks had approximately 180 full-time employees in
product development. Research and development expenses are comprised primarily
of salaries and a portion of DataWorks' overhead for its in-house staff and
amounts paid to outside consultants, as appropriate, to supplement the product
development efforts of its in-house staff. Research and development expenses are
charged to operations as incurred. Gross research and development expenditures
totaled approximately $14.3 million in 1997 and $11.4 million in 1996. Gross
research and development expenditures in such periods included amounts for
capitalized software totaling $3.8 million and $2.5 million, respectively.

     DataWorks plans to continue to enhance its Vista, Vantage, and Avante
application products and to develop its Impresa for Backoffice system to suit
the evolving needs of the manufacturing market served by DataWorks. In
particular, DataWorks intends to pursue improved functionality on existing
application modules and the creation of new modules. In addition to applications
development, DataWorks will seek to improve its object-oriented development
environment, with two fundamental objectives: continued user empowerment with
emphasis on ease-of-use, and increased flexibility to make changes to the base
products to suit specific customer requirements. Internet/Intranet enabled
applications will continue to be a focus of development throughout the entire
product line. The DataWorks Open Integration Environment will expand traditional
supply chain EDI communication protocols with Object EDI and encapsulated
"business objects." DataWorks expects to continue to enhance the capabilities of
its MES and factory data collection applications to address the increasing focus
on real time, wireless data collection and acquisition. The Company also expects
to enhance its strategic planning and decision support capabilities through
offerings in the area of third party report writers, data warehousing and data
mining products. DataWorks plans to continue to expand its API and object
frameworks across all products thereby enhancing each systems ability to access
the global supply chain.

SALES AND MARKETING

DOMESTIC

     The Company sells its products in the United States primarily through a
direct sales force. As of December 31, 1997, the Company had 175 full-time and
48 part-time employees in its domestic sales organization, including sales
representatives, pre-sale consultants, telemarketers and sales management
personnel.

     The key components of DataWorks' domestic sales strategy include
sophisticated prospect development and sales cycle management processes.
DataWorks uses a combination of electronic prospective client databases,
computer aided telemarketing and field sales methodologies to identify potential
candidates for its ERP systems from within its targeted markets who are in the
early stages of searching for a new business management system. This process
accounts for a large percentage of the Company's new accounts and lessens the
need for the sales force to engage in territory prospecting activities of its
own. Prospective DataWorks customers are monitored through a comprehensive
prospect management system that breaks the sales cycle into several phases, each
with multiple measurement points, to properly assess the prospective client
base.

     The Company's domestic sales strategy also emphasizes a "regionalization"
concept. DataWorks believes a strong local presence is an important factor in
addressing the needs of mid-range manufacturers and establishing mutually
beneficial long-term relationships. Under the Company's regionalization
approach, the

                                       13
<PAGE>   15

Company has decentralized much of its client development activity, customer
services and customer account responsibilities. DataWorks has regional centers
in Irvine, California; San Jose, California; Chicago, Illinois; Boston,
Massachusetts; Dallas, Texas; Philadelphia, Pennsylvania; and Atlanta, Georgia.
In addition, DataWorks has local offices in 10 other locations across the United
States. DataWorks intends to open two additional full-service regional centers
by late 1998.

INTERNATIONAL

     DataWorks currently addresses the international market with direct sales
efforts through its wholly-owned subsidiaries in the United Kingdom and France
and through product-specific distributor agreements in Germany, Australia and
Canada. To date, the Company has not generated a material amount of revenue
through these distributor agreements. DataWorks plans to increase its
international sales efforts through expanded direct sales and additional
distribution arrangements, each to be supported by the Company's domestically
developed prospect development and sales cycle management processes.

COMPETITION

     The business information systems industry is intensely competitive, rapidly
changing and significantly affected by new product offerings and other market
activities. A number of companies offer products similar to the Company's
products, which are directed at the market for ERP systems. Many of the
Company's existing competitors, as well as a number of potential competitors,
have more established and larger marketing and sales organizations,
significantly greater financial and technical resources and a larger installed
base of customers than the Company. In addition, customers who have a large
installed base of legacy systems may resist committing the time and resources
necessary to convert to an open systems, client/server-based software product.
The Company has no significant proprietary barriers to entry which would limit
competitors from developing similar products or selling competing products in
the Company's markets. Accordingly, there can be no assurance that such
competitors will not offer or develop products that are superior to the
Company's products or that achieve greater market acceptance.

     In addition, suppliers of RDBMS or companies that develop management
information software applications for large multinational manufacturers are
beginning to market to the upper tier of the mid-range market targeted by the
Company or otherwise develop applications that compete effectively in the
Company's markets. Furthermore, the Company intends to expand its marketing and
product development efforts toward the upper end of its target market, which
could result in increased competition. As a result, competition (including price
competition) is likely to increase substantially, which may result in price
reductions and loss of market share. In addition, potential customers may
increasingly demand that ERP systems incorporate certain popular RDBMS software
not currently integrated into certain of DataWorks' product offerings that are
offered by its competitors. As the client/server computing market expands, a
large number of companies, some with significantly greater resources than the
Company, may enter the market or increase their market share by acquiring or
entering into alliances with competitors of the Company. There can be no
assurance that the Company will be able to compete successfully against its
competitors or that the competitive pressures faced by the Company will not
adversely affect its financial performance.

     The Company has a large number of competitors that vary in size, primary
computer platforms and overall product scope. Within its market, the primary
competition comes from independent software vendors in four distinct groups
including (i) large multinational system developers in the upper tier of the
Company's mid-range market, including Baan Company, Oracle and QAD, Inc., (ii)
companies offering high levels of functionality on the AS/400 platform such as
System Software Associates, Inc. and J.D. Edwards Company, (iii) traditional
mid-range market sector firms such as ROI Systems, Inc. and Symic Systems, Inc.,
and (iv) lower priced PC network-based offerings from companies such as Fourth
Shift Corporation, Lilly Software Associates and Macola Software, Inc. There is
also a large number of regional manufacturing software suppliers who leverage as
competitive advantages their concentrated local support, reputation and,
typically, lower price.

                                       14
<PAGE>   16

     The Company's principal market is highly fragmented and consists of a few
large multinational suppliers and a much larger number of small, regional
competitors. The Company believes that its industry will experience
consolidation as business information systems become more complex and as more
manufacturers adopt sophisticated business information systems, forcing smaller
companies in the industry to specialize or merge with their competitors. In
order to compete effectively in the broad markets which the Company presently
targets, the Company will need to continue to grow and attain sufficient size to
ensure that it can develop new products on a timely basis in response to
evolving technology and new customer demands and can sell such products to a
variety of manufacturing industries worldwide. No assurance can be given that
the Company will be able to grow sufficiently to enable it to compete
effectively.

     The Company believes its use of open systems technologies is an important
competitive factor. The Company also believes that the number of competitors
offering open systems solutions will grow significantly over the next several
years. Additionally, the Company believes that the typical mid-range customer
desires an easy-to-use, highly functional 4GL environment, fully integrated
throughout the ERP system, which the Company has provided through its internally
produced development tool set. The Company anticipates that a significant source
of future competition may be from larger manufacturing software companies that
may tailor their products for the mid-range market. Only a few of the larger and
better capitalized software systems companies currently compete in the Company's
targeted market. There can be no assurance that such companies will not develop
products that are superior to the Company's products or that achieve greater
market acceptance.

     The principal elements affecting the buying decision of customers in the
mid-range sector are comprehensive application functionality that addresses a
wide range of business areas, rapid system deployment, ease-of-use, strong
performance, quality of customer support, a fully integrated application set
supported by a user-oriented 4GL development environment that allows for easy
modification to applications where needed, price and customer references. It is
also mandatory that the ERP system be enhanced on a regular basis throughout the
license or maintenance term and that such product enhancements be properly
supported by necessary revision control software provided by the vendor. In
order to be successful in the future, the Company must respond effectively to
customer needs and properly select and incorporate those technologies and
application functionalities that will meet the challenges posed by competitors'
innovations. To accomplish this critical objective, the Company must continue to
invest in enhancing its current products and, when necessary, introduce new
products to remain competitive. There can be no assurance that the Company will
be able to continue to invest in such enhancements or new products, or introduce
such enhancements or new products in a timely fashion or at all.

INTELLECTUAL PROPERTY

     DataWorks regards its products as proprietary trade secrets and
confidential information. DataWorks relies on a combination of copyright,
trademark and trade secret laws, employee and third party nondisclosure
agreements and other industry standard methods for protecting ownership of its
proprietary software. There can be no assurance, however, that, in spite of
these precautions, an unauthorized third party will not copy or reverse-engineer
certain portions of DataWorks' products or obtain and use information that
DataWorks regards as proprietary. In addition, the laws of some foreign
countries do not protect DataWorks' proprietary rights to the same extent as do
the laws of the United States. There can be no assurance that the mechanisms
used by DataWorks to protect its software will be adequate or that DataWorks'
competitors will not independently develop software products that are
substantially equivalent or superior to DataWorks' software products.

     DataWorks licenses products to end users under license agreements which are
generally in standard form, although each license is individually negotiated and
may contain variations. The standard form agreement allows the end user to use
the products solely on the end user's computer equipment for the end user's
internal purposes, and the end user is generally not permitted to sublicense or
transfer the products. DataWorks licenses the source code for its application
software to its customers to enable them to customize the software to meet
particular requirements. DataWorks' standard form agreement includes a
confidentiality clause protecting the products. In the event of termination of
the license agreement, the end user remains responsible

                                       15
<PAGE>   17

for any accrued and unpaid license fees and confidentiality obligations.
However, there can be no assurance that such customers will take adequate
precautions to protect DataWorks' source code or other confidential information.

     DataWorks' has one software patent application pending, but there can be no
assurances that a patent will be issued or that, if a patent is issued, it will
provide the Company with competitive advantages or will not be challenged by
others. DataWorks believes that it has all necessary rights to market its
products, although there can be no assurance that third parties will not assert
infringement claims in the future. DataWorks may receive notices from third
parties claiming that DataWorks' products infringe third party proprietary
rights. DataWorks expects that, as the number of software products in the
industry increases and the functionality of these products further overlaps,
software products will increasingly be subject to such claims. Any such claim,
with or without merit, could result in costly litigation and require DataWorks
to enter into royalty or license arrangements. Such royalty or license
arrangements, if required, may not be available on terms acceptable to DataWorks
or at all.

     DataWorks believes that, due to the rapid pace of innovation within the
computer industry, factors such as technological and creative skill of
personnel, knowledge and experience of management, name recognition, maintenance
and support of software products, the ability to develop, enhance, market and
acquire software products and services, and strategic relationships in the
industry are more important in establishing and maintaining a leading position
within the industry than are patent, copyright and other legal protections for
intellectual property.

EMPLOYEES

     At December 31, 1997, DataWorks had 1,003 full-time employees, including
235 in sales and marketing, 179 in product development, 490 in support services
and 99 in finance and administration. DataWorks also has 67 part-time employees,
primarily in the telemarketing area. DataWorks' employees are not represented by
any collective bargaining organization, and DataWorks has never experienced a
work stoppage. DataWorks believes that its relations with its employees are
good. The loss of certain key employees or DataWorks' inability to attract and
retain other qualified employees could have a material adverse effect on
DataWorks' business and operations.

                               EXECUTIVE OFFICERS

     The executive officers of DataWorks and their ages as of March 2, 1998 are
as follows:

<TABLE>
<CAPTION>
NAME                       AGE                         POSITION
----                       ---                         --------
<S>                        <C>    <C>
Stuart W. Clifton........  53     Chairman of the Board, President and Chief
                                  Executive Officer
Norman R. Farquhar.......  51     Executive Vice President, Chief Financial Officer
                                  and Director
Robert C. Vernon.........  53     President, International and Director
Mark Hellinger...........  38     President, ERP Systems Group
Rick E. Russo............  46     Vice President, Finance and Secretary
</TABLE>

     Stuart W. Clifton has served as President, Chief Executive Officer and as
Chairman of the Board of Directors since January 1987, when he acquired control
of the Company. Between 1971 and 1987, Mr. Clifton held various management
positions at Triad Systems Corporation, a vertical distribution software
company, in which he was involved from its inception, most recently as Executive
Vice President and General Manager.

     Norman R. Farquhar has served as Executive Vice President and Chief
Financial Officer of the Company since February 1996 and as a director of the
Company since August 1995. From April 1993 to December 1995, Mr. Farquhar served
as Senior Vice President, Chief Financial Officer and Secretary of Wonderware
Corporation, a manufacturer of software for the industrial automation industry.
From December 1991 to April 1993, he was Vice President of Finance and Chief
Financial Officer of MTI Technology Corporation, a developer of system-managed
storage solutions.

                                       16
<PAGE>   18

     Robert C. Vernon has served as President, International Operations of the
Company since September 1997. Prior to joining the Company, Mr. Vernon had been
employed by Interactive since 1975, where he served as Chief Executive Officer
and a director of Interactive from 1978 to September 1997 and Chairman of the
Board of Directors from 1979 to September 1997. From 1978 to 1996, Mr. Vernon
also served as President of Interactive. From 1973 to 1975, Mr. Vernon served as
Director, Software Development for SDA Digital, a software developer for the
security industry, and, from 1971 to 1973, as a Project Manager for Computer
Sciences Corporation, a software developer and integrator.

     Mark Hellinger has served as President, ERP Systems Group of the Company
since September 1997. Prior to joining the Company, Mr. Hellinger had been
employed by Interactive since 1985, where he served as President and Chief
Operating Officer from 1996 to September 1997, Vice President and General
Manager from 1994 to 1996, and as a director from October 1992 to September
1997. From 1990 to 1994, Mr. Hellinger served as Vice President, Operations of
Interactive. From 1985 to 1990, Mr. Hellinger served as branch manager of
Interactive's New York office.

     Rick E. Russo has served as Vice President, Finance since July 1994 and as
Secretary since April 1995. From February 1992 to July 1994, Mr. Russo served as
Chief Financial Officer of MCC. Prior to joining the Company, Mr. Russo served
from 1985 to 1991 as Vice President of Finance for Media Duplication Services
Ltd., a subsidiary of Polaroid Corporation which provided software manufacturing
services. Mr. Russo is a Certified Public Accountant.

             CERTAIN RISK FACTORS RELATED TO THE COMPANY'S BUSINESS

     In addition to those risks identified elsewhere in this Annual Report on
Form 10-K, the Company's business and results of operations are subject to other
risks, including the following risk factors:

     Fluctuations in Quarterly Operating Results.  The Company has experienced
significant fluctuations in its revenues and operating results from quarter to
quarter and anticipates that it will continue to experience such quarterly
fluctuations. The Company's revenues and operating results have generally been
higher in the fourth quarter than in any preceding quarter of the year. The
Company believes that fourth quarter revenues are positively impacted by
year-end capital purchases by most customers, as well as by the Company's sales
compensation plans. Seasonal factors, which the Company believes are common in
the computer software industry, are likely to increase as the Company focuses on
larger corporate accounts. As a result of these seasonal factors, first quarter
revenues in any year are typically lower than revenues in the immediately
preceding fourth quarter. In addition, the Company's revenues occur
predominantly in the third month of each quarter and tend to be concentrated in
the latter half of that third month. Accordingly, the Company's quarterly
results of operations are difficult to predict, and delays in product delivery
or in closings of sales near the end of a quarter could cause quarterly revenues
and, to a greater degree, net income to fall substantially short of anticipated
levels. Factors that may contribute to such fluctuations in addition to seasonal
factors include: the number of new orders and product shipments; the size and
timing of individual orders; the timing of shipment of hardware or database
software by third party vendors necessary in order for the Company to recognize
revenues; the timing of introduction of products or product enhancements by the
Company, the Company's competitors or other providers of hardware, software and
components for the Company's market; competition and pricing in the software
industry; market acceptance of new products; reduction in demand for existing
products and shortening of product life cycles as a result of new product
introductions by competitors; product quality problems; customer order deferrals
in anticipation of new products; changes in customer budgets; changes in Company
strategy; changes in Company operating expenses; personnel changes; fluctuations
in foreign currency exchange rates; changes in the mix of products sold;
conditions or events in the manufacturing industry; and general economic
conditions. In addition, the achievement of anticipated revenues is
substantially dependent on the ability of the Company to attract, on a timely
basis, and retain skilled personnel, especially sales, service and
implementation personnel. As a result of these factors, revenues for any quarter
are subject to significant variation, and the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as

                                       17
<PAGE>   19

indications of future performance. Fluctuations in operating results may also
result in volatility in the price of the Company's Common Stock.

     Lengthy Sales Cycle.  The Company's sales figures for Avante, the Company's
principal product, generally reflect a relatively high amount of revenues per
order. The loss or delay of individual orders for this product, therefore, could
have a more significant impact on the revenues and quarterly results of the
Company than on those of companies with higher sales volumes and lower revenues
per order. The Company's software products generally are shipped as orders are
received, and revenues are recognized upon delivery of the products, provided no
significant vendor obligations exist and collection of the related receivable is
deemed probable. As a result, software license revenues in any quarter are
substantially dependent on orders booked and shipped in that quarter. The timing
of license revenues derived from sales of the Company's Avante product is
difficult to predict because of the length of the sales cycle for this product,
which is typically three to nine months from the initial contact. Because the
Company's operating expenses are based on anticipated revenue trends and because
a high percentage of the Company's expenses are relatively fixed, a delay in the
recognition of revenue from a limited number of license transactions could cause
significant variations in operating results from quarter to quarter and could
result in losses. To the extent such expenses are not offset by increased
revenues, the Company's operating results would be materially adversely
affected.

     Competition.  The business information systems industry is intensely
competitive, rapidly changing and significantly affected by new product
offerings and other market activities. A number of companies offer products
similar to the Company's products, which are directed at the market for ERP
systems. Many of the Company's existing competitors, as well as a number of
potential competitors, have more established and larger marketing and sales
organizations, significantly greater financial and technical resources and a
larger installed base of customers than the Company. In addition, potential
customers that have a large installed base of legacy systems may resist
committing the time and resources necessary to convert to an open systems-based
client/server software product. The Company has no proprietary barriers to entry
which would limit competitors from developing similar products or selling
competing products in the Company's markets. Accordingly, there can be no
assurance that such competitors will not offer or develop products that are
superior to the Company's products or that achieve greater market acceptance. In
addition, suppliers of RDBMS or companies that develop management information
software applications for large multinational manufacturers are beginning to
market to the upper tier of the mid-range market targeted by the Company or
otherwise develop applications that compete effectively in the Company's
markets. Furthermore, the Company intends to focus its marketing and product
development efforts increasingly toward the upper end of its target market,
which could result in increased competition. As a result, competition (including
price competition) is likely to increase substantially, which may result in
price reductions and loss of market share. In addition, potential customers may
increasingly demand that ERP systems incorporate certain popular RDBMS software
not currently integrated into certain of DataWorks' product offerings that are
offered by its competitors. As the client/server computing market expands, a
large number of companies, some with significantly greater resources than the
Company, may enter the market or increase their market share by acquiring or
entering into alliances with competitors of the Company. There can be no
assurance that the Company will be able to compete successfully against its
competitors or that the competitive pressures faced by the Company will not
adversely affect its financial performance.

     The Company sells its products and services in a highly fragmented market
and its competitors consist of a few large multi-national suppliers and a much
larger number of small regional competitors. The Company believes that its
industry will experience consolidation as business information systems become
more complex and as more manufacturers adopt sophisticated business information
systems, forcing smaller companies in the industry to specialize or merge with
their competitors. In order to compete effectively in the broad markets which
the Company presently targets, the Company will need to continue to grow and
attain sufficient size to ensure that it can develop new products on a timely
basis in response to evolving technology and new customer demands and can sell
such products to a variety of manufacturing industries worldwide. No assurance
can be given that the Company will be able to grow sufficiently to enable it to
compete effectively. The Company anticipates that a significant source of future
competition may be from larger manufacturing software companies that may tailor
their products for the mid-range market. Only a few of the larger and better

                                       18
<PAGE>   20

capitalized software systems companies currently compete in the Company's
targeted market. There can be no assurance that such companies will not develop
products that are superior to the Company's products or that achieve greater
market acceptance.

     Ability to Recruit Sales, Service and Implementation Personnel.  The
ability to achieve anticipated revenues is substantially dependent on the
ability of the Company to attract on a timely basis and retain skilled
personnel, especially sales, service and implementation personnel. In addition,
the Company believes that its future success will depend in large part on its
ability to attract and retain highly skilled technical, managerial, marketing
and professional services personnel to ensure the quality of products and
services provided to its customers. Competition for such personnel, in
particular for product development, sales and implementation personnel, is
intense, and the Company competes in the market for such personnel against
numerous companies, including larger, more established companies with
significantly greater financial resources than the Company. There can be no
assurance that the Company will be successful in attracting and retaining
skilled personnel. The Company's inability to attract and retain qualified
employees could have a material adverse effect on the Company's business and
operations.

     Introduction of Impresa for Backoffice System.  The Company currently
anticipates commencing customer shipments of its Impresa for Backoffice system
in late 1998. Historically, however, the Company has not commenced shipment of
its Impresa for Backoffice product at the anticipated time and there can be no
assurance that the Company will commence such shipments in 1998, or at all.
Furthermore, the Company has limited experience in selling products to customers
in the upper tier of the mid-range manufacturing market and anticipates that
selling products to such customers will result in a longer sales cycle and will
require a different strategy than that employed by the Company in selling
products to customers in the mid-tier market. For example, as part of its upper
tier marketing strategy, the Company is exploring potential relationships with
third party integrators to facilitate implementation of the Impresa for
Backoffice system. There can be no assurance that any such relationships will be
formed or, if formed, will prove beneficial to the Company. Accordingly, even if
customer shipments of the Impresa for Backoffice system are timely commenced,
there can be no assurance that the Company will be successful in effectively
marketing the Impresa for Backoffice system or that the Impresa for Backoffice
system will achieve market acceptance.

     Integration of DataWorks and Interactive Operations.  The Company acquired
Interactive in September 1997. The process of rationalizing management services,
administrative organizations, facilities, management information systems and
other aspects of operations, while managing a larger and geographically expanded
entity, presents a significant challenge to the management of DataWorks. There
can be no assurance that the integration process will be successful or that the
anticipated benefits of the business combination will be fully realized. The
dedication of management resources to such integration may detract attention
from the day-to-day business of the Company. The difficulties of integration may
be increased by the necessity of coordinating geographically separated
organizations, integrating personnel with disparate business backgrounds and
combining different corporate cultures. Integrating the two companies has caused
the Company to incur certain additional expenses, and there can be no assurance
that there will not continue to be substantial costs associated with the
integration process, that such activities will not result in a decrease in
revenues or that there will not be other material adverse effects of these
integration efforts. Such effects could materially reduce the earnings of the
Company. The Company incurred acquisition and related costs totaling $15.6
million in the third quarter of 1997. There can be no assurance that DataWorks
will not incur additional charges in future quarters to reflect costs associated
with the acquisition.

     Management of Growth.  The Company's business has grown rapidly, both
internally and through acquisitions, with total revenues increasing to $147.0
million for the year ended December 31, 1997 from $116.9 million for the year
ended December 31, 1996. There can be no assurance that the Company will be able
to manage its recent growth and assimilate its new employees and products
successfully. To manage its growth effectively, the Company will be required to
expand, train and manage its employee base, enhance its operating and financial
systems, and effectively expand its product line. If the Company continues to
grow, there can be no assurance that the management skills and systems currently
in place will be adequate or that the Company will be able to manage any
additional growth effectively.

                                       19
<PAGE>   21

     Dependence on Key Employees.  The Company's continued success depends to a
significant extent upon its ability to retain certain key employees, including
Stuart W. Clifton, Norman R. Farquhar, Robert C. Vernon and Mark Hellinger. The
loss of certain key employees or the Company's inability to attract and retain
other qualified employees could have a material adverse effect on the Company's
business and operations.

     Rapid Technological Change and New Products.  The market for the Company's
software products is characterized by rapid technological advances, evolving
industry standards, changes in end-user requirements and frequent new product
introductions and enhancements. The introduction of products embodying new
technologies, such as the planned introduction of the Impresa for Backoffice
system, and the emergence of new industry standards, could render the Company's
existing products and products currently under development obsolete and
unmarketable. Accordingly, the Company's future success will depend upon its
ability to enhance its current products and develop and introduce new products
that keep pace with technological developments, satisfy varying end-user
requirements and achieve market acceptance. Any failure by the Company to
anticipate or respond adequately to technological developments or end-user
requirements, or any significant delays in product development or introduction,
could damage the Company's competitive position and have an adverse effect on
revenues. There can be no assurance that the Company will be successful in
developing and marketing new products, including the Impresa for Backoffice
system, or product enhancements on a timely basis or that the Company will not
experience significant delays in the future, which could have a material adverse
effect on the Company's business and operations. In addition, there can be no
assurance that new products or product enhancements developed by the Company
will achieve market acceptance. The Company may need to increase the size of its
product development staff in the near term to meet these challenges. There can
be no assurance that the Company will be successful in hiring and training an
adequate number of qualified product development personnel to meet its needs.

     Software programs as complex as those offered by the Company may contain
undetected errors or "bugs" when first introduced or as new versions are
released that, despite testing by the Company, are discovered only after a
product has been installed and used by customers. There can be no assurance that
errors will not be found in future releases of the Company's software, or that
any such errors will not impair the market acceptance of these products and
adversely affect operating results. Problems encountered by customers installing
and implementing new releases or with the performance of the Company's products
could have a material adverse effect on the Company's business and operations.

     Dependence on Manufacturing Industry.  The Company's business depends
substantially upon the capital expenditures of mid-range discrete manufacturers,
which in part depend upon the demand for such manufacturers' products. A
recession or other adverse events affecting the manufacturing industry in the
United States or other markets served by the Company could affect such demand,
forcing manufacturers in the Company's target markets to curtail or postpone
capital expenditures on business information systems. Any such change in the
amount or timing of capital expenditures in its target markets could have a
material adverse effect on the Company's business and operations.

     Dependence on Principal Products.  Substantially all of the Company's
revenue is derived from the sale of manufacturing information systems and
related support services. Accordingly, any event that adversely affects fees
derived from sale of such systems, such as competition from other products,
significant flaws in the Company's software products or incompatibility with
third party hardware or software products, negative publicity or evaluation, or
obsolescence of the hardware platforms or software environments in which the
systems run, would have a material adverse effect on the Company's results of
operations. The Company's future financial performance will depend, in
substantial part, on the continued development and introduction of new and
enhanced versions of the Avante product and customer acceptance of such new and
enhanced products.

     Dependence on Third Party Software and Hardware.  Most of the Company's
products incorporate and use software products and computer hardware and
equipment developed by other entities. The relational database management
systems currently used in the Company's products are those which the Company
believes are best suited for the particular applications required by the
mid-range discrete manufacturers. These RDBMS have been developed by Ardent
Software, Inc. (formerly Unidata and VMark), Progress and

                                       20
<PAGE>   22

Microsoft. The operating systems on which the Company's products can function
(UNIX, SCO-UNIX, UnixWare, VMS and Microsoft NT) have been developed or are
owned by Novell Corporation ("Novell"), DEC and Microsoft. The computer hardware
and related equipment sold as part of the Company's turnkey systems are
manufactured by Hewlett-Packard, IBM, DEC and others. There can be no assurance
that all of these entities will remain in business, that such entities will
continue to support these product lines, that their product lines will remain
viable or that these products will otherwise continue to be available to the
Company or available on terms satisfactory to the Company. If any of these
entities ceases to do business or abandons or fails to enhance a particular
product line, the Company may need to seek other suppliers. This could have a
material adverse effect on the Company's business and operations. In addition,
there can be no assurance that the Company's current suppliers will not
significantly alter their pricing in a manner adverse to the Company.

     International Operations and Currency Fluctuations.  The Company derived
approximately 17% of its revenues from operations outside North America in 1997
and 1996. The international business is subject to various risks common to
international activities, including exposure to currency fluctuations, political
and economic instability, the greater difficulty of administering business
abroad, and the need to comply with a wide variety of foreign import and United
States export laws and regulatory requirements. The Company does not currently
engage in foreign currency hedging transactions.

     Intellectual Property and Proprietary Rights.  The Company relies on a
combination of copyright, trademark and trade secret laws, employee and
third-party nondisclosure agreements and other industry standard methods for
protecting ownership of its proprietary software. There can be no assurance,
however, that, in spite of these precautions, an unauthorized third party will
not copy or reverse-engineer certain portions of the Company's products or
obtain and use information that the Company regards as proprietary. The Company
provides the source code for its application software under licenses to its
customers to enable them to customize the software to meet particular
requirements. Although the Company's source code license contains
confidentiality and nondisclosure provisions, there can be no assurance that
such customers will take adequate precautions to protect the Company's source
code or other confidential information. In addition, the laws of some foreign
countries do not protect the Company's proprietary rights to the same extent as
do the laws of the United States. There can be no assurance that the mechanisms
used by the Company to protect its software will be adequate or that the
Company's competitors will not independently develop software products that are
substantially equivalent or superior to the Company's software products.

     The Company has and may from time to time receive notices from third
parties claiming that the Company's products infringe upon third party
proprietary rights. The Company expects that, as the number of software products
in the industry increases and the functionality of these products further
overlaps, software products will increasingly be subject to such claims. Any
such claim, with or without merit, could result in costly litigation and require
the Company to enter into royalty or licensing arrangements. Such royalty or
license arrangements, if required, may not be available on terms acceptable to
the Company or at all.

     Product Liability.  Because the Company markets and sells its software
products on a turnkey basis, which includes rendering professional consulting
services, the Company incurs significant risks of professional and other
liability. No assurance can be given that the limitations of liability set forth
in the Company's license agreements or other contracts would be enforceable or
would otherwise protect the Company from liability for damages to a customer
resulting from a defect in one of the Company's products or arising as a result
of professional services rendered by the Company. Such a claim, if successful
and of sufficient magnitude, could have a material adverse effect on the
Company's business and operations.

     Year 2000 Compliance.  Significant uncertainty exists in the software
industry concerning the potential effects from the Year 2000 issue associated
with the date codes used in computer software and hardware systems. The Company
believes that all of its existing products are Year 2000 compliant and new
products are being designed to be Year 2000 compliant. Although products have
undergone the Company's normal quality testing procedures, there can be no
assurance that the Company's software products contain all necessary date code
changes. Any failure of the Company's products to perform, including system
malfunctions due to the onset of the calendar year 2000, could have a material
adverse effect on the Company's business, financial condition and results of
operations.

                                       21
<PAGE>   23

     The Company is also currently in the process of evaluating its information
technology infrastructure for Year 2000 compliance, including reviewing what
actions are required to make all software systems used internally Year 2000
compliant as well as actions needed to mitigate vulnerability to problems with
suppliers and other third parties' systems. The Company is assessing the extent
of the necessary modifications to its computer software, and management does not
anticipate that the Company will incur significant operating expenses or be
required to invest heavily in computer system improvements to be Year 2000
compliant. There can be no assurance that such measures will alleviate the Year
2000 problems which could have a material adverse effect upon the Company's
business, operating results and financial condition.

     Influence of Existing Shareholders.  As of March 2, 1998, the Company's
executive officers, directors and their affiliates beneficially owned
approximately 21% of the Company's outstanding shares of Common Stock. As a
result, these shareholders, if acting together, would be able to influence
matters requiring approval by the shareholders of the Company, including the
election of a majority of the directors. The voting power of these shareholders
under certain circumstances could have the effect of delaying or preventing a
change in control of the Company. The Company has entered into agreements with
its executive officers and directors indemnifying them against losses they may
incur in legal proceedings arising from their service to the Company.

     Possible Volatility of Stock Price.  The market price of the Company's
Common Stock has fluctuated since its initial public offering in October 1995.
The price of the Company's stock may be subject to significant fluctuations in
the future in response to variations in quarterly operating results of the
Company, announcements of new products by the Company or by its competitors, and
general trends in the software industry, as well as fluctuations in the stock
market that are unrelated to the operating performance of particular companies.
Also, the Company's revenues or operating results in future quarters may be
below the expectations of public market securities analysts and investors, which
could cause the price of the Company's stock to decline, perhaps substantially.
Such stock price and market fluctuations could adversely affect the Company.

     Effect of Certain Charter Provisions.  The Company's Board of Directors has
the authority to issue up to 5,000,000 shares of Preferred Stock and to
determine the price, rights, preferences and privileges of those shares without
any further vote or action by the shareholders. The rights of the holders of
Common Stock will be subject to, and may be adversely affected by, the rights of
the holders of any Preferred Stock that may be issued in the future. The
issuance of Preferred Stock, while providing flexibility in connection with
possible acquisitions and other corporate purposes, could have the effect of
making it more difficult for a third party to acquire a majority of the
outstanding voting stock of the Company. The Company has no present plan to
issue any shares of Preferred Stock.

                                       22
<PAGE>   24

ITEM 2.  PROPERTIES

     The Company leases the majority of its facilities in or near the following
cities:

<TABLE>
<CAPTION>
                                       APPROXIMATE          LEASE
              LOCATION                 SQUARE FEET     EXPIRATION DATE     PRINCIPAL ACTIVITIES
              --------                 ------------    ---------------     --------------------
<S>                                    <C>             <C>                <C>
San Diego, CA........................     48,000         June 1999        Corporate HQ, Sales
                                                                          and Marketing
San Diego, CA........................     44,000        January 2000      Product Development
                                                                          and Customer Support
San Diego, CA........................     22,500       February 1998      Interactive's
                                                                          Corporate HQ
Irvine, CA...........................     25,000        August 2001       Sales, Marketing and
                                                                          Customer Support
Minneapolis, MN......................     30,000         April 2002       DCD Operations
Minneapolis, MN......................     12,000        January 2002      Impresa for MRO
                                                                          Operations (formerly
                                                                          JIT)
Boston, MA...........................     11,000       February 1999      Sales, Marketing and
                                                                          Customer Support
London, England......................     14,000       September 2004     Regional HQ, Sales,
                                                                          Marketing and Customer
                                                                          Support
Paris, France........................      5,000         July 1998        Sales, Marketing,
                                                                          Customer Support and
                                                                          Administration
</TABLE>

     DataWorks also has approximately 17,000 square feet of office space under
lease and rental agreements in various locations across the United States and
approximately 13,000 square feet of office space in the United Kingdom and
Europe in support of its regional activities with expiration dates ranging from
1998 through 2004.

     The Company believes that its facilities are adequate for its current needs
and that suitable additional or substitute space will be available as needed to
accommodate expansion of the Company's operations.

ITEM 3.  LEGAL PROCEEDINGS

     The Company is engaged in legal actions arising in the ordinary course of
its business and believes that the ultimate outcome of these actions will not
have a material adverse effect on its financial position or results of
operations.

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

     Not applicable.

                                       23
<PAGE>   25

                                    PART II

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

     The Common Stock of DataWorks has traded on the Nasdaq National Market
under the symbol "DWRX" since the Company's initial public offering in October
1995. The following table sets forth the high and low sales prices, as reported
on the Nasdaq National Market, for each of the quarters in the past two years.
Such quotations represent inter-dealer prices without retail markup, markdown or
commission and may not necessarily represent actual transactions.

<TABLE>
<CAPTION>
                                                               HIGH      LOW
                                                              ------    ------
<S>                                                           <C>       <C>
1997
  Fourth Quarter............................................  $20.00    $14.25
  Third Quarter.............................................   21.50     12.63
  Second Quarter............................................   22.38     13.63
  First Quarter.............................................   25.25     14.00

1996
  Fourth Quarter............................................  $34.25    $20.75
  Third Quarter.............................................   28.00     15.75
  Second Quarter............................................   19.50     11.50
  First Quarter.............................................   14.50     10.25
</TABLE>

     The Company has never declared or paid any cash dividends on its Common
Stock. The Company currently intends to retain any future earnings for use in
its business and does not anticipate paying any cash dividends in the
foreseeable future.

     The Company had approximately 223 shareholders of record as of March 2,
1998. The last sales price for the Company's Common Stock, as reported by Nasdaq
on March 2, 1998, was $24.31.

                                       24
<PAGE>   26

ITEM 6.  SELECTED FINANCIAL DATA

     The following selected financial data should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," the Consolidated Financial Statements of the Company and related
notes thereto included elsewhere in this Annual Report on Form 10-K.

<TABLE>
<CAPTION>
                                                             YEARS ENDED DECEMBER 31,
                                                 -------------------------------------------------
                                                   1997       1996      1995      1994      1993
                                                 --------   --------   -------   -------   -------
                                                     (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                              <C>        <C>        <C>       <C>       <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA(1):
Revenues:
  Software licenses............................  $ 74,742   $ 55,169   $34,129   $22,260   $13,060
  Maintenance and other services...............    60,868     48,327    29,519    19,790    14,908
  Hardware.....................................    11,353     13,443    12,356     9,656     9,286
                                                 --------   --------   -------   -------   -------
     Total revenues............................   146,963    116,939    76,004    51,706    37,254
Cost of revenues:
  Software licenses............................     9,222      6,584     4,772     3,981     1,901
  Maintenance and other services...............    42,818     35,632    18,577    12,270     9,935
  Hardware.....................................     8,638      9,966     9,309     7,436     6,304
                                                 --------   --------   -------   -------   -------
     Total cost of revenues....................    60,678     52,182    32,658    23,687    18,140
                                                 --------   --------   -------   -------   -------
Gross profit...................................    86,285     64,757    43,346    28,019    19,114
Operating expenses:
  Sales and marketing..........................    40,456     29,632    19,817    13,412     8,091
  General and administrative...................    19,346     14,659    10,017     6,505     5,193
  Research and development.....................    10,505      8,918     8,648     4,126     2,432
  Acquisition and related costs................    15,565      3,656        --        --        --
  ESOP contribution............................        --         --       446       429       387
                                                 --------   --------   -------   -------   -------
     Total operating expenses..................    85,872     56,865    38,928    24,472    16,103
                                                 --------   --------   -------   -------   -------
Income from operations.........................       413      7,892     4,418     3,547     3,011
  Other income (expense), net..................     1,629        247    (1,250)   (1,221)     (634)
                                                 --------   --------   -------   -------   -------
Income before income taxes and extraordinary
  item.........................................     2,042      8,139     3,168     2,326     2,377
Provision (credit) for income taxes............     2,846      3,642       932      (708)     (216)
                                                 --------   --------   -------   -------   -------
Income (loss) before extraordinary item........      (804)     4,497     2,236     1,618     2,161
Extraordinary item, net of income taxes........        --         --    (1,017)     (157)       --
                                                 --------   --------   -------   -------   -------
Net income (loss)..............................  $   (804)  $  4,497   $ 1,219   $ 1,461   $ 2,161
                                                 --------   --------   -------   -------   -------
Basic earnings (loss) per share before
  extraordinary item...........................  $  (0.06)  $   0.39   $  0.32   $  0.26   $  0.36
Extraordinary item.............................        --         --     (0.15)    (0.03)       --
                                                 --------   --------   -------   -------   -------
Net earnings (loss) per share -- basic.........  $  (0.06)  $   0.39   $  0.17   $  0.23   $  0.36
                                                 ========   ========   =======   =======   =======
Diluted earnings (loss) per share before
  extraordinary item...........................  $  (0.06)  $   0.38   $  0.29   $  0.24   $  0.36
Extraordinary item.............................        --         --     (0.13)    (0.02)       --
                                                 --------   --------   -------   -------   -------
Net earnings (loss) per share -- diluted ......  $  (0.06)  $   0.38   $  0.16   $  0.22   $  0.36
                                                 ========   ========   =======   =======   =======
Common shares outstanding -- basic(1)..........    13,811     11,392     6,929     6,260     5,924
                                                 ========   ========   =======   =======   =======
Common shares outstanding -- diluted(1)........    13,811     11,954     7,807     6,768     6,023
                                                 ========   ========   =======   =======   =======
</TABLE>

                                       25
<PAGE>   27

<TABLE>
<CAPTION>
                                                                   DECEMBER 31,
                                                 -------------------------------------------------
                                                   1997       1996      1995      1994      1993
                                                 --------   --------   -------   -------   -------
                                                                  (IN THOUSANDS)
<S>                                              <C>        <C>        <C>       <C>       <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents......................  $ 17,418   $ 50,825   $17,472   $ 3,179   $ 1,892
Working capital (deficit)......................    66,656     66,700    20,566    (2,019)   (4,607)
Total assets...................................   131,136    121,202    62,916    27,301    12,861
Long-term debt, less current portion...........     1,493      1,864     2,105     8,073     1,860
Total shareholders' equity (deficit)(2)........    84,066     82,089    31,240    (2,229)   (4,339)
</TABLE>

---------------
(1) See Note 1 of Notes to Consolidated Financial Statements describing the
    determination of the number of shares used in computing per share
    information.

(2) In October 1995, the Company completed its initial public offering resulting
    in net proceeds to the Company of $18.0 million. The net proceeds from such
    offering were used to repay outstanding indebtedness, to increase working
    capital and for general corporate purposes. In December 1996, the Company
    completed a follow-on equity offering resulting in net proceeds to the
    Company of $41.3 million. The net proceeds were for additional working
    capital, general corporate purposes, including expansion of general sales
    and marketing and customer support activities, international expansion and
    possible acquisitions and joint ventures.

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

OVERVIEW

     DataWorks was incorporated in 1986 and develops, markets, implements and
supports open systems, client/server-based ERP software for mid-range, discrete
manufacturing companies with annual revenues between $3 million and $1 billion.
The Company's products and services facilitate enterprise-wide management of
resources and information and allow mid-range manufacturers to reduce order
fulfillment cycle times, improve operating efficiencies and measure critical
company performance against defined plan objectives.

     In September 1997, the Company acquired Interactive Group, Inc.
("Interactive") in a stock-for-stock transaction that was accounted for as a
pooling-of-interests. The financial results of Interactive have been included in
the financial results of the Company included in this Annual Report. The Company
believes its acquisition of Interactive offers major advantages in three key
areas: significantly enhanced international operations, including established
international channels, six offices in Europe as well as a substantial
distributor in Germany; more comprehensive mid-tier product offerings; and
substantial critical mass which makes DataWorks one of the largest mid-range ERP
providers in the world.

     In September 1996, the Company acquired DCD Corporation ("DCD") in a
stock-for-stock transaction that was accounted for as a pooling-of-interests.
The financial results of DCD have been included in the financial results of the
Company included in this Annual Report. In May 1994, DataWorks acquired Madic-
Compufact Corporation ("MCC") principally for cash in a transaction accounted
for as a purchase. DataWorks believes that the DCD and MCC acquisitions allowed
it to achieve several important strategic objectives, including the ability to
better serve the lower tier of mid-range manufacturers and the addition of
complementary products to better serve the make-to-order markets. The
acquisitions also allowed the Company to expand geographically and to increase
its customer and revenue base.

     In December 1995, Interactive acquired all the outstanding shares of Just
In Time Enterprise, Inc. ("JIT") for cash, a note payable and the assumption of
liabilities in a transaction accounted for as a purchase. The acquisition of JIT
and its Oracle-based manufacturing software may allow the Company to participate
in the more lucrative high end market for relational database and software
development technology. Because the acquisition of JIT was accounted for as a
purchase, the financial results of JIT prior to January 1995 are not included in
DataWorks' financial results.

     Due to intense competition in the computer hardware market and an
increasing tendency for customers, particularly new accounts, to purchase
hardware directly from third party vendors, the Company has
                                       26
<PAGE>   28

experienced declining hardware revenues as a percentage of each system it sells
and declining profit margins with respect to such hardware revenues. In the
past, gross profit from hardware sales has not been a significant part of the
Company's total gross profit, and the Company believes this trend will continue.

     The Company believes its success has been due in part to its strategy of
focusing marketing and development resources on eight "highly engineered
product" industries within the mid-range discrete manufacturing market sector.
The Company is unaware of any of its competitors specifically targeting the same
group of industries. There can be no assurance that competitors with
significantly greater financial, technical and marketing resources than the
Company will not target these particular industries.

     The following discussion should be read in conjunction with the
consolidated financial statements included elsewhere within this Annual Report.
Fluctuations in quarterly and annual results may occur as a result of factors
affecting demand for the Company's products such as the timing of the Company's
and competitors' new product introductions and product enhancements. Due to such
fluctuations, historical results and percentage relationships are not
necessarily indicative of the operating results for any future period. The
forward-looking statements contained in the following discussion involve risks
and uncertainties. The Company's actual results may differ materially from those
discussed here. Factors that could cause or contribute to such differences can
be found in the following discussion and elsewhere throughout this Annual Report
on Form 10-K. See "Risk Factors".

RESULTS OF OPERATIONS

     The following table sets forth, for the periods indicated, the percentage
of total revenues represented by certain condensed consolidated statement of
operations data:

<TABLE>
<CAPTION>
                                                                  YEARS ENDED
                                                                  DECEMBER 31,
                                                              --------------------
                                                              1997    1996    1995
                                                              ----    ----    ----
<S>                                                           <C>     <C>     <C>
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS DATA
REVENUES:
  Software licenses.........................................   51%     47%     45%
  Maintenance and other services............................   41      41      39
  Hardware..................................................    8      12      16
                                                              ---     ---     ---
     Total revenues.........................................  100     100     100
Cost of revenues............................................   41      45      43
                                                              ---     ---     ---
Gross profit................................................   59      55      57
OPERATING EXPENSES:
  Sales and marketing.......................................   28      25      26
  General and administrative................................   13      13      13
  Research and development..................................    7       8      11
  Acquisition and related costs.............................   11       2      --
  ESOP contribution.........................................   --      --       1
                                                              ---     ---     ---
     Total operating expenses...............................   59      48      51
                                                              ---     ---     ---
Income from operations......................................    0%      7%      6%
                                                              ===     ===     ===
</TABLE>

COMPARISON OF YEARS ENDED DECEMBER 31, 1997 AND 1996

     Total Revenues -- Software license fees and related services, including
software maintenance, consulting and custom programming, are DataWorks'
principal sources of revenues. In addition, DataWorks resells third party
hardware and operating systems software to provide turnkey systems solutions.

     Total revenues for the year ended December 31, 1997 increased $30.1 million
or 26% to $147.0 million from $116.9 million in 1996. The growth in total
revenues was primarily a result of increases in the sales of

                                       27
<PAGE>   29

software licenses and in maintenance and other service revenues offset slightly
by a reduction in third party hardware sales. Revenues from the Company's
international operations as a percentage of total revenues remained unchanged at
17% for both 1997 and 1996.

     Software License Revenues -- Revenues from DataWorks' non-cancelable
software licenses are recognized upon delivery of the products, provided no
significant Company obligations remain and collection of the related receivable
is deemed probable. Software license fees accounted for $74.7 million or 51% of
total revenues in 1997, up from $55.1 million or 47% of total revenues in 1996,
an increase of $19.6 million or 35% in absolute dollars. This growth was
primarily attributable to continued demand, which was strengthened by the recent
acquisition of Interactive, for the Company's ERP systems from its targeted
companies. In addition, the increase in system sales was indirectly a result of
expansion of the domestic and international sales force and increased marketing
efforts.

     Cost of Software License Revenues -- The cost of software license revenues
consists primarily of the cost of software products and firmware security
devices provided by third party suppliers and sold with DataWorks' systems. For
the year 1997, the cost of software license revenues increased $2.6 million or
40% to $9.2 million compared to $6.6 million in 1996. As a percentage of
software license revenues, cost of software licenses remained unchanged at 12%
for 1997 and 1996. The increase in absolute dollars was directly related to the
increase in software license revenues.

     Maintenance and Other Service Revenues -- Maintenance and other service
revenues include fees primarily from software maintenance, consulting, education
and custom programming services. The Company's software license agreements
provide on-going maintenance, education, and installation support services.
Software maintenance revenues are generally prepaid and recognized ratably over
the maintenance agreement period. Consulting, education and custom programming
revenues are generally paid and recognized as the services are performed.
Revenues from maintenance and other services increased $12.5 million or 26% to
$60.9 million in 1997 compared to $48.3 million in 1996. However, as a
percentage of total revenues, it remained at a constant level of 41% for both
years. The absolute dollar increase was reflective of the Company's growing
installed customer base which subscribes to ongoing maintenance support and, to
a greater extent, an increase in revenues from support services generated by the
Company's expanding professional services staff.

     Cost of Maintenance and Other Service Revenues -- DataWorks provides its
software maintenance, consulting and custom programming services through a
professional in-house staff. The cost of these services is primarily salaries
and a portion of DataWorks' overhead cost and, to a lesser extent, third party
product support costs. For the year 1997, cost of maintenance and other services
increased $7.2 million or 20% to $42.8 million compared to $35.6 million in
1996. As a percentage of related revenues, cost of maintenance and other
services decreased to 70% in 1997 compared to 74% in the prior year. Conversely,
the gross profit percentage increased to 30% in 1997 compared to 26% experienced
in 1996. The increase in absolute dollars was primarily attributable to the
continued expansion of the Company's professional service organization required
to support growth in new customer accounts which included the addition of 56
professional staff during 1997. The increase in gross profit percentage
experienced from maintenance and other service activities resulted from improved
productivity of the Company's consulting staff, particularly related to a
significant number of technical professionals hired and internally trained
during 1996.

     Hardware Revenues -- Hardware revenues include computers (primarily
servers), data collection equipment, peripherals and related network and
communications products purchased from third party vendors and sold through
DataWorks to its customers. Hardware revenues decreased $2.1 million or 16% to
$11.3 million in 1997 from $13.4 million in 1996. As a percentage of total
revenues, hardware revenues represented 8% in 1997 compared to 12% in the prior
year. The reduction in hardware revenues reflects an increasing tendency for new
customers, who purchase smaller systems, to purchase hardware directly from
third party vendors. This tendency and the increased pressure on profit margins
in computer hardware caused by increased competition has caused DataWorks to
experience declining hardware revenues, and the Company anticipates the trend to
continue in the future.

                                       28
<PAGE>   30

     Cost of Hardware Revenues -- The cost of hardware revenues consists
primarily of the cost of the computers (primarily servers), data collection
equipment, peripherals and related network and communications products purchased
from third party vendors. For the year 1997, the cost of hardware decreased $1.3
million or 13% to $8.6 million compared to $9.9 million in 1996. As a percentage
of hardware revenues, cost of hardware increased to 76% for 1997 compared to 74%
in 1996. The decrease in absolute dollars was directly related to the decrease
in hardware revenues whereas the decrease in gross profit percentage was
attributable to the increased competition in the computer hardware market.
Recently, gross profit from hardware sales has not been a significant part of
DataWorks' total gross profit, and the Company believes this trend will
continue.

     Gross Profit.  Gross profit increased $21.5 million or 33% to $86.3 million
in 1997 from $64.8 million in 1996 and increased as a percentage of total
revenues to 59% from 55%, respectively. These increases were due primarily to
the increase in software license revenues, (which carry a higher gross profit
percentage), as a percentage of total revenues, and to a lesser extent, the
increase in maintenance and other services revenues experienced in 1997.

     Sales and Marketing Expenses -- Sales and marketing expenses consist of
salaries, commissions and related overhead costs for the sales and marketing
activities of the Company, including advertising, promotion, trade show
participation and public relations costs. Sales and marketing expenses increased
$10.8 million or 37% to $40.5 million in 1997 compared to $29.7 million in 1996
and increased as a percentage of revenues to 28% from 25% for the same period.
The increases in sales and marketing expenses were attributable to the Company's
direct sales force expansion and enhanced marketing efforts, travel, commissions
and other expenses directly related to the increased sales activity. In
conjunction with these efforts, the Company hired 47 additional sales and
marketing personnel during 1997, with an emphasis on increasing its European
presence. DataWorks expects sales and marketing expenses will continue to
increase in absolute dollars as the Company continues to expand its sales and
marketing programs.

     General and Administrative Expenses -- General and administrative expenses
include costs of corporate services functions including accounting, human
resources and legal services, as well as the corporate executive staff. General
and administrative expenses increased $4.6 million or 32% to $19.3 million in
1997 compared to $14.7 million in 1996. As a percentage of total revenues,
general and administrative expenses remained unchanged at 13% for 1997 and 1996.
The increase in absolute dollars was attributable to the Company's continued
expansion into Europe, which included the business development and
infrastructure costs for regional offices in France, Nordic, Ireland and the
Netherlands, and expenses associated with the development and support of the
Evosoft distributorship for Germany and Hungary. Domestically, the increase was
due to additional personnel required to support the growth in the Company's
operations. DataWorks anticipates that these costs will continue to increase in
absolute dollars.

     Research and Development Expenses -- Research and development expenses are
comprised primarily of salaries and a portion of the Company's overhead for its
in-house staff and amounts paid to outside consultants, as appropriate, to
supplement the product development efforts of its in-house staff. Research and
development expenses are charged to operations as incurred. Certain software
production costs related to DataWorks' Impresa for Backoffice product
(previously called ECS), however, are capitalized as required by Statement of
Financial Accounting Standards No. 86, "Accounting for Software Cost." In
addition, the Company includes in capitalized software purchases of research and
development which has reached technological feasibility. In connection with the
Interactive acquisition, the Company acquired certain Oracle-based products
which has allowed the Company to redirect and focus its Impresa for Backoffice
product to the Microsoft-centric Sequel Server-based product. As a result of the
overlap in development efforts, the Company wrote-off $3.6 million of
capitalized software costs related to Impresa for Backoffice as acquisition and
related costs during 1997. As of December 31, 1997, the amount capitalized for
Impresa for Backoffice, totaled approximately $4.3 million. Amortization of
these costs will begin when the product is initially released, which is expected
in late 1998. DataWorks does not capitalize internally developed software costs
for any product other than Impresa for Backoffice.

                                       29
<PAGE>   31

     Gross research and development expenditures increased $2.9 million or 25%
to $14.3 million in 1997 compared to $11.4 million in 1996, which represents 10%
of total revenues for each year. Gross research and development expenditures in
1997 and 1996 included amounts for capitalized software totaling $3.8 million
and $2.5 million, respectively. The increase in gross expenditures was due
primarily to the employment of additional development personnel and related
overhead costs required to support the Company's level of investment in research
and development and the translation and localization of the Company's software
which it believes are necessary to maintain a competitive position in its
targeted market. DataWorks anticipates continued increased expenditures on
research and development for both the enhancement of current products and the
addition of new products.

     Acquisition and Related Costs -- Acquisition and related costs of $15.6
million in 1997 represent the costs incurred in connection with the acquisition
of Interactive. These costs included investment banking fees, legal and
accounting fees and expenses necessary to integrate and combine the operations
of the two companies. At December 31, 1997, included in other accrued
liabilities were approximately $1.5 million of anticipated integration and
severance costs anticipated to be paid during 1998. There can be no assurance
that the Company will not incur additional charges in future periods to reflect
costs associated with the integration of the two companies. For the 1996 year,
acquisition and related costs of $3.7 million represent the transaction costs
incurred in connection with the acquisition of DCD.

     Other Income (Expense), net -- Other net income (expense) consists
primarily of interest income and expense. For the 1997 year, interest income,
net of interest expense, increased $1.4 million to $1.6 million compared to $0.2
million in 1996. The net increase consisted primarily of additional interest and
dividend income earned from the investment of the net proceeds from DataWorks'
follow-on equity offering in December 1996. The increase in investment income
was offset in part by interest expense associated with the Company's line of
credit borrowings and other interest bearing long-term obligations. The majority
of these obligations were repaid in September 1997.

     Income Taxes -- DataWorks' effective income tax rates for 1997 and 1996
were 139% and 45%, respectively. The effective income tax rates were higher than
the statutory rates due primarily to the non-deductibility of certain
Interactive and DCD acquisition and related costs incurred in 1997 and 1996,
respectively, offset partially by the benefits realized from tax exempt
investment income and the utilization of net operating loss carryforwards and
research tax credits. The effective tax rate for such periods without the
acquisition costs would have been approximately 38%.

     Net Income (Loss) -- The net loss of $0.8 million experienced for the 1997
year included one-time acquisition costs of $15.6 million, with an offsetting
income tax benefit of approximately $3.7 million, incurred in connection with
the acquisition of Interactive. Net income without such one-time costs and
related tax consequences would have been approximately $11.1 million. Net income
for 1996 of $4.5 million included similar one-time acquisition costs of $3.7
million, with an offsetting income tax benefit of approximately $0.8 million,
incurred in connection with the acquisition of DCD. Net income without such
one-time costs and related tax consequences would have been approximately $7.4
million.

COMPARISON OF YEARS ENDED DECEMBER 31, 1996 AND 1995

     Total Revenues -- Total revenues increased $40.9 million or 54% to $116.9
million in 1996 from $76.0 million in 1995. This was primarily due to an
increase in software license sales to new accounts and an overall increase in
maintenance and other service revenues.

     Software License Revenues -- Software license revenues increased $21.0
million or 62% to $55.2 million in 1996 from $34.1 million in 1995. This growth
consisted of system sales and upgrades to new and existing customers and was
attributable, in Management's opinion, to increased marketing efforts, expansion
of the sales force and increased functionality in both the Vista and Vantage
products.

     Cost of Software License Revenues -- The cost of software license revenues
increased $1.8 million or 38% to $6.6 million in 1996 from $4.8 million in 1995.
This increase was directly related to the increase in software license revenues.
The cost of software license revenues represented approximately 12% and 14% of
software

                                       30
<PAGE>   32

license revenues for 1996 and 1995, respectively. This decrease in software
license cost, as a percentage of software license revenues, was due primarily to
database costs reductions on a per user basis.

     Maintenance and Other Service Revenues -- Maintenance and other service
revenues increased $18.8 million or 64% to $48.3 million in 1996 from $29.5
million in 1995. This growth was due primarily to the increase in new customers
and increased capacity created by the growth in DataWorks' service organization.

     Cost of Maintenance and Other Service Revenues -- Cost of maintenance and
other services increased $17.0 million or 91% to $35.6 million in 1996 from
$18.6 million in 1995. This increase was primarily due to the continued
expansion of DataWorks' professional service organization required to support
growth in new customer accounts. Gross profit, as a percentage of maintenance
and other service revenues, decreased to 26% in 1996 from 37% in 1995. The
decrease in gross profit percentage was primarily attributable to lower
utilization of revenue-generating personnel in 1996 which resulted from
re-educating the existing service personnel on new releases of the Company's
products and orientating an unusually large number of newly hired service
personnel on the various current releases.

     Hardware Revenues -- Hardware revenues increased $1.0 million or 8% to
$13.4 million in 1996 from $12.4 million in 1995. This represented approximately
12% of total revenues in 1996 as compared to approximately 16% of total revenues
in 1995, reflecting an increasing tendency for new customers, who purchase
smaller systems, to purchase hardware directly from third party vendors. This
tendency and the increased pressure on profit margins in computer hardware
caused by increased competition has caused DataWorks to experience declining
hardware revenues as a percentage of new account systems.

     Cost of Hardware Revenues -- The cost of hardware revenues increased $0.7
million or 7% to $10.0 million in 1996 from $9.3 million in 1995. The increase
was directly related to the additional hardware revenues realized in 1996
compared to 1995. The Company attempts to maintain a 20% gross profit on
hardware sales. In the past, gross profit from hardware sales has not been a
significant part of DataWorks' total gross profit, and DataWorks believes this
trend will continue.

     Gross Profit -- Gross profit increased $21.5 million or 50% to $64.8
million in 1996 from $43.3 million in 1995 primarily due to the increase in
total revenues. Gross profit as a percentage of total revenues decreased to 55%
from 57% in 1996 as compared to 1995. This decrease was primarily attributable
to higher personnel and related costs coupled with a lower utilization of
revenue generating service personnel as mentioned above.

     Sales and Marketing Expenses -- Sales and marketing expenses increased $9.8
million or 50% to $29.6 million in 1996 from $19.8 million in 1995 and decreased
as a percentage of revenues to 25% from 26% for the same period. The increase in
absolute dollars was attributable to DataWorks' expansion of its direct sales
force, increased marketing efforts, travel, commissions and other expenses
related directly to the increased sales activity.

     General and Administrative Expenses -- General and administrative expenses
increased $4.6 million or 46% to $14.7 million in 1996 from $10.1 million in
1995. This increase was largely due to the increase in administrative staff and
the related facility costs necessary to support the growth of DataWorks,
including the operations of JIT which was acquired in December 1995. General and
administrative expenses in 1995 included $0.9 million of non-recurring
compensation expense recorded in connection with a final stock grant and related
cash bonus pursuant to a compensation arrangement with an officer of the
Company. As a percentage of total revenues, general and administrative expenses
was unchanged at 13% for 1996 and 1995.

     Research and Development Expenses -- Research and development expenses are
comprised primarily of salaries and a portion of DataWorks' overhead for its
in-house staff and amounts paid to outside consultants, as appropriate, to
supplement the product development efforts of its in-house staff. Research and
development expenses are charged to operations as incurred. Certain software
production costs related to DataWorks' Impresa for Backoffice product, however,
are capitalized as required by Statement of Financial Accounting Standards No.
86, "Accounting for Software Cost." Amortization of these costs will begin when
the product is initially released. DataWorks does not capitalize internally
developed software costs for any product other than Impresa for Backoffice. As
of December 31, 1996, the amount capitalized for Impresa for Backoffice was
approximately $4.4 million.

                                       31
<PAGE>   33

     Gross research and development expenditures increased $1.5 million or 15%
to $11.4 million in 1996 from $9.9 million in 1995, which represented 10% of
total revenues in 1996 compared to 13% in 1995. Gross research and development
expenditures in such periods included amounts for capitalized software totaling
$2.5 million and $1.3 million, respectively. Also included in 1995 was
approximately $3.3 million of research and development costs purchased, in
connection with the acquisition of JIT, which had not yet reached technological
feasibility. The increase in gross expenditures was due primarily to the
employment of additional development personnel and reflects DataWorks' belief
that investments in research and development are necessary to maintain a
competitive position in its targeted market.

     Acquisition and Related Costs -- Acquisition and related costs of $3.7
million in 1996 represent the transaction costs incurred in connection with the
acquisition of DCD. These costs included investment banking fees, legal and
accounting fees and expenses necessary to integrate and combine the operations
of the two companies.

     ESOP Contributions and Dividends -- DCD established the ESOP in 1992 for
the benefit of all of its employees meeting certain eligibility requirements.
The ESOP was assumed by DataWorks in connection with its acquisition of DCD. In
1992, DCD obtained financing from a commercial bank and advanced proceeds to the
ESOP in order to purchase certain shares from a selling shareholder. See Note 4
of Notes to Consolidated Financial Statements.

     Other Income and Expense -- DataWorks reported net interest income of $0.2
million in 1996 as compared to net interest expense of $1.3 million in 1995. The
net interest income for 1996 related primarily to the earnings from the
investment of a portion of the net proceeds from DataWorks' initial public
offering in October 1995 and its follow-on equity offering in December 1996
which was partially offset by interest expense from long-term debt incurred in
connection with the JIT acquisition. For the year 1995, net interest expense
consisted primarily of interest expense from long-term debt, the amortization of
debt discount and issue costs, and the ESOP obligation, net of a small amount of
interest income related to the investment of a portion of the net proceeds from
Interactive's initial public offering in May 1995. Substantially all outstanding
debt incurred in connection with prior financings was retired from the proceeds
of DataWorks' Series A Preferred Stock financing and the October 1995 initial
public offering. With the prepayment of such indebtedness, DataWorks recognized
an extraordinary expense of $1.0 million, net of income tax benefit, arising
from the write-off of unamortized debt issue cost, debt discount and other
related fees.

     Income Taxes -- DataWorks' effective tax rate for 1996 was 45%, due
primarily to the non-deductibility of certain DCD acquisition and related costs.
The effective tax rate without the acquisition and related costs would have been
approximately 38%. DataWorks' effective tax rate for 1995 was 29%. DataWorks
realized tax benefits in 1995 from the deduction of certain tax credits and from
contributions and dividends paid on Common Stock held by the ESOP used to make
ESOP debt service payments, which reduced DataWorks' effective tax rate in such
period. See Note 8 of Notes to Consolidated Financial Statements.

     Net Income (Loss) -- The net income of $4.5 million experienced for the
1996 year included one-time acquisition costs of $3.7 million, with an
offsetting income tax benefit of approximately $0.8 million incurred in
connection with the acquisition of DCD Corporation. Net income without such
one-time costs and related tax consequences would have been approximately $7.4
million.

LIQUIDITY AND CAPITAL RESOURCES

     The Company generated cash of $6.5 million from its operating activities
for the year ended December 31, 1997. The primary source of cash was from the
Company's results of operations adjusted for non-cash expenses, which included a
$0.8 million net loss and $13.3 million of non-cash expenses, resulting in a net
increase in cash of $12.5 million. The increase was partially offset by cash
used for working capital purposes of $6.0 million. The net use of working
capital was primarily attributable to an increase in accounts receivable at
December 31, 1997 which was partially offset by increases in accrued
compensation, deferred revenue and accounts payable. The increases in accounts
receivable and deferred revenue resulted from the growth in customer licensing
activity combined with increases in maintenance support and other services
provided to the Company's expanding customer base, a portion of which relates to
services to be provided in 1998. The

                                       32
<PAGE>   34

increase in accrued compensation resulted from the effects of recent growth in
personnel, an increase in commissions due to higher sales activities near year
end and bonuses accrued at year end.

     Cash used for investing activities was $39.7 million in 1997 primarily for
net purchases of short-term investments of $30.5 million. Additional uses of
cash included $4.9 million of capital expenditures and $3.8 million in
capitalized software development costs. The Company anticipates the level of
expenditures during 1998 for capital equipment to increase moderately and
capitalized software development to be slightly reduced.

     Financing activities utilized net cash of $0.3 million in 1997. Concurrent
with the acquisition of Interactive in September 1997, the Company repaid a
majority of the obligations Interactive had outstanding, excluding a line of
credit draw which was subsequently repaid in early 1998. The issuance of common
stock under the Company's stock plans provided $2.1 million of cash in 1997.

     The Company has a $6.0 million uncommitted line of credit with a domestic
bank. This arrangement can be withdrawn by the lender any time, at their option.
The Company also has a line of credit with a United Kingdom financial
institution under which it may borrow up to $1.3 million. As of December 31,
1997, the Company had $721,000 outstanding under this line of credit which was
subsequently repaid in early 1998.

     As of December 31, 1997, DataWorks had $66.7 million in working capital
including $17.4 million in cash and cash equivalents and $30.5 million in
short-term investments consisting of high-quality municipal bonds, U.S.
government debt securities and commercial paper and auction securities.
DataWorks' principal commitments as of December 31, 1997 consist primarily of
facilities and equipment leases. In addition, the Company is obligated under
various software resell agreements with third party providers to render
quarterly or annual minimum royalty and maintenance support payments.

     DataWorks' capital resources may be used to support working capital
requirements, product development, capital equipment requirements and possible
acquisitions of businesses, products or technologies complementary to DataWorks'
current business. The Company believes that its current cash and short-term
investments, available lines of credit and cash flow from operations are
sufficient to fund its operations for at least the next 12 months. However,
during this period or thereafter the Company may require additional financing.
There can be no assurance that additional financing will be available on terms
favorable to the Company, or at all.

IMPACT OF INFLATION

     The Company believes that inflation has not had a material effect on its
operations and considers the future risk to be minimal.

FOREIGN CURRENCY EXPOSURES

     Revenues from international operations accounted for approximately 17% of
the Company's total revenues in 1997. International sales are predominantly
invoiced and paid in major foreign currencies which exposes the Company to the
impact of fluctuation of foreign currencies versus the U.S. dollar. The
operating impact of such fluctuations, however, is offset to the extent expenses
of the Company's international operations are incurred and paid in the
respective local currencies. Historically, foreign currency fluctuations have
not had a material effect on the Company's operations and management considers
the future risk to be minimal.

YEAR 2000 COMPLIANCE

     Significant uncertainty exists in the software industry concerning the
potential effects from the Year 2000 issue associated with the date codes used
in computer software and hardware systems. The Company believes that all of its
existing products are Year 2000 compliant, and new products are being designed
to be Year 2000 compliant. Although products have undergone the Company's normal
quality testing procedures, there can be no assurance that the Company's
software products contain all necessary date code changes. Any failure of the

                                       33
<PAGE>   35

Company's products to perform, including system malfunctions due to the onset of
the calendar year 2000, could have a material adverse effect on the Company's
business, financial condition and results of operations.

     The Company is also currently in the process of evaluating its information
technology infrastructure for Year 2000 compliance, including reviewing what
actions are required to make all software systems used internally Year 2000
compliant as well as actions needed to mitigate vulnerability to problems with
suppliers and other third parties' systems. The Company is assessing the extent
of the necessary modifications to its computer software, and management does not
anticipate that the Company will incur significant operating expenses or be
required to invest heavily in computer system improvements to be Year 2000
compliant. There can be no assurance that such measures will alleviate the Year
2000 problems, which could have a material adverse effect upon the Company's
business, operating results and financial condition.

RECENT ACCOUNTING PRONOUNCEMENTS

     The Company has determined that the adoption of recently issued Statements
of Financial Accounting Standards ("SFAS") No.129, "Disclosure of Information
about Capital Structure," No. 130, "Reporting Comprehensive Income," and No.
131, "Disclosures about Segments of an Enterprise and Related Information," will
not have a material impact on its financial condition or results of operations.
The Company is currently evaluating the impact SOP 97-2, "Software Revenue
Recognition" will have on the Company's financial condition and results of
operations. SFAS No. 129 and SOP 97-2 are effective for fiscal 1998, and SFAS
Nos. 130 and 131 are effective for fiscal 1999.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Not applicable.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The financial statements and supplementary data of the Company required by
this item are listed under item 14(a)(1) and (2).

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

     None.

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     See the section entitled "Executive Officers" in Part I, Item 1 hereof for
information regarding executive officers.

     The information required by this item with respect to directors is
incorporated by reference from the information under the caption of "Election of
Directors," contained in the Company's Definitive Proxy Statement to be filed
with the Commission pursuant to Regulation 14A in connection with the 1998
Annual Meeting (the "Proxy Statement").

ITEM 11.  EXECUTIVE COMPENSATION

     The information required by this item is incorporated by reference to the
information under the caption "Executive Compensation" contained in the Proxy
Statement.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information required by this item is incorporated by reference to the
information under the caption "Security Ownership of Certain Beneficial Owners
and Management" contained in the Proxy Statement.

                                       34
<PAGE>   36

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required by this item is incorporated by reference to the
information under the caption contained in "Certain Transactions" contained in
the Proxy Statement.

                                    PART IV

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

(a)(1) Index to Consolidated Financial Statements

     The consolidated financial statements required by this item are submitted
in a separate section beginning on page F-1 of this Annual Report on Form 10-K.

<TABLE>
<CAPTION>
                                                               PAGE
                                                              NUMBER
                                                              ------
<S>                                                           <C>
Report of Ernst & Young LLP, Independent Auditors...........   F-2
Report of Price Waterhouse LLP, Independent Accountants.....   F-3
Consolidated Balance Sheets at December 31, 1997 and 1996...   F-4
Consolidated Statements of Operations for Each of the Three
  Years in the Period Ended December 31, 1997...............   F-5
Consolidated Statement of Shareholders' Equity (Deficit) for
  Each of the Three Years in the Period Ended December 31,
  1997......................................................   F-6
Consolidated Statements of Cash Flows for Each of the Three
  Years in the Period Ended December 31, 1997...............   F-7
Notes to Consolidated Financial Statements..................   F-8
</TABLE>

(a)(2) Index to Financial Statement Schedules

     All schedules have been omitted since they are either not required, not
applicable, or because the information required is included in the consolidated
financial statements or the notes thereto.

(a)(3) Index to Exhibits

<TABLE>
<CAPTION>
EXHIBIT   EXHIBIT
FOOTNOTE  NUMBER
--------  -------
<C>       <C>       <S>
(1)        3.1      Registrant's Amended and Restated Articles of Incorporation.
           3.2      Registrant's Amended and Restated Bylaws.
(1)        4.1      Amended and Restated Registration Rights Agreement dated
                    August 24, 1995.
(1)        4.2      Specimen stock certificate.
(5)        4.3      Agreement and Plan of Merger and Reorganization by and among
                    the Registrant, DataWorks Acquisition Sub., Inc., DCD
                    Corporation and certain shareholders of DCD Corporation,
                    dated as of August 16, 1996.
(1)       10.1      Form of Indemnity Agreement entered into between the
                    Registrant and its directors and officers, with related
                    schedule.
(3)       10.2      Registrant's 1995 Equity Incentive Plan (the "Equity Plan"),
                    as amended.
(1)(3)    10.3      Forms of Incentive Stock Option and Nonstatutory Stock
                    Option under the Equity Plan.
(1)(3)    10.4      Form of Stock Option outside the Equity Plan.
(3)       10.5      Registrant's 1995 Non-Employee Directors' Stock Option Plan,
                    as amended.
(3)       10.6      Registrant's 1995 Employee Stock Purchase Plan and form of
                    Employee Stock Purchase Plan Offering, as amended.
(1)(3)    10.7      Agreement entered into between the Registrant and Rick E.
                    Russo.
(3)(5)    10.8      Offer Letter, dated as of January 17, 1996, entered into
                    between the Registrant and Norman R. Farquhar.
</TABLE>

                                       35
<PAGE>   37

<TABLE>
<CAPTION>
EXHIBIT   EXHIBIT
FOOTNOTE  NUMBER
--------  -------
<C>       <C>       <S>
(1)       10.9      Sublease Agreement dated November 22, 1991 between the
                    Registrant and the Titan Corporation (the "Sublease").
(1)       10.10     First Amendment to Sublease dated December 1, 1994.
(2)(5)    10.11     Value Added Reseller Agreement dated December 27, 1995
                    between the Registrant and VMARK Software, Inc.
(1)(2)    10.12     Value Added Remarketer Agreement dated December 16, 1993
                    between the Registrant and Sybase, Inc.
(1)(2)    10.13     Value Added Reseller Agreement dated March 1, 1994 between
                    the Registrant and UniData, Inc.
(4)       10.14     Reference is made to Exhibit 4.3.*
(6)       10.15     Lease Agreement dated January 16, 1997 between Registrant
                    and Whiop Real Estate Limited Partnership.
(3)(6)    10.16     Registrant's 1996 Executive Compensation Plan, dated
                    February 2, 1996.
(3)(6)    10.17     Executive Employment Agreement dated September 27, 1996
                    entered into between the Registrant and Robert W. Brandel.
(3)(6)    10.18     Form of Split Dollar Insurance Agreement (Endorsement) and
                    underlying agreements, entered into between Registrant and
                    certain of its executive officers.
(3)(6)    10.19     Form of Split Dollar Insurance Agreement (Collateral
                    Assignment) and underlying agreements, entered into between
                    Registrant and certain of its executive officers.
(3)       10.20     Employment Agreement dated September 29, 1997 between the
                    Registrant and Robert C. Vernon.
(3)       10.21     Employment Agreement dated September 29, 1997 between the
                    Registrant and Mark Hellinger.
(3)       10.22     Noncompetition Agreement dated September 29, 1997 between
                    the Registrant and Robert C. Vernon.
(3)       10.23     Noncompetition Agreement dated September 29, 1997 between
                    the Registrant and Mark Hellinger.
(3)       10.24     Executive Employment Agreement dated December 19, 1997
                    entered into between the Registrant and Stuart W. Clifton.
(9)       10.25     1995 Stock Option Plan, as amended of Interactive (the
                    "Interactive Option Plan").
(7)       10.26     Form of Incentive Stock Option under the Interactive Option
                    Plan.
(7)       10.27     Form of Representative's Warrant Agreement issued by
                    Interactive to Cruttenden Roth Incorporated.
          10.28     Warrant to Purchase 104,702 shares of Common Stock issued by
                    the Registrant to Cruttenden Roth Incorporated.
(2)(7)    10.29     Value Added Reseller Agreement between UniData, Inc. and
                    Interactive dated January 15, 1992, as amended August 17,
                    1993.
(2)(7)    10.30     Distributorship Agreement between VMARK Software, Inc. and
                    Interactive dated January 1, 1993.
</TABLE>

                                       36
<PAGE>   38

<TABLE>
<CAPTION>
EXHIBIT   EXHIBIT
FOOTNOTE  NUMBER
--------  -------
<C>       <C>       <S>
(2)(7)    10.31     Letter Agreement between System Builder and Interactive
                    (formerly Intrepid Software, Inc.) dated June 8, 1994.
(7)       10.32     Office Building Lease between Sunland Diversified and
                    Interactive dated October 1, 1994.
(7)       10.33     Lease between James S. Hekimian and William G. Finard, as
                    Trustees of Burlington Woods Office Trust No. 11 under a
                    Declaration of Trust dated September 10, 1980, and
                    Interactive (formerly Intrepid Software, Inc.) dated
                    September 23, 1991.
(7)       10.34     Plan and Agreement of Merger between Interactive, Inc.,
                    Intrepid Software, Inc. and Randolph S. Naylor dated March
                    17, 1995.
(9)       10.35     Standard Office Lease between Appletree Ltd. and Interactive
                    dated September 6, 1996.
(2)(9)    10.36     Distribution Agreement between evosoft Softwarevertrieb GmbH
                    and Interactive dated September 6, 1996.
(10)      10.37     Purchase and Sale Agreement between Interactive and Fourth
                    Shift Corporation dated December 15, 1995.
(11)      10.38     Agreement for Sale and Purchase of Stock among Interactive,
                    Genie Productique/Gestion de Production and Sodriv dated
                    July 25, 1997.
(12)      10.39     1997 Nonstatutory Stock Option Plan of Interactive.
(3)       10.40     Description of Compensation for Registrant's Executive Group
                    per Board Compensation Committee approval on January 27,
                    1998.
          21.1      Subsidiaries of Registrant.
          23.1      Consent of Ernst & Young LLP, Independent Auditors
          23.2      Consent of Price Waterhouse LLP, Independent Accountants
          24.1      Power of Attorney. Reference is made to page 33
          27        Financial Data Schedule
</TABLE>

---------------
  *  Schedules omitted pursuant to Regulation S-K, Item 601(b)(2) of the
     Commission. Registrant undertakes to furnish such schedules to the
     Commission supplementally upon request.

 (1) Filed as an exhibit to the Registrant's Registration Statement on From SB-2
     (No. 33-97022 LA) or amendments thereto and incorporated herein by
     reference.

 (2) Certain confidential portions deleted.

 (3) Indicates management or compensatory plan or arrangement required to be
     identified pursuant to Item 14(c).

 (4) Filed as an exhibit to the Registrant's Registration Statement on Form S-4
     (No. 333-11741) and incorporated herein by reference.

 (5) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the
     year ended December 31, 1995 and incorporated herein by reference.

 (6) Filed as an exhibit to the Registrant's Annual Report on Form 10-K for the
     year ended December 31, 1996 and incorporated herein by reference.

                                       37
<PAGE>   39

 (7) Filed as an exhibit to Interactive Group, Inc.'s Registration Statement on
     Form S-1 (No. 33-90816) and incorporated herein by reference.

 (8) Filed as an exhibit to Interactive Group, Inc.'s Annual Report on Form 10-K
     for the year ended December 31, 1995, and incorporated herein by reference.

 (9) Filed as an exhibit to Interactive Group, Inc.'s Annual Report on Form 10-K
     for the year ended December 31, 1996, and incorporated herein by reference.

(10) Filed as an exhibit to Interactive Group, Inc.'s Current Report on Form 8-K
     dated December 29, 1995, and incorporated herein by reference.

(11) Filed as an exhibit to Interactive Group, Inc.'s Quarterly Report on Form
     10-Q for the quarter ended June 30, 1997, and incorporated herein by
     reference.

(12) Filed as an exhibit to Interactive Group, Inc.'s Registration Statement on
     Form S-8 (No. 333-30259) and incorporated herein by reference.

(b) Reports on Form 8-K

     Not applicable.

(c) Exhibits

     The exhibits required by this item are listed under Item 14(a)(3).

(d) Financial Statement Schedules

     The financial statement schedules required by this item are listed under
Item 14(a)(2).

                                       38
<PAGE>   40

                                   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.

                                          DATAWORKS CORPORATION

                                          By:     /s/ STUART W. CLIFTON
                                            ------------------------------------
                                                     Stuart W. Clifton
                                              Chairman of the Board, President
                                                and Chief Executive Officer
Date: March 30, 1998

                               POWER OF ATTORNEY

     KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Stuart W. Clifton and Norman R. Farquhar,
and each of them, as his true and lawful attorneys-in-fact and agents, with full
power of substitution and resubstitution, for him and in his name, place, and
stead, in any and all capacities, to sign any and all amendments to this Report,
and to file the same, with all exhibits thereto, and other documents in
connection therewith, with the Securities and Exchange Commission, granting unto
said attorneys-in-fact and agents, and each of them, full power and authority to
do and perform each and every act and thing requisite and necessary to be done
in connection therewith, as fully to all intents and purposes as he might or
could do in person, hereby ratifying and confirming that all said
attorneys-in-fact and agents, or any of them or their or his substitute or
substituted, may lawfully do or cause to be done by virtue hereof.

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

<TABLE>
<CAPTION>
                    SIGNATURES                                     TITLE                     DATE
                    ----------                                     -----                     ----
<C>                                                  <S>                                <C>
               /s/ STUART W. CLIFTON                 Chairman of the Board, President   March 30, 1998
---------------------------------------------------    and Chief Executive Officer
                (Stuart W. Clifton)                    (Principal Executive Officer)

              /s/ NORMAN R. FARQUHAR                 Executive Vice President, Chief    March 30, 1998
---------------------------------------------------    Financial Officer and Director
               (Norman R. Farquhar)                    (Principal Financial Officer)

               /s/ ROBERT C. VERNON                  President -- International         March 30, 1998
---------------------------------------------------    Operations and Director
                (Robert C. Vernon)

                 /s/ RICK E. RUSSO                   Vice President, Finance and        March 30, 1998
---------------------------------------------------    Secretary (Principal Accounting
                  (Rick E. Russo)                      Officer)

               /s/ RONALD S. PARKER                  Director                           March 30, 1998
---------------------------------------------------
                (Ronald S. Parker)
</TABLE>

                                       39
<PAGE>   41

<TABLE>
<CAPTION>
                    SIGNATURES                                     TITLE                     DATE
                    ----------                                     -----                     ----
<C>                                                  <S>                                <C>
                 /s/ WILLIAM FOLEY                   Director                           March 30, 1998
---------------------------------------------------
                  (William Foley)

              /s/ ROY THIELE-SARDINA                 Director                           March 30, 1998
---------------------------------------------------
               (Roy Thiele-Sardina)

                 /s/ TONY N. DOMIT                   Director                           March 30, 1998
---------------------------------------------------
                  (Tony N. Domit)

                /s/ NATHAN W. BELL                   Director                           March 30, 1998
---------------------------------------------------
                 (Nathan W. Bell)
</TABLE>

                                       40
<PAGE>   42

                             DATAWORKS CORPORATION

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                               PAGE
                                                              NUMBER
                                                              ------
<S>                                                           <C>

Report of Ernst & Young LLP, Independent Auditors...........   F-2

Report of Price Waterhouse LLP, Independent Accountants.....   F-3

Consolidated Balance Sheets at December 31, 1997 and 1996...   F-4

Consolidated Statements of Operations for Each of the Three
  Years in the Period Ended December 31, 1997...............   F-5

Consolidated Statement of Shareholders' Equity for Each of
  the Three Years in the Period Ended December 31, 1997.....   F-6

Consolidated Statements of Cash Flows for Each of the Three
  Years in the Period Ended December 31, 1997...............   F-7

Notes to Consolidated Financial Statements..................   F-8
</TABLE>

                                       F-1
<PAGE>   43

               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Shareholders
DataWorks Corporation

     We have audited the accompanying consolidated balance sheets of DataWorks
Corporation as of December 31, 1997 and 1996, and the related consolidated
statements of operations, shareholders' equity and cash flows for each of the
three years in the period ended December 31, 1997. These financial statements
are the responsibility of DataWorks' management. Our responsibility is to
express an opinion on these financial statements based on our audits. We did not
audit the financial statements of DCD Corporation, which statements reflect
total revenues of $11,482,867 for the year ended December 31, 1995. Those
statements were audited by other auditors whose reports have been furnished to
us, and our opinion, insofar as it relates to data included for DCD Corporation,
is based solely on the report of the other auditors.

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

     In our opinion, based on our audits and the report of other auditors, the
financial statements referred to above present fairly, in all material respects,
the consolidated financial position of DataWorks Corporation at December 31,
1997 and 1996, and the consolidated results of its operations and its cash flows
for each of the three years in the period ended December 31, 1997 in conformity
with generally accepted accounting principles.

                                          ERNST & YOUNG LLP

San Diego, California
January 26, 1998

                                       F-2
<PAGE>   44

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of
DCD Corporation

     In our opinion, the statements of operations, of stockholders' equity and
of cash flows of DCD Corporation (not presented separately herein) present
fairly, in all material respects, the results of its operations and its cash
flows for the year ended December 31, 1995, in conformity with generally
accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on theses financial statements based on our audit. We conducted our
audit of these statements in accordance with generally accepted auditing
standards which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for the opinion expressed above. We have not
audited the financial statements of DCD Corporation for any period subsequent to
December 31, 1995.

                                          PRICE WATERHOUSE LLP

Minneapolis, Minnesota
April 5, 1996

                                       F-3
<PAGE>   45

                             DATAWORKS CORPORATION

                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              --------------------
                                                                1997        1996
                                                              --------    --------
<S>                                                           <C>         <C>
                                      ASSETS
Current assets:
  Cash and cash equivalents.................................  $ 17,418    $ 50,825
  Short-term investments, available-for-sale................    30,503          --
Accounts receivable, net of allowance for doubtful accounts
  of $2,360 and $1,527 at December 31, 1997 and 1996,
  respectively..............................................    53,617      40,427
  Deferred income taxes.....................................     3,377       3,098
  Other current assets......................................     6,354       6,798
                                                              --------    --------
Total current assets........................................   111,269     101,148
Equipment, furniture and fixtures, net......................     8,184       7,070
Capitalized software costs, net.............................     4,807       5,034
Intangible assets, net......................................     6,083       6,201
Deferred income taxes.......................................        --       1,134
Other assets................................................       793         615
                                                              --------    --------
Total assets................................................  $131,136    $121,202
                                                              ========    ========

                       LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable..........................................  $ 11,802    $ 10,178
  Accrued compensation......................................    10,476       5,069
  Income taxes payable......................................     1,732       1,387
  Deferred revenue..........................................    14,271       9,939
  Short-term borrowings and current portion of long-term
     obligations............................................       721       2,013
  Other accrued liabilities.................................     5,611       5,862
                                                              --------    --------
Total current liabilities...................................    44,613      34,448
Deferred income taxes.......................................       964       2,801
Long-term obligations, less current portion.................     1,493       1,864
Commitments
Shareholders' equity:
  Common shares, no stated par value:
     Authorized shares -- 25,000
     Issued and outstanding shares -- 13,967 and 13,570 at
      December 31, 1997 and 1996, respectively..............    81,458      78,703
  Retained earnings.........................................     2,445       3,249
  Cumulative foreign currency translation adjustments.......       163         137
                                                              --------    --------
Total shareholders' equity..................................    84,066      82,089
                                                              --------    --------
Total liabilities and shareholders' equity..................  $131,136    $121,202
                                                              ========    ========
</TABLE>

                            See accompanying notes.
                                       F-4
<PAGE>   46

                             DATAWORKS CORPORATION

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                  (IN THOUSANDS, EXCEPT PER SHARE INFORMATION)

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                              -------------------------------
                                                                1997        1996       1995
                                                              --------    --------    -------
<S>                                                           <C>         <C>         <C>
Revenues:
  Software licenses.........................................  $ 74,742    $ 55,169    $34,129
  Maintenance and other services............................    60,868      48,327     29,519
  Hardware..................................................    11,353      13,443     12,356
                                                              --------    --------    -------
Total revenues..............................................   146,963     116,939     76,004
Cost of revenues:
  Software licenses.........................................     9,222       6,584      4,772
  Maintenance and other services............................    42,818      35,632     18,577
  Hardware..................................................     8,638       9,966      9,309
                                                              --------    --------    -------
Total cost of revenues......................................    60,678      52,182     32,658
                                                              --------    --------    -------
Gross profit................................................    86,285      64,757     43,346
Operating expenses:
  Sales and marketing.......................................    40,456      29,632     19,817
  General and administrative................................    19,346      14,659     10,017
  Research and development..................................    10,505       8,918      8,648
  Acquisition and related costs.............................    15,565       3,656         --
  ESOP contribution.........................................        --          --        446
                                                              --------    --------    -------
Total operating expenses....................................    85,872      56,865     38,928
                                                              --------    --------    -------
Income from operations......................................       413       7,892      4,418
Other income (expense), net.................................     1,629         247     (1,250)
                                                              --------    --------    -------
Income before income taxes and extraordinary item...........     2,042       8,139      3,168
Provision for income taxes..................................     2,846       3,642        932
                                                              --------    --------    -------
Income (loss) before extraordinary item.....................      (804)      4,497      2,236
Extraordinary item, net of income taxes.....................        --          --     (1,017)
                                                              --------    --------    -------
Net income (loss)...........................................  $   (804)   $  4,497    $ 1,219
                                                              ========    ========    =======
Basic earnings (loss) per share before extraordinary item...  $  (0.06)   $   0.39    $  0.32
Extraordinary item..........................................        --          --      (0.15)
                                                              --------    --------    -------
Net earnings (loss) per share -- basic......................  $  (0.06)   $   0.39    $  0.17
                                                              ========    ========    =======
Diluted earnings (loss) per share before extraordinary
  item......................................................  $  (0.06)   $   0.38    $  0.29
Extraordinary item..........................................        --          --      (0.13)
                                                              --------    --------    -------
Net earnings (loss) per share -- diluted....................  $  (0.06)   $   0.38    $  0.16
                                                              ========    ========    =======
Common shares outstanding -- basic..........................    13,811      11,392      6,929
                                                              ========    ========    =======
Common shares outstanding -- diluted........................    13,811      11,954      7,807
                                                              ========    ========    =======
</TABLE>

                            See accompanying notes.

                                       F-5
<PAGE>   47

                             DATAWORKS CORPORATION

                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                  YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                                      CUMULATIVE
                                                                                                        FOREIGN
                                       PREFERRED SHARES    COMMON SHARES     RETAINED                  CURRENCY     SHAREHOLDERS'
                                       ----------------   ----------------   EARNINGS    RECEIVABLE   TRANSLATION      EQUITY
                                       SHARES   AMOUNT    SHARES   AMOUNT    (DEFICIT)   FROM ESOP    ADJUSTMENTS     (DEFICIT)
                                       ------   -------   ------   -------   ---------   ----------   -----------   -------------
<S>                                    <C>      <C>       <C>      <C>       <C>         <C>          <C>           <C>
Balance at January 1, 1995...........     --    $   --    6,635    $  649     $(1,818)    $(1,088)       $ 27          $(2,230)
  Issuance of common stock to comply
    with certain antidilution
    provisions.......................     --        --        2        --          --          --          --               --
  Issuance of warrants to purchase
    shares of common stock...........     --        --       --        29          --          --          --               29
  Issuance of Series A preferred
    stock net........................    865     5,938       --        --          --          --          --            5,938
  Issuance of common stock upon
    exercise of warrants and stock
    options..........................     --        --    1,229     1,532          --          --          --            1,532
  Conversion of Series A preferred
    stock upon initial public
    offering.........................   (865)   (5,938)     865     5,938          --          --          --               --
  Issuance of common stock upon
    initial public offering, net.....     --        --    2,566    24,195          --          --          --           24,195
  Dividends declared on common
    stock............................     --        --       --        --        (649)         --          --             (649)
  Repayments of ESOP receivable......     --        --       --        --          --       1,088          --            1,088
  Compensation relating to the
    granting of stock options and
    stock bonus......................     --        --       91       466          --          --          --              466
  Repurchase of common stock.........     --        --     (431)     (400)         --          --          --             (400)
  Tax benefit related to stock
    options exercised................     --        --       --        62          --          --          --               62
  Foreign currency translation
    adjustment.......................     --        --       --        --          --          --         (10)             (10)
  Net income.........................     --        --       --        --       1,219          --          --            1,219
                                        ----    -------   ------   -------    -------     -------        ----          -------
Balance at December 31, 1995.........     --        --    10,957   32,471      (1,248)         --          17           31,240
  Issuance of common stock upon
    exercise of stock options........     --        --      335       226          --          --          --              226
  Issuance of common stock upon
    exercise of warrants.............     --        --       14       122          --          --          --              122
  Issuance of common stock in
    follow-on public offering, net...     --        --    2,113    41,330          --          --          --           41,330
  Issuance of common stock under
    Employee Stock Purchase Plan.....     --        --      154     1,231          --          --          --            1,231
  Tax benefit related to exercise of
    stock options....................     --        --       --     3,180          --          --          --            3,180
  Compensation relating to the
    granting of stock options........     --        --       --       161          --          --          --              161
  Repurchase of common stock.........     --        --       (3)      (18)         --          --          --              (18)
  Foreign currency translation
    adjustment.......................     --        --       --        --          --          --         120              120
  Net income.........................     --        --       --        --       4,497          --          --            4,497
                                        ----    -------   ------   -------    -------     -------        ----          -------
Balance at December 31, 1996.........     --        --    13,570   78,703       3,249          --         137           82,089
  Issuance of common stock upon
    exercise of stock options........     --        --      217       458          --          --          --              458
  Issuance of common stock upon
    exercise of warrants                  --        --        1         3          --          --          --                3
  Issuance of common stock under
    Employee Stock Purchase Plan.....     --        --      179     1,672          --          --          --            1,672
  Tax benefit related to exercise of
    stock options....................     --        --       --       533          --          --          --              533
  Compensation relating to the
    granting of stock options........     --        --       --        89          --          --          --               89
  Foreign currency translation
    adjustment.......................     --        --       --        --          --          --          26               26
  Net loss...........................     --        --       --        --        (804)         --          --             (804)
                                        ----    -------   ------   -------    -------     -------        ----          -------
Balance at December 31, 1997.........     --    $   --    13,967   $81,458    $ 2,445     $    --        $163          $84,066
                                        ====    =======   ======   =======    =======     =======        ====          =======
</TABLE>

                            See accompanying notes.
                                       F-6
<PAGE>   48

                             DATAWORKS CORPORATION

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                YEARS ENDED DECEMBER 31,
                                                              -----------------------------
                                                                1997       1996      1995
                                                              --------   --------   -------
<S>                                                           <C>        <C>        <C>
OPERATING ACTIVITIES
Net income (loss)...........................................  $   (804)  $  4,497   $ 1,219
Adjustments to reconcile net income to net cash provided by
  (used in) operating activities:
  Depreciation and amortization of intangible assets........     5,172      3,474     1,742
  Provision for doubtful accounts...........................     1,813      1,206     1,020
  Amortization of debt discount and debt issue costs........        --         --       214
  Non-cash acquisition and related costs....................     6,641         --        --
  Reduction of advances to officers charged to operating
    expenses................................................        --         --       109
  Compensation relating to the granting of options and stock
    bonus...................................................        89        161       466
  Purchased research and development........................        --         --     3,250
  Write-off of software license.............................        --         --       235
  Deferred income taxes.....................................      (449)       774    (1,605)
  Extraordinary item, non-cash portion......................        --         --       886
  Other.....................................................        --        (48)       85
  Changes in operating assets and liabilities:
    Accounts receivable.....................................   (16,253)   (15,897)  (10,917)
    Other current assets....................................    (1,159)    (2,801)   (1,684)
    Accounts payable........................................     1,624      1,917       820
    Accrued compensation....................................     5,407      2,161       707
    Deferred revenue........................................     4,332      1,081     2,314
    Other accrued liabilities and income taxes payable......        94      1,737     2,032
                                                              --------   --------   -------
Net cash provided by (used in) operating activities.........     6,507     (1,738)      893
INVESTING ACTIVITIES
Purchases of equipment, furniture and fixtures..............    (4,902)    (4,757)   (2,499)
Purchases of short-term investments.........................   (54,014)        --        --
Sale of short-term investments..............................    23,511         --        --
Additions to capitalized software costs.....................    (3,785)    (2,979)   (1,334)
Increase in intangible assets...............................      (296)        --      (310)
Advances to officers........................................        --         --      (224)
Acquisition of businesses...................................        --         --    (1,500)
Other assets................................................      (178)         8      (115)
                                                              --------   --------   -------
Net cash used in investing activities.......................   (39,664)    (7,728)   (5,982)
FINANCING ACTIVITIES
Net decrease in obligations under lines of credit...........      (479)        --    (2,751)
Proceeds from notes payable.................................       908      1,200     1,250
Repayments of notes payable.................................    (2,838)    (1,377)   (6,978)
Deferred debt issue costs...................................        --         --      (164)
Repayment of payables to shareholder........................        --         --       (50)
Repurchase of common stock..................................        --        (18)     (400)
Issuance of series A preferred stock, net...................        --         --     4,688
Dividend paid on class A common stock.......................        --         --      (649)
Issuance of common stock, net...............................     2,133     42,909    24,402
                                                              --------   --------   -------
Net cash (used in) provided by financing activities.........      (276)    42,714    19,348
Effect of exchange rate on cash.............................        26        105        34
                                                              --------   --------   -------
Net (decrease) increase in cash and cash equivalents........   (33,407)    33,353    14,293
Cash and cash equivalents at beginning of year..............    50,825     17,472     3,179
                                                              --------   --------   -------
Cash and cash equivalents at end of year....................  $ 17,418   $ 50,825   $17,472
                                                              ========   ========   =======
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for interest......................  $    355   $    290   $ 1,389
                                                              ========   ========   =======
Cash paid during the year for income taxes..................  $  2,511   $  1,875   $   930
                                                              ========   ========   =======
NON-CASH TRANSACTIONS:
Note payable for business acquisition.......................  $     --         --   $ 2,500
                                                              ========   ========   =======
Earnouts payable for business acquisitions..................  $    746   $    573   $    --
                                                              ========   ========   =======
</TABLE>

                            See accompanying notes.
                                       F-7
<PAGE>   49

                             DATAWORKS CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Organization and Basis of Presentation

     DataWorks Corporation ("DataWorks" or "the Company") is a California
corporation which develops, markets, implements and supports open systems,
client/server-based Enterprise Resource Planning software for mid-range discrete
manufacturing companies.

     As described more fully in Note 2, on September 29, 1997, the Company
acquired Interactive Group, Inc. ("Interactive"). The acquisition was accounted
for as a pooling of interests and, accordingly, the consolidated financial
statements reflect the combined financial position and operating results for the
Company and Interactive for all periods presented. In addition, the consolidated
financial statements include the accounts of DataWorks' wholly-owned
subsidiaries DCD Corporation ("DCD") and DataWorks (Europe) Ltd. All significant
intercompany accounts and transactions have been eliminated in consolidation.

     On December 31, 1995, Interactive acquired all of the outstanding shares of
Just-In-Time Enterprise Systems, Inc. ("JIT") from Fourth Shift Corporation
("FSC") of Minneapolis, Minnesota, a publicly traded manufacturing software
company (Note 2). This acquisition was accounted for under the purchase method
of accounting. The results of operations of JIT are included in the consolidated
statements of operations since the date of the acquisition.

  Use of Estimates in the Preparation of Financial Statements

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

  Cash and Cash Equivalents

     Cash and cash equivalents consist of cash and highly liquid investments
with remaining maturities, when acquired, of three months or less. Included in
cash and cash equivalents are $4,803,000 and $42,388,000 of debt and equity
securities classified as available-for-sale stated at cost which approximates
fair value at December 31, 1997 and 1996, respectively. DataWorks evaluates the
financial strength of institutions at which significant investments are made and
believes the related credit risk is limited to an acceptable level.

  Short-term Investments, available-for-sale

     Management determines the appropriate classification of its investments in
marketable debt and equity securities at the time of purchase and re-evaluates
such designation as of each balance sheet date. The Company has classified all
securities as available-for-sale in accordance with Statement of Financial
Accounting Standards No. 115, Accounting for Certain Investments in Debt and
Equity Securities. Available-for-sale securities are carried at amounts which
approximate fair value, with unrealized gains and losses reported net of related
taxes as a separate component of shareholders' equity. Realized gains and losses
and declines in value judged to be other-than-temporary, if any, on
available-for-sale securities are included in earnings and computed using the
specific identification cost method. At December 31, 1997, short-term
investments include those securities with maturities less than one year from the
balance sheet date.

  Equipment, Furniture and Fixtures

     Equipment, furniture and fixtures are recorded at cost. DataWorks provides
for depreciation on equipment, furniture and fixtures using the straight-line
method over the estimated useful lives of the assets,

                                       F-8
<PAGE>   50
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

generally three to seven years. Leasehold improvements are amortized over the
lesser of their estimated useful life or term of the lease.

  Capitalized Software Costs

     In accordance with Statement of Financial Accounting Standards No. 86
Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise
Marketed, costs incurred in the research and development of new software
products and significant enhancements to existing software products are charged
against operations as incurred until the technological feasibility of the
product has been established. After technological feasibility has been
established, direct production costs, including programming and testing, are
capitalized. Amortization of these costs will begin when the product becomes
available for sale.

     Capitalized software costs are amortized using the greater of the amount
computed using the ratio of current product revenues to estimated total product
revenues or the straight-line method over the estimated economic lives of the
products. It is possible that estimated total product revenues, the estimated
economic life of the product, or both will be reduced in the future. As a
result, the carrying amount of capitalized software costs may be reduced in the
future, which could result in material charges to the results of operations in
future periods.

     In connection with the Interactive acquisition, the Company acquired
certain Oracle-based products which has allowed the Company to redirect and
focus its Impresa for Backoffice product (previously called ECS) to the
Microsoft centric sequel server-based product. As a result of the overlap in
development efforts, the Company wrote-off capitalized software costs related to
Impresa for Backoffice totaling approximately $3.6 million and included this
charge in acquisition and related costs during 1997.

  Intangible Assets

     Intangible assets arose from the acquisitions of various companies,
including Madic, JIT and GP2 (see Note 2). The excess of cost over the fair
value of the net assets purchased has been allocated to goodwill, customer list,
non-compete agreements, trademarks and trade names, assembled work forces, and
developed technology. These intangible assets are being amortized over estimated
useful lives ranging from three to ten years. Periodically, management assesses
whether there has been a permanent impairment in the value of intangible assets
and the amount of such impairment is determined by comparing anticipated
undiscounted future cash flows from operating activities with the carrying value
of intangible assets.

  Foreign Currency Translation

     The Company has determined that the local currency of the United Kingdom
operations is the functional currency. Accordingly, assets and liabilities are
translated at the current exchange rate at the balance sheet date, and revenues
and expenses are translated at the average exchange rate in effect during the
period. Translation adjustments are reported as a separate component of
shareholders' equity. Realized gains and losses related to foreign currency
transactions are reported as income or expense in the period presented. Such
gains and losses were not material for any period presented.

  Revenue Recognition

     Revenue is derived from licensing software, the sale of hardware,
maintenance, implementation and installation, consulting and custom programming
services. Contract revenue related to software licenses and hardware sales is
recognized upon delivery of the products, provided that no significant vendor
obligations remain and the collection of the related receivable is deemed
probable, net of estimated future returns. Maintenance contract revenue is
recognized ratably over the period the service is provided. Revenue from
implementation and installation, consulting and custom programming is billed and
recognized as the services

                                       F-9
<PAGE>   51
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

are provided. Amounts billed but not recognized are deferred in the accompanying
consolidated balance sheets. DataWorks' policy is in compliance with the
provisions of the American Institute of Certified Public Accountants Statement
of Position No. 91-1, Software Revenue Recognition.

  Concentration of Credit Risk

     DataWorks sells its products primarily to manufacturing companies located
throughout the United States and, to a lesser extent, Europe. Credit is extended
based on an evaluation of the customer's financial condition and terms of
DataWorks' sales normally require a significant up-front cash deposit. DataWorks
estimates its potential losses on trade receivables on an ongoing basis and
provides for anticipated losses in the period in which the revenues are
recognized. Actual losses may differ from DataWorks' estimates, which could have
a material impact on DataWorks' results of operations in future periods. For the
three years ended December 31, 1997, the Company had no individual customer
which accounted for 10% or more of total annual revenues.

  Earnings Per Share

     In 1997, the Financial Accounting Standards Board (FASB) issued Statement
No. 128, Earnings Per Share (SFAS 128). SFAS 128 replaced the calculation of
primary and fully diluted earnings per share with basic and diluted earnings per
share. Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is similar to the previously reported fully diluted earnings
per share. All earnings per share amounts presented, and where appropriate, have
been restated to conform to the SFAS 128 requirements.

  Accounting Standard on Impairment of Long-Lived Assets

     Effective January 1, 1996, DataWorks adopted Statement of Financial
Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets
and Long-Lived Assets to be Disposed Of. The adoption in 1996 had no material
effect on the consolidated financial statements.

  New Accounting Standards

     In June 1997, the FASB issued Statement of Financial Accounting Standards
No. 130, Reporting Comprehensive Income (SFAS 130), which the Company is
required to adopt for 1998. This statement will require the Company to report in
the financial statements, in addition to net income, comprehensive income and
its components including foreign currency items and unrealized gains and losses
on certain investments in debt and equity securities. Upon adoption of SFAS 130,
the Company is also required to reclassify financial statements for earlier
periods provided for comparative purposes. The adoption of SFAS 130 will not
have a significant impact on the Company's consolidated financial statement
disclosures.

     In June 1997, the FASB issued Statement of Financial Accounting Standards
No. 131, Disclosures about Segments of an Enterprise and Related Information
(SFAS 131), which the Company is required to adopt for its 1998 annual financial
statements. This statement establishes standards for reporting information about
operating segments in annual financial statements and requires selected
information about operating segments in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. Under SFAS 131,
operating segments are to be determined consistent with the way that management
organizes and evaluates financial information internally for making operating
decisions and assessing performance. The Company has not determined the impact
of the adoption of this new accounting standard on its consolidated financial
statement disclosures.

     In November 1997, the American Institute of Certified Public Accountants
issued Statement of Position No. 97-2, Software Revenue Recognition (SOP 97-2),
which the Company is required to adopt for

                                      F-10
<PAGE>   52
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

agreements entered into with customers beginning in 1998. This statement
provides guidance for recognizing revenue related to sales by software vendors.
The Company is currently evaluating the impact this statement will have on its
financial condition and results of operations.

  Reclassifications

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

2.  BUSINESS COMBINATIONS

     On September 29, 1997, the Company acquired Interactive Group, Inc., a
Delaware corporation, and its wholly-owned subsidiaries Interactive (UK) Ltd.,
JIT and Interactive France which develops, markets, implements and supports
integrated business information systems that enable discrete manufacturers to
manage their enterprise-wide information requirements. Under the terms of the
acquisition agreement, stockholders of Interactive received 3,709,165 shares of
common stock of the Company based on an exchange ratio of 0.8054 shares for each
share of Interactive common stock they owned at the time the acquisition was
consummated. In addition, options and warrants to acquire Interactive common
stock were converted as a result of the acquisition into equivalent options and
warrants to acquire the Company's common stock, based upon the exchange ratio.
The acquisition has been accounted for under the pooling-of-interests method of
accounting. Accordingly, the historical financial statements for periods prior
to the consummation of the combination have been restated as though the
companies had been combined for all periods presented.

     In connection with the acquisition of Interactive, the Company recorded
one-time acquisition and related costs during the third quarter of 1997 of $15.6
million. These costs included investment banking fees, legal and accounting
fees, certain capitalized software and asset write-offs and various estimated
expenses associated with the integration of operations. At December 31, 1997,
approximately $1.5 million of anticipated integration and severance costs are
included in other accrued liabilities.

     On September 27, 1996, the Company acquired DCD, a Minnesota corporation,
which designs, develops, markets and supports management software for use by
lower tier mid-range manufacturers in the make-to-order manufacturing industry.
In connection with the acquisition, the shareholders of DCD received 1,763,704
shares of common stock of the Company. The acquisition has been accounted for
under the pooling-of-interests method of accounting. Accordingly, the historical
financial statements for periods prior to the consummation of the combination
have been restated as though the companies had been combined for all periods
presented. In connection with the acquisition of DCD, the Company recorded
one-time acquisition and related costs of $3.7 million which consisted of
investment banking fees, legal and accounting fees and certain expenses
associated with the integration of operations.

                                      F-11
<PAGE>   53
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     Total revenues and net income (loss) of DataWorks and Interactive for the
periods preceding the acquisition were as follows (in thousands):

<TABLE>
<CAPTION>
                                                     DATAWORKS    INTERACTIVE    COMBINED
                                                     ---------    -----------    --------
<S>                                                  <C>          <C>            <C>
Six months ended June 30, 1997
  Total revenues...................................   $34,002       $28,442      $ 62,444
  Net income (loss)................................     2,963           367         3,330
Year ended December 31, 1996
  Total revenues...................................    60,748        56,191       116,939
  Net income.......................................     3,236         1,261         4,497
Year ended December 31, 1995
  Total revenues...................................    43,011        32,993        76,004
  Extraordinary item, net of income taxes..........    (1,017)           --        (1,017)
  Net income (loss)................................     2,357        (1,138)        1,219
</TABLE>

     In January 1996, DataWorks purchased certain assets of Arrowkey Systems
("Arrowkey") for $450,000. In accordance with the terms of the agreement, the
Company paid an additional $75,000 in January 1997 and may be required to pay up
to $75,000 in January 1998 and 1999 if certain sales levels of Arrowkey software
products are achieved (as defined). The owner of Arrowkey is an employee of
DataWorks.

     On December 31, 1995, Interactive acquired all of the outstanding shares of
JIT in exchange for $1.5 million of cash, a $2.5 million note payable, and the
assumption of net liabilities of $4.3 million. These liabilities do not take
into account any potential losses associated with litigation that JIT is subject
to in the normal course of business. In the opinion of management, the
resolution of these matters will not have a material adverse effect on the
Company's results of operations or financial position.

     In addition, $1.2 million of contingent consideration is payable in two
installments due January 1998 and 1999 based on a percentage of revenues
generated from the JIT software. During the years ended December 31, 1997 and
1996, Interactive accrued $282,000 and $415,000, respectively, under the earnout
calculation and recorded corresponding increases to its intangible assets
related to the purchase price of JIT (Note 6). A summary of the purchase price
and the allocation of costs to the assets acquired from JIT is as follows as of
December 31, 1995 (in thousands):

<TABLE>
<S>                                                  <C>
Current assets.....................................  $ 2,165
Fixed assets.......................................      863
Intangible assets..................................    2,455
In-process research and development................    3,250
                                                     -------
                                                     $ 8,733
                                                     =======
</TABLE>

     During 1995, following the acquisition of JIT, Interactive wrote-off the
purchased in-process research and development and this amount is included in
research and development expense.

     On July 25, 1997, Interactive acquired substantially all of the outstanding
shares of Genie Productique/ Gestion de Production ("GP2"), subsequently renamed
Interactive France, a small provider of ERP software solutions to the
manufacturing mid-market in France, in exchange for approximately $420,000 plus
an additional $167,000 of contingent consideration payable over three years
based on a percentage of revenues generated primarily from Interactive France's
installed base of customers. The transaction was accounted for as a purchase and
DataWorks' statements of operations include the results of operations of
Interactive France from the date of acquisition. The excess of cost over the
fair value of the net assets purchased has been allocated to customer base and
assembled work force.

                                      F-12
<PAGE>   54
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

3.  FINANCIAL STATEMENT INFORMATION

  Equipment, Furniture and Fixtures

     Equipment, furniture and fixtures consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              -------------------
                                                                1997       1996
                                                              --------    -------
<S>                                                           <C>         <C>
Computer equipment..........................................  $ 11,133    $ 9,051
Office furniture, fixtures and equipment and other..........     7,574      5,337
                                                              --------    -------
                                                                18,707     14,388

Less accumulated depreciation and amortization..............   (10,523)    (7,318)
                                                              --------    -------
                                                              $  8,184    $ 7,070
                                                              ========    =======
</TABLE>

  Intangible Assets

     Intangible assets consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              ------------------
                                                               1997       1996
                                                              -------    -------
<S>                                                           <C>        <C>
Customer list...............................................  $ 3,300    $ 3,300
Goodwill....................................................    1,531      1,531
Covenant not to compete.....................................      960        810
Assembled workforce.........................................    1,013        831
Trademarks and trade names..................................      457        457
Customer base...............................................      990        563
Developed technology........................................    1,053        770
Other.......................................................       68         68
                                                              -------    -------
                                                                9,372      8,330
Less accumulated amortization...............................   (3,289)    (2,129)
                                                              -------    -------
                                                              $ 6,083    $ 6,201
                                                              =======    =======
</TABLE>

4.  SHORT-TERM INVESTMENTS

     At December 31, 1997, the amortized cost of short-term investments
classified as available-for-sale was as follows (in thousands):

<TABLE>
<CAPTION>
                                                              AMORTIZED
                                                                COST
                                                              ---------
<S>                                                           <C>
U.S. government debt securities.............................   $ 2,739
Tax exempt commercial paper and auction securities..........     1,007
Municipal bonds.............................................    26,757
                                                               -------
                                                               $30,503
                                                               =======
</TABLE>

     The amortized cost of these securities approximates fair value at December
31, 1997. No significant gains or losses were realized during the years ended
December 31, 1997 and 1996.

                                      F-13
<PAGE>   55
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

5.  EMPLOYEE STOCK OWNERSHIP PLAN AND RECAPITALIZATION

     DCD established an ESOP in 1992 for the benefit of all employees meeting
certain eligibility requirements. In 1992, DCD obtained financing of $2,550,000
from a commercial bank and advanced the proceeds to the ESOP which purchased
899,640 shares of common stock from a DCD stockholder. The ESOP note payable was
secured by the assets of DCD and a $500,000 personal guarantee of the selling
stockholder. During 1995, the ESOP note payable and "Receivable from ESOP" were
paid in full.

     DCD recorded the funds advanced to the ESOP as a "Receivable from ESOP"
which was a reduction of stockholders' equity. As DCD made discretionary
contributions and dividends to the ESOP, these amounts were used to repay the
"Receivable from ESOP" and the related ESOP note payable. As the principal
amount of the loan was repaid, the "Receivable from ESOP" was reduced
accordingly. The amount of the repayments during 1995 was $1,087,503.

     During 1995, DCD paid $56,408 of interest expense, contributed $438,477 to
the ESOP and incurred $7,073 of other ESOP related expenses. Also during 1995,
DCD paid dividends of $649,026 on common stock owned by the ESOP. At December
31, 1995, the ESOP had released and allocated 899,640 shares.

6.  LONG-TERM OBLIGATIONS

     Long-term obligations consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                              -----------------
                                                               1997      1996
                                                              ------    -------
<S>                                                           <C>       <C>
8.75% note payable to Fourth Shift Corporation; principal
  and interest payable in twelve equal quarterly
  installments of $239,130 each, commencing on April 1,
  1996; paid September 30, 1997.............................  $   --    $ 1,934
Revolving line of credit agreement with Royal Bank of
  Scotland plc (the "Royal Bank of Scotland Agreement");
  interest payable monthly at the bank's prime rate, plus 2%
  (9.25% at December 31, 1997); expires July 31, 1998.......     721         --
Revolving line of credit agreement; interest payable
  monthly; repaid and cancelled September 30, 1997..........      --      1,200
Non-interest bearing earnout payable to FSC; due in varying
  amounts until January 31, 1999............................     697        415
Non-interest bearing earnout payable to GP2; due in varying
  amounts until July 25, 2000...............................     420         --
Other.......................................................     376        328
                                                              ------    -------
                                                               2,214      3,877
Less current portion of long-term obligations...............    (721)    (2,013)
                                                              ------    -------
                                                              $1,493    $ 1,864
                                                              ======    =======
</TABLE>

     Maturities of long-term obligations are as follows (in thousands):

<TABLE>
<CAPTION>
              YEARS ENDED DECEMBER 31,
              ------------------------
<S>                                                   <C>
1998................................................  $  721
1999................................................   1,264
2000................................................     200
2001................................................      26
2002 and thereafter.................................       3
                                                      ------
                                                      $2,214
                                                      ======
</TABLE>

                                      F-14
<PAGE>   56
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     The Royal Bank of Scotland Agreement is limited to borrowings of 800,000
British pounds (approximately $1.3 million at December 31, 1997) and is secured
by the accounts receivable of Interactive (U.K.) Ltd. The Royal Bank of Scotland
Agreement contains restrictive covenants, including limitations on the payment
of dividends. At December 31, 1997, the Company was in compliance with all such
covenants.

     In June 1997, the Company amended its banking facility agreement to be
uncommitted. This facility provides for borrowings up to a maximum of $6 million
and bears interest at the bank's prime rate (8.5% at December 31, 1997). This
uncommitted arrangement can be withdrawn by the lender at any time, at their
option. At December 31, 1997, DataWorks had no borrowings outstanding under the
banking facility.

7.  EXTRAORDINARY ITEM

     In connection with the repayment of a senior term note payable in September
1995 and the settlement of subordinated notes payable in August and November
1995, the related unamortized debt issue costs and debt discount were written
off. In addition, DataWorks also incurred prepayment and other cash charges
related to the payment of the senior term note. In accordance with generally
accepted accounting principles, these write-offs and cash charges, net of the
related income tax benefits, have been reported as extraordinary items in the
accompanying consolidated statements of operations. The composition of the
extraordinary items are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                 YEAR ENDED
                                                              DECEMBER 31, 1995
                                                              -----------------
<S>                                                           <C>
Write-off of unamortized debt issue costs and debt
  discount..................................................       $  886
Cash prepayment penalty and other cash charges..............          838
                                                                   ------
                                                                    1,724
Income tax benefit..........................................         (707)
                                                                   ------
                                                                   $1,017
                                                                   ======
</TABLE>

8.  INCOME TAXES

     The provision for income taxes consists of the following (in thousands):

<TABLE>
<CAPTION>
                                                            YEARS ENDED DECEMBER 31,
                                                           --------------------------
                                                            1997      1996      1995
                                                           ------    ------    ------
<S>                                                        <C>       <C>       <C>
Current:
  Federal................................................  $2,324    $1,827    $1,113
  Foreign................................................     611       561       398
  State..................................................     717       480       269
                                                           ------    ------    ------
                                                            3,652     2,868     1,780
Deferred:
  Federal................................................    (622)      720      (779)
  Foreign................................................      --        --        --
  State..................................................    (184)       54       (69)
                                                           ------    ------    ------
                                                             (806)      774      (848)
                                                           ------    ------    ------
                                                           $2,846    $3,642    $  932
                                                           ======    ======    ======
</TABLE>

                                      F-15
<PAGE>   57
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     Deferred income taxes are provided for temporary differences in recognizing
certain income and expense items for financial reporting and tax reporting
purposes. Significant components of deferred tax assets and liabilities are as
follows (in thousands):

<TABLE>
<CAPTION>
                                                                 YEARS ENDED
                                                                 DECEMBER 31,
                                                              ------------------
                                                               1997       1996
                                                              -------    -------
<S>                                                           <C>        <C>
Deferred tax liabilities:
  Difference in tax basis of acquired intangibles...........  $  (847)   $(1,066)
  Capitalized software costs................................   (1,665)    (1,735)
  Depreciation..............................................       --        (49)
  Other.....................................................      (70)      (110)
                                                              -------    -------
Total deferred tax liabilities..............................   (2,582)    (2,960)
Deferred tax assets:
  Net operating loss and credit carryforwards...............      323      1,205
  Deferred revenue and expenses.............................       38        500
  Allowance for doubtful accounts and product returns.......      889        307
  Depreciation..............................................      394         --
  Purchased research and development........................    1,155      1,183
  Accrued liabilities and other.............................    2,196      1,347
                                                              -------    -------
Total deferred tax assets...................................    4,995      4,542
                                                              -------    -------
Net deferred tax assets.....................................  $ 2,413    $ 1,582
                                                              =======    =======
</TABLE>

     The effective income tax rate varied from the statutory federal rate as
follows:

<TABLE>
<CAPTION>
                                                            YEARS ENDED DECEMBER 31,
                                                           --------------------------
                                                            1997      1996      1995
                                                           ------    ------    ------
<S>                                                        <C>       <C>       <C>
Income tax provision at statutory rate...................  $  695    $2,784    $1,077
State income tax provision, net of federal benefits......     352       410       163
Benefit of tax credits...................................    (416)     (278)     (105)
Non deductible merger expenses...........................   1,901       682        --
ESOP dividend tax benefit................................      --        --      (256)
Effect of foreign rates..................................      --        16       (38)
Utilization of research tax credits and net operating
  loss carryforwards.....................................      --      (228)       --
Permanent differences....................................    (477)       73       (54)
Other....................................................     791       183       145
                                                           ------    ------    ------
                                                           $2,846    $3,642    $  932
                                                           ======    ======    ======
</TABLE>

     At December 31, 1997, DataWorks has a consolidated federal research and
development credit carryforward of approximately $312,000 which will begin to
expire in 2012, unless previously utilized.

     In accordance with Sections 382 and 383 of the Internal Revenue Code, a
change in ownership of greater than fifty percent of a corporation within a
three-year period will place an annual limitation on the corporation's ability
to utilize its existing carryforwards.

                                      F-16
<PAGE>   58
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

9.  RECEIVABLE FROM OFFICER

     At December 31, 1997 and 1996, the receivable from officer is from one of
DataWorks' principal officers and shareholders and consists of net advances
totaling $97,000 and $155,300, respectively, and is included in other assets.
The advances will be repaid or offset against any future performance bonuses
earned and approved by the Board of Directors.

10.  COMMITMENTS AND CONTINGENCIES

     The Company is obligated under various noncancellable operating leases for
equipment, vehicles and office space through 2004. Certain of the leases provide
that the Company pay all or a portion of taxes, maintenance, insurance and other
operating expenses, and certain of the rents are subject to adjustment for
changes as determined by certain consumer price indices and exchange rates. Two
of DataWorks' corporate office lease agreements provide for deferred payment
terms. For financial reporting purposes, rent expense is recorded on the
straight-line basis over the term of the lease and the difference between rent
expense accrued and amounts paid under the lease agreements are included in
other liabilities in the accompanying consolidated balance sheets.

     Minimum lease commitments for noncancellable operating leases as of
December 31, 1997 are as follows (in thousands):

<TABLE>
<CAPTION>
             YEARS ENDED DECEMBER 31,
             ------------------------
<S>                                                  <C>
1998...............................................  $ 4,160
1999...............................................    3,360
2000...............................................    2,356
2001...............................................    2,187
2002 and thereafter................................    2,231
                                                     -------
                                                     $14,294
                                                     =======
</TABLE>

     Aggregate rent expense was approximately $4,162,000, $3,437,000 and
$2,663,000 in 1997, 1996 and 1995, respectively.

     During 1997, the Company entered into various software resell agreements
with third party software providers. These resell agreements generally require
certain minimum levels of renumeration during the term of the agreements in the
form of quarterly or annual minimum royalty and maintenance support payments. At
December 31, 1997, the Company is obligated to make minimum payments related to
these resell agreements as follows (in thousands):

<TABLE>
<CAPTION>
            YEARS ENDED DECEMBER 31,
            ------------------------
<S>                                                  <C>
1998.............................................    $ 1,927
1999.............................................      3,360
2000.............................................      2,261
2001.............................................      2,968
                                                     -------
                                                     $10,516
                                                     =======
</TABLE>

  Contingencies

     The Company is subject to legal proceedings and claims that arise in the
normal course of business. While the outcome of the proceedings and claims
cannot be predicted with certainty, management does not believe that the outcome
of any of these matters will have a material adverse effect on the Company's
consolidated financial condition or results of operations.

                                      F-17
<PAGE>   59
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

11.  SHAREHOLDERS' EQUITY

  Common Stock

     In January 1991, the Company entered into a stock and cash bonus
arrangement (the "Arrangement") with an officer of the Company that provided for
the issuance of common stock as a bonus for services rendered. On January 1,
1995, the Company issued 90,849 shares of common stock and a related cash bonus
sufficient to cover the related income tax under the Arrangement. No further
cash or stock bonuses have been provided for under this Arrangement. On March
20, 1995, the Company removed the forfeiture provisions associated with the
Arrangement, and compensation expense of $871,000 related to this bonus was
recorded which consisted of the then current fair value of the common stock and
the related cash bonus under the Arrangement.

  Preferred Stock

     As of December 31, 1997, DataWorks is authorized to issue 5,000,000 shares
of preferred stock; no shares are outstanding.

  Warrants

     In connection with various financing arrangements, the Company issued
warrants to purchase 1,382,183 shares of DataWorks' common stock at prices
ranging from $0.26 to $8.68 per share. In connection with the completion of the
initial public offering in November 1995, 1,345,869 warrants were converted to
1,050,843 shares of common stock for cash proceeds of $175,439 and the
settlement of $1,300,000 of subordinated notes payable. During 1997 and 1996,
warrants were exercised for the purchase of 988 and 14,092 shares of common
stock, respectively, at $8.68 per share. At December 31, 1997, warrants to
purchase 21,234 shares of common stock at $8.68 per share remain outstanding.
The warrants expire in August, 2000.

     In addition, in May 1995, the Company granted a warrant to an underwriter
for the purchase of up to 104,702 shares of common stock at an exercise price of
$9.68 per share. The warrant expires in May, 2000.

     In 1990, a warrant was issued to a shareholder to purchase 113,852 shares
of Company common stock at $0.22 per share. The warrant was exercised in March,
1995 by reducing the subordinated debenture payable to the shareholder.

  Stock Option Exercised by Officer

     In July 1996, an officer of DCD exercised an option to acquire 37% of DCD's
common shares in accordance with the terms of the option. For tax purposes, the
exercise of the option is compensatory. Accordingly, for the year ended December
31, 1996, the Company recorded a tax benefit of approximately $2.5 million as an
addition to common stock.

  Stock Option Plans

     The Company has elected to follow Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees (APB 25) and related
Interpretations, in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under
Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation (SFAS 123), requires use of option valuation models that were not
developed for use in valuing employee stock options. Under APB 25, because the
exercise price of the Company's employee stock options equals the market price
of the underlying stock on the date of grant, no compensation expense is
recognized.

     DataWorks has an Equity Incentive Plan (the "Plan") under which 2,824,127
shares of common stock are reserved for issuance to eligible employees,
directors and consultants of DataWorks. The Plan provides for

                                      F-18
<PAGE>   60
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

awards in the form of options, stock bonuses, restricted shares or stock
appreciation rights ("SARs"). The terms of any stock awards under the Plan,
including vesting requirements, are determined by the Board of Directors,
subject to the provisions of the Plan. Options issued under the Plan are either
incentive stock options ("ISOs") or nonstatutory stock options ("NSOs"). The
exercise price of the ISOs is not less than the fair market value on the date of
grant and the exercise price of the NSOs is determined by the Board of
Directors. Options granted under the Plan generally become exercisable over a
period of four years and the maximum term of options granted is ten years. For
the years ended December 31, 1997, 1996 and 1995, the Company recorded $89,000,
$91,000 and $15,000, respectively, in compensation expense related to employee
stock options granted at less than fair market value on the date of grant.

     On September 13, 1995, DataWorks adopted the Non-Employee Directors' Stock
Option Plan (the "Directors' Plan") under which 150,000 shares of common stock
are reserved for issuance upon exercise of options granted by DataWorks to
non-employee members of the board of directors. The exercise price of the
options will be at the fair market value of the stock on the date of grant.
Options granted under the Directors' Plan will become exercisable over three
years and expire ten years from the date of grant. As of December 31, 1997,
100,000 options were granted under the Directors' Plan.

     In addition, at December 31, 1997, DataWorks has outstanding options to
purchase an additional 102,169 shares of common stock at prices ranging from
$1.30 to $5.20 per share outside of the plans, of which 47,172 were exercisable.
The Company recorded $70,000 of expense related to the estimated fair market
value of certain of these options on their date of grant during the year ended
December 31, 1996.

     Pro forma information regarding net income and earnings per share is
required by SFAS 123, and has been determined as if the Company has accounted
for its employee stock options under the fair value method of that Statement.
The fair value of these options was estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions for 1997, 1996 and 1995, respectively: risk-free interest rates of
6.25%, 6% and 6%; dividend yield of 0%; volatility factors of the expected
market price of the Company's common stock of 76.5%, 67.5% and 67.5% for 1997,
1996 and 1995, respectively, and a weighted-average life of the options of 5.15,
4.06 and 4.09 years for 1997, 1996 and 1995, respectively.

     The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which 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 employee 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 employee stock options.

     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 (in thousands, except for earnings per share
information):

<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,
                                                          ---------------------------
                                                           1997       1996      1995
                                                          -------    ------    ------
<S>                                                       <C>        <C>       <C>
Pro forma net income (loss).............................  $(2,913)   $3,406    $1,147
                                                          =======    ======    ======
Pro forma basic earnings (loss) per share...............  $ (0.21)   $ 0.30    $ 0.17
                                                          =======    ======    ======
Pro forma diluted earnings (loss) per share.............  $ (0.21)   $ 0.28    $ 0.15
                                                          =======    ======    ======
</TABLE>

     The results above are not likely to be representative of the effects of
applying FAS 123 on reported net income or loss for future years as these
amounts reflect the expense for only one, two or three years vesting.

                                      F-19
<PAGE>   61
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     A summary of the Company's stock option activity, including those issued
outside of the plans, and related information for the years ended December 31
follows:

<TABLE>
<CAPTION>
                                    1997                    1996                    1995
                            ---------------------   ---------------------   ---------------------
                                        WEIGHTED-               WEIGHTED-               WEIGHTED-
                                         AVERAGE                 AVERAGE                 AVERAGE
                                        EXERCISE                EXERCISE                EXERCISE
                             OPTIONS      PRICE      OPTIONS      PRICE      OPTIONS      PRICE
                            ---------   ---------   ---------   ---------   ---------   ---------
<S>                         <C>         <C>         <C>         <C>         <C>         <C>
Outstanding -- beginning
  of year.................  1,399,516    $11.16     1,104,927    $ 3.91       525,788     $ .26
  Granted.................    877,878     15.08       662,301     17.67       682,359      6.06
  Exercised...............   (172,207)     1.95      (335,158)      .67       (64,759)      .49
  Forfeited...............   (125,601)    11.56       (32,554)     7.02       (38,461)      .39
                            ---------               ---------               ---------
Outstanding -- end of
  year....................  1,979,586    $13.85     1,399,516    $11.16     1,104,927     $3.91
                            =========               =========               =========
Exercisable at end of
  year....................    584,465                 390,351                 358,761
Weighted-average fair
  value of options granted
  during year.............  $   11.93               $    9.27               $    2.04
</TABLE>

     The weighted-average remaining contractual life of the options outstanding
at December 31, 1997 is 8.45 years.

     The following table summarizes information about stock options outstanding
at December 31, 1997:

<TABLE>
<CAPTION>
                                 OUTSTANDING                           EXERCISABLE
                  ------------------------------------------   ----------------------------
                                 REMAINING       WEIGHTED                    EXERCISE PRICE
   RANGE OF         NUMBER      CONTRACTUAL      AVERAGE         NUMBER         WEIGHTED
EXERCISE PRICES   OUTSTANDING      LIFE       EXERCISE PRICE   EXERCISABLE      AVERAGE
---------------   -----------   -----------   --------------   -----------   --------------
<S>               <C>           <C>           <C>              <C>           <C>
$ 0.26 to  0.65      52,311        6.12           $  .46          37,204         $ 0.39
  2.86 to  3.72     107,891        6.21             3.25          64,350           3.29
  5.02 to  6.83     239,841        8.79             6.30          50,167           5.87
     7.53           150,340        7.81             7.53          80,360           7.53
  9.31 to  1.06     243,989        7.97            10.59         157,945          10.60
     11.50          126,415        8.00            11.50          55,602          11.50
 13.25 to 14.50      90,527        9.50            13.89           4,443          14.50
 15.30 to 16.00     334,106        8.34            15.64          22,859          16.00
 18.13 to 18.50     312,166        9.67            18.46          11,804          18.20
 21.75 to 25.75     322,000        8.78            25.23          99,731          25.26
</TABLE>

     At December 31, 1997, options for 560,461 shares were available for future
grant.

  Employee Stock Purchase Plan

     On September 13, 1995, DataWorks adopted an Employee Stock Purchase Plan
(the "Purchase Plan") under which 440,734 shares of common stock were reserved
for sale to employees. DataWorks' Board of Directors may grant eligible
employees the right to purchase a fixed number of shares of common stock (up to
but not exceeding 15% of each employee's earnings) over a fixed offering period
(not to exceed 27 months) at the lesser of 85% of the fair market value of the
stock on the grant date or 85% of the fair market value on the purchase date or
dates specified on the date of grant. At December 31, 1997, 333,150 shares have
been issued under the Purchase Plan.

                                      F-20
<PAGE>   62
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

  Shares Reserved for Future Issuance

     The following common stock is reserved for future issuance at December 31,
1997:

<TABLE>
<S>                                                           <C>
Stock options:
  Granted and outstanding...................................  1,979,586
  Reserved for future grants................................    560,461
                                                              ---------
                                                              2,540,047
Warrants....................................................    125,936
Employee stock purchase plan................................    107,584
                                                              ---------
                                                              2,773,567
                                                              =========
</TABLE>

12.  EMPLOYEE RETIREMENT AND PROFIT SHARING PLANS

     Effective July 1, 1994, DataWorks established a 401(k) defined contribution
retirement plan (the "Retirement Plan") covering all employees. The Retirement
Plan provides for voluntary employee contributions from 1% to 15% of annual
compensation (as defined). DataWorks may contribute such amounts as determined
by the Board of Directors. Participants vest in employer contributions over five
years at a rate of 20% for each year of service. There were no employer
contributions to the Retirement Plan during the years ended December 31, 1997,
1996 or 1995.

     Interactive maintains profit sharing and deferred savings plans for its
employees, which allow participants to make contributions by salary reduction
pursuant to Section 401(k) of the Internal Revenue Code. Under both plans,
Interactive contributions are discretionary, and employees vest immediately in
their contributions. Interactive U.K. Subsidiary also maintains a defined
contribution pension plan for its employees. Expenses for the plans aggregated
approximately $790,000, $571,000, and $314,000 for the years ended December 31,
1997, 1996 and 1995, respectively.

     In addition, DCD has a profit sharing plan which provides for an annual
contribution not to exceed the maximum allowed as a deduction under the Internal
Revenue Code. The plan covers substantially all employees after specified
periods of service and the attainment of minimum age requirements. Each year's
contribution is determined by the Board of Directors. No Company contributions
to the plan were declared or made during 1997, 1996 or 1995.

     Effective July 1996, DCD established a 401(k) defined contribution
retirement plan (the "DCD plan") covering all employees of DCD. The DCD plan
provides for voluntary employee contributions from 1% to 15% of annual
compensation (as defined). DCD may match these contributions at 50% on the first
6% of employee contributions. For the years ended December 31, 1997 and 1996,
DCD contributions to the plan totaled $0 and $87,000, respectively.

13.  EARNINGS PER SHARE

     The following table sets forth the computation of basic and diluted
earnings per share (in thousands except per share amounts):

<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,
                                                         ----------------------------
                                                          1997       1996       1995
                                                         -------    -------    ------
<S>                                                      <C>        <C>        <C>
Numerator
  Net income (loss)....................................  $  (804)   $ 4,497    $1,219
                                                         =======    =======    ======
  Numerator for basic and diluted earnings per
     share -- income (loss) available to common
     shareholders......................................  $  (804)   $ 4,497    $1,219
                                                         =======    =======    ======
</TABLE>

                                      F-21
<PAGE>   63
                             DATAWORKS CORPORATION

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,
                                                         ----------------------------
                                                          1997       1996       1995
                                                         -------    -------    ------
<S>                                                      <C>        <C>        <C>
Denominator
  Weighted average common shares outstanding -- shares
     used in computing basic earnings per share........   13,811     11,392     6,929
     Weighted average options and warrants to purchase
       common stock as determined by the treasury
       method..........................................       --        562       878
                                                         -------    -------    ------
  Shares used in computing diluted earnings per
     share.............................................   13,811     11,954     7,807
                                                         =======    =======    ======
Basic earnings (loss) per share........................  $ (0.06)   $  0.39    $ 0.17
                                                         =======    =======    ======
Diluted earnings (loss) per share......................  $ (0.06)   $  0.38    $ 0.16
                                                         =======    =======    ======
</TABLE>

     The earnings (loss) per share information was computed applying the
requirements of recently effective Statement of Financial Accounting Standards
No. 128 and SEC Staff Accounting Bulletin No. 98.

14.  GEOGRAPHIC DATA

     The Company's operations consist of one business segment: the development,
marketing, implementation, and support of integrated business information
systems for the discrete manufacturing industry. The Company has operations in
North America and Europe. The operations and identifiable assets of the Company
by geographic area are as follows (in thousands):

<TABLE>
<CAPTION>
                                                         YEARS ENDED DECEMBER 31,
                                                     --------------------------------
                                                       1997         1996       1995
                                                     --------     --------    -------
<S>                                                  <C>          <C>         <C>
Revenues from unaffiliated customers:
  North America....................................  $121,689     $ 96,794    $62,768
  Europe...........................................    25,274       20,145     13,236
                                                     --------     --------    -------
                                                     $146,963     $116,939    $76,004
                                                     ========     ========    =======
Income (loss) before income taxes:
  North America....................................  $ (1,402)(a) $  6,138(b) $ 1,995
  Europe...........................................     3,444        2,001      1,173
                                                     --------     --------    -------
                                                     $  2,042     $  8,139    $ 3,168
                                                     ========     ========    =======
Identifiable assets:
  North America....................................  $116,775     $111,797    $55,777
  Europe...........................................    14,361        9,405      7,139
                                                     --------     --------    -------
                                                     $131,136     $121,202    $62,916
                                                     ========     ========    =======
</TABLE>

---------------
(a) Includes one-time charges in the aggregate, after-tax amount of $11.9
    million in connection with the Interactive acquisition.

(b) Includes one-time charges in the aggregate, after-tax amount of $2.1 million
    in connection with the DCD acquisition.

                                      F-22