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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                           Washington, D.C. 20549

                                   FORM 10-K

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

(Mark One)

  /X/  Annual report pursuant to Section 13 or 15(d) of the Securities
       Exchange Act of 1934.

                 For the fiscal year ended December 31, 1997

                                      or

  / /  Transition report pursuant to section 13 or 15(d) of the Securities
       Exchange Act of 1934.

            For the transition period from __________ to __________

                        Commission File Number 0-26778

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

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

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

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


           5020 148th Avenue N.E., Redmond, Washington 98052-5172
                                (425) 882-2000
      (Address, including zip code, of Registrant's principal executive
              offices and telephone number, including area code)

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

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

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

Common stock: 6,904,015 shares outstanding as of March 20, 1998

    The aggregate market value of the Common Stock held by non-affiliates of
the registrant, based on the closing price on March 20, 1998, as reported on
NASDAQ, was $19,776,415.(1)

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

                      DOCUMENTS INCORPORATED BY REFERENCE

    Portions of the registrant's Proxy Statement relating to the registrant's
1998 Annual Meeting of Stockholders to be held on May 22, 1998, are
incorporated by reference into Part III of this Report.

    This report includes exhibits consists of 53 pages. The exhibit index
appears on page 49.

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                               TABLE OF CONTENTS

<TABLE>
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                                                                     PAGE
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<S>                                                                  <C>

Part I.

Item 1.   Business...................................................   1

Item 2.   Properties.................................................  14

Item 3.   Legal Proceedings..........................................  14

Item 4.   Submission of Matters to a Vote of Security Holders........  14

Item 4A.  Executive Officers of the Registrant.......................  15

Part II.

Item 5.   Market for Registrant's Common Equity and Related
          Stockholder Matters........................................  16

Item 6.   Selected Financial Data....................................  17

Item 7.   Management's Discussion and Analysis of Financial
          Condition and Results of Operations........................  17

Item 8.   Financial Statements and Supplementary Data................  24

Item 9.   Changes in and Disagreements with Accountants on
          Accounting and Financial Disclosure........................  45

Part III.

Item 10.  Directors and Executive Officers of the Registrant.........  45

Item 11.    Executive Compensation...................................  45

Item 12.    Security Ownership of Certain Beneficial Owners and
            Management...............................................  45

Item 13.    Certain Relationships and Related Transactions...........  45

Part IV.

Item 14.    Exhibits, Financial Statement Schedules, and Reports
            on Form 8-K..............................................  45

</TABLE>

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                                     PART I

ITEM 1. BUSINESS

OVERVIEW

    Applied Microsystems is a leading provider of hardware-enhanced software
tools for the design, debugging and testing of embedded software. The Company
believes that by using its tools manufacturers are able to improve the
quality and performance of their embedded software, reduce development costs
and accelerate time-to-market.

INDUSTRY BACKGROUND

    Manufacturers worldwide are making increasing use of embedded systems to
enhance the functionality and performance, reduce the cost and size, and
improve the reliability of a broad variety of products. Embedded systems are
incorporated within electronic devices and are dedicated to performing
specific tasks quickly and reliably in response to rapidly occurring external
events. Embedded systems generally include an embedded microprocessor (often
referred to as a microcontroller or MCU), a read-only memory ("ROM"),
real-time operating system ("RTOS") software and custom software to implement
assigned applications. Embedded systems are used extensively in industries
such as internetworking, telecommunications, computer peripherals, office
products, medical instrumentation and industrial process control, as well as
in consumer markets such as the automotive and entertainment industries. For
example, cellular telephone switching systems use embedded systems to
coordinate the routing and connection of thousands of simultaneous calls as
users move from cell to cell. Use of embedded systems is now widespread among
manufacturers of a wide variety of products, including automotive braking
systems, hospital patient monitors, airplane flight control systems, modems
and facsimile machines, stereo equipment, cellular telephones, automated
teller machines and video games.

    Industry sources estimate that embedded microprocessors accounted for
more than 90% of all microprocessors sold worldwide in 1996. As the computing
power of embedded microprocessors has grown from early 4- and 8-bit
architectures to today's 16- and 32-bit architectures, and as unit prices for
most embedded microprocessors have declined, manufacturers have been able to
incorporate vastly improved features, speed and reliability into their
products at relatively low incremental cost. According to industry sources,
microprocessors manufactured by Intel, AMD and Motorola account for a
majority of the 16- and 32-bit embedded microprocessors purchased annually on
a worldwide basis.

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

    The absence of any visual display, keyboard or other input/output device,
and the need to translate embedded software from the engineer's programming
language into machine code that can be understood by the embedded
microprocessor, both complicate the technical challenge posed by embedded
systems development. The software development phase of the process, as well
as the system integration phase in which hardware and software are first
operated together, are highly iterative,

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error-prone and time-consuming phases during which software bugs and system
errors are identified and remedied. Following system integration, during the
system test and validation phase, the performance and reliability of the
embedded software are assessed, typically by means of relatively incomplete
and time-consuming testing procedures.

    As the volume and complexity of embedded software have increased in
recent years, the Company believes that many manufacturers have come to view
the design, debugging and testing of embedded software as a bottleneck that
may impede the timely development of new products. In an effort to address
the complex challenges posed by these necessary tasks, manufacturers
typically purchase development tools from third-party vendors. A variety of
alternative technical solutions are available to help embedded systems
developers in their efforts to shorten product development cycles and deliver
high-quality, reliable products. These solutions fall into two major groups:
software-only solutions and hardware-enhanced software solutions.

    Software-only solutions, such as ROM monitors and high-level language
debuggers, reside partially in the embedded system and partially on the
software engineer's workstation or personal computer. These products have the
advantage of relatively low cost and ease-of-use, but require extra system
memory and an input/output path, one or both of which may not exist in the
embedded system's design. They also are vulnerable to complete system
failures (or "crashes") and can interfere with the real-time behavior of the
embedded system. These drawbacks render such software-only solutions less
effective for many applications, especially those in which the embedded
system must deal with multiple, high-speed, random inputs where timing
considerations are critical.

    Hardware-enhanced software solutions, such as in-circuit emulators and
logic analyzers, utilize both software and hardware components in performing
design, debugging and testing functions. In an emulator, for example, the
software component resides partially on the engineer's workstation and
partially within the emulator's hardware. An emulator's hardware includes
control, communications and memory components, connected to the embedded
system's circuitry through a "probe" which replaces or attaches to the
embedded microprocessor. Both the software and hardware components of a
hardware-enhanced software tool are generally designed for use with a
specific type of embedded microprocessor. By emulating the embedded
microprocessor and its memory, emulators can perform design and debugging
functions at earlier stages of the development process than software-only
solutions. Emulators are also less susceptible to system crashes, can provide
the software engineer with broader features and capabilities, and allow
operation of the embedded system in real-time with minimal interference from
the tool. Hardware-enhanced software solutions, however, are typically more
expensive than software-only solutions, and historically have been relatively
difficult to learn to use and to operate.

    Both software-only and hardware-enhanced software solutions, although
capable of performing some basic testing functions, have traditionally been
used primarily for debugging embedded systems. Neither class of tools has
historically been optimized to perform a broad range of tests for embedded
software. As a result, real-time testing of embedded software has remained an
especially difficult problem for which the tools available to software
engineers have provided limited solutions.

    In their efforts to remain competitive, manufacturers are increasingly
faced with the demands of two fundamental but conflicting pressures. As they
incorporate increasing numbers of 16- and 32-bit embedded microprocessors
into their products, these manufacturers must hire more software engineers,
develop more embedded software, and intensify their debugging and testing
efforts, all of which tend to lengthen product development cycles or increase
development costs. At the same time, competitive demands for technologically
superior products without corresponding cost increases and decreasing
electronics product life cycles create pressures to minimize development
costs and time-to-market. The

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Company's products are designed to help electronics manufacturers respond
successfully to both of these conflicting demands.

THE APPLIED MICROSYSTEMS SOLUTION

    The Company is a leading provider of hardware-enhanced software tools for
the design, debugging and testing of embedded software. Its software design
and debugging tools, including CodeICE-TM-, CodeTAP-TM-, SuperTAP-TM- and EL
Series in-circuit emulation devices and NetROM-TM- ROM emulator, enable
software engineers to observe and control software functions in a high-level
programming language during the design and system integration phases of
embedded software development. The Company's CodeTEST-TM- software testing
tools are designed to measure the performance and reliability of embedded
software in a minimally intrusive manner, as well as the adequacy of the test
process itself, and to present these measurements in a format designed to be
understood easily by software engineers. The Company's VSP/TAP-TM-/Eagle
co-verification tools allow a project team to simulate their entire design,
both hardware and software, prior to committing to expensive custom
integrated circuits and printed circuit boards. The Company's tools are used
in a variety of industries characterized by rapid technological advances and
competitive pressures to shorten development cycles, with a resulting need
for extensive debugging and testing of embedded software prior to product
release. The Company believes that, by using the Company's tools, customers
are able to improve the quality and reliability of their embedded software
and the performance of their products, shorten product development cycles,
increase engineering productivity and reduce overall embedded systems
development costs.

    The Company's products support a broad range of 16- and 32-bit embedded
microprocessors manufactured primarily by Intel, AMD and Motorola. Its tools
are designed to run at the highest clock speeds of the microprocessors
supported by the Company, which allows debugging and testing to be conducted
in real-time. Each of the Company's products includes two specialized
components: a hardware probe that replaces or attaches to the embedded
microprocessor, and software that resides in the hardware and on the
engineer's workstation. The hardware component provides an input/output path
through which the software engineer can observe and in certain cases control
the microprocessor's execution of software. The software component permits
the engineer to observe, test or control embedded software functions in a
high-level programming language and at real-time speeds without significantly
interfering with the embedded system's performance. The hardware and software
components of the Company's tools work together to perform design, debugging
and testing tasks, and are designed specifically for use with a particular
type of embedded microprocessor. In addition to supporting a broad range of
embedded microprocessors, the Company's tools offer a variety of easy-to-use
features and capabilities, across a range of prices.

BUSINESS STRATEGY

    The Company's principal business objective is to be the leading worldwide
solutions provider of tools for use in the design, debugging and testing of
embedded software. The central elements of the Company's business strategy
include:

    -  MAINTAIN TECHNOLOGY LEADERSHIP.  The Company has established a
       technology leadership position in a number of areas, including
       emulator speeds, emulator form factors, embedded software testing
       tools and hardware/software co-verification. Through the use of ASICs
       and certain hardware design techniques, the Company has been able to
       develop smaller tools capable of operating at the highest clock speeds
       of the microprocessors supported by the Company. With its patented
       CodeTAP design, the Company believes it was the first to provide
       emulation capabilities in a pocket-sized form factor. It believes that
       its CodeTEST tools are the only commercially available hardware
       enhanced tools to offer a broad range of

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       real time testing capabilities to embedded software developers. It
       also believes that its VSP-TAP-TM- and Core-TAP-TM- tools, are the first
       tools available that allow developers to use the actual microprocessor
       to integrate and verify software and hardware early in the design cycle,
       before physical hardware is available. The Company intends to continue
       expanding these and other technologies in order to enhance its
       competitive position.

    -  OFFER COST-EFFECTIVE SOLUTIONS. The Company's pocket-sized CodeTAP and
       its more fully featured SuperTAP products utilize advanced hardware
       designs to reduce both the size and cost of high-speed emulation. The
       Company believes that, by using a combination of its emulation
       products, customers can reduce the per-engineer cost of equipping
       increasing numbers of software engineers. Most of the Company's
       products have a common user interface, which reduces customer
       retraining costs.

    -  BROADEN PRODUCT OFFERINGS.  The Company plans to continue its focus on
       products that enable embedded systems developers to shorten product
       development cycles while at the same time addressing the increasing
       complexity of embedded software designs. For example, the Company's
       CodeTEST tools offer embedded software developers a previously
       unavailable range of testing capabilities. The Company intends to
       leverage its customer base by expanding its product offerings to
       address additional needs within the embedded software development
       process. In order to achieve these objectives, the Company intends to
       pursue internal product development and to explore potential
       relationships that could involve acquisitions of other businesses,
       products or technologies in related market segments and/or related
       licensing, re-selling and/or joint selling of said products or
       technologies.

    -  TARGET HIGH-GROWTH EMBEDDED SYSTEMS SECTORS. The Company focuses its
       product development and marketing efforts on tools for use with those
       microprocessors that it believes are most commonly specified for use
       in embedded system design starts. Its tools are designed for use
       predominantly with embedded microprocessors produced primarily by
       Intel, AMD and Motorola, which together account for a majority of 16-
       and 32-bit embedded microprocessors purchased annually on a worldwide
       basis. Currently, the Company's marketing efforts are concentrated
       principally on industries which it believes are experiencing rapid
       growth in design starts, such as internetworking, telecommunications
       and computer peripherals.

    -  PURSUE STRATEGIC RELATIONSHIPS.  The Company intends to enter into an
       increasing number of development, marketing and other strategic
       relationships in order to expand sales and broaden its product
       offerings. The Company maintains close working relationships with
       Intel, AMD and Motorola to coordinate the design of its tools for use
       with their embedded microprocessors, and engages in joint sales
       activities with these manufacturers. The Company also participates in
       cooperative marketing activities and, in certain cases, reselling,
       licensing or joint product development arrangements with providers of
       other embedded systems development tools, such as compilers, debuggers
       and RTOS software and CAE vendors.

    -  EMPHASIZE GLOBAL DIRECT SALES.  The Company believes that both
       customer loyalty and the effectiveness of its sales force are enhanced
       by relying principally on direct sales employees, both domestically
       and internationally. The Company believes that its substantial
       international sales, which accounted for over 49% of net sales in
       1997, allow it to maintain close working relationships with major
       semiconductor manufacturers, take advantage of worldwide growth in
       embedded systems development and serve the needs of multinational
       customers.

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PRODUCTS

    The Company provides design, debugging and testing tools for use
principally by software engineers in the development of embedded software.
The Company designs its products to support a broad range of 16-and 32-bit
embedded microprocessors primarily manufactured by Intel, AMD and Motorola,
and to run at the highest clock speeds of the microprocessors supported by
the Company. The Company's products are designed to address three distinct
requirements of embedded software developers: software design and debugging,
testing, and hardware/software co-verification tools.

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

    The majority of the Company's tools are designed specifically for use
with a particular type of embedded microprocessor. As a result, customers
desiring to utilize the Company's tools for a different microprocessor must
purchase either a new version of the Company's tools or, where available, an
upgrade package. Although software engineers often require considerable
training in order to realize the full benefit of the Company's design and
debugging tools, the Company's products generally employ a common user
interface within a family of microprocessor, which reduces customer
retraining costs.

    SOFTWARE DESIGN AND DEBUGGING TOOLS

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

    The Company's in-circuit microprocessor emulators perform four basic
functions (the Company's ROM emulators support a subset of these functions):

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

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

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

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

    The Company offers a broad selection of hardware-enhanced software design
and debugging tools with a variety of features and prices. The Company's
principal software design and debugging tools include its EL Series
emulators, originally introduced in 1989 and now subject to limited
continuing development; its CodeICE product, introduced in 1994 as an
economical, next-generation alternative to traditional chassis emulators; its
pocket-sized CodeTAP product, which was reengineered in 1993; its SuperTAP
product, introduced in 1996, which incorporates the features of a CodeICE
product in a form factor only slightly larger than a CodeTAP; and its NetROM
product, which provides low cost target ethernet access and memory
substitution. The Company believes that the breadth of its product offerings
enables manufacturers to reduce the per-engineer cost of equipping increasing
numbers of software engineers with hardware-assisted software tools by using
a combination of more expensive CodeICE, or EL Series emulators, mid-priced
SuperTAP emulators and more economical CodeTAP and NetROM emulators. The
following table highlights key characteristics pertaining to the Company's
software design and debugging tools:

<TABLE>
<CAPTION>
                                                                       PRINCIPAL
                     ARCHITECTURE/          PRICE     CURRENT        MICROPROCESSOR                             CORE
MODEL                 FORM FACTOR           RANGE     PRODUCTS       FAMILIES SERVED                        CAPABILITIES
---------------  ------------------------  ---------  ---------  ---------------------------  ------------------------------------
<S>              <C>                       <C>        <C>        <C>                          <C>
EL Series        Modular, multi-board       $15,000    40 Mhz    Intel 80960CX; Motorola      Full-featured emulation; up to 4Mb
                 architecture/desktop         to                 68000, 68302,                overlay memory; advanced trace and
                 form factor                $50,000              68330/340/360                event system

CodeICE          Motherboard                $15,000    66 Mhz    Intel 80960JX; 80960HX,      High-speed, full featured emulation;
                 architecture/compact         to                 80960 RP; Motorola           up to 16Mb overlay memory; advanced
                 desktop form factor        $35,000              68020/30/40/60, MCF5102      trace and event systems.

SuperTAP         Single-board               $12,000    40 Mhz    Intel 80186/386/486 AMD      High-speed, full featured emulation;
                 architecture/pocket-         to                 80186/386/486 Motorola       up to 16Mb overlay memory; advanced
                 sized form factor          $20,000              PPC 850/860, 68302           trace and event systems.

CodeTAP          Single-board               $3,000     40 Mhz    Intel 80186, 80386, 80960    Limited to features frequently used
                 architecture/pocket-         to                 CX, 80960 HX, 80960 RP,      by software engineers; up to 1Mb
                 sized form factor          $12,000              AMD 80186, 80386;            overlay memory; modest trace and
                                                                 Motorola CPU 32, 68331/2;    event systems.
                                                                 PPC 603/740/750/8XX

NetROM           Single-board               $6,000    Access     Many different 8, 16         Memory overlay, target connection
                 architecture with            to     time > 45   and 32 bit ROM devices       through ROM, integrated w/3rd Party
                 probing cables             $8,200      ns                                    Software


</TABLE>

    The Company intends during 1998 to continue developing additional
software design and debugging tools for use with certain embedded
microprocessors, which are intended to operate at the increased processing
speeds of certain of such microprocessors, as indicated in the above table.
In addition to the products listed above, the Company believes it will be
necessary to develop additional products to support existing and future
microprocessors, as well as to continue to enhance and broaden its
user-interface technology. The process of developing such additional products
is subject to the challenges and uncertainties normally associated with
product development, and there can be no assurance that the Company will be
able to complete these development efforts successfully or in a timely manner.

SOFTWARE TESTING TOOLS

    The Company produces a line of software testing tools called CodeTEST,
which are designed specifically to offer a broad range of testing
capabilities to developers of embedded software. These tools are designed to
measure the performance and reliability of embedded software, as well as the
adequacy of

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the test process itself, in a minimally intrusive manner, and to present
these measurements in a format designed to be understood easily by software
engineers. These products are expected to be utilized by software engineers
during the software development, system integration, and system test and
validation phases of embedded systems development.

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

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

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

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

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

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

    The CodeTEST line includes six software modules sold separately
(Performance, Basic Block Coverage, MCDC, Decision Coverage, Memory Analysis,
Software Trace), and a separate hardware probe designed for use with a
specific embedded microprocessor. CodeTEST support includes probes for Intel
80960 JX, HX, and CX, Intel 486 and 386EX, Intel 80C186/188 EA and XL, AMD
486 and 386EX, AMD 186/188, Motorola 68020, 68030, 68040, 68060, 68HC000,
68EC000, 68340, 68360, 68302 and 68LC302, PPC860, PPC850, and MIPS 3000, as
well as VME Bus, and a microprocessor universal probe. The Company plans to
support additional embedded microprocessors with additional releases during
1998, but there can be no assurance as to the success or timeliness of such
development efforts. Prices for the Company's software testing tools range
from $11,000 to $50,000, depending on the software modules purchased.

HARDWARE/SOFTWARE CO-VERIFICATION TOOLS

    The Company has an agreement with Synopsis, Inc., to distribute
worldwide, their Eaglei-TM- products of hardware/software co-verification
tools for the embedded market and to jointly develop interface products that
allows both companies products to work together. The resulting products
enable software and hardware engineers to debug software and hardware
interaction prior to having a prototype. This capability is useful when a
microprocessor is being coupled with an ASIC either in discrete form or when
used as an embedded microprocessor plus ASIC on the same piece of silicon.
The Company's

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products are VSP-TAP for use with standard microprocessors such as 68360,
PPC860 and Core-TAP for development with an embedded microprocessor core such
as ARM7. When combined with a VSP-TAP or Core-TAP and a hardware simulator,
designers can use Applied and Eaglei to integrate hardware and software
without waiting for the actual prototype.

    VSP-TAP and Core-TAP enables a high speed connection from an Applied
debug tool (with the actual target processor) to many commercially available
hardware simulators through Eaglei. Embedded developers can use the actual
microprocessor with full software debug interfaces to integrate and verify
software and hardware early in the design cycle, before physical hardware is
available, when errors can be detected and corrected much faster and at lower
cost than at the physical prototype stage. These tools enable the Company's
existing products for debugging and testing software to be used earlier in
the development cycle, gaining familiarity with their use. This makes for
easier and more efficient use of the tool once prototype hardware is
available.

CUSTOMERS

    The Company's sales are presently concentrated primarily in the
internetworking, telecommunications and computer peripherals segments of the
electronics industry. The following table sets forth representative
industries and customers for the Company's products, and representative
applications for embedded microprocessors supported by the Company's products:

<TABLE>
<CAPTION>

         INDUSTRY                          REPRESENTATIVE CUSTOMERS                                REPRESENTATIVE APPLICATIONS
------------------------------  ----------------------------------------------------------------  ------------------------------
<S>                             <C>                             <C>                               <C>

Internetworking                 Ascend/Cascade                  FujitsuNetwork Communications     ATM Equipment, Bridges,
                                Communications Bay Networks     Hitachi                           Concentrators, Hubs, ISDN
                                Cabletron                       Hughes Network Systems            Equipment, Network Cards,
                                Cisco                           Newbridge                         Routers

Telecommunications              AG Communications               NORTEL                            Cellular Phones, Central Office
                                Alcatel                         NTT                               Switches, Pagers, PBXs, Satellite
                                DSC Communications              OKI Electric                      Communications,
                                GPT Communications              Qualcomm                          Teleconferencing, Telephone
                                Lucent                          Samsung                           Switches, Voice Mail Systems
                                Matsushita                      Siemens
                                Mitsubishi                      Tellabs
                                Motorola                        Toshiba

Computer Peripherals/ Office    Canon                           LG Electronics                    Copiers, Disk Drives, Fax
Products                        Compaq                          Lucent                            Machines, Modems, PC Plug-In
                                Distributed Processing Tech.    NEC                               Cards, Printers
                                Eastman Kodak                   Picturetel
                                Fuji Xerox                      Ricoh
                                Fujitsu                         Samsung
                                Hewlett-Packard                 Storage Technology
                                Hitachi                         Tandem

Other                           Acuson                          Litton                            Avionics, Bar Code Scanners,
                                Honeywell                       Lockheed Martin                   Defibrillators, Defense, Global
                                Garmin                          Panasonic                         Positioning Systems, RAID
                                GTE                             Physio-Control                    Controllers, Test Instrumentation,
                                International Games Tech.       Rockwell                          Ultrasound, Video Games
                                IBM                             Siemens
                                ITT                             Tektronix

</TABLE>

    Although the composition of the Company's customers has changed from year
to year, a relatively limited number of customers have historically accounted
for a substantial portion of the Company's net sales. In addition, sales to
leasing and rental companies serving customers in Japan are a significant
portion of net sales. During 1997 and 1996, sales to Orix Rentec, a leasing
and rental company in Japan, accounted for 9.1% and 10.1% of net sales,
respectively. The Company expects that a substantial portion of its net sales
will continue to be concentrated among a relatively limited number of
customers for the foreseeable future and that, so long as sales in Japan
remain a significant portion of net

                                       8

<PAGE>

sales, sales to leasing and rental companies will continue to constitute a
significant percentage of net sales as customers in Japan are more likely to
finance equipment acquisitions through leasing or rental arrangements. Other
than its distributor agreements, the Company currently has no long-term
contracts with any of its customers, and sales are generally made pursuant to
purchase orders.

SALES, MARKETING AND CUSTOMER SUPPORT

    The Company markets its products and services primarily through its
domestic and international direct sales organization. As of December 31,
1997, the Company had 65 sales and support employees worldwide, including 42
field sales engineers, inside sales specialists and field application
engineers located at the Company's headquarters and in direct or home sales
offices throughout North America, and in the Company's wholly-owned
subsidiaries in Japan, Germany, France and the United Kingdom. Due to the
highly technical nature of its products, the Company believes that an
important aspect of its direct sales strategy is the technical support and
training provided to customers, and that a high level of customer service and
support is critical to customer adoption and successful utilization of
design, debugging and testing technology. The Company's field application
engineers offer ongoing support and product demonstration, and assist
customers to incorporate the Company's design, debugging and testing tools
into their design process. Support for international customers is provided by
field support engineers from the Company's overseas direct sales offices,
with assistance from field application engineers located at the Company's
headquarters in Redmond. The Company also offers its customers renewable
annual service contracts which entitle customers to receive technical and
emergency support, as well as software updates and hardware repair.

    International sales represented 49.4%, 47.6% and 48.7% of the Company's
net sales in 1997, 1996 and 1995, respectively. Sales through the Company's
subsidiary in Japan accounted for 33.6%, 33.3 and 33.5 of the Company's net
sales in 1997, 1996 and 1995, respectively. The Company also has
international distribution agreements covering 24 countries. Sales to the
Company's international distributors in 1997, 1996 and 1995 accounted for
approximately 8.3%, 11.0% and 13.2%, respectively, of the Company's net
sales. Generally, the Company's agreements with its international
distributors have a term of 12 months and are exclusive on a
country-by-country basis.

    The sale of software development tools in foreign countries involves
risks associated with currency exchange rate fluctuations and restrictions,
export-import regulations, customs matters, longer payment cycles, foreign
collection problems, and military, political and transportation risks. The
Company's sales through its foreign subsidiaries are generally denominated in
foreign currencies. As a result, fluctuations in currency exchange rates can
have a significant effect on the Company's sales, even in the absence of an
increase or decrease of unit sales to foreign customers. For example, the
Company estimates that currency fluctuations affecting sales by the Company's
foreign subsidiaries, especially in Japan, accounted for 3.7% decrease, 7.0%
decrease and a 3.4% increase in the dollar value of the Company's net sales
value in 1997, 1996 and 1995, respectively. In addition, foreign sales
involve uncertainties arising from local business practices and cultural
considerations, and risks associated with international trade tensions. Sales
of the Company's products in Japan, in particular, are subject to the risks
associated with trade tensions between the United States and Japan, which
could adversely affect the volume of U.S.-manufactured microprocessors
purchased by Japanese embedded systems developers, thus reducing the need for
the Company's products in Japan. The Company expects that international
sales, in particular sales in Japan, will continue to account for a
significant portion of the Company's net sales in the future.

    The Company participates in cooperative marketing activities with other
embedded systems development tools providers and embedded microprocessor
manufacturers, such as Intel, AMD, Motorola, Microtec division of Mentor
Graphics, Integrated Systems and Wind River Systems. These relationships
enable the Company to further leverage its technical capabilities, customer
relationships

                                       9

<PAGE>

and international sales and support infrastructure. The Company believes that
developing and maintaining these relationships is important to its ability to
achieve broad market penetration. The Company's marketing efforts also
include attending trade shows, publishing articles and advertising in trade
magazines and journals, direct mail and product demonstrations. The Company
also maintains a home page on the World Wide Web at http:\\www.amc.com.

    The time between order and delivery of the Company's products is often
quite short. The number of orders, as well as the size of individual orders,
can vary substantially from month to month. Because of the short period
between order receipt and shipment of products, the Company typically does
not have a backlog of unfilled orders and believes a backlog is neither
significant to an understanding of its business nor representative of
potential revenue for any future period.

COMPETITION

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

    The principal competition for the Company's hardware-enhanced software
design and debugging tools comes primarily from Hewlett-Packard, from various
other domestic and international providers of in-circuit emulators, many of
which focus primarily on developing products to support either Intel or
Motorola microprocessors, and, to a lesser extent, from domestic providers of
embedded microprocessor simulators, RTOS debugging software, logic analyzers,
ROM monitors and ROM emulators. The Company anticipates that competition for
its CodeTEST product line will come principally from domestic providers of
embedded debug software, emulators and logic analyzers, which are generally
able to perform only portions of the software testing functions offered by
CodeTEST tools. The Company believes that at present there are no other
commercially available hardware enhanced testing products that offer the
ability to perform both coverage analysis and memory allocation analysis on
embedded software, although there can be no assurance that competitors will
not develop such products in the future. For its co-verification tools, the
Company's major competition is currently from Mentor Graphics. The Company
expects other domestic CAE (computer aided engineering) vendors to offer
products in the future. The Company has also historically experienced
competition from the engineering departments of major manufacturers, which
occasionally develop internal technical solutions to their design, debugging
or testing problems.

    Competition among providers of embedded software design and debugging,
testing, and co-verification tools focuses on a variety of factors, including
the availability of tools that are compatible with the customer's chosen
embedded microprocessor, engineering workstation and other software
development equipment; performance characteristics and features such as
high-speed processing, real-time visibility and control, high-level
programming language and ease-of-use; product reliability; price/performance
characteristics; customer service and worldwide support; and product
availability and delivery time. The Company believes that the relative
importance of each of these factors to a prospective customer varies for each
development project depending upon the complexity of the embedded system
design, the microprocessor to be used, the project development schedule and
the software engineer's budget and experience level. The Company believes its
products are most competitive in situations involving high-speed, complex 16-
and 32-bit microprocessor designs.

                                      10

<PAGE>

    The Company anticipates that the embedded systems development market is
likely to experience consolidation as providers of various embedded software
development tools strive to broaden their product offerings. The Company
expects competition to increase from both established and emerging companies.
The Company believes that much of its competition is now, and will
increasingly be, from larger companies having substantially greater
technical, financial and marketing resources, as well as larger customer
bases and greater name recognition, than the Company. To compete effectively,
the Company may find it necessary to enter into alliances with other
providers, or to acquire other technologies or product lines, in order to
broaden its product offerings. Some of the Company's competitors bundle their
design and debugging solutions with sales of other embedded systems
development products, and the Company anticipates that such competitive
tactics may increase as competitors broaden their product offerings. Major
semiconductor manufacturers have increasingly been incorporating features
into their newer embedded microprocessors which facilitate visibility into
and control over internal software debugging functions. This trend may
further lower technological barriers to entry and encourage new or lower-cost
competition, and could render the Company's technologies or products wholly
or partially unnecessary or obsolete. Increased competition could result in
price reductions, reduced margins or loss of market share, any of which could
materially adversely affect the Company's business, financial condition and
results of operations. If the Company is unable to compete successfully
against current and future competitors, its business, financial condition and
results of operations will be materially adversely affected.

MANUFACTURING

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

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

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

                                      11

<PAGE>

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

    The Company is subject to a variety of federal, state and local
governmental regulations related to the storage, use, discharge and disposal
of toxic, volatile or otherwise hazardous chemicals used in its manufacturing
process. There can be no assurance that changes in environmental regulations
will not impose the need for additional capital equipment or other
requirements. Any failure by the Company to control the use of, or adequately
to restrict the discharge of, hazardous substances under present or future
regulations could subject the Company to liability. The Company does not
believe such liability would have a material adverse effect on the Company's
business, financial condition and results of operations.

RESEARCH AND DEVELOPMENT

    The Company has made and intends to continue making substantial
investments in the development of new technologies and products. Because of
the competitive importance of offering tools that are compatible with the
particular microprocessors and other equipment to be used in developing
embedded systems, tool providers are under continuing pressure to support
major new families of embedded microprocessors, as well as advances in other
development equipment. The Company believes that its future growth and
financial performance will depend heavily on its ability to enhance its
existing products, develop and introduce new products and features that
address the increasingly sophisticated needs of its customers, and respond to
technological advances, emerging industry standards and practices and
competitive developments.

    A major portion of the Company's annual research and development budget
is devoted to the development of tools for use with new embedded
microprocessors, particularly 32-bit microprocessors which the Company
believes are most commonly specified for use in embedded system design
starts. In general, however, there can be no assurance that the Company will
be able to anticipate levels of future usage of particular new embedded
microprocessors so as to allow timely development of related tools, that
tools for use with particular embedded microprocessors will be developed
successfully or in a timely manner, or that new embedded microprocessors for
which the Company has developed tools will be released successfully or in a
timely manner by their manufacturers.

    The Company intends to continue to enhance and expand its existing
product lines and to offer new or additional products for the embedded
systems software development market. While the Company expects that many of
these product enhancements and new products may be developed internally, the
Company may also, based on timing and cost considerations, seek to expand its
product offerings through acquisitions, technology licensing or joint
development relationships with other providers. There can be no assurance
that the Company's efforts to enhance its existing products or develop new
products will be completed successfully or in a timely manner, or that such
enhancements or new products will achieve market acceptance. The Company has
in the past experienced delays in product development and there can be no
assurance that the Company will not experience similar delays in the future.
If the Company is unable, for technological or other reasons, to develop and
introduce new products or features in a timely manner and achieve market
acceptance, its business, financial condition and results of operations will
be materially adversely affected.

                                      12

<PAGE>

PROPRIETARY RIGHTS

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

    The embedded systems development market is characterized by rapid
technological change, with frequent introductions of new products and
technologies. As a result, industry participants often find it necessary to
develop products and features similar to those introduced by others,
increasing the risk that their products and processes may give rise to claims
that they infringe the patents of others. Accordingly, the Company's current
and future products and processes, or uses thereof, may conflict with patents
that have been granted or may be granted to competitors or others. Such
competitors or others could bring legal actions against the Company or its
customers, claiming damages and seeking to enjoin manufacturing, marketing or
use of the affected product or processes. Similarly, the Company may in the
future find it necessary to commence litigation in order to enforce and
protect its proprietary rights. If the Company becomes involved in such
litigation, it could consume a substantial portion of the Company's resources
and result in a significant diversion of management attention. If the outcome
of any such litigation were adverse to the Company or its customers, the
Company's business, financial condition and results of operations could be
materially and adversely affected. In addition to any potential liability for
damages, the Company or its customers could be enjoined from continuing to
manufacture or market the affected product or use the affected process, and
could be required to obtain a license to continue to manufacture or market
the affected product or use the affected process. There can be no assurance
that the Company or its customers would prevail in any such action or that
any license required under any such patent would be made available on
acceptable terms, if at all .

    Third parties have in the past made patent infringement claims against
the Company. In certain cases, the Company has resolved these claims by
obtaining a license to the technology. The Company has also asserted claims
of infringement of its trade secrets and certain of its patents against
various competitors and in one instance has brought suit to protect trade
secrets and enforce patent rights relating to its CodeTAP product. In that
instance, the competitor settled by paying damages for past infringement and
obtaining a license to the patented technology. The Company has filed suit
and is currently involved in the initial stages of disputes concerning
potential patent infringement relating to the same technology by a
competitor, which has asserted various defenses, including prior art, and has
filed an opposition to the Company's European patent relating to such
technology. There can be no assurance as to the outcome of any pending or
future claims, litigation or proceedings involving the Company's proprietary
rights.

                                      13

<PAGE>

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

EMPLOYEES

    As of December 31, 1997, the Company had 236 employees, of whom 205 were
based in the United States and 31 were based overseas. Of the total, 126 were
engaged in Sales, General and Administrative, 68 were in research and
development and 42 were in manufacturing. None of the Company's employees is
represented by a labor union. The Company has not experienced any work
stoppages and considers its relations with its employees to be good.

ITEM 2. PROPERTIES

    The Company's principal administrative, sales, marketing, research and
development and manufacturing facility is located in an approximately 59,000
square-foot building in Redmond, Washington that is leased through May 31,
2001. The Company also leases nine other domestic sales and support offices
in the United States and five international sales offices in Japan, France,
Germany and the United Kingdom. The Company believes that its facilities are
adequate to satisfy its projected requirements, including its requirements
for production capacity into 1998 and that additional space will be available
as needed.

ITEM 3. LEGAL PROCEEDINGS

    Neither the Company nor its properties are currently subject to any
material legal proceedings. See "--Proprietary Rights."

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

    None.

                                      14

<PAGE>

ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT

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

<TABLE>
<CAPTION>
NAME                           AGE                            POSITION
-------------------------      ---      -----------------------------------------------------
<S>                            <C>      <C>
Robert L. Deinhammer            52      President, Chief Executive Officer and Director

A. James Beach                  41      Vice President, Secretary, Treasurer and Chief
                                        Financial Officer

Douglas A. Fullaway             46      Vice President, Worldwide Sales

Larry Ritter                    39      Vice President and Division General Manager

</TABLE>

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

    A. James Beach has served as the Company's Vice President and Chief
Financial Officer since October 1992, and was elected Secretary and Treasurer
in November 1992. Before joining the Company, Mr. Beach spent eight years at
Microcosm Inc., where he served as Vice President of Finance & Administration
from June 1984 to October 1988 and as President and General Manager from
October 1988 to May 1992. Microcosm Inc. was acquired by Microtek
International Inc. in April 1990. From April 1980 to June 1984, he served as
a senior auditor with the Technology and Emerging Business Practice at the
accounting and consulting firm of Deloitte & Touche.

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

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

                                      15

<PAGE>

PART II

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

    Applied Microsystems' common stock has been traded on the NASDAQ National
Market System under the symbol APMC since the Company's initial public
offering on November 14, 1995.

    The closing price of the Company's common stock as reported by the NASDAQ
National Market on March 20, 1998 was $6.06 per share. The price per share in
the following table sets forth the low and high closing prices in the NASDAQ
National Market for the quarter indicated below:

<TABLE>
<CAPTION>
                                      LOW          HIGH
                                   ----------   -----------
<S>                                <C>          <C>
1995
  November 15 to December 31       $ 6 3/4      $10 3/4

1996
  First Quarter                      7 3/4       12 3/4
  Second Quarter                     9           20 3/4
  Third Quarter                     11 1/4       23 7/8
  Fourth Quarter                     9           23 3/4

1997
  First Quarter                      4 7/8       16
  Second Quarter                     3 7/8       10 1/2
  Third Quarter                      8           12 7/8
  Fourth Quarter                     5           12 5/8

</TABLE>

    The Company has not paid dividends and does not plan to pay dividends on
its common stock in the foreseeable future. The Company estimates that at
March 20, 1998, there were approximately 2,200 beneficial owners of the
common stock of the Company.

    Proceeds from the Company's initial public offering were $13.0 million
net of costs. Since the offering, the Company has used $2.7 million to
purchase capital equipment, $2.5 million to pay off bank debt, $.5 million to
purchase a product line and the remaining proceeds of $7.3 million have been
invested in short term commercial and government paper and money market funds.

                                      16

<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                            YEAR ENDED DECEMBER 31,
                                                             -----------------------------------------------------
(IN THOUSANDS, EXCEPT FOR EARNINGS PER SHARE)                  1997       1996       1995       1994       1993
                                                             ---------  ---------  ---------  ---------  ---------
<S>                                                          <C>        <C>        <C>        <C>        <C>
Statement of Income Data:
Net Sales..................................................  $  39,124  $  38,662  $  31,039  $  25,663  $  21,273
Cost of Sales..............................................     10,532     10,793      9,530      8,903      8,531
                                                             ---------  ---------  ---------  ---------  ---------
Gross Profit...............................................     28,592     27,869     21,509     16,760     12,742
Operating expenses:
  Sales, general and administrative........................     18,542     15,142     13,321     11,715      9,985
  Research and development.................................      8,468      7,988      6,275      4,482      4,025
                                                             ---------  ---------  ---------  ---------  ---------
  Total operating expenses.................................     27,010     23,130     19,596     16,197     14,010
                                                             ---------  ---------  ---------  ---------  ---------
Income from operations.....................................      1,582      4,739      1,913        563     (1,268)
Interest Expense and other income..........................        669        559       (154)      (465)      (355)
                                                             ---------  ---------  ---------  ---------  ---------
Income (loss) Before income taxes..........................      2,251      5,298      1,759         98     (1,623)
Provision for Income Taxes.................................        349      1,582        305         68          0
                                                             ---------  ---------  ---------  ---------  ---------
Net Income (loss)..........................................      1,902      3,716      1,454         30     (1,623)
                                                             ---------  ---------  ---------  ---------  ---------
                                                             ---------  ---------  ---------  ---------  ---------
Diluted Net Income (loss) per Share........................  $    0.26  $    0.52  $    0.27  $    0.01     $(0.49)
Average Number of Common and Equivalent Shares
  Outstanding..............................................      7,297      7,097      5,329      3,502      3,294

</TABLE>

The 1995, 1994 and 1993 dilutive earnings (loss) per share have been restated
to comply with SFAS 128 and new SEC requirements.

<TABLE>
<CAPTION>

                                                                                   DECEMBER 31,
                                                               -----------------------------------------------------
            (IN THOUSANDS)                                        1997       1996       1995       1994       1993
                                                               ---------  ---------  ---------  ---------  ---------
<S>                                                            <C>        <C>        <C>        <C>        <C>
Balance Sheet Data:
Working Capital..............................................  $  20,547  $  19,415  $  15,756  $   1,800  $     981
Total Assets.................................................     32,582     30,824     26,846     14,011     13,388
Long-term Debt, Net of Current...............................     --             15         68        385        649
Shareholders' Equity.........................................     24,291     22,607     18,654      4,286      4,065

</TABLE>

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

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

OVERVIEW

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

    Beginning in mid-1992, the Company assembled a new management team that
devised and began implementing a new business strategy. As a part of this new
strategy, management effected a restructuring of the Company, which included
significant headcount reductions and a refocusing of its product line by
concentrating marketing and engineering activity on new hardware-enhanced
software tools for use with a broad range of Intel and Motorola 16- and
32-bit embedded microprocessors, employing advanced hardware designs to
reduce size and cost, and emphasizing ease-of-use by software engineers.
Following this restructuring, the Company reengineered its pocket-sized
CodeTAP emulator

                                      17

<PAGE>

in late 1993; introduced its compact and more affordable CodeICE emulator in
1994; and began shipping CodeTEST software testing tools focused on embedded
test in late 1995. In 1996, the Company released SuperTAP, which brings full
featured emulation into a CodeTAP form factor, and introduced its
hardware/software co-verification tool, VSP-TAP, to enhance its distribution
agreement with Eagle Design Automation. In 1997, the Company released
CodeTEST-Registered Trademark--ACT, an enhanced suite of MCDC software test
and analysis tools for C language applications, and CodeTRACE-TM-, a
source-level trace analysis tool. The Company's strategy has resulted in
lower average selling prices and increased unit volumes.

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

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

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

RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>

                                                          YEAR ENDED DECEMBER 31,
                                                      -------------------------------
                                                         1997       1996       1995
                                                      ---------  ---------  ---------
<S>                                                   <C>        <C>        <C>
Net Sales.........................................      100.0%     100.0%     100.0%
Cost of Sales.....................................       26.9       27.9       30.7
                                                      ---------  ---------  ---------
Gross profit......................................       73.1       72.1       69.3
Operating expenses:
 Sales, general and administrative................       47.4       39.2       43.0
 Research and development.........................       21.6       20.7       20.2
                                                      ---------  ---------  ---------
 Total operating expenses.........................       69.0       59.9       63.2
                                                      ---------  ---------  ---------
                                                      ---------  ---------  ---------
Operating income..................................        4.1       12.2        6.1
Interest expense and other income.................        1.7        1.5       (0.5)
                                                      ---------  ---------  ---------
Income before income taxes........................        5.8       13.7        5.6
Income taxes......................................        0.9        4.1        1.0
                                                      ---------  ---------  ---------
Net income........................................        4.9%       9.6%       4.6%
                                                      ---------  ---------  ---------
                                                      ---------  ---------  ---------

</TABLE>

YEARS ENDED DECEMBER 31, 1997 AND 1996

    NET SALES.  Net sales increased by 1.2% to $39.1 million in 1997 from
$38.7 million in 1996. The increase was primarily attributable to the unit
growth and average selling price in sales of low cost debug and CodeTEST-TM-
tools and an increase in support contract revenues. The increase was
partially

                                      18

<PAGE>

offset by a decline in unit sales of higher priced debug tools and to a
lesser extent currency exchange rate fluctuations affecting the dollar value
of international sales. The Company's net sales are presently derived
predominantly from sales of software design, debugging and testing tools. The
Company's net sales also include product support revenues, which represented
12.6% and 8.3% of net sales in 1997 and 1996, respectively, as well as patent
license royalties. The Company generally recognizes revenues from product
sales upon shipment, and recognizes product support revenues ratably over the
life of each maintenance contract, typically 12 months. See Note 1 of Notes
to Consolidated Financial Statements.

    International sales outside of North America in U.S. dollars increased by
4.9% in 1997 over the comparable period of 1996, to 49.4% of net sales as
compared to 47.6% of net sales in the prior year. The increase in
international sales is attributable to increased unit sales, which is due
primarily to increased sales and marketing efforts. The Company estimates
that unfavorable currency rate fluctuations affecting the dollar value of
sales by the Company's foreign subsidiaries, especially in Japan, resulted in
a 3.7% reduction in the Company's net sales in 1997 based upon the change
from the average 1996 rate.

    GROSS PROFIT.  The Company's gross profit increased to $28.6 million, or
73.1% of net sales, in 1997 from $27.9 million, or 72.1% of net sales, in
1996. The increases in gross profit as a percentage of net sales was
primarily attributable to an increase in higher margin support contract
revenue, an increase in the percentage of net sales attributable to newer low
cost debug and CodeTEST products that have lower material costs as a
percentage of sales price, and favorable cost reductions on certain hardware
components. These savings were partially offset by declines in sales revenue
due to unfavorable currency exchange rate fluctuations and an increase in
factory overhead.

    SALES, GENERAL AND ADMINISTRATIVE. Sales, general and administrative
expenses were $18.5 million or 47.4% of net sales, and $15.1 million, or
39.2% of net sales, in 1997 and 1996, respectively. The dollar amount
increase between comparable periods was primarily attributable to increased
compensation-related expenses resulting principally from increased headcount
and salaries, and to a lesser extent, increases in travel and entertainment,
recruiting, and promotional costs and foreign exchange losses. The percentage
increase between comparable periods was primarily attributable to lower than
anticipated revenues for the year as compared to the increase in budgeted
costs. The Company expects its sales and marketing expenditures to continue
to increase in absolute dollars in the future as it introduces and markets
new products, and continues to expand its sales, general and administrative
organization.

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

    RESEARCH AND DEVELOPMENT.  Research and development expenses were $8.5
million, or 21.6% of net sales, and $8.0 million, or 20.7% of net sales, in
1997 and 1996, respectively. The 6.0% increase in the dollar amount of
research and development expenses between comparable periods was primarily
attributable to a decrease in external development funding received from
third parties that offsets expenses and to an increase hardware prototype
related costs. The Company intends to continue to make substantial
investments in product development, including development of software design,
debugging and test tools for additional embedded microprocessors as well as
continued advanced development in future directions. As a result, the Company
anticipates that net research and development expenses are likely to increase
for the foreseeable future.


                                      19
<PAGE>


    INCOME TAXES.  The Company's income tax provision for 1997, 1996 and 1995
reflects utilization of Net Operating Loss (NOL) and General Business Credit
carryforwards. As of December 31, 1997 the Company had remaining NOL
carryforwards of $2.3 million and research and development credit
carryforwards of $1.2 million, both of which will expire in various amounts
through 2012. The utilization of these amounts in the future is subject to an
annual limit of approximately $392,000 under the Internal Revenue Code. As a
result of these limitations, the Company anticipates that in the future its
effective tax rate will approach the statutory rate in future years. See Note
7 of Notes to Consolidated Financial Statements.

YEARS ENDED DECEMBER 31, 1996 AND 1995

    NET SALES.  Net sales increased by 24.6% to $38.7 million in 1996 from
$31.0 million in 1995. This increase was primarily attributable to increased
unit sales of debug products and to sales of CodeTEST (which began shipping
in November, 1995) which were partially offset by a decline in average
selling prices due to an increased proportion of sales represented by
lower-priced CodeTAP and NetROM tools and to negative currency exchange rate
fluctuation. The Company's net sales also include product support revenues,
which represented 8.3% and 8.4% of net sales in 1996 and 1995, respectively,
as well as patent license royalties commencing in the second quarter of 1995.

    International sales outside of North America in U.S. dollars increased by
21.8% in 1996 over the comparable period of 1995, to 47.6% of net sales as
compared to 48.7% of net sales in the prior year. The increase in
international sales is attributable to increased unit sales, which is due
primarily to increased sales and marketing efforts. The Company estimates
that unfavorable currency rate fluctuations affecting sales by the Company's
foreign subsidiaries, especially in Japan, resulted in a 7.0% reduction in
the Company's net sales in 1996 based upon the change from the 1995 rate.

    GROSS PROFIT.  The Company's gross profit increased to $27.9 million, or
72.1% of net sales, in 1996 from $21.5 million, or 69.3% of net sales, in
1995. The increases in gross profit as a percentage of net sales was
primarily attributable to an increase in the percentage of net sales
attributable to newer debug and recently introduced CodeTEST products that
have lower material and labor costs, and to a lesser extent, increased
leverage of fixed and semi-variable manufacturing costs, and favorable cost
reductions on certain hardware components. These savings were partially
offset by declines in sales revenue due to unfavorable currency exchange rate
fluctuations.

    SALES, GENERAL AND ADMINISTRATIVE. Sales, general and administrative
expenses were $15.1 million or 39.2% of net sales, and $13.3 million, or
43.0% of net sales, in 1996 and 1995, respectively. The dollar amount
increase between comparable periods was primarily attributable to increased
compensation-related expenses resulting principally from increased sales
force headcount. Sales, general and administrative expenses declined as a
percentage of net sales due to the Company's ability to leverage certain
fixed selling, general and administrative expenses over an increased sales
base.

    RESEARCH AND DEVELOPMENT.  Research and development expenses were $8.0
million, or 20.7% of net sales, and $6.3 million, or 20.2% of net sales, in
1996 and 1995, respectively. The 27.3% increase in the dollar amount of
research and development expenses between comparable periods was primarily
attributable to increased compensation-related expenses resulting principally
from increased engineering headcount relating to new product development.
Aggregate amounts devoted to product development, prior to offsetting such
amounts with external development funding from semiconductor manufacturers,
increased to $8.3 million in 1996 from $6.7 million in 1995.

                                      20

<PAGE>

QUARTERLY RESULTS OF OPERATIONS

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

    The Company's net sales have historically reflected some seasonality in
that sales growth typically tends to flatten between the second and third
quarters of the year, coincident with the slowing of business activity during
the summer months in many industrialized nations. Moreover, a significant
portion of the Company's net sales in each quarter generally results from
shipments during the last few weeks of the quarter.

LIQUIDITY AND CAPITAL RESOURCES

    The Company requires capital principally for the financing of inventory,
capital equipment and accounts receivable, and for investment in product
development activities and new technologies. To date, the Company has
financed its operations primarily through cash flow from operations, bank
borrowings and private placements of equity securities. In November 1995, the
Company completed its initial public offering pursuant to which it sold
1,500,000 shares of common stock and received net proceeds of approximately
$13 million. During 1997, the Company generated $5.3 million of cash from
operations; utilized $1.5 million of cash for equipment purchases; and
utilized $53,000 of cash for net debt reduction. As of December 31, 1997, the
Company had working capital of $20.6 million, including $16.7 million of cash
and cash equivalents.

    The Company has revolving credit facilities aggregating $7.0 million from
a commercial bank. There were no outstanding balances under these facilities
as of December 31, 1997. The credit facilities bear interest at the bank's
floating prime rate and are unsecured. The loan documents also contain
customary negative covenants. The credit facilities expire in May 1998 and
the Company anticipates renegotiating a new line at comparable terms.

    The Company currently has no specific commitments with regard to capital
expenditures, but expects to spend an aggregate of approximately $1.6 million
in 1998 for new capital equipment. The Company anticipates that its annual
capital expenditures will increase gradually in the future as a function of
replacement cycles and anticipated growth of the Company's business. The
Company's capital needs may be further affected by its plans to broaden
product offerings through a combination of internal development, third party
relationships and acquisitions of other business products or technologies.

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

                                      21

<PAGE>

IMPACT OF YEAR 2000

    Some of the Company's older computer programs were written using two
digits rather than four to define the applicable year. As a result, those
computer programs have time-sensitive software that recognize a date using
"00" as the year 1900 rather than the year 2000. This could cause a system
failure or miscalculations causing disruptions of operations, including,
among other things, a temporary inability to process transactions, send
invoices, or engage in similar normal business activities.

    The Company has completed an assessment with its software vendors and
will have to upgrade portions of its software so that its computer systems
will functions properly with respect to dates in the year 2000 and
thereafter.. The Company systematically upgrades its software to take
advantage of bug fixes, feature enhancement and performance improvements as a
standard course of business. The upgrades scheduled for 1998 will address all
identified Year 2000 issues and will not involve any extra costs that would
not normally occur in the standard course of business. The Company believes
that with the upgrades to existing software, the Year 2000 Issue will not
pose significant operational problems for its computer systems. However, if
such upgrades are not made, or are not completed timely, the Year 2000 Issue
could have a material impact on the operations of the Company.

    The Company is also planning to inquire with key suppliers and financial
institutions, to verify that they will not be at risk from this problem. The
Company believes its products are not subject to this problem and plans to
test its products before the year 2000

OUTLOOK: ISSUES AND UNCERTAINTIES

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

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

    MANUFACTURING UNCERTAINTIES. A number of the Company's components are
manufactured by a single source or distributed through a limited number of
outlets. There can be no assurance that the Company will be able in the
future to obtain key components in a timely manner, in sufficient quantities,
or on favorable price terms.

                                      22

<PAGE>

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

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

    COST OF SALES.  Although cost of sales as a percentage of net sales
decreased in 1995 and 1996, it varies with channel mix and product mix within
channels. Such mix factors may increase cost of sales as a percentage of
revenues in future periods.

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

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

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

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

    MANAGEMENT OF GROWTH. The Company has grown rapidly since 1993 and plans
to continue to invest in product lines and sales and marketing. The Company's
growth plans will present management, competitive and other challenges to the
Company's managers and employees.

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

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

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

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

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

                                      23

<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                        APPLIED MICROSYSTEMS CORPORATION

                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>

AUDITED ANNUAL FINANCIAL STATEMENTS:                                 PAGE
                                                                     ----
<S>                                                                  <C>
Report of Ernst & Young LLP, Independent Auditors...................  25

Balance Sheets as of December 31, 1997 and 1996.....................  26

Statements of Income for the Years Ended
  December 31, 1997, 1996 and 1995..................................  27

Statements of Stockholders' Equity for the Years Ended
  December 31, 1997, 1996 and 1995..................................  28

Statements of Cash Flows for the Years Ended
  December 31, 1997, 1996 and 1995..................................  29

Notes to Financial Statements.......................................  30

</TABLE>

                                      24

<PAGE>

               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

Shareholders and Board of Directors
Applied Microsystems Corporation

    We have audited the accompanying consolidated balance sheets of Applied
Microsystems Corporation as of December 31, 1997 and 1996, and the related
consolidated statements of income, shareholders' equity, and cash flows for
each of the three years in the period ended December 31, 1997. Our audits
also included the financial statement schedule listed in the Index at Item
14(a). These financial statements and schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

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

    In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Applied Microsystems Corporation at December 31, 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. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material
respects the information set forth therein.

                                                       ERNST & YOUNG LLP

Seattle, Washington
February 5, 1998

                                       25
<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                          CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
                                                               ------------------------
                                                                 1997           1996
                                                               ---------     ----------
                                                                    (IN THOUSANDS)
<S>                                                            <C>          <C>
                          ASSETS

Current assets:
Cash and cash equivalents....................................   $  6,336     $   7,208
Short term investments.......................................     10,345         5,931
Accounts receivable, net of allowance for doubtful accounts
  of $611 and $264, respectively.............................      7,741        10,261
Inventories..................................................      3,465         3,197
Prepaid and other current assets.............................        951         1,020
                                                               ---------    ----------
Total current assets.........................................     28,838        27,617

Property and equipment, net..................................      2,900         2,441
Other assets.................................................        844           766
                                                               ---------     ----------
Total assets.................................................   $ 32,582      $  30,824
                                                               ---------     ----------
                                                               ---------     ----------
              LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Accounts payable.............................................   $  2,804      $   2,394
Accrued payroll..............................................      1,684          1,839
Other accrued expenses.......................................        991          1,220
Deferred revenue.............................................      2,797          2,696
Current portion of long-term obligations.....................         15             53
                                                               ---------     ----------
Total current liabilities....................................      8,291          8,202

Long-term obligations, less current portion..................         --             15

Shareholders' equity:
Preferred stock, par value $.01
    Authorized--5,000,000 shares                                      --             --
Common stock, par value $.01
    Authorized--25,000,000 shares
    Issued--6,827,000 shares (6,634,000 shares in 1996)......     26,387         26,068
Cumulative translation adjustment............................       (869)          (332)
Accumulated deficit..........................................     (1,227)        (3,129)
                                                               ---------      ---------
Total shareholders' equity...................................     24,291         22,607
                                                               ---------      ---------
Total liabilities and shareholders' equity...................    $32,582      $  30,824
                                                               ---------      ---------
                                                               ---------      ---------
</TABLE>

                            See accompanying notes.

                                       26
<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                       CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
                                                          YEAR ENDED DECEMBER 31,
                                                      -------------------------------
                                                        1997       1996       1995
                                                      ---------  ---------  ---------
                                                      (IN THOUSANDS, EXCEPT PER SHARE
                                                                 AMOUNTS)
<S>                                                   <C>        <C>        <C>
Net sales...........................................  $  39,124  $  38,662  $  31,039
Cost of sales.......................................     10,532     10,793      9,530
                                                      ---------  ---------  ---------
Gross profit........................................     28,592     27,869     21,509
Operating expenses:
Sales, general and administrative...................     18,542     15,142     13,321
Research and development............................      8,468      7,988      6,275
                                                      ---------  ---------  ---------
Total operating expenses............................     27,010     23,130     19,596
                                                      ---------  ---------  ---------
Income from operations..............................      1,582      4,739      1,913
Interest income and other...........................        682        601         76
Interest expense....................................        (13)       (42)      (230)
                                                      ---------  ---------  ---------
Income before income taxes..........................      2,251      5,298      1,759
Income taxes........................................        349      1,582        305
                                                      ---------  ---------  ---------
Net income..........................................  $   1,902  $   3,716  $   1,454
                                                      ---------  ---------  ---------
                                                      ---------  ---------  ---------
Basic income per share..............................  $    0.28  $    0.57  $    0.94
Shares used in basic per share calculation..........      6,769      6,545      1,551
Diluted income per share............................  $    0.26  $    0.52  $    0.27
Shares used in diluted per share calculation........      7,297      7,097      5,329
</TABLE>

    See accompanying notes.

                                       27
<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>

                                               PREFERRED STOCK         COMMON STOCK     CUMULATIVE                      TOTAL
                                             ------------------  --------------------   TRANSLATION   ACCCUMULATED   SHAREHOLDERS
                                              SHARES    AMOUNT     SHARES     AMOUNT    ADJUSTMENTS      DEFICIT        EQUITY
                                             --------  --------  ---------  ---------  -------------  ------------   ------------
<S>                                          <C>        <C>        <C>        <C>        <C>          <C>            <C>
                                                                        (IN THOUSANDS)

Balance at December 31, 1994................     1,789                694     $   418      $  68         $(8,299)       $ 4,286

Foreign currency translation adjustment ....       ---       ---      ---         ---       (224)            ---           (224)
Common stock repurchased ...................       ---       ---      (38)        (40)       ---             ---            (40)
Stock options exercised ....................       ---       ---      411          29        ---             ---             29
Issuance of common stock upon exercise
  of preferred stock warrants ..............       ---       ---       21          59        ---             ---             59
Issuance of common stock upon exercise
  of common stock warrants..................       ---       ---       45          66        ---             ---             66
Issuance of common stock upon conversion
  of preferred stock........................    (1,789)  (12,099)   3,835      12,099        ---             ---            ---
Issuance of common stock to public,
  net of issuance costs of $1,975 ..........       ---       ---    1,500      13,024        ---             ---         13,024
Net Income .................................       ---       ---      ---         ---        ---           1,454          1,454
                                                ------   --------   -----     -------      -----        --------        -------
Balance at December 31, 1995 ...............       ---       ---    6,468      25,655       (156)         (6,845)        18,654
Foreign currency translation adjustment ....       ---       ---      ---         ---       (176)            ---           (176)
Issuance of common stock upon exercise
  of common stock warrants..................       ---       ---       35         ---        ---             ---            ---
Stock option exercised......................       ---       ---      115          23        ---             ---             23
Income tax benefit from stock plans.........       ---       ---      ---         204        ---             ---            204
Sale of common stock to employees...........       ---       ---       16         186        ---             ---            186
Net Income .................................       ---       ---      ---         ---        ---           3,716          3,716
                                                ------   --------   -----     -------      -----        --------        -------
Balance at December 31, 1996................       ---       ---    6,634      26,068       (332)         (3,129)        22,607
Foreign currency translation adjustment.....       ---       ---      ---         ---       (537)            ---           (537)
Issuance of common stock upon exercise
of common stock warrants....................       ---       ---       59         ---        ---             ---            ---
Stock option exercised .....................       ---       ---       88          17        ---             ---             17
Income tax benefit from stock plans.........       ---       ---      ---          55        ---             ---             55
Sale of common stock to employees...........       ---       ---       46         247        ---             ---            247
Net Income .................................       ---       ---      ---         ---        ---           1,902          1,902
                                                ------   --------   -----     -------      -----        --------        -------
Balance at December 31, 1997................       ---       ---    6,827     $26,387      $(869)        $(1,227)       $24,291
                                                ------   --------   -----     -------      -----        --------        -------
                                                ------   --------   -----     -------      -----        --------        -------
</TABLE>


    See accompanying notes.

                                       28
<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                                       YEAR ENDED DECEMBER 31,
                                                                   -------------------------------
                                                                     1997       1996       1995
                                                                   ---------  ---------  ---------
                                                                           (IN THOUSANDS)
<S>                                                                <C>        <C>        <C>
Cash flows from operating activities:
Net income.......................................................  $   1,902  $   3,716  $   1,454
Adjustments to reconcile net income to net
   cash provided byoperating activities:
Depreciation and amortization....................................      1,148      1,116      1,154
Changes in operating assets and liabilities:
  Accounts receivable............................................      2,520     (2,751)    (1,863)
  Inventories....................................................       (268)       (52)      (247)
  Prepaid expenses and other current assets......................         69       (566)        29
  Other assets...................................................       (217)       (96)       106
  Deferred revenue...............................................        101        862        356
  Accounts payable and accrued expenses..........................         82       (566)     2,019
                                                                   ---------  ---------  ---------
     Net cash provided by operating activities...................      5,337      1,663      3,008

Cash flows from investing activities:
  Purchase of short-term investments.............................     (4,414)    (5,931)      ---
  Property and equipment additions...............................     (1,469)    (1,261)      (905)
  Purchase of product line ......................................        ---        ---       (450)
                                                                   ---------  ---------  ---------
     Net cash used in investing activities.......................     (5,883)    (7,192)    (1,355)
Cash flows from financing activities:
  Sale of common stock to employees..............................        247        186        ---
  Stock options exercised........................................         17         23         29
  Proceeds from stock warrants exercised ........................        ---        ---        125
  Public offering of Common stock, net ofissuance costs..........        ---        ---      13,024
  Proceeds from long-term obligations ...........................        ---        ---         918
  Repayment of long-term obligations.............................        (53)       (67)    (1,502)
  Proceeds from notes payable to banks ..........................        ---        ---     16,450
  Repayment of notes payable to banks ...........................        ---        ---    (19,774)
                                                                   ---------  ---------  ---------
Net cash provided by financing activities........................        211        142      9,270
Effects of foreign exchange rate changes on cash.................       (537)      (176)      (224)
                                                                   ---------  ---------  ---------
Increase (decrease) in cash and cash equivalents.................       (872)    (5,563)    10,699
Cash and cash equivalents at beginning of year...................      7,208     12,771      2,072
                                                                   ---------  ---------  ---------
Cash and cash equivalents at end of year.........................  $   6,336  $   7,208  $  12,771
                                                                   ---------  ---------  ---------
                                                                   ---------  ---------  ---------
Supplemental disclosures of cash paid:
  Interest.......................................................  $      13  $      42  $     246
  Income Taxes...................................................  $     642  $   1,320  $      81
Supplemental disclosures of non-cash activities:
  Tax benefit realized from non-qualifying
     dispositions of stock options...............................  $      55  $     204       ---
</TABLE>

    See accompanying notes.

                                       29

<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. THE COMPANY AND SIGNIFICANT ACCOUNTING POLICIES

    Applied Microsystems Corporation (the Company) provides design, debugging
and testing tools for use principally by software engineers in the development
of embedded software. The Company designs its products to support a broad range
of embedded 16 and 32 bit microprocessor, primarily those manufactured by Intel,
AMD and Motorola, and to run at the highest clock speeds of the microprocessors
supported by the Company. The Company's products are designed to address two
distinct requirements of embedded software developers: software development and
debugging tools and software testing tools. The Company markets its products and
services primarily through its domestic and international direct sales
organizations in the United States, Japan, the United Kingdom, Germany, and
France, and is supplemented with distributors throughout the rest of the world

    PRINCIPLES OF CONSOLIDATION

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

    INVENTORIES

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

    CASH EQUIVALENTS

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

    SECURITIES AVAILABLE FOR SALE

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



                                       30
<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

    FINANCIAL INSTRUMENTS

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

    PROPERTY AND EQUIPMENT

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

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

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

    REVENUE RECOGNITION

    Generally, revenues from sales of products are recognized when products are
shipped unless the Company has obligations remaining under a sales or licensing
agreement, in which case revenue is deferred until all obligations are
satisfied. Revenues from sales of maintenance contracts are deferred and
recognized ratably over the contract period. Revenues from maintenance contracts
in 1997, 1996, and 1995 were $4,644,000, $3,158,000, and $2,590,000,
respectively.

    In October 1997, the AICPA issued SOP 97-2, "Software Revenue Recognition,"
which changes the requirements for revenue recognition effective for the
transactions that the Company will enter into beginning January 1, 1998. The
Company has not yet assessed what impact the SOP will have on its fiscal 1998
financial statements.

    USE OF ESTIMATES

    The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results that could differ from estimates include
sales returns, doubtful accounts and obsolescence of inventory.

    RESEARCH AND DEVELOPMENT COSTS

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


                                       31
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

    ACQUIRED TECHNOLOGY

    Costs to acquire technology are capitalized to the extent the products are
technologically feasible and are included in other assets in the balance sheet.
The Company's policy is to amortize these costs to match the associated revenue
stream for the products containing the acquired technology. As of December 31,
1997 and 1996, amounts capitalized, net of accumulated amortization of $139,000
and $47,000, were $561,000 and $405,000, respectively. Amortization expense was
$92,000 and $47,000 in 1997 and 1996, respectively.

    FOREIGN CURRENCIES

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

    The Company has a program in place to manage foreign currency risk.  As part
of that program, the Company has entered into foreign currency forward contracts
to hedge anticipated foreign currency transactions, primarily intercompany
accounts resulting from sales to international subsidiaries. The forward
contracts typically mature within three months. Gains and losses on contracts
that are designated and effective as hedges of such transactions are deferred
and recognized in income in the same period as the hedged transactions. At
December 31, 1997, contracts totaling 120,000,000 Yen with maturity dates
through February 1998 were outstanding.

    INCOME TAXES

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

    CONCENTRATION OF CREDIT RISK

    Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of cash equivalents, short-term
investments and trade accounts receivable. By policy, the Company places its
investments only in high credit quality financial securities and limits the
amounts invested in any one institution or in any type of instrument. The
Company's trade accounts receivable are geographically dispersed and include
customers in many different industries. The Company performs ongoing credit
evaluations of its customers' financial condition and limits its exposure to
losses from bad debts by limiting the amount of credit extended whenever deemed
necessary and generally does not require collateral. The Company sells certain
trade account receivable in Japan with recourse in the ordinary course of
business. At December 31, 1997 accounts receivable sold with recourse totaled
$71,000.

                                      32
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

    NET INCOME PER SHARE

    In 1997, the Financial Accounting Standards Board (FASB) issued Statement
No. 128, "Earnings per Share" (FAS 128). FAS 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 very similar to the previously
reported earnings per share. In addition, the Securities and Exchange
Commission (SEC) previously had requirements for common and common stock
equivalent shares issued during the 12-month period prior to filing of an
initial public offering to be included in the calculation of earnings per
share as if they were outstanding for all periods presented using the
treasury stock method assuming the initial public offering price. In 1998,
the SEC issued new requirements for dilutive common stock equivalent shares.
All earnings per share amounts for all periods have been presented to conform
with FAS 128 and new the SEC requirements. As a result of the adoption of
SFAS No. 128 and the new SEC requirements, the Company's previously reported
net income per share changed from $0.25 to $0.27 on a diluted basis for the
year ended December 31, 1995.

    STOCK-BASED COMPENSATION

    In accordance with the provisions of SFAS No. 123, the Company applies APB
Opinion 25 and related interpretations in accounting for its stock option plan
and, accordingly, compensation expense, if any, is generally determined based on
the difference between the exercise price of stock options or awards and the
related fair market value of the common stock. Note 8 to the Consolidated
Financial Statements contains a summary of the pro forma effects to reported net
income and earnings per share if the Company had elected to recognize
compensation expense based on the fair value of the options granted at grant
date as prescribed by SFAS No. 123.

    RECLASSIFICATIONS

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

    RECENT ACCOUNTING PRONOUNCEMENTS

    The FASB issued Statement No. 130, "Reporting Comprehensive income" (FAS
130) and Statement No 131, "Disclosure about Segments of an Enterprise and
Related Information" (FAS 131). FAS 130 established standards for reporting
comprehensive income in annual and interim financial statements. FAS 131
established standards for the way a public business enterprise reports
information about operating segments in annual financial statements and requires
that those enterprises report 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. FAS 130 and 131 are effective for financial statements having fiscal
years beginning after December 15, 1997. The adoption of FAS 130 and 131 is not
expected to have a significant impact on the Company's consolidated results of
operations, financial position or cash flow.


                                       33
<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2. SECURITIES AVAILABLE FOR SALE

    Securities available-for-sale consist of the following as of December 31:
<TABLE>
<CAPTION>
                                                                                1997
                                                     ----------------------------------------------------------
                                                                       GROSS            GROSS
                                                      AMORTIZED     UNREALIZED       UNREALIZED
                                                        COST           GAINS           LOSSES       FAIR VALUE
                                                     -----------  ---------------  ---------------  -----------
                                                                           (IN THOUSANDS)
<S>                                                  <C>          <C>              <C>              <C>
U.S. Treasury securities and other
  U.S Government obligations.......................   $   2,956      $    0            $    0        $   2,956
Corporate debt securities..........................       7,387           2                 0        $   7,389
                                                     -----------     ------            ------       -----------
                                                      $  10,343      $    2            $    0        $  10,345
                                                     -----------     ------            ------       -----------
                                                     -----------     ------            ------       -----------
</TABLE>
<TABLE>
<CAPTION>
                                                                                1996
                                                     ----------------------------------------------------------
                                                                       GROSS            GROSS
                                                      AMORTIZED     UNREALIZED       UNREALIZED
                                                        COST           GAINS           LOSSES       FAIR VALUE
                                                     -----------  ---------------  ---------------  -----------
                                                                           (IN THOUSANDS)
<S>                                                  <C>          <C>              <C>              <C>
U.S. Treasury securities and other
  U.S Government obligations.......................   $   2,964      $    0              $    0        $   2,964
Corporate debt securities..........................       2,967           0                   0        $   2,967
                                                     -----------     ------              ------       -----------
                                                      $   5,931      $    0              $    0        $   5,931
                                                     -----------     ------              ------       -----------
                                                     -----------     ------              ------       -----------
</TABLE>

    As of December 31, 1997, the securities available for sale have contractual
maturities of less than one year. Expected maturities will differ from
contractual maturities because the issuers of the securities may have the right
to prepay obligations without prepayment penalties.



                                      34

<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


3. INVENTORIES

    Inventories consist of:

<TABLE>
<CAPTION>
                                                                      DECEMBER 31,
                                                                  --------------------
                                                                    1997       1996
                                                                  ---------  ---------
                                                                     (IN THOUSANDS)
<S>                                                               <C>        <C>
Finished goods..................................................  $   1,303  $   1,282
Work in process.................................................        157        168
Purchased parts.................................................      2,005      1,747
                                                                  ---------  ---------
                                                                  $   3,465  $   3,197
                                                                  ---------  ---------
                                                                  ---------  ---------
</TABLE>


4. PROPERTY AND EQUIPMENT

    Property and equipment consist of:
<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                         --------------------
                                                           1997       1996
                                                         ---------  ---------
                                                            (IN THOUSANDS)
<S>                                                      <C>        <C>
Machinery and equipment................................  $   3,973  $   3,845
Office furniture and equipment.........................      2,465      2,388
Leased equipment.......................................        410        410
                                                         ---------  ---------
                                                             6,848      6,643
Less accumulated depreciation and amortization.........      3,948      4,202
                                                         ---------  ---------
                                                         $   2,900  $   2,441
                                                         ---------  ---------
                                                         ---------  ---------
</TABLE>

5. REVOLVING LINE OF CREDIT AGREEMENTS

    In January 1997, the Company negotiated a revolving line of credit agreement
with a commercial bank aggregating $7.0 million, which expires in May 1998.
Borrowings pursuant to this agreement bear interest at the bank's prime lending
rate and provide an option to take $2.0 million of the available line and
amortize over a five year term. The line of credit agreement is unsecured,
except for the term loan option, and includes certain financial covenants.

                                       35


<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. COMMITMENTS AND CONTINGENCIES

    The Company leases office space and equipment under noncancelable operating
leases and equipment under capital leases. Certain leases contain renewal
options. Future minimum payments under these leases are as follows:
<TABLE>
<CAPTION>
                                                     DECEMBER 31, 1997
                                                  ------------------------
                                                    CAPITAL     OPERATING
                                                    LEASES       LEASES
                                                  -----------  -----------
                                                       (IN THOUSANDS)
<S>                                               <C>          <C>
1998 ......................................         $    16   $   1,215
1999 ......................................              --         912
2000 ......................................              --         865
2001 ......................................              --         420
2002 ......................................              --          73
Thereafter.................................              --         456
                                                     -------   -----------
                                                          16    $   3,941
                                                     -------   -----------
                                                     -------   -----------
Less amount representing interest...............           1
                                                     -------
Present value of net minimum capital
  lease obligations.............................          15
Less current portion............................          15
                                                     -------
Capital lease obligations,
  less current portion..........................     $     0
                                                     -------
                                                     -------
</TABLE>

    Total rent expense for the years ended December 31, 1997, 1996 and 1995 was
$1,378,000, $1,278,000, and $1,361,000, respectively.

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

                                      36

<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

7. INCOME TAXES

    The provision for incomes taxes in 1997, 1996 and 1995 is as follows:
<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                                -------------------------------
                                                  1997       1996       1995
                                                ---------  ---------  ---------
                                                        (IN THOUSANDS)
<S>                                             <C>        <C>        <C>
Federal.......................................  $     179  $   1,402  $     187
Foreign.......................................        105         90         90
State.........................................         65         90         28
                                                ---------  ---------  ---------
                                                $     349  $   1,582  $     305
                                                ---------  ---------  ---------
                                                ---------  ---------  ---------
</TABLE>

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

<TABLE>
<CAPTION>
                                                            YEAR ENDED DECEMBER
                                                                    31,
                                                            --------------------
                                                              1997       1996
                                                            ---------  ---------
                                                               (IN THOUSANDS)
<S>                                                         <C>        <C>
Deferred tax assets:
Accrued and other expenses................................  $     166  $     179
Inventories...............................................        568        348
Net operating loss carryforwards..........................        791        849
Tax credit carryforwards..................................      1,208        953
                                                            ---------  ---------
Total deferred tax assets.................................      2,733      2,329
Deferred tax liabilities:
Depreciation..............................................         11         81
Intangible and other assets...............................        219         25
                                                            ---------  ---------
Total deferred tax liabilities............................        230        106
Valuation allowance.......................................     (2,503)    (2,223)
                                                            ---------  ---------
Net deferred taxes........................................  $       0  $       0
                                                            ---------  ---------
                                                            ---------  ---------
</TABLE>

    As of December 31, 1997, the Company has net operating loss carryforwards
for federal tax purposes of approximately $2,261,000 available to offset
future taxable income. The Company also has research and development credits
of approximately $1,208,000, which may be carried forward, subject to certain
limitations, to offset future tax liabilities. The net operating loss and
research and development tax credit carryforwards expire in various amounts
from 1998 to 2012. Sections 382 and 383 of the Internal Revenue Code of 1986,
as amended, set forth annual limits for the utilization of tax net operating
loss and credit carryforwards in the event of a significant change in
ownership. The issuance of preferred stock in 1992 resulted in such
"ownership change." Accordingly, utilization of the net operating loss
carryforwards is limited to approximately $392,000 per year.

                                         37
<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

    The valuation allowance for deferred tax assets increased approximately
$280,000 and decreased approximately $529,000 during 1997 and 1996,
respectively.

   A reconciliation from the U.S. statutory rate to the effective tax rate is
as follows:
<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                          -------------------------------
                                                            1997       1996       1995
                                                          ---------  ---------  ---------
                                                                  (IN THOUSANDS)
<S>                                                       <C>        <C>        <C>
Tax at U.S. statutory rate of 35%.......................  $     788  $   1,854  $     616
Utilization of net operating loss
      and tax credit carryforwards......................       (137)      (532)      (429)

Benefit of foreign sales corporation....................       (122)       (98)       ---
Alternative minimum tax.................................         57        ---        ---
Foreign taxes...........................................        105         90         90
State taxes, net of federal effect......................         42         59         28
Foreign losseswith no tax benefit.......................        404        212        ---
Loss on deemed liquidation of subsidiaries.............        (845)       ---        ---
Other...................................................         57         (3)       ---
                                                          ---------  ---------  ---------
                                                          $     349  $   1,582  $     305
                                                          ---------  ---------  ---------
                                                          ---------  ---------  ---------
</TABLE>

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

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

    Income taxes paid during 1997, 1996 and 1995, including deposits, were
$642,000, $1,320,000 and $81,000 respectively.

                                       38

<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

8. INCOME PER SHARE

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

<TABLE>
<CAPTION>
                                                                                           YEAR ENDED DECEMBER 31,
                                                                                       -------------------------------
<S>                                                                                    <C>        <C>        <C>
                                                                                          1997       1996       1995
                                                                                       ---------  ---------  ---------
(in thousands, except per share amount)
Numerator:
  Numerator for basic and diluted income per share-
  net income.........................................................................  $   1,902  $   3,716  $   1,454
                                                                                       ---------  ---------  ---------
                                                                                       ---------  ---------  ---------
Denominator:
  Denominator for basic income per share--weighted
    average common shares............................................................      6,769      6,545      1,551
  Effect of dilutive securities:
  Stock options and warrants based on the treasury
    stock method using average market price..........................................        528        552        375
  Convertible preferred stock........................................................         --         --      3,403
                                                                                       ---------  ---------  ---------
  Denominator for diluted income per share...........................................      7,297      7,097      5,329
                                                                                       ---------  ---------  ---------
                                                                                       ---------  ---------  ---------
Basic income per share...............................................................  $    0.28  $    0.57  $    0.94
                                                                                       ---------  ---------  ---------
                                                                                       ---------  ---------  ---------
Diluted income per share.............................................................  $    0.26  $    0.52  $    0.27
                                                                                       ---------  ---------  ---------
                                                                                       ---------  ---------  ---------
</TABLE>

9. SHAREHOLDERS' EQUITY

    On November 14, 1995, the Company completed its initial public offering of
1,500,000 shares of common stock at $10.00 a share. All outstanding shares of
preferred stock were converted to common stock at that time.

STOCK OPTIONS

    Stock option plans (the Plans) have been established that authorize the
issuance of options for 2,175,317 shares of common stock to selected directors,
officers, employees, and consultants of the Company. As of December 31, 1997
options for 848,620 shares are outstanding and exercisable, of which options for
593,636 shares are unvested. Options for 234,648 shares are available to be
granted.

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

    On September 11, 1995, the Company's shareholders adopted the Director Stock
Option Plan which authorized the annual issuance of 2,500 shares of common stock
per outside director upon the exercise of stock options that may be granted
pursuant to this plan. As of December 31, 1997, options for 15,000 shares are
outstanding and exercisable and options for 7,500 shares contain repurchase
rights.

                                       39


<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

A summary of stock option transactions for the years ended December 31 follows:
<TABLE>
<CAPTION>
                                                             1997                                  1996
                                         -------------------------------------------  ------------------------------
                                           OPTIONS    WEIGHTED-AVERAGE     OPTIONS    WEIGHTED-AVERAGE     OPTIONS
                                            (000)      EXERCISE PRICE       (000)      EXERCISE PRICE       (000)
                                         -----------  -----------------  -----------  -----------------  -----------
<S>                                      <C>          <C>                <C>          <C>                <C>
Outstanding-beginning of year..........         729       $    5.99             541       $     .31             927
Granted................................         631       $    4.62             326       $   13.18              40
Forfeited..............................        (407)      $   11.19             (25)      $    3.06             (15)
Exercised..............................         (89)      $     .20            (113)      $     .20            (411)
                                              -----          ------             ---          ------            ----
Outstanding-end of year................         864       $    3.13             729       $    5.99             541

                                              -----          ------             ---          ------            ----
                                              -----          ------             ---          ------            ----
Vested options.........................         262      $      .67             287       $     .14              258
                                              -----          ------             ---          ------            ----
                                              -----          ------             ---          ------            ----
Weighted-average fair value of options
  granted during the year..............   $    3.19                        $  10.14                              --

<CAPTION>
                                               1995
                                         WEIGHTED-AVERAGE
                                          EXERCISE PRICE
                                         -----------------
<S>                                      <C>
Outstanding-beginning of year..........      $     .11
Granted................................      $    2.53
Forfeited..............................      $     .25
Exercised..............................      $     .07
                                                 -----
Outstanding-end of year................      $     .31
Vested options.........................      $     .14

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

    The following table summarizes information related to outstanding and
exercisable options at December 31, 1997:

<TABLE>
<CAPTION>
                                                                          VESTED
                        OUTSTANDING AND EXERCISABLE                      OPTIONS
                   --------------------------------------------------  -----------
                                                     WEIGHTED
                                 WEIGHTED             AVERAGE                              WEIGHTED
RANGE OF                          AVERAGE            REMAINING                              AVERAGE
EXERCISE PRICES   SHARES(000)   EXERCISE PRICE     CONTRACTUAL LIFE    SHARES(000)      EXERCISE PRICE
-----------------  -----------  -----------------  -------------------  -----------     --------------
<S>              <C>                <C>          <C>                <C>                  <C>
$.02--2.00......           295       $     .18             5.1                 255        $     .15
$4.13--6.50.....           531       $    4.27             9.2                  --               --
$7.00--8.75.....            29       $    7.94             9.5                  --               --
$12.25--17.50...             9       $   16.75             8.4                   8        $   17.29
                           ---      -----------                                ---       -----------
$.02--13.38.....           864       $    3.13             7.8                 263        $     .67
                           ---                                                 ---
                           ---                                                 ---
</TABLE>

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

<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE AMOUNT)                                                  1997       1996       1995
-------------------------------------------------------------------------------------  ---------  ---------  ---------
<S>                                                                                    <C>        <C>        <C>
Net income--as reported..............................................................  $   1,902  $   3,716  $   1,454
Net income--pro forma................................................................  $   1,411  $   3,282  $   1,450
Diluted net income per share as reported.............................................  $     .26  $     .52  $     .27
Diluted net Income per share pro-forma...............................................  $     .19  $     .46  $     .27
</TABLE>

                                       40
<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

<TABLE>
<CAPTION>
                                                                                  1997        1996        1995
                                                                               ----------  ----------  ----------
<S>                                                                            <C>         <C>         <C>
Annualized volatility........................................................  93.9%       89.6%       25.0%
Risk-free interest rate......................................................   6.0%        6.4%        6.2%
Forfeiture rate..............................................................   6.6%        6.2%        7.0%
Expected life................................................................  4.0 years   5.8 years   4.7 years
Expected dividend rate.......................................................   nil         nil         nil
</TABLE>

STOCK WARRANTS

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

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

EMPLOYEE STOCK PURCHASE PLAN

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

COMMON STOCK RESERVED

Common stock reserved for future issuance at December 31, 1997 is as follows:

<TABLE>
<S>                                                                                <C>
Employee Stock Purchase Plan.....................................................    187,991
Common stock options.............................................................  1,118,268
                                                                                   ---------
                                                                                   1,306,259
                                                                                   ---------
                                                                                   ---------
</TABLE>
                                       41

<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

10. EMPLOYEE BENEFIT PLAN

    The Company maintains a Profit Sharing Plan (the Plan) under section 401K of
the Internal Revenue Code. All U.S. based employees are eligible to participate
in the Plan at the start of each calendar quarter. Contributions by the company
are based on a matching formula as defined in the Plan. The Company may also
make discretionary contributions. During 1997, 1996 and 1995, the Company made
contributions of $162,000, $133,000 and $58,000, respectively.

11. PRODUCT DEVELOPMENT CONTRACTS

    The Company has entered into various product development agreements
whereby the costs of certain product development projects are subsidized
through periodic nonrefundable support subsidies from third parties based on
the achievement of previously established milestones. These contracts can be
terminated by either party at any stage of the contract. Total costs incurred
on these product development projects and the related support subsidies,
which are recognized as a reduction of product development expense, were as
follows:

<TABLE>
<CAPTION>
                                                                                                  YEAR ENDED DECEMBER 31,
                                                                                               -------------------------------
                                                                                                1997        1996       1995
                                                                                                -----     ---------  ---------
<S>                                                                                            <C>        <C>        <C>
Direct product development costs...........................................................    $   0       $ 269     $  575
Related product development support subsidies..............................................        0         335        450
</TABLE>

                                       42

<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

12. GEOGRAPHIC INFORMATION

    The Company is engaged in one line of business: the design, manufacture, and
marketing of specialized test instruments and software for the microprocessor
industry. Certain financial information of operations by geographic area is
provided in the table below based on the location of the Company's facilities.
Sales are not recognized for financial statement purposes until there has been a
sale to an unaffiliated customer.
<TABLE>
<CAPTION>
                                                                                       YEAR ENDED DECEMBER 31,
                                                                                   -------------------------------
                                                                                     1997       1996       1995
                                                                                   ---------  ---------  ---------
                                                                                             (IN THOUSANDS)
<S>                                                                               <C>        <C>        <C>
Net Sales:
United States....................................................................  $  22,247  $  22,615  $  17,839
Japan............................................................................     13,132     12,842     10,412
Europe...........................................................................      3,745      3,205      2,788
                                                                                   ---------  ---------  ---------
Consolidated net sales...........................................................  $  39,124  $  38,662  $  31,039
                                                                                   ---------  ---------  ---------
                                                                                   ---------  ---------  ---------
Export Sales to unaffiliated customers...........................................  $   2,446  $   2,367  $   1,917
                                                                                   ---------  ---------  ---------
                                                                                   ---------  ---------  ---------
Income(Loss) before income taxes:
United States....................................................................  $   4,121  $   5,900  $   2,778
Japan............................................................................        107        266        183
Europe...........................................................................       (623)      (214)      (413)
Corporate elimination's..........................................................     (1,354)      (654)      (789)
                                                                                   ---------  ---------  ---------
Consolidated income before income tax............................................  $   2,251  $   5,298  $   1,759
                                                                                   ---------  ---------  ---------
                                                                                   ---------  ---------  ---------
Identifiable assets:
United States....................................................................  $  25,646  $  24,071  $  21,638
Japan............................................................................      5,112      5,225      3,888
Europe...........................................................................      1,824      1,528      1,320
                                                                                   ---------  ---------  ---------
Consolidated assets..............................................................  $  32,582  $  30,824  $  26,846
                                                                                   ---------  ---------  ---------
                                                                                   ---------  ---------  ---------
</TABLE>

                                       43

<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

13. Quarterly Financial Information (unaudited)

Summarized quarterly financial information for 1997 and 1996 is as follows:

<TABLE>
<CAPTION>
                                                                                             1997
                                                                          ------------------------------------------
FOR THE QUARTERS ENDED:                                                    MAR. 31    JUNE 30   SEPT. 30    DEC. 31
------------------------------------------------------------------------  ---------  ---------  ---------  ---------
<S>                                                                       <C>        <C>        <C>        <C>
(In thousands, except per share data)
  Net sales.............................................................  $   8,902  $  10,009  $  10,758  $   9,455
  Gross profit..........................................................      6,446      7,310      7,897      6,939
  Net Income............................................................         42        647      1,012        201
  Diluted earnings per share:
  Net income............................................................  $    0.01  $    0.09  $    0.14  $    0.03
  Weighted average common shares and equivalents........................      7,101      7,259      7,393      7,397
  Market price per share:
    High................................................................  $   16.00  $   10.50  $   12.88  $   12.63
    Low.................................................................       4.88       3.88       8.00       5.00
</TABLE>

<TABLE>
<CAPTION>
                                                                                             1996
                                                                          ------------------------------------------
FOR THE QUARTERS ENDED:                                                    MAR. 31    JUNE 30   SEPT. 30    DEC. 31
------------------------------------------------------------------------  ---------  ---------  ---------  ---------
<S>                                                                       <C>        <C>        <C>        <C>
(In thousands, except per share data)
  Net sales.............................................................  $   8,704  $   9,750  $   9,711  $  10,496
  Gross profit..........................................................      6,147      6,944      7,101      7,677
  Net Income............................................................        702        996        967      1,052
  Diluted earnings per share:
  Net income............................................................  $    0.10  $    0.14  $    0.14  $    0.15
  Weighted average common shares and equivalents........................      7,083      7,106      7,128      7,094
  Market price per share:
    High................................................................  $   12.75  $   20.75  $  23.875  $   23.75
    Low.................................................................       7.75       9.00      11.25       9.00
</TABLE>

    The 1996 and first three quarters of 1997 dilutive earnings per share have
been restated to comply with SFAS 128 which was adopted on the fourth quarter of
1997.

                                       44

<PAGE>

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

    None.

                                  PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

    The information required by this Item is contained in part in the sections
captioned "Board of Directors      Nominees for Director" and "Voting Securities
and Principal Holders      Exchange Act Compliance" in the Proxy Statement for
the Company's Annual Meeting of Stockholders scheduled to be held on May 22,
1998, and such information is incorporated herein by reference.

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

ITEM 11. EXECUTIVE COMPENSATION

    The information required by this Item is incorporated by reference to the
information contained in the section captioned "Compensation and Benefits" of
the Proxy Statement for the Company's Annual Meeting of Stockholders scheduled
to be held on May 22, 1998.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

    The information required by this Item is incorporated by reference to the
information contained in the sections captioned "Voting Securities and Principal
Holders" and "Compensation and Benefits      Certain Transactions" of the Proxy
Statement for the Company's Annual Meeting of Stockholders scheduled to be held
on May 22, 1998.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    The information required by this Item is incorporated by reference to the
information contained in the section captioned "Compensation and
Benefits      Certain Transactions" of the Proxy Statement for the Company's
Annual Meeting of Stockholders scheduled to be held on May 22, 1998.

                                  PART IV

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

    The following documents are filed as part of this report:

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

(a)(2) Financial Statement Schedules

    Schedule II: Valuation and Qualifying Accounts

                                       45

<PAGE>

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

(a)(3) Exhibits

    The following exhibits are filed with this report:

Exhibit No. 3: Articles of Incorporation and Bylaws

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

Exhibit No. 10: Material Contracts

EXECUTIVE COMPENSATION PLANS AND AGREEMENTS

    10.1  Employment Agreement between the Registrant and Robert L. Deinhammer
          dated July 31, 1992
    10.2  1990 Stock Benefit Plan
    10.3  1992 Performance Stock Plan
    10.4  1995 Directors Stock Option Plan

OTHER MATERIAL CONTRACTS

    10.5  Loan and Security Agreement between the Registrant and Silicon Valley
Bank dated October 20, 1992; Schedule to Loan and Security Agreement dated
October 20, 1992; Amendment to Loan and Security Agreement dated June 15, 1993;
Loan Modification Agreements to Loan and Security Agreement dated June 13, 1994,
March 27, 1995 and June 27, 1995; and Secured Promissory Notes dated March 27,
1995 and June 27, 1995

    10.6  Loan and Security Agreement (Exim) between the Registrant and
Silicon Valley Bank dated October 20, 1992; Schedule to Loan and Security
Agreement (Exim) dated October 20, 1992; Amendments to Loan and Security
Agreement (Exim) dated June 15, 1993 and August 15, 1993; Loan Modification
Agreements to Loan and Security Agreement (Exim) dated June 13, 1994 and June
27, 1995; Exim Working Capital Borrower Agreement dated June 27, 1995; Letter
Agreement dated June 29, 1995 modifying Loan Modification Agreement (Exim)
dated June 27, 1995; and Secured Promissory Note dated October 20, 1992

    10.7  Lease Agreement between W. R.C. Properties, Inc. and the Registrant
dated February 27, 1989; and Amendments to Lease Agreement dated November 7,
1990, May 11, 1992, August 18, 1993 and March 31, 1994

    10.8  Third Amended and Restated Investment Agreement dated as of
September 15, 1995

    10.10 Tools Development and Bond-Out License Agreement between the
Registrant and Intel Corporation dated September 30, 1993, as amended April
13, 1994

    10.11 Bond-Out License Agreement between the Registrant and Intel
Corporation dated September 16, 1994

    10.12 Source License and Distribution Agreement between the Registrant
and Microtec Research, Inc. dated August 1, 1994

    10.15 Processor feature Technology License Agreement between the
Registrant and Intel Corporation dated September 21, 1995

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

                                       46
<PAGE>

Exhibit No. 21: Subsidiaries of Registrant

(b) Reports on Form 8-K

    None.


                                       47

<PAGE>

                                   SIGNATURES

    Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of
Seattle, State of Washington, on March 27, 1998.

                                        APPLIED MICROSYSTEMS CORPORATION



                                        By /s/ A. James Beach
                                           ------------------
                                           A. James Beach
                                           Chief Financial Officer

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

<TABLE>
<CAPTION>
          SIGNATURE                        TITLE                         DATE
         -----------                      --------                      -------
<S>                             <C>                                 <C>
 /s/ Robert L. Deinhammer         President, Chief Executive         March 27, 1998
------------------------------      Officer and Director
     Robert L. Deinhammer           (Principal Executive Officer)


 /s/ A. James Beach               Vice President, Chief               March 27, 1998
------------------------------      Financial Officer, Secretary
     A. James Beach                 and Treasurer (Principal
                                    Financial and Accounting
                                    Officer)

 /s/ Anthony Miadich              Chairman of the Board               March 27,  1998
------------------------------
     Anthony Miadich

 /s/ Elwood D. Howse, Jr.         Director                            March 27, 1998
------------------------------
     Elwood D. Howse, Jr.

 /s/ Paul N. Risinger             Director                            March 27, 1998
------------------------------
     Paul N. Risinger

</TABLE>
                                       48

<PAGE>

                                          EXHIBIT INDEX

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

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

10.1                 Employment Agreement between the Registrant and Robert
                     L. Deinhammer dated July 31, 1992 (incorporated by
                     reference from Exhibit 10.3 to the Registrant's
                     Registration Statement on Form S-1 filed with the
                     Securities and Exchange Commission on September 15, 1995
                     (File No. 33-97002)

10.2                 1990 Stock Benefit Plan (incorporated by reference from
                     Exhibit 10.5 to the Registrant's Registration Statement
                     on Form S-1 filed with the Securities and Exchange
                     Commission on September 15, 1995 (File No. 33-97002)
10.3                 1992 Performance Stock Plan (incorporated by reference
                     from Exhibit 10.6 to the Registrant's Registration
                     Statement on Form S-1 filed with the Securities and
                     Exchange Commission on September 15, 1995 (File No.
                     33-97002)

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

10.5                 Loan and Security Agreement between the Registrant and
                     Silicon Valley Bank dated October 20, 1992; Schedule to
                     Loan and Security Agreement dated October 20, 1992;
                     Amendment to Loan and Security Agreement dated June 15,
                     1993; Loan Modification Agreements to Loan and Security
                     Agreement dated June 13, 1994, March 27, 1995 and June
                     27, 1995; and Secured Promissory Notes dated March 27,
                     1995 and June 27, 1995 (incorporated by reference from
                     Exhibit 10.1 to the Registrant's Registration Statement
                     on Form S-1 filed with the Securities and Exchange
                     Commission on September 15, 1995 (File No. 33-97002)

10.6                 Loan and Security Agreement (Exim) between the
                     Registrant and Silicon Valley Bank dated October 20,
                     1992; Schedule to Loan and Security Agreement (Exim)
                     dated October 20,
</TABLE>
                                       49

<PAGE>
<TABLE>
<CAPTION>
EXHIBIT NO.                                  DESCRIPTION
<S>                    <C>

                       1992; Amendments to Loan and Security
                       Agreement (Exim) dated June 15, 1993 and August 15,
                       1993; Loan Modification Agreements to Loan and Security
                       Agreement (Exim) dated June 13, 1994 and June 27, 1995;
                       Exim Working Capital Borrower Agreement dated June 27,
                       1995; Letter Agreement dated June 29, 1995 modifying
                       Loan Modification Agreement (Exim) dated June 27, 1995;
                       and Secured Promissory Note dated October 20, 1992
                       (incorporated by reference from Exhibit 10.2 to the
                       Registrant's Registration Statement on Form S-1 filed
                       with the Securities and Exchange Commission on September
                       15, 1995 (File No. 33-97002)

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

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

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

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

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

**10.12                Source License and Distribution Agreement between the

</TABLE>
                                       50

<PAGE>
<TABLE>
<CAPTION>
EXHIBIT NO.                                  DESCRIPTION
<S>                    <C>
                       Registrant and Microtec Research, Inc. dated August 1,
                       1994 (incorporated by reference from Exhibit 10.12 to
                       the Registrant's Registration Statement on Form S-1
                       filed with the Securities and Exchange Commission on
                       September 15, 1995 (File No. 33-97002)
**10.15                Processor feature Technology License Agreement between
                       the Registrant and Intel Corporation dated September 21,
                       1995 (incorporated by reference from Exhibit 10.15 to
                       the Registrant's Registration Statement on Form S-1
                       filed with the Securities and Exchange Commission on
                       September 15, 1995 (File No. 33-97002))

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

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

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

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

                                       51
<PAGE>
                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

                        APPLIED MICROSYSTEMS CORPORATION

                 Years Ended December 31, 1997, 1996 and 1995

<TABLE>
<CAPTION>
                                                                  COL C.
                                                                ADDITIONS
                                                          -------------------------
                                                              (1)          (2)
                                                COL B.    CHARGED TO    CHARGED TO                  COL. E.
                                              BALANCE AT     COSTS        OTHER        COL D.        BALANCE
           COL A.                             BEGINNING       AND       ACCOUNTS:    DEDUCTIONS:     END OF
        DESCRIPTION                           OF PERIOD    EXPENSES      DESCRIBE     DESCRIBE       PERIOD
-------------------------------------------  ----------  -----------  ------------  -----------   -----------
<S>                                         <C>         <C>          <C>           <C>            <C>
Year ended December 31, 1997:
Deducted from asset accounts:
  Allowance for doubtful accounts...........  $ 52,000    $32,000              --            --      $  84,000
  Allowance for sales returns...............  $212,000         --       670,000(B)    (355,000)(C)   $ 527,000
                                              ----------  -----------  ------------  -----------   -----------
  Totals....................................  $264,000    $32,000      $670,000      $(355,000)      $ 611,000
                                              ----------  -----------  ------------  -----------   -----------
                                              ----------  -----------  ------------  -----------   -----------
Year ended December 31, 1996:
Deducted from asset accounts:
  Allowance for doubtful accounts...........  $ 55,000    $(3,000)            --            --        $ 52,000
  Allowance for sales returns...............  $113,000         --        507,000(B)   (408,000)(C)    $212,000
                                              ----------  -----------  ------------  -----------   -----------
  Totals....................................  $168,000    $(3,000)      $507,000     $(408,000)       $264,000
                                              ----------  -----------  ------------  -----------   -----------
                                              ----------  -----------  ------------  -----------   -----------
Year ended December 31, 1995:
Deducted from asset accounts:
  Allowance for doubtful accounts............  $ 48,000   $14,000             --      $  (7,000)(A)   $ 55,000
  Allowance for sales returns................  $ 97,000        --        140,000(B)    (124,000 (C)   $113,000
                                              ----------  -----------  ------------  -----------   -----------
  Totals.....................................  $145,000   $14,000      $ 140,000      $(131,000       $168,000
                                              ----------  -----------  ------------  -----------   -----------
                                              ----------  -----------  ------------  -----------   -----------
</TABLE>

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

                                       52