<PAGE>

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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                    FORM 10-Q
                             ----------------------      
(Mark One)
[X]  Quarterly report pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934.

                For the quarterly period ended September 30, 1998

                                       or

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

                 For the transition period from ______ to ______

                         COMMISSION FILE NUMBER 0-26778

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

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

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

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

             5020 148TH AVENUE N.E., REDMOND, WASHINGTON 98052-5172
                                 (425) 882-2000

 (Address, including zip code, of Registrant's principal executive offices and
                     telephone number, including area code)

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

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

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

Common stock: 6,664,679 shares outstanding as of October 31, 1998

     This report including exhibits consists of 15 pages.

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<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

                                    FORM 10-Q

                        QUARTER ENDED SEPTEMBER 30, 1998

                                      INDEX
<TABLE>
<CAPTION>

                                                                           PAGE
                                                                           ----
<S>                                                                        <C>

PART I:   FINANCIAL INFORMATION

Item 1.   Financial Statements:

          Consolidated Statements of Operations for the quarter and nine
          months ended September 30, 1998 and 1997 ...........................3

          Consolidated Balance Sheets as of September 30, 1998 and
          December 31, 1997 ..................................................4

          Consolidated Statements of Cash Flows for the nine months ended
          September 30, 1998 and 1997 ........................................5

          Notes to Consolidated Financial Statements .........................6

Item 2.   Management's Discussion and Analysis of Financial Condition and
          Results of Operations...............................................8


PART II:  OTHER INFORMATION

Item 6.   Exhibits and Reports on Form 8-K...................................14

          Signatures.........................................................15
</TABLE>

                                      - 2 -
<PAGE>

PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                        APPLIED MICROSYSTEMS CORPORATION

                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                 THREE MONTHS ENDED SEPTEMBER 30     NINE MONTHS ENDED SEPTEMBER 30
                                                 --------------------------------    --------------------------------
                                                     1998              1997              1998              1997
                                                 --------------    --------------    --------------    --------------
<S>                                              <C>               <C>               <C>               <C>           
                                                              (IN THOUSANDS , EXCEPT PER SHARE AMOUNT)
                                                                             (UNAUDITED)

Net sales ......................................       $  9,957          $ 10,758          $ 27,365          $ 29,669
Cost of sales ..................................          2,525             2,861             7,163             8,015
                                                      ---------          --------         ---------           -------
Gross profit ...................................          7,432             7,897            20,202            21,654

Operating expenses:
     Sales, general and administrative .........          4,825             4,870            13,584            13,838
     Research and development ..................          2,659             2,010             7,592             6,300
                                                      ---------          --------         ---------           -------
Total operating expenses .......................          7,484             6,880            21,176            20,138
                                                      ---------          --------         ---------           -------
Income (loss) from operations ..................            (52)            1,017              (974)            1,516

Interest income and other ......................            184               178               606               509
Interest expense ...............................             --                (3)               (1)              (11)
                                                      ---------          --------         ---------           -------
Income (loss) before income taxes ..............            132             1,192              (369)            2,014
Income taxes ...................................             19               180                19               313
                                                      ---------          --------         ---------           -------
Net income (loss) ..............................      $     113          $  1,012         ($    388)          $ 1,701
                                                      ---------          --------         ---------           -------
                                                      ---------          --------         ---------           -------
Basic income (loss) per share ..................      $    0.02          $   0.15         ($   0.06)          $  0.25
Shares used in basic per share calculation......          6,789             6,798             6,861             6,768

Diluted income (loss) per share ................      $    0.02          $   0.14         ($   0.06)          $  0.23
Shares used in diluted per share calculation ...          6,983             7,393             6,861             7,273

</TABLE>

  The accompanying notes are an integral part of these consolidated financial
                                  statements.

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                                      - 3 -

<PAGE>

                        APPLIED MICROSYSTEMS CORPORATION

                           CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>
                                                                        SEPTEMBER 30,     DECEMBER 31,
                                                                            1998              1997
                                                                        -------------    --------------
                                                                         (UNAUDITED)
                                                                        <C>              <C>
                                     ASSETS
<S>
Current assets:
     Cash and cash equivalents ..........................................   $ 4,360         $ 6,336
     Short term investments .............................................    11,143          10,345
     Accounts receivable ................................................     9,995           7,741
     Inventories ........................................................     3,337           3,465
     Prepaid and other current assets ...................................       406             951
                                                                            -------         -------
         Total current assets ...........................................    29,241          28,838

Property and equipment, net .............................................     2,957           2,900
Other assets ............................................................       952             844
                                                                            -------         -------
         Total assets ...................................................   $33,150         $32,582
                                                                            -------         -------
                                                                            -------         -------
                      LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
     Accounts payable ...................................................   $ 2,882         $ 2,804
     Accrued payroll ....................................................     2,251           1,684
     Other accrued expenses .............................................     1,510             991
     Deferred revenue ...................................................     3,413           2,797
     Current portion of long-term obligations ...........................        --              15
                                                                            -------         -------
         Total current liabilities ......................................    10,056           8,291

Shareholders' equity:
     Preferred stock, par value $.01
         Authorized - 5,000,000 shares ..................................        --              --
     Common stock, par value $.01
         Authorized - 25,000,000 shares
         Issued - 6,670,000 and 6,827,000 shares at September 30,
         1998 and December 31, 1997, respectively .......................    25,443          26,387
     Cumulative translation adjustment ..................................      (734)           (869)
     Accumulated deficit ................................................    (1,615)         (1,227)
                                                                            -------         -------
         Total shareholders' equity .....................................    23,094          24,291
                                                                            -------         -------
         Total liabilities and shareholders' equity .....................   $33,150         $32,582
                                                                            -------         -------
                                                                            -------         -------
</TABLE>

          The accompanying notes are an integral part of these consolidated 
                                financial statements.

                                               - 4 -

<PAGE>

                                    APPLIED MICROSYSTEMS CORPORATION

                                 CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                        NINE MONTHS ENDED SEPTEMBER 30,
                                                                             1998             1997
                                                                        --------------   --------------
                                                                                 (IN THOUSANDS)
                                                                                   (UNAUDITED)
                                                                            <C>             <C>
<S>
Cash flows from operating activities:
Net income (loss) .......................................................   ($  388)        $ 1,701
Adjustments to reconcile net income (loss) to net cash provided by
   operating activities:
     Depreciation and amortization ......................................       901             858
Changes in operating assets and liabilities:
     Accounts receivable ................................................    (2,254)            229
     Inventories ........................................................       128            (217)
     Prepaid expenses ...................................................       545             231
     Other assets .......................................................      (247)           (133)
     Deferred revenue ...................................................       616             332
     Accounts payable and accrued expenses ..............................     1,164             (97)
                                                                            -------         -------
         Net cash provided by operating activities ......................       465           2,904

Cash flows from investing activities:
     Purchase of short-term investments .................................      (798)         (2,773)
     Property and equipment additions ...................................      (819)         (1,201)
                                                                            -------         -------
         Net cash used in investing activities ..........................    (1,617)         (3,974)

Cash flows from financing activities:
     Sale of common stock to employees ..................................       145             186
     Stock options exercised ............................................        10              12
     Purchase of treasury stock .........................................    (1,099)             --
     Repayment of long-term obligations .................................       (15)            (39)
                                                                            -------         -------
         Net cash provided by (used in) financing activities ............      (959)            159

Effects of foreign exchange rate changes on cash ........................       135            (170)
                                                                            -------         -------
Decrease in cash and cash equivalents ...................................    (1,976)         (1,081)
Cash and cash equivalents at beginning of period ........................     6,336           7,208
                                                                            -------         -------
Cash and cash equivalents at end of period ..............................   $ 4,360         $ 6,127
                                                                            -------         -------
                                                                            -------         -------
Supplemental disclosures of cash paid (received):
     Interest ...........................................................   $     0         $    11
     Income Taxes .......................................................   ($   19)        $   729
</TABLE>

           The accompanying notes are an integral part of these consolidated
                                 financial statements.

                                                 - 5 -

<PAGE>
                        APPLIED MICROSYSTEMS CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.   BASIS OF PRESENTATION

     The consolidated financial statements for the nine month period ended 
September 30, 1998 and 1997 and the related footnote information are 
unaudited and have been prepared on a basis substantially consistent with the 
1997 audited consolidated financial statements. In the opinion of management, 
the financial statements include all adjustments (consisting of only normal 
recurring adjustments) necessary for fair presentation of the results of this 
interim period. These statements should be read in conjunction with the 
consolidated financial statements and related notes included in the Company's 
1997 Annual Report to Shareholders. The results of operations for the nine 
months ended September 30, 1998 are not necessarily indicative of the results 
to be expected for the entire year.

     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.

2.   COMPUTATION OF EARNINGS (LOSS) 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 (loss) per share amounts for all periods have been presented to 
conform with FAS 128 and the new SEC requirements.

3.   COMPREHENSIVE INCOME (LOSS)

     As of January 1, 1998, the Company adopted Statement 130, REPORTING 
COMPREHENSIVE INCOME. Statement 130 establishes new rules for the reporting 
and display of comprehensive income and its components; however the 
adaptation of this Statement has no impact on the Company's net income or 
shareholders' equity. Statement 130 requires the Company's foreign currency 
translation adjustments, which are reported separately in shareholders' 
equity to be included in other comprehensive income.

     During the third quarter of 1998 and 1997, total comprehensive income 
amounted to $417,000 and $877,000. For the first nine months of 1998 and 
1997, total comprehensive loss and income, respectively, amounted to 
($253,000) and $1.5 million.

                                     - 6 -
<PAGE>

4.   SOFTWARE REVENUE RECOGNITION

     As of January 1, 1998, the Company adopted AICPA SOP 97-2, Software 
Revenue Recognition, which was effective for transactions that the Company 
entered into in 1998. Prior years were not restated. The effect of adopting 
SOP 97-2 was not material.

5.   INCOME (LOSS) PER SHARE
<TABLE>
<CAPTION>
                                                             THREE MONTHS ENDED SEPTEMBER 30,
                                                                 1998                 1997
                                                             -----------           -----------
<S>                                                          <C>                   <C>
(in thousands, except per share amount)
Numerator:
    Numerator for basic and diluted income per share -
      net income ...........................................   $  113                $1,012
                                                             -----------           -----------
                                                             -----------           -----------
Denominator:
    Denominator for basic income per share - weighted
      average common shares ................................    6,789                 6,798
    Effect of dilutive securities:
    Stock options based on the treasury
      stock method using average market price ..............      194                   595
                                                             -----------           -----------
    Denominator for diluted income per share ...............    6,983                 7,393
                                                             -----------           -----------
                                                             -----------           -----------
Basic income per share .....................................   $ 0.02                $ 0.15
                                                             -----------           -----------
                                                             -----------           -----------
Diluted income per share ...................................   $ 0.02                $ 0.14
                                                             -----------           -----------
                                                             -----------           -----------
</TABLE>

<TABLE>
<CAPTION>
                                                             NINE MONTHS ENDED SEPTEMBER 30,
                                                                 1998               1997
                                                             ------------       ------------
<S>                                                          <C>                <C>
(in thousands, except per share amount)
Numerator:
    Numerator for basic and diluted income per share -
      net income(loss) .....................................    ($ 388)            $1,701
                                                             ------------       ------------
                                                             ------------       ------------
Denominator:
    Denominator for basic income per share - weighted
      average common shares ................................     6,861              6,768
    Effect of dilutive securities:
    Stock options and warrants based on the treasury
      stock method using average market price ..............        --                505
                                                             ------------       ------------
    Denominator for diluted income per share ...............     6,861              7,273
                                                             ------------       ------------
                                                             ------------       ------------
Basic income (loss) per share ..............................    ($0.06)            $ 0.25
                                                             ------------       ------------
                                                             ------------       ------------
Diluted income (loss) per share ............................    ($0.06)            $ 0.23
                                                             ------------       ------------
                                                             ------------       ------------
</TABLE>

For the nine months ended September 30, 1998, the effect of outstanding 
options and warrants have been excluded from the diluted calculation because 
they are antidilutive.

                                     - 7 -
<PAGE>

6.   INVENTORIES

Inventories consist of:
<TABLE>
<CAPTION>
                            SEPTEMBER 30,   DECEMBER 31,
                               1998            1997
                            ------------    ------------
                                    (IN THOUSANDS)
<S>                         <C>             <C>
Finished goods ...........    $1,427          $1,303
Work in process ..........        82             157
Purchased parts ..........     1,828           2,005
                            ------------    ------------
                              $3,337          $3,465
                            ------------    ------------
                            ------------    ------------
</TABLE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

     Management's Discussion and Analysis of Financial Conditions and Results 
of Operations should be read in conjunction with the accompanying financial 
statements for the periods specified and the associated notes. Further 
reference should be made to the Company's 1997 Annual Report to Shareholders.

RESULTS OF OPERATIONS

     The following table sets forth for the period indicated the percentage 
of total revenue represented by each line item in the Company's condensed 
consolidated statements of income and the percentage change from comparative 
prior period in each line item.
<TABLE>
<CAPTION>
                                                      Percent of            Period-to-Period
                                                       Net Sales            Percentage Change
                                                -------------------------  --------------------
                                                  Three months Ended        Three months Ended
                                                     September 30,          September 30, 1998
                                                   1998             1997     Compared to 1997
                                                -------           -------  --------------------
<S>                                             <C>               <C>       <C>
Net sales ....................................    100.0%           100.0%           (7.4%)
Cost of sales ................................     25.4             26.6           (11.7)
                                                --------          -------
Gross profit .................................     74.6             73.4            (5.9)

Operating expenses:
     Sales, general and administrative .......     48.4             45.3            (0.9)
     Research and development ................     26.7             18.7            32.3
                                                --------          -------
Total operating expenses .....................     75.1             64.0             8.8
                                                --------          -------
Loss from operations .........................     (0.5)             9.4          (105.1)

Interest income and other ....................      1.8              1.7             3.4
Interest expense .............................       --               --              --
                                                --------          -------
Income (loss) before income taxes ............      1.3             11.1           (88.9)
Income taxes .................................       .2              1.7           (89.4)
                                                --------          -------
Net income ...................................      1.1%             9.4%          (88.8%)
                                                --------          -------
                                                --------          -------
</TABLE>

                                     - 8 -
<PAGE>

<TABLE>
<CAPTION>
                                                    PERCENT OF                    PERIOD-TO-PERIOD
                                                     NET SALES                    PERCENTAGE CHANGE
                                          --------------------------------    --------------------------
                                                 NINE MONTHS ENDED                NINE MONTHS ENDED
                                                   SEPTEMBER 30,                 SEPTEMBER 30, 1998
                                              1998              1997              COMPARED TO 1997
                                          -------------      -------------    --------------------------
<S>                                       <C>                <C>              <C>

Net sales ...............................    100.0%             100.0%                   (7.8%)         
Cost of sales ...........................     26.2               27.0                   (10.6)
                                          -------------      -------------                     
Gross profit ............................     73.8               73.0                    (6.7)

Operating expenses:
     Sales, general and administrative ..     49.6               46.6                    (1.8)
     Research and development ...........     27.7               21.2                    20.5
                                          -------------      -------------                     
Total operating expenses ................     77.3               67.8                     5.2
                                          -------------      -------------                     
Loss from operations ....................     (3.5)               5.2                  (164.2)

Interest income and other ...............      2.2                1.6                    19.1
Interest expense ........................       --                 --                      --
                                          -------------      -------------                     
Income (loss) before income taxes .......     (1.3)               6.8                      --
Income taxes ............................      0.1                1.1                      --
                                          -------------      -------------                     
Net income (loss) .......................     (1.4%)              5.7%                     --
                                          -------------      -------------                     
                                          -------------      -------------                     
</TABLE>

NET SALES

     Net sales decreased by 7.4% to $10.0 million from $10.8 million for the 
quarters ended September 30, 1998 and 1997, respectively. For the first nine 
months of 1998, revenue decreased by 7.8% to $27.4 million from $29.7 million 
for the same period of 1997. These decreases were primarily attributable to 
the reduction in unit sales of higher priced debug solutions, and to a lesser 
extent currency exchange rate fluctuations affecting international sales. The 
decreases were partially offset by an increase in unit sales of the low cost 
debug solutions and to a lesser extent, consulting services. The Company's 
net sales are presently derived predominantly from sales of software design, 
debugging, and testing solutions and support and consulting service revenues. 
The Company generally recognizes revenues from product sales upon shipment. 
Product support revenues decreased by 6.3% over the prior year's three months 
but increased as a percentage of sales to 11.4% from 11.2%. The revenue 
decrease relates to reduced revenue levels in prior quarters that the 
associated service contracts are sold against, but recognized ratably over 
the life of each maintenance contract, typically 12 months. Product support 
revenues increased by 1.5% and increased as a percentage of sales to 12.7% 
from 11.5% over the prior years nine months. The increases in product support 
revenue as a percentage of net sales is due primarily to the continued pro 
rata recognition of revenue from product support contracts entered into in 
prior periods, in combination with a decrease in product sales revenue 
compared to prior periods.

     International sales expressed in U.S. dollars decreased by 30.5% for the 
quarter ended September 30, 1998 over the comparable period of 1997, to 42.2% 
of net sales as compared to 56.2% of net sales in the prior comparable 
quarter. For the nine months ending September 30, 1998, international sales 
decreased 23.6% over the same period in 1997, representing 43.2% of the total 
sales versus 52.1% in the prior comparable period. The reduction in 
international revenues as expressed in U.S. dollars is primarily attributable 
to the Asian financial crisis that resulted in decreases in unit sales and 
average selling price in Japan and other Pacific Rim nations and currency 
exchange rates, and to a lesser extent, decreases in units sales in Europe. 
The Company's sales through its foreign subsidiaries are generally 
denominated in local currencies, and as a result, fluctuations in currency 
exchange rates can have a

                                      - 9 -
<PAGE>

significant effect on the Company's reported net sales. Had the exchange 
rates remained the same from the prior comparable periods, especially in 
Japan, overall company sales would have decreased 4.3 percentage points for 
the quarter ended September 30, 1998 and decreased 3.6 percentage points for 
the nine months ended September 30, 1998. The Company is 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.

GROSS PROFIT

     The Company's gross profit decreased to $7.4 million, or 74.6% of net 
sales, from $7.9 million, or 73.4% of net sales, in the quarters ended 
September 30, 1998 and 1997, respectively. For the nine months ending 
September 30, 1998, the Company's gross profit decreased to $20.2 million 
from $21.7 million in the prior comparable period, representing 73.8% and 
73.0% of net sales, respectively. The increase in gross profit as a 
percentage of net sales was primarily attributable to an increase in net 
sales of the higher margin low cost debug solutions, decrease in third party 
royalty fees and an increase in patent and software licenses that had nominal 
costs. These were partially offset by lower unit production over which to 
spread fixed manufacturing overhead costs and to a lesser extent due to 
declines in sales revenue due to unfavorable currency exchange rate 
fluctuations. The company expects its gross profit to fluctuate based upon 
its product mix, geographic mix, product and patent licenses and variances in 
volume and related absorption of factory overhead costs.

SALES, GENERAL AND ADMINISTRATIVE

     Sales, general and administrative expenses were $4.8 million or 48.4% of 
net sales, and $4.9 million, or 45.3% of net sales, for the quarters ended 
September 30, 1998 and 1997, respectively. For the nine month periods ended 
September 30, 1998 and 1997, sales, general and administrative expenses were 
$13.6 million or 49.6% of net sales, and $13.8 million or 46.6% of net sales, 
respectively. The dollar amount decreases between comparable periods were 
primarily attributable to reduction in foreign currency exchange losses and 
promotional expenses, which were partially offset by increased compensation 
related expense in connection with the company's expansion of its sales and 
marketing efforts. The percentage increase between comparable periods was 
primarily attributable to lower revenues for the quarter ending September 30, 
1998. 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.

                                      - 10 -
<PAGE>

RESEARCH AND DEVELOPMENT

     Research and development expenses were $2.7 million, or 26.7% of net 
sales, and $2.0 million, or 18.7% of net sales, for the quarters ended 
September 30, 1998 and 1997, respectively. For the nine month periods ending 
September 30, 1998 and September 30 1997, research and development expenses 
were $7.6 million, or 27.7% of net sales, and $6.3 million, or 21.2% of net 
sales, respectively. The increase in the dollar amount between comparable 
periods was primarily attributable to an increase in contract labor, 
headcount and compensation related expenses which was partially offset by a 
reduction in recruiting 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 new product and 
market directions. As a result, the Company anticipates that net research and 
development expenses are likely to increase for the foreseeable future.

OTHER

     The Company's interest (net) and other income increased by $9,000 
between the comparable three month periods and $107,000 between the 
comparable nine month periods due primarily to an increase in marketable 
securities generated from operations and a one time interest payment for 
settlement of a business tax refund.

TAXES

     The Company's estimated annualized effective tax rate has been reduced 
from 15% in 1997 to 0% in 1998. The company anticipates that, for tax 
purposes, deductible temporary differences will result in a loss for the year 
and accordingly no current tax liability. A full valuation allowance has been 
provided for all deferred tax assets, including net operating loss 
carryforwards. (See Note 7 of "Notes to Consolidated Financial Statements" 
included in the Company's 1997 Annual Report to Shareholders.)

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, new technologies and potential company or product 
line acquisitions. Proceeds from the Company's initial public offering were 
$13.0 million net of costs. Since the offering, the Company has used $3.5 
million to purchase capital equipment, $2.4 million to pay off bank debt, $.5 
million to purchase a product line and the remaining proceeds of $6.6 million 
have been invested in short term commercial and government paper and money 
market funds. For the nine months ended September 30, 1998 and 1997, the 
Company generated $465,000 and $2.9 million, respectively, of cash from 
operations, and utilized $1.6 million and $4.0 million, respectively, of cash 
for purchases of short-term investments and equipment. As of September 30, 
1998, the Company had working capital of $19.2 million, including $15.5 
million of cash, cash equivalents and short-term investments.

     The Company believes that its existing working capital, together with 
funds from operations and available revolving credit line, 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 new 
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.

                                      - 11 -

<PAGE>

IMPACT OF  YEAR 2000

The Company is taking steps to evaluate and minimize the risk presented by 
the potential impact of the Year 2000 issue. The Company formed a committee 
to conduct an assessment of the Company's preparedness for the Year 2000, as 
well as the preparedness of third parties relevant to the Company's business. 
The assessment consists of five phases: Awareness, which consist of making 
Company personnel, and those at third parties, aware of the Year 2000 issue; 
Inventory, which consist of identifying the Company's operations or systems 
which are Year 2000 sensitive; Analysis, which consists of determining 
whether sensitive areas will in fact be adversely impacted by Year 2000 
issues; Remediation, which consists of addressing potential Year 2000 issues; 
and Contingency Planning, which consists of developing strategies for those 
areas where remediation may not be effective or practicable. In conducting 
its assessment, the committee evaluated the Company's internal information 
system, the engineering and product development software, the Company's 
hardware, and general facilities infrastructure. The assessment has been 
completed for the Company's information system and general facilities 
infrastructure. The Company has completed the awareness and inventory phases 
with respect to other systems, and believes it will have completed the 
analysis phase by the end of November, 1998. Based on results of analysis 
conducted to date, the Company believes the remediation phase will be 
completed prior to December, 1998. The Company anticipates that it will 
complete its contingency planning within 2 months after completing the other 
phases of its assessment.

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

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

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

CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS

     Statements in this report concerning sales, costs, expenses, adequacy of 
working capital and other matters which are not historical facts, constitute 
forward-looking statements which are subject to a

                                      - 12 -
<PAGE>

number of risks and uncertainties which might cause actual results to differ 
materially from stated expectations. Such risks and uncertainties include 
delays in shipments of the Company's new products, declining product prices 
and margins, ability of its suppliers to provide components and assemblies, 
uncertain market acceptance of new products, growth in the marketplace in 
which the Company operates, competitive product offerings, continuation of 
Asian financial crisis, unfavorable foreign currency fluctuations and adverse 
changes in general economic conditions in any of the countries in which the 
Company does business, level of compliance with Year 2000 issues by the 
Company and third parties and other risks set forth in the Company's filings 
with the Securities and Exchange Commission, including its annual report for 
the year ended December 31, 1997 on Form 10-K. During the last twelve months, 
the Company's competitors have continued to make a variety of product 
announcements and offerings. The Company continues to release new versions of 
its product lines and the successful acceptance of these products will be a 
key determinant of future growth. The impact of any of these factors is 
difficult to predict or forecast.

     The Company's future earnings and stock price may be subject to 
significant volatility, particularly on a quarterly basis, due to a variety 
of factors, including factors noted above. Any shortfall in revenue or 
earnings from levels expected by securities analysts could have an immediate 
and significant adverse effect on the trading price of the Company's common 
stock in any given period. Additionally, the Company often does not learn of 
such shortfalls until late in the fiscal quarter, or even after the quarter 
is over, at which time budgeted expenses have already been committed, which 
could result in an even more immediate and adverse effect on the trading 
price of the Company's common stock. The Company participates in a highly 
dynamic industry, which often results in significant volatility of the 
Company's common stock price. Consequently, purchasing or holding of the 
Company's stock involves a high degree of risk.

                                      - 13 -

<PAGE>
PART II - OTHER INFORMATION

ITEM 6.        EXHIBITS AND REPORTS ON FORM 8-K

          (A)  The following exhibits are filed as part of this report.

               None.

          (B)  Report on Form 8-K

               The registrant did not file any reports on Form 8-K during the
               quarter ended September 30, 1998.

                                    - 14 -
<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
Redmond, State of Washington, on November 6, 1998.

                                   APPLIED MICROSYSTEMS CORPORATION
                                   (Registrant)

                                   By /s/ A. James Beach
                                      ------------------
                                      A. James Beach
                                      VICE PRESIDENT, CHIEF FINANCIAL OFFICER,
                                      SECRETARY AND TREASURER
                                      (PRINCIPAL FINANCIAL AND ACCOUNTING
                                      OFFICER)

                                   -  15 -