<PAGE>   1
                                                                      EXHIBIT 13

                                                                              13
Selected Consolidated Financial Data                                  
(In thousands, except per share data)
<TABLE>
<CAPTION>
                                                                     YEARS ENDED DECEMBER 31,


                                                         1994       1995       1996       1997        1998
-------------------------------------------------------------------------------------------------------------
<S>                                                     <C>        <C>        <C>        <C>          <C>      
STATEMENT OF OPERATIONS DATA (1):
Revenue                                               $ 24,126   $ 50,812   $ 86,417   $ 140,630    $ 171,334
Cost of revenue                                          4,927      8,999     18,431      28,704       40,781
Gross profit                                            19,199     41,813     67,986     111,926      130,553
Costs and expenses:
 Research and development                                4,344      7,260     13,682      27,180       31,981
 Marketing and selling                                   8,991     14,478     24,829      41,926       66,788
 General and administrative                              3,428     10,775     14,603      17,171       19,007
 Legal settlement                                           --         --         --          --        1,872
 Merger and integration                                     --         --      6,100       5,700        2,600
                                                      -------------------------------------------------------
   Total                                                16,763     32,513     59,214      91,977      122,248
                                                      -------------------------------------------------------
Income from operations                                   2,436      9,300      8,772      19,949        8,305
Interest income and other                                  265      1,917      4,889       6,273        8,676
Gain on sale of marketable securities                       --         --     11,027       4,264           --   
Gain on sale of VeriSign common stock                       --         --         --          --       31,285
Gain from increase in investment value                      --         --         --          --       11,976
Equity in loss from operations of equity investment         --         --         --          --       (4,187)
Investment valuation adjustment                             --         --         --          --       (3,647)
Income before provision for income taxes                 2,701     11,217     24,688      30,486       52,408
Provision for income taxes                               1,453      3,487     11,003      13,324       23,571
Minority interests                                          --         --         --        (114)         578
                                                      -------------------------------------------------------
Net income                                            $  1,248   $  7,730   $ 13,685   $  17,048    $  29,415
                                                      -------------------------------------------------------
BASIC EARNINGS PER SHARE:
Net income                                            $   0.05   $   0.24   $   0.37   $    0.44    $    0.72
                                                      -------------------------------------------------------
Weighted average shares                                 24,382     32,577     37,165      38,956       40,909
                                                      -------------------------------------------------------
DILUTED EARNINGS PER SHARE:
Net income                                            $   0.05   $   0.22   $   0.35   $    0.42    $    0.69
                                                      -------------------------------------------------------
 Shares:
   Weighted average shares                              24,382     32,577     37,165      38,956       40,909
   Effect of dilutive options                            1,633      2,209      2,533       1,692        1,588
                                                      -------------------------------------------------------
   Adjusted weighted average shares                     26,015     34,786     39,698      40,648       42,497
                                                      =======================================================
</TABLE>

<TABLE>
<CAPTION>

                                                                           DECEMBER 31,
                                                     --------------------------------------------------------       
(in thousands)                                          1994      1995         1996       1997         1998
-------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA (1):
<S>                                                  <C>       <C>          <C>        <C>          <C>      
Cash, cash equivalents and marketable securities     $ 28,006  $ 112,643    $ 107,008  $ 164,659    $ 158,236
Working capital                                        28,612    104,753      110,103    178,348      180,885
Total assets                                           29,190    129,279      147,355    233,975      280,855
Stockholders' equity                                   29,796    109,442      125,104    200,653      242,720
</TABLE>


(1) Selected Consolidated Financial Data for all periods prior to the
    acquisitions have been restated for the acquisitions of Intrusion
    Detection, Inc., Dynasoft AB and RSA Data Security, Inc., respectively,
    which have been accounted for as poolings of interests. See Note 2 of Notes
    to the Company's Consolidated Financial Statements.

  
<PAGE>   2
14

Management's Discussion and Analysis of Financial Condition and Results of
Operations
SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES


OVERVIEW
This Annual Report to Stockholders contains forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934, as amended,
and Section 27A of the Securities Act of 1933, as amended. For this purpose, any
statement contained herein that are not statements of historical fact may be
deemed forward-looking statements. Without limiting the foregoing, the words
"believes," "anticipates," "plans," "expects," and similar expressions are
intended to identify forward-looking statements. There are a number of factors
that could cause the Company's actual results to differ materially from those
indicated by such forward-looking statements. These factors include, without
limitation, those set forth below under the caption "Certain Factors That May
Affect Future Results."

The Company is a leading provider of enterprise network and data security
solutions to corporate end user ("Enterprise") and to original equipment
manufacturer ("OEM") customers. The Company was founded in 1984, began shipping
its SecurID tokens and Access Control Module ("ACM") hardware products in 1986,
and introduced its first ACM software products for minicomputers and mainframe
computers in 1988. Prior to 1986, the Company was primarily engaged in research
and development activities. In December 1991, the Company introduced its
ACE/Server software products for enterprise information protection using
client/server architecture. The Company believes that its growth has
historically been driven by the emergence of local and wide-area networks and a
corresponding increase in users with direct access to core enterprise systems
and confidential data. The Company also believes that the number of users with
such direct access is increasing because of the growth of the Internet and
corporate intranets and extranets.

On March 26, 1998, the Company completed the acquisition of Intrusion Detection,
Inc. ("IDI") (the "IDI Acquisition"); on July 15, 1997, the Company completed
the acquisition of DynaSoft AB, ("DynaSoft") (the "DynaSoft Acquisition"), and
on July 26, 1996, the Company completed a merger with RSA Data Security, Inc.
("RSA") (the "RSA Merger"). The IDI Acquisition, the DynaSoft Acquisition and
the RSA Merger have been accounted for as poolings of interests in the Company's
historical consolidated financial statements. All financial information included
in the discussion which follows prior to the acquisition has been restated to
include the results of IDI, DynaSoft and RSA for all periods presented.

The Company's revenue is derived primarily from sales of SecurID tokens;
licensing of ACE/Server, Keon (formerly known as BoKS) and RSA SecurPC software;
licensing of BSAFE, TIPEM, and SSL encryption engines and protocol products;
licensing of Kane Security Analyst and Kane Security Monitor software; licensing
of patents; and revenues from maintenance and professional services. Sales to
existing customers typically include sales of SecurID tokens and ACE/Server
software for use by different branches or divisions, sales of replacement
tokens (which are programmed at the request of the customer to operate for a
fixed period of up to four years) and sales of additional tokens for use by
vendors, suppliers, customers and clients of the Company's customers. Sales to
existing ACE/Server and Keon customers are typically associated with an increase
in the number of users authorized under a license, and the sales of additional
functionality that can be added to the customer installation. ACE/Server, Keon,
Kane Security Analyst and Kane Security Monitor software license fees are
typically based on the number of users authorized under a license. Sales to
existing customers also include revenue associated with amendments to encryption
engine and patent licensing agreements, usually in order to accommodate
licensing of new software or technology to the customer, to increase the field
of use rights of the customer, or both. Encryption engine and protocol software
licensing terms vary by product, and are typically composed of both initial fees
plus ongoing royalties paid as a percentage of the OEM's product or service
revenues. Sales of ACM hardware and software products have been decreasing
relative to sales of ACE/Server software for several years due to increased
emphasis by the Company on sales to customers with larger security needs better
met by client/server software solutions such as ACE/Server software. The Company
believes that this trend will continue.

The Company's direct sales to customers in countries outside of the United
States are denominated in the local currency. As a result, fluctuations in
currency exchange rates could affect the profitability in U.S. dollars of the
Company's products sold in these markets. See Note 8 of Notes to the Company's
Consolidated Financial Statements. The Company's sales through indirect
distribution channels are generally denominated in U.S. dollars.

The Company's cost of revenue consists primarily of costs associated with the
manufacture and delivery of SecurID tokens and hardware products. The Company
utilizes assembly contractors for most manufacturing. Cost of revenue also
includes royalty fees incurred on the sale of ACE/Server software, royalty fees
payable on the licensing of patent technology and royalties payable under
certain OEM agreements. Cost of revenue includes customer support costs and
production costs, which include labor costs associated with the programming of
SecurID tokens, inspection and quality control functions and shipping costs. In
the future, gross profit may be affected by several factors, including changes
in product mix and distribution channels, price reductions (resulting from
volume discounts or otherwise), competition, changes in the cost of revenue
(including any software license fees or royalties payable by the Company) and
other factors.

Operating expenses are incurred for research and development, marketing and
selling and general and administrative activities. Research and development
expenses consist primarily of personnel expenses as well as fees for

<PAGE>   3
                                                                              15


development services provided by consultants. From time to time the Company has
also purchased, and expensed, research and development technology. Marketing and
selling expenses consist primarily of personnel expenses, commissions and travel
expenses of direct sales and marketing personnel and marketing program expenses.
General and administrative expenses consist primarily of personnel expenses for
administration, finance, human resources, general management and legal and
accounting fees.

Interest and other income consists primarily of interest earned on the Company's
cash balances and marketable securities.

The Company has been profitable for each of the years in the nine-year period
ended December 31, 1998.

In the first quarter of 1999, the Company commenced consolidation of certain 
operations in order to promote operational efficiency. The Company expects to 
incur costs, mostly in the first quarter of 1999 and primarily severance and 
facilities exit costs, of between $5.0 million and $7.0 million in connection 
with this effort.

RESULTS OF OPERATIONS 
The following table sets forth certain consolidated financial data as a
percentage of revenue:

<TABLE>
<CAPTION>
                                                        Years Ended December 31
                                                        ------------------------    
                                                         1996     1997     1998
--------------------------------------------------------------------------------
<S>                                                     <C>      <C>      <C>   
Revenue                                                 100.0%   100.0%   100.0%
 Cost of revenue                                         21.3     20.4     23.8
                                                        -----    -----    -----
 Gross profit                                            78.7     79.6     76.2
Costs and expenses:
 Research and development                                15.9     19.3     18.6
 Marketing and selling                                   28.7     29.8     39.0
 General and administrative                              16.9     12.2     11.1
 Legal settlement                                          --       --      1.1
 Merger and integration                                   7.1      4.1      1.5
    Total                                                68.6     65.4     71.3

Income from operations                                   10.1     14.2      4.9

Interest income and other                                 5.7      4.5      5.1
Gain on sale of marketable securities                    12.8      3.0       --   
Gain on sale of VeriSign common stock                      --       --     18.3
Gain from increase in investment value                     --       --      7.0
Equity in loss from operations of equity investment        --       --     (2.4)
Investment valuation adjustment                            --       --     (2.1)
Income before provision for income taxes                 28.6     21.7     30.6
Provision for income taxes                               12.7      9.5     13.8
Minority interests                                         --       --      0.3
                                                        ------------------------    
Net income                                               15.9%    12.2%    17.2%
                                                        ========================    
</TABLE>


<PAGE>   4
16
Management's Discussion and Analysis of Financial Condition and Results of
Operations
continued

1998 Compared with 1997

REVENUE
Total revenue increased 21.8% in 1998 to $171.3 million from $140.6 million in
1997. Approximately 50% of the increase in revenue in 1998 was attributable to
increased sales of SecurID tokens, approximately 24% of the increase was
attributable to increased sales of encryption engine licenses, approximately 26%
of the increase was attributable to increased sales of ACE/Server software
licenses and approximately 13% of the increase was attributable to increased
maintenance and professional services revenues. These increases in revenue were
offset in part by decreased revenues from sales of RSA SecurPC software and from
decreased revenue from sales of hardware. Revenue from sales of Keon software
and from sales of Kane Security Analyst and Kane Security Monitor software
decrease slightly in 1998 compared to 1997. The Company believes that the
overall increase in sales was attributable in part to growth of the information
security market, with increased use of the Internet and corporate intranets and
extranets continuing to play significant roles in developing new opportunities
for the Company.

International revenue (outside of the United States) increased 36.4% in 1998 to
$59.3 million from $43.5 million in 1997 and was 34.6% of revenue in 1998 and
30.9% of revenue in 1997. The increase in international revenue was primarily
attributable to the continuing expansion of the Company's international sales
force and increased market penetration of the Company's products in foreign
markets.

During 1998, the Company reached a favorable settlement in lawsuits relating to
certain of its intellectual property rights. This settlement was recorded as
revenue and represented less than 5% of consolidated revenue in 1998.

COST OF REVENUE AND GROSS PROFIT
The Company's gross profit increased 16.6% in 1998 to $130.6 million, from
$111.9 million in revenue in 1997. Gross profit as a percentage of revenue
declined, however, in 1998 to 76.2% from 79.6% of revenue in 1997, primarily due
to write-offs in 1998 to cost of revenue of prepaid license fees of $4.1 million
under secure VPN and secure email license agreements with a third parties
determined to have no future value and costs of $1.2 million associated with
exiting certain hardware product lines. The proportion of software revenues to
total revenue in 1998 approximated those in 1997. Excluding the effects of the
write-offs, gross profit remained relatively consistent and as a percentage of
revenue was 79.3% in 1998 compared to 79.6% in 1997. During 1998 and excluding
the effect of the write-offs, approximately 75% of the increase in gross profit
was attributable to increased unit sales of SecurID tokens, approximately 31% of
the increase in gross profit was attributable to increased licensing sales of
ACE/Server software and approximately 27% of the increase in gross profit was
attributable to increased licensing sales of encryption engine technology and
patent licensing. Gross profit from maintenance and professional services in
1998 approximated those in 1997. Gross profit increases in 1998 were offset in
part by decreased gross profit associated with decreased revenue from sales of
RSA SecurPC software, hardware, Keon and Kane Security Analyst and Kane Security
Monitor software compared to 1997.

RESEARCH AND DEVELOPMENT
Research and development expenses increased 17.7% in 1998 to $32.0 million from
$27.2 million in 1997. Research and development expenses decreased as a
percentage of revenue to 18.6% in 1998 from 19.3% in 1997. Excluding purchased
research and development, the majority of the increase in research and
development expenses resulted from increased payroll expenses associated with
the employment of additional staff. During 1998 the Company purchased and
recorded as purchased research and development expense certain technology from
VeriSign, Inc. ("VeriSign") for $0.5 million and, from other parties for $1.3
million. The Company is incorporating these technologies into PKI ("Public Key
Infrastructure") based products offered for sale worldwide.

During 1997, the Company purchased, and recorded as purchased research and
development expense, certain technology from Netscape Communications Corporation
("Netscape") for $3.0 million, VeriSign for $2.7 million, and from another third
party for $.5 million. The Company plans to incorporate the technologies into
products which are expected to offer electronic signature, certificate authority
and a Java-based encryption engine, respectively. The Java-based encryption
engine was released for sale in 1998.

MARKETING AND SELLING
Marketing and selling expenses increased 59.3% in 1998 to $66.8 million from
$41.9 million in 1997. Marketing and selling expenses increased as a percentage
of revenue in 1998 to 39.0% from 29.8% in 1997. Approximately 52% of the
increase in marketing and selling expenses in 1998 resulted from an increase in
payroll costs associated with the employment of additional staff and
approximately 31% of the increase was attributable to increased sales
commissions. Sales commissions increased due to increased revenues and due to
compensation programs designed to incent sales personnel to increase sales
through the indirect channel and, in particular, the Internet and
telecommunication service provider channels. The remainder of the increase in
marketing and selling expenses resulted primarily from increased marketing
program costs.

GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 10.7% in 1998 to $19.0 million,
from $17.2 million in 1997, but decreased as a percentage of revenue to 11.1% in
1998 compared to 12.2% in 1997. Approximately 68% of the increase in general and

<PAGE>   5
                                                                              17


administrative expenses was due to increased payroll expenses associated with
the employment of additional staff and approximately 31% of the increase in
general and administrative expenses was due to increased professional fees
offset by expense reduction synergies achieved in connection with the DynaSoft
and IDI Acquisitions.

LEGAL SETTLEMENT
In September 1998, the Company granted options to purchase an aggregate of
325,000 shares of common stock in connection with the settlement of threatened
litigation arising out of the IDI Acquisition. The value of the options was
determined, using the Black-Scholes option-pricing model, to be $1.9 million,
based on an expected life of 2.5 years, a risk-free interest rate of 6% and
expected volatility of the underlying stock of 75%.

MERGER AND INTEGRATION
In 1998 the Company incurred merger and integration expenses in connection with
the IDI Acquisition of approximately $2.6 million.

In the third quarter of 1997, the Company accrued a charge of $7.0 million,
representing estimated direct costs of the DynaSoft Acquisition. In the fourth
quarter of 1997, the Company's actual direct costs were determined to be
approximately $5.4 million, a difference of $1.6 million. The difference
resulted from lower than expected legal and other professional fees and from a
change in the planned use of the DynaSoft facilities. As a result, the Company
reversed $1.6 million of the original accrual in the fourth quarter of 1997.

In December 1997, the company commenced a plan to integrate certain DynaSoft
operations and accrued $.3 million for severance and related costs.

INTEREST INCOME AND OTHER
Interest income increased 38.3% in 1998 to $8.7 million from $6.3 million in
1997 due to interest earned on higher cash and marketable securities balances.

GAIN ON SALE OF MARKETABLE SECURITIES
In 1997, the Company had a gain on sale of marketable securities of $4.3
million.

GAIN ON SALE OF VERISIGN COMMON STOCK
In 1998, the Company sold 895,500 shares of its VeriSign common stock for a gain
of $31.3 million.

GAIN FROM INCREASE IN INVESTMENT VALUE
In 1998 the Company recorded a gain of $12.0 million from the write-up under the
equity method of its investment in VeriSign upon VeriSign's initial public
offering.

EQUITY IN LOSS FROM OPERATIONS OF EQUITY INVESTMENT
The Company recognizes its proportionate interest in VeriSign's operating
results one quarter in arrears. The Company's proportionate share of VeriSign's
losses were $4.2 million in 1998.

INVESTMENT VALUATION ADJUSTMENT
The Company routinely evaluates the realizable value of its investments using
qualitative and quantitative factors including discounted cash flow analysis and
liquidation value assessments. Based on these evaluations, the Company reduced
investments by $3.6 million in December 1998.

MINORITY INTERESTS
An aggregate 26% of RSA's Japanese subsidiary is owned by minority stockholders.
Minority interests in the subsidiary's net (income), loss were $0.6 million in
1998 and $(0.1) million in 1997.

PROVISION FOR INCOME TAXES
The provision for income taxes increased to $23.6 million during 1998 from $13.3
million in 1997, primarily due to higher pre-tax income. The Company's estimated
effective tax rate increased to 45.0% in 1998 from 43.7% in 1997 primarily due
to the effect of state income taxes on investment gains and differences in
amounts of nondeductible merger expenses in 1998 compared to 1997.

NET INCOME
As a result of the above factors, net income in 1998 increased to $29.4 million,
or 17.2% of revenue, from $17.0 million, or 12.2% of revenue, in 1997.

1997 Compared with 1996

REVENUE
Total revenue increased 62.7% in 1997 to $140.6 million from $86.4 million in
1996. This increase in revenue reflected increases in unit sales of all of the
Company's products, except ACM/400 and ACM/1600 hardware products. Approximately
41% of the increase in revenue in 1997 was attributable to increased sales of
SecurID tokens, approximately 19% of the increase was attributable to increased
sales of ACE/Server software licenses and approximately 26% of the increase was
attributable to increased sales of encryption engine licenses. The balance of
the increase in revenue primarily resulted from sales of Keon, Kane Security
Analyst and Kane Security Monitor software licenses, software patent licenses
and maintenance revenue, offset by decreased hardware revenue.

International revenue (outside of the United States) increased 82.4% in 1997 to
$43.5 million from $23.8 million in 1996. International revenue accounted for
30.9% and 27.6% of total revenue in 1997 and 1996, respectively. The increase in
international revenue was primarily attributable to the continuing expansion of
the Company's international direct sales force and increased market penetration
of the Company's products in foreign markets.

COST OF REVENUE AND GROSS PROFIT
The Company's gross profit increased 64.6% in 1997 to $111.9 million, from $68.0
million in 1996, and remained relatively constant as a percentage of revenue at
79.6% in 1997 compared to 78.7% in 1996. Approximately 37% of the increase in
gross profit during 1997 was attributable to

<PAGE>   6
18

Management's Discussion and Analysis of Financial Condition and Results of
Operations
continued

increased unit sales of SecurID tokens, approximately 26% to increased licensing
sales of encryption engine technology and approximately 28% to increased
licensing sales of ACE/Server software. In addition, gross profit increased due
to increased patent licensing sales, royalties and maintenance revenue, offset
by reduced sales of ACM/400 and ACM/1600 hardware products.

RESEARCH AND DEVELOPMENT
Research and development expenses increased 98.7% in 1997 to $27.2 million from
$13.7 million in 1996. Research and development expenses increased as a
percentage of revenue to 19.3% in 1997 from 15.9% in 1996. Excluding purchased
research and development, approximately 58% of the increase in 1997 in research
and development expenses resulted from an increase in payroll costs associated
with the employment of additional staff, with the remaining attributable to
occupancy costs, consulting fees and purchases of computer equipment, resulting
in higher depreciation charges. During 1997, the Company purchased, and recorded
as purchased research and development expense, certain technology from Netscape
for $3.0 million, from VeriSign for $2.7 million and from another third party
for $0.5 million. The Company plans to incorporate the technologies into
products which are expected to offer electronic signature, certificate authority
and a Java-based encryption engine, respectively.

During the fourth quarter of 1996, the Company purchased and recorded as
purchased research and development expense technology from Worldtalk Corporation
("Worldtalk") for $1.0 million. The technology was incorporated into the
Company's BSAFE S/MIME-C developer kit, a standards-based secure messaging
solution for third-party software developers designed to provide a secure
messaging infrastructure based on the S/MIME protocol.

MARKETING AND SELLING
Marketing and selling expenses increased 69.0% in 1997 to $41.9 million from
$24.8 million in 1996. Marketing and selling expenses increased as a percentage
of revenue in 1997 to 29.8% from 28.7% in 1996. During 1997, approximately 35%
of the increase in marketing and selling expenses resulted from an increase in
payroll costs associated with the employment of additional staff and
approximately 33% of the increase was attributable to sales commissions on
increased revenues. The remainder of the increase in marketing and selling
expenses resulted from increased travel expenses, marketing program costs and
occupancy costs.

GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 17.8% in 1997 to $17.2 million
from $14.6 million in 1996, but decreased as a percentage of revenue to 12.2% in
1997 compared to 16.9% in 1996. The increase in general and administrative
expenses was due to the employment of additional staff offset by reduced legal
expenses. Legal expenses decreased approximately $2.3 million in 1997 compared
to 1996 due to the settlement of certain of the Company's legal proceedings in
1996.

MERGER AND INTEGRATION
In 1997, the Company incurred direct costs in connection with the DynaSoft
Acquisition and subsequently incurred costs in connection with the integration
of DynaSoft, primarily for severance. Total merger and integration costs were
$5.7 million in 1997. Expenses incurred in connection with the RSA Merger were
$6.1 million in the third quarter of 1996. See Note 2 to the Company's
Consolidated Financial Statements.

INTEREST INCOME AND OTHER
Interest income increased 28.6% in 1997 to $6.3 million from $4.9 million in
1996 due to interest earned on higher cash and marketable securities balances.

GAIN ON SALE OF MARKETABLE SECURITIES
The gain on sale of marketable securities was $4.3 million in 1997, compared to
$11.0 million in 1996.

MINORITY INTERESTS
Minority interests in the consolidated net income were $(0.1) million in 1997.
In 1997 and 1996, the Company sold an aggregate of 26% interest to minority
stockholders of RSA's Japanese subsidiary.

PROVISION FOR INCOME TAXES
The provision for income taxes increased to $13.3 million during 1997 from $11.0
million in 1996, primarily due to higher pre-tax income. The Company's estimated
effective tax rate decreased to 43.7% in 1997 from 44.6% in 1996 due to
differences in amounts of nondeductible merger expenses in 1997 compared to
1996.

NET INCOME
As a result of the above factors, net income in 1997 increased to $17.0 million,
or 12.2% of revenue, from $13.7 million, or 15.9% of revenue, in 1996.

Liquidity and Capital Resources 

LIQUIDITY
At December 31, 1998, the Company had cash, cash equivalents and marketable
securities of $158.2 million and working capital of $180.9 million. The Company
has historically funded its operations primarily from cash generated from its
operating activities. During 1998 the Company used the cash provided by
investment sales and common stock sales principally for working capital needs,
to finance marketable securities purchases, property and equipment purchases, a
share repurchase program and to

<PAGE>   7
                                                                              19


finance IDI Acquisition costs. The Company believes that working capital will be
sufficient to meet its anticipated cash requirements through at least 2001.

MERGERS AND ACQUISITIONS
On July 26, 1996, the Company acquired RSA. The RSA merger costs were
approximately $6.1 million. On July 15, 1997, the Company acquired approximately
95% of the outstanding shares and certain of the outstanding options to acquire
shares of DynaSoft in exchange for approximately 2.7 million shares of the
Company's Common Stock. The Company also paid approximately $6.0 million in cash
to certain stockholders of DynaSoft in exchange for the remaining outstanding
shares and options. On March 26, 1998 the Company issued approximately 784,000
shares of Common Stock in exchange for all of IDI's outstanding common stock.
The IDI Acquisition costs were approximately $2.6 million. These acquisitions
were accounted for as poolings of interests. See Note 2 of Notes to the
Company's Consolidated Financial Statements.

The Company intends to seek acquisitions of businesses, strategic investments,
products and technologies that are complementary to those of the Company. The
Company is continuing to identify and prioritize additional security
technologies which it may wish to develop, either internally or through the
licensing or acquisition of products from third parties. While the Company
engages from time to time in discussions with respect to potential acquisitions,
there can be no assurances that any such acquisitions will be made or that the
Company will be able to successfully integrate any acquired business. In order
to finance such acquisitions, it may be necessary for the Company to raise
additional funds through public or private financing. Any equity or debt
financing, if available at all, may be on terms which are not favorable to the
Company and, in the case of equity financing, may result in dilution to the
Company's stockholders.

SALES OF COMMON STOCK
In October 1997, the Company sold 1,626,000 shares of Common Stock in a
follow-on public offering, which generated $61.1 million of net cash proceeds to
the Company. The Company generated approximately $3.4 million of cash from the
exercise of stock options and employee stock purchase plan purchases during 1998
and realized tax benefits from option exercises of approximately $4.5 million.

STRATEGIC INVESTMENTS

VERISIGN, INC.
In January 1998, VeriSign had an initial public offering of three million shares
of its common stock. The VeriSign series A and B convertible preferred stock
held by the Company converted to common stock in connection with the offering.
The offering diluted the Company's ownership but increased the value of the
Company's equity in VeriSign.

As a result of VeriSign's initial public offering, in accordance with the equity
method of accounting, the Company recognized as a gain the increase in the
amount of its investment in VeriSign of $12.0 million, representing its
proportionate share of VeriSign's equity as of December 31, 1997, after
considering VeriSign's net proceeds from the offering. The Company sold 895,500
shares of its VeriSign common stock for a gain of $31.3 million in 1998. As of
December 31, 1998 the Company owned approximately 3.6 million shares of VeriSign
common stock, an approximate ownership percentage of 16%, with a market value of
approximately $213.0 million. In January 1999 VeriSign completed a secondary
offering of 3.2 million shares of its common stock, including the sale of 1.0
million shares held by the Company. The Company realized a gain of $74.7 million
on the sale in January 1999. In the second quarter of 1999, the Company will
recognize, as a gain the increase in the amount of its investment in VeriSign of
$12.6 million, representing its proportionate share of VeriSign's net increase
in equity from this offering.

The Company recognizes its proportionate interest in VeriSign's operating
results one quarter in arrears. The Company's proportionate share of VeriSign's
net loss was $4.2 million in 1998. On January 25, 1999, VeriSign announced that
it had incurred a net loss of $19.7 million for the year ended December 31, 1998
and $2.5 million for the three months ended December 31, 1998 and at December
31, 1998 had total assets and liabilities of $64.3 million and $22.6 million
respectively. A Director of the Company serves as Chairman of the Board of
VeriSign.

VPNET TECHNOLOGIES, INC.
In December 1996, the Company purchased 250,000 shares of Series B Preferred
Stock of VPNet Technologies, Inc. ("VPNet") of San Jose, California, for an
aggregate purchase price of $1.5 million. VPNet was organized to develop and
market products and technologies for implementing high-performance virtual
private networks. In January 1998, the Company purchased $0.1 million of VPNet
8% convertible debt. The debt is convertible into preferred stock, which is
convertible into common stock. The Company also received a warrant to purchase
VPNet Common Stock. The Company's investment in VPNet represents a minority
interest of less than 10% of VPNet's capitalization. A Director of the Company
serves as a director of VPNet.

<PAGE>   8
20

Management's Discussion and Analysis of Financial Condition and Results of
Operations
continued


TRINTECH GROUP
In March 1998 the Company purchased, in a non-cash transaction, 482,756 ordinary
shares of Trintech Group ("Trintech") valued at $2.0 million. Trintech is an
Irish development company organized to develop and market software products
designed to enable secure payment in the electronic marketplace. In June 1998,
the Company purchased 500,000 shares of Trintech's Series A Convertible
Preferred Shares for $3.0 million cash. The Company's investment represents a
minority interest of less than 10% of Trintech's capitalization.

NCIPHER CORPORATION LIMITED
In October 1997, the Company purchased 175,285 ordinary shares of nCipher
Corporation Limited ("nCipher") for an aggregate purchase price of $0.5 million.
nCipher is located in the United Kingdom and develops products designed to
accelerate cryptographic processes in Internet security, electronic commerce and
other applications. In January and July 1998, the Company purchased 93,896 and
563,910 ordinary shares of nCipher for aggregate purchase price of $0.3 million
and $2.5 million, respectively. The Company's investment in nCipher represents a
minority interest of less than 20% of nCipher's capitalization.

C2NET, INC.
In June 1998, the Company made a one-year bridge loan to C2Net, Inc. ("C2Net")
in the amount of $0.2 million. The debt is convertible at the Company's option
into equity of C2Net or may be used to offset any financial obligation which may
arise from future licensing agreements between the Company and C2Net. C2Net is
located in California and was organized to develop commercial Internet security
software.

FINJAN SOFTWARE LTD.
In August 1997, the Company purchased 877,193 Series C Preferred Shares of
Finjan Software Ltd. ("Finjan") for an aggregate purchase price of $1.0 million.
Finjan is an Israeli software company organized to develop and market products
for the Java Internet security market. The Company's investment in Finjan
represents a minority interest of less than 5% of Finjan's capitalization.

INVESTMENT VALUATION ADJUSTMENT
The Company routinely evaluates the realizable value of its investments using
qualitative and quantitative factors including discounted cash flow analysis and
liquidation value assessments. Based on these evaluations the Company reduced
investments by $3.6 million in December 1998.

CAPITAL EXPENDITURES
The Company's capital expenditures during 1998 were $18.9 million, and were for
additional leasehold improvements, office furniture and equipment, as well as
computer equipment for product development, testing and support to accommodate
the Company's continued growth. During the fourth quarter of 1997, the Company
commenced implementation of an information system which is designed to better
meet the Company's growing worldwide information and business process needs. The
system, which is represented by the manufacturer to be Year 2000 compliant,
became operational in October 1998. See "Year 2000 Issues." The Company
estimates the total cost at approximately $5.2 million, of which approximately
$4.8 million was spent in 1998. The Company continues to configure certain
elements of the system in order to, among other matters, include the operations
of certain subsidiaries. The Company estimates that an additional $4.0 million
will be spent on the system; most of which will be spent in the first quarter of
1999.

LEASING EXPENDITURES
The Company's principal administrative, sales and marketing, research and
development and support facilities are located in Bedford, Massachusetts under
non-cancelable ten year leases expiring in August 2008. The facilities aggregate
approximately 183,000 square feet of office space, and the annual base rents
aggregate approximately $3.0 million including certain operating expenses. The
Company also leases facilities for research and development and sales and
marketing in San Mateo, California under non-cancelable ten-year leases expiring
in 2008. The facilities aggregate approximately 58,000 square feet of office
space, and the annual base rents aggregate approximately $2.0 million including
certain operating expenses. Annual rent escalation provisions for all of theses
leases are based on the Consumer Price Index. The Company also leases facilities
for administration, field sales and customer support throughout the United
States, Canada, Asia, Japan and Europe at annual base rents aggregating
approximately $1.4 million.

In connection with the consolidation of certain operations commenced in January
1999, the Company is actively seeking to sublet approximately 50,000 square feet
of facilities at various locations. The successful sublet of these facilities
will reduce the Company's annual rental payment obligations by approximately
$0.1 million per month.

CERTAIN AGREEMENTS
The Company has an agreement with Progress Software Corporation ("Progress
Software") for the right to use certain of its software to enhance the
functionality of the Company's ACE/Server and Keon software. The agreement has
been amended several times. In order to obtain favorable pricing, the Company
has, from time to time, prepaid Progress Software royalties due under the
agreement. In the first quarter of 1997 the Company prepaid $2.5 million and in
1998 the Company prepaid an aggregate of $6.0 million in three installments. The
prepaid royalty is recorded as a

<PAGE>   9
                                                                              21
component of cost of sales as the related products are sold. Un-amortized
prepaid royalties were $4.5 million at December 31, 1997 and $4.8 million at
December 31, 1998.

In connection with refinements of its product offering strategy, the Company
determined it will no longer actively market certain secure VPN and secure email
products obtained from third parties under license agreements. Fees prepaid
under the license agreements of $4.1 million were determined to have no future
value and were charged to cost of revenue in 1998.

As of April 14, 1996 and November 1, 1997, the Company entered into employment
agreements with two of its executive officers, which require total annual
minimum salaries of $.5 million and expire in July 1998 and November 1999,
respectively. One of the agreements includes a post retirement benefit, to be
paid by the Company for the executive. The Company is recognizing the present
value of the benefit over the applicable service period.

During September 1998, the Company entered into Employment Agreements with
substantially all of the Company's management team, including most of the
Company's executive officers. The Board of Directors determined that such
Employment Agreements were necessary to effectively incent and retain key
management team members in a competitive employment marketplace. The Employment
Agreements generally provide for minimum annual salaries aggregating $1.9
million, and, among other things, that during the period commencing on
September 1, 1998 and ending on March 1, 2000, the Company may terminate the
employee only for nonperformance of his or her duties, or for cause, subject to
criteria and definitions set forth therein.

In December 1998, the Company and VeriSign amended the Development Agreement
(the "Amendment") to appoint the Company the exclusive distributor of VeriSign's
certificate authority software. The Amendment provides, among other things, that
each year during the first five years following the date of the Amendment, the
Company may elect to retain its exclusive status, subject to payment by the
Company of certain prepaid license fees each year during that five year period.
In addition to $.5 million paid at the execution of the agreement, prepaid
license fees are due in minimum quarterly installments and aggregate $1.1
million in 1999, $2.3 million in 2000, $3.0 million in 2001, $4.0 million in
2002, and $4.0 million in 2003.

In December 1998, RSA and VeriSign amended its BSAFE/TIPEM OEM Master License
Agreement with VeriSign to provide, among other things, that VeriSign will
execute RSA's support and maintenance agreement in order to receive upgrades and
updates to RSA's BSAFE software.

STOCK OPTION REPRICING
On July 24, 1998 and August 6, 1998, the Board of Directors of the Company
approved a stock option repricing program pursuant to which each holder (other
than certain executive officers and the directors of the Company) of an
outstanding stock option granted under the Company's 1994 Stock Option Plan, as
amended and restated (the "Plan")during the period commencing on January 1, 1996
and ending on June 30, 1998 (collectively, the "Old Options"), could elect to
receive a new stock option (collectively, "New Options") granted on August 12,
1998 under the Plan in exchange for cancellation of such holder's Old Option.
The Company repriced the Old Options because the exercise prices of such options
were significantly higher than the fair market value of the Company's Common
Stock, and therefore did not provide the desired incentive to employees. The
Company believes that stock options are a valuable tool in retaining employees.
Each New Option, among other things, (i) is exercisable for the number of shares
of the Company's Common Stock covered by the outstanding unexercised portion of
the Old Option canceled in exchange therefore; (ii) has an exercise price of
$12.0625 (equal to the closing price of the Common Stock on the Nasdaq National
Market on August 12, 1998 and the fair market value of the Common Stock on such
date); and (iii) has the identical vesting schedule as the Old Option, provided,
however, that each such New Option shall not be exercisable prior to February
12, 1999, with such prohibition on exercise expiring at a rate of 25% at the end
of each three-month period thereafter. New Options to purchase an aggregate of
approximately 5.3 million shares of Common Stock were granted in exchange for
Old Options with exercise prices ranging from $19.00 to $44.125.

SHARE REPURCHASE PROGRAM
On October 12, 1998 the Company announced that its Board of Directors had
authorized the Company to repurchase up to four million shares of its Common
Stock during the 12-month period ending October 11, 1999. The timing and amount
of shares repurchased will be determined by the Company's management based on
its evaluation of market and economic conditions. Repurchased shares will be
used for the Company's stock option plans, employee stock purchase plan and
other stock benefit plans, and for general corporate purposes. As of December
31, 1998 the Company had repurchased 1,058,000 shares of its Common Stock, for
an aggregate purchase price of $12.1 million.

YEAR 2000 ISSUES

OVERVIEW
Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field. These date code fields
must accept four digit entries to distinguish 21st century dates from 20th
century dates. As a result, software and computer systems may need to be
upgraded or replaced in order to comply with such "Year 2000" requirements.

<PAGE>   10
22

Management's Discussion and Analysis of Financial Condition and Results of
Operations
continued


STATE OF READINESS
COMPANY PRODUCTS
The Company has implemented a testing program to ensure that its products
continue to operate after December 31, 1999. The testing program has been
completed for the most recent versions of all of the Company's software
products, and the Company is in the process of testing prior versions of certain
of the Company's ACE/Server software products and the Company's ACE/Sentry
hardware product. The Company does not expect to implement a test plan for the
Company's ACM 100, 400 or 1600 hardware products.

In measuring Year 2000 readiness, the Company has applied the following
specifications: "Year 2000 Ready" means that: (1) no value for current date will
cause any interruption in operation; (2) date-based functionality must be
consistent for dates prior to, during and after Year 2000; (3) in all interfaces
and data storage, the century in any date must be specified either explicitly or
by unambiguous algorithms or inferencing rules; and (4) Year 2000 must be
recognized as a leap year.

The Company's SecurID Tokens are Year 2000 Ready. Assuming that a customer is
utilizing the Company's software products in conjunction with a Year 2000 Ready
operating system, then the Company's most recent software releases, ACE/Server
v3.3, Kane Security Analyst v4.5, Kane Security Monitor v3.2, Keon Security
Server v4, Keon Desktop v4, Keon Agents v4, Keon Agent SDK, Keon UNIX Platform
Security v4, (Keon software products were formerly known as BoKS), SoftID, RSA
SecurPC, BSAFE-Crypto-C, BSAFECrypto-J, BSAFE Cert-C, BSAFE SSL-C and BSAFE
SSL-J, are Year 2000 Ready. Certain prior versions of the Company's software
products, as well as the Company's ACE/Sentry, ACM 100, 400 and 1600 hardware
products, are not fully Year 2000 Ready, and customers are being informed of the
status of the Company's products in the ordinary course of business. In certain
circumstances, the Company may make available to customers who have implemented
prior releases of the Company's software products software patches to make the
products Year 2000 Ready. The Company is currently seeking to obtain written
representations from third-party vendors of software contained in the Company's
ACE/Server and Kane software products that such components are Year 2000 Ready.

While the Company has created and implemented what it believes to be an
effective Year 2000 Readiness testing program for its products, the Company's
products may contain undetected errors or defects associated with Year 2000 date
functions. Such errors or defects in the Company's products could result in
delay or loss of revenue and diversion of development resources, which might
materially adversely affect the Company's business, financial condition or
results of operations.

COMPANY SYSTEMS
The Company has established a Year 2000 task force to determine the state of
readiness of all Company information technology ("IT") and non-IT systems,
including the microprocessors contained in infrastructure products, such as
card-swipe entry devices, which are used at the Company's facilities. The task
force consists of employees with expertise in areas the Company believes could
be affected if any system is not Year 2000 Ready. The task force has established
a Year 2000 compliance plan. The scope of the plan is to (i) identify the
third-party equipment, software, vendors, systems and suppliers used by the
Company which are not Year 2000 Ready, and (ii) replace non-Year 2000 Ready
third-party equipment and software with Year 2000 Ready equipment and software.

The Year 2000 compliance plan is divided into the following phases: (1) the
Inventory Phase, in which the Company identifies all products and systems which
are created or used by the Company in the course of its operations; (2) the
Analysis Phase, in which the Company determines what, if any, Year 2000
Readiness issues may exist with respect to any product or system; (3) the
Solution Development Phase, in which the Company designs and/or obtains from
third-party vendors methods to correct any Year 2000 Readiness issues which were
identified in the prior phase; and (4) the Implementation Phase, in which the
Company deploys solutions for the identified problems.

The Company's Year 2000 task force has substantially completed the Inventory and
Analysis Phases for all of the Company's IT and non-IT systems. The task force
has commenced the Solution Development and Implementation Phases for all of the
Company's systems, and expects the entire project to be substantially completed
by June 30, 1999.

The Year 2000 task force has identified certain IT systems licensed by the
Company's Customer Support and Engineering groups that must be upgraded in order
to make the systems Year 2000 Ready. In each case, the Company has purchased
maintenance and support from those application vendors, and expects to receive
upgrades from the vendors at no additional cost. With respect to certain other
business applications and systems licensed by the Company from third parties
(including but not limited to the Company's PBX and the Company's management
information system installed in 1998), the Company is relying on those
licensors' written representations that the applications are Year 2000 Ready.

COSTS TO ADDRESS YEAR 2000 ISSUES
The Company anticipates that it will incur direct costs to modify or replace
existing systems used by the Company in the operation of its business to ensure
that all systems will become Year 2000 Ready. Except for the implementation of
the worldwide management information system described above, the Company
believes that total amounts spent by it to date and which it expects to spend
during 1999 addressing this issue are not material. See "Capital Expenditures."

In addition, the Company has spent substantial time and effort testing and
evaluating its own products to determine Year 2000 Readiness of those products.
In the case of prior

<PAGE>   11
                                                                              23

product releases which are not Year 2000 Ready, the Company expects to devote
internal engineering and customer support resources to resolving issues for
existing customers of those products. This effort may result in a longer
development cycle for new Company products.

RISKS TO THE COMPANY
In the event of a failure of some or all of the Company's IT and non-IT systems
on January 1, 2000, the Company's operations may be substantially curtailed
until the Company or its third-party suppliers develop a solution to address
each system's failure. In such event, the Company might be unable to: (a)
produce SecurID tokens, (b) track development of Company software products, (c)
book orders for products, (d) access customer support records, (e) operate its
Internet site, (f) receive email, or (g) prepare its financial statements for
fourth quarter 1999 or periods thereafter.

In addition, the Company has made representations and warranties, both in
contracts and in written communications, to certain of its customers regarding
the Year 2000 Readiness of its products. The Company has reviewed all of those
representations to determine the accuracy of those statements, given the ongoing
Year 2000 testing of the Company's products. The Company has determined that it
made Year 2000 Readiness representations in fewer than 10% of its customer
contracts; many of those customers have requested, and received, Year 2000 Ready
versions of the Company products. The cost of compliance with these
representations and warranties has not been and is not expected to be material.

In the event that any contractual representation made by the Company regarding
Year 2000 Readiness is not accurate, the Company will seek to upgrade the
affected customer to the Company's current, Year 2000 Ready, version of the
product(s) being used by that customer. In the event any affected customer
chooses not to upgrade to the most recent versions of the Company's products,
the Company will seek to amend the affected license agreement to address the
error. In the event that the Company: (i) has made a materially inaccurate
statement regarding Year 2000 Readiness of its products, and (ii) is not able to
amend the contract to address the error, the Company may face the risk of one or
more lawsuits from its customers alleging breach of representation.

CONTINGENCY PLANS
As described above, the Company has identified potential vulnerabilities
associated with the change of the century, both in its own product offerings and
in the systems utilized by the Company in the ordinary course of business. The
Company is devoting resources to resolving the issues inherent in its own
product offerings, as well as working with providers of systems to the Company
to ensure that business is not substantially interrupted as a result of the date
change. However, given the possibility of system failure as a result of the
century change, the Company is currently in the process of formulating one or
more contingency plans. The Company anticipates implementing contingency plans
on or before June 30, 1999. The foregoing shall be considered a Year 2000
readiness disclosure to the maximum extent allowed under the Year 2000
Information and Readiness Disclosure Act.

RECENT ACCOUNTING PRONOUNCEMENTS
In October 1997, the AICPA issued SOP No. 97-2, "Software Revenue Recognition,"
which supersedes SOP No. 91-1. The Company adopted SOP No. 97-2 prospectively on
January 1, 1998. SOP No. 97-2 generally requires revenue earned on software
arrangements involving multiple elements to be allocated to each element based
on the relative fair values of the elements. In March 1998, the AICPA postponed
the adoption date of certain provisions of SOP No. 97-2. The adoption of SOP No.
97-2 did not have a material effect on the Company's revenues and operating
results for 1998.

In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." The
Company adopted the provisions of this statement in its annual financial
statements in 1998. SFAS No. 131 established new standards for reporting
information about operating segments.

CONVERSION TO EURO
Certain of the common member countries of the European Union have agreed to
adopt a new currency, the Euro, as their legal currency. On January 1, 1999, the
countries established fixed conversion rates between their existing currencies
and the Euro. The Company's systems are configured to process Euro denominated
transactions. The Company does not believe the Euro will have a significant
effect on its business, financial position, cash flows or the results of its
operations.

Certain Factors That May Affect Future Results
A number of uncertainties exist that could affect the Company's future operating
results, including, without limitation, general economic conditions, the
Company's continued ability to develop and introduce products, the introduction
of new products by competitors, pricing practices of competitors, expansion of
the Company's sales distribution capability, the cost and availability of
components and the Company's ability to control costs.

The Company's success is dependent on the success of its Keon product line,
which is a family of enterprise security solutions being developed by the
Company that would enable organizations to support and manage the growing use of
public and private keys, digital signatures and digital certificates for
verifying user identities and establishing information access privileges for
such users in an enterprise. The success of the Keon software is dependent on a
number of factors, including without limitation delays in product development,
undetected software errors or bugs, competitive pressures, technical
difficulties, market acceptance of new technologies, including without
limitation the use and implementation of various certificate management and key
management technologies,

<PAGE>   12
24

Management's Discussion and Analysis of Financial Condition and Results of
Operations
continued


changes in customer requirements and government regulations, delays in
developing strategic partnerships and general economic conditions.

The Company's success is highly dependent on its ability to enhance its existing
products and to develop and introduce new products in a timely manner. If the
Company were to fail to introduce new products on a timely basis, the Company's
operating results could be adversely affected. To date, substantially all of the
Company's revenues have been attributable to sales of its enterprise network and
data security products, the licensing of encryption engines and the provision of
related services. Existing and new versions of such products are expected to
continue to represent a high percentage of the Company's revenue for the
foreseeable future. As a result, any factor adversely affecting sales of these
products and services could have a materially adverse effect on the Company's
financial condition and results of operations.

Certain components of the Company's products are currently purchased from a
single or limited sources and any interruption in the supply of such components
could adversely affect the Company's operating results.

The Company's quarterly operating results may vary significantly depending on a
number of factors, including the timing of the introduction or enhancement of
products by the Company or its competitors, the sizes, timing and shipment of
individual orders, market acceptance of new products, changes in the Company's
operating expenses, personnel changes, mix of products sold, changes in product
pricing, development of the Company's direct and indirect distribution channels
and general economic conditions.

International sales have represented a significant portion of the Company's
sales. The international business and financial performance of the Company may
be affected by general economic conditions abroad, fluctuations in foreign
exchange rates, difficulties in managing accounts receivable, tariff regulations
and difficulties in obtaining export licenses.

All of the Company's products are subject to export controls under U.S. law and
applicable foreign government restrictions, including, without limitation
restrictions on the export of encryption technology. The Company believes it has
obtained necessary approvals for the export of the products it currently
exports. There can be no assurance, however, that the list of products and
countries for which export approval is required, and the regulatory policies
with respect thereto, will not be revised from time to time or that the Company
will be able to obtain necessary regulatory approvals for the export of future
products. The inability of the Company to obtain required approvals under these
regulations could adversely affect the ability of the Company to make
international sales. In addition, the Company may be at a disadvantage in
competing for international sales compared to companies located outside the
United States that are not subject to such restrictions.

LEGAL PROCEEDINGS
On December 11, 1998, a purported class action lawsuit was filed against the
Company and certain of its officers and directors in the United States District
Court for the District of Massachusetts. The plaintiff claims to represent all
purchasers of the Company's common stock during the period from September 30,
1997 through July 15, 1998, and seeks unspecified damages on their behalf. The
plaintiff alleges that the defendants misled the investing public concerning
demand for the Company's products, the strengths of its technologies, and
certain trends in the Company's business. The company is vigorously contesting
the suit and believes the plaintiff's allegations are without merit.

<PAGE>   13
                                                                              25


On November 2, 1998 the company commenced litigation in a patent infringement
lawsuit filed in the United States District Court for the District of
Massachusetts against VASCO Data Security, Inc. ("VASCO"). The suit alleges that
VASCO's Digipass token products infringe certain of the Company's patents. The
company seeks monetary damages for such infringement and injunctive relief. In
connection with this litigation, VASCO has filed counterclaims against the
Company seeking a declaratory judgement of noninfringement and invalidation of
the Company's patents at issue and alleging that the Company's infringement suit
against VASCO represents a breach of contract between the parties.

On January 6, 1999, the Company commenced litigation in a patent infringement
lawsuit filed in the United States District Court for the District of
Massachusetts against VASCO. The suit alleges that VASCO's RSA cards and RSA
chips products infringe the RSA patent. The Company seeks monetary damages for
such infringement and injunctive relief. In connection with this litigation,
VASCO has filed counterclaims against the Company seeking a declaratory
judgement of non-infringement and invalidation of the patent at issue, and
alleging that the Company's suit against VASCO represents a violation of
antitrust laws.

MARKET RISK
The Company does not use derivative financial instruments. The Company generally
places its marketable security investments in high credit quality instruments,
primarily U.S.Government and Federal Agency obligations, tax-exempt municipal
obligations and corporate obligations with contractual maturities of ten years
or less. The Company does not expect any material loss from its marketable
security investments and therefore believes that its potential interest rate
exposure is not material. The Company also makes strategic equity investments
determined by the Board of Directors to be strategically synergistic to the
Company. The Company routinely evaluates the realizable value of these
investments using qualitative and quantitative factors including discounted cash
flow analysis and liquidation value assessments. Based on these evaluations the
Company reduced investments by $3.6 million in December 1998.

The Company invoices customers primarily in U.S. Dollars and in local currency
in those countries in which the Company has branch and subsidiary operations.
The Company is exposed to foreign exchange rate fluctuations from when customers
are invoiced in local currency until collection occurs. The company does not
enter into foreign currency hedge transactions. Through December 31, 1998,
foreign currency fluctuations have not had a material impact on the Company's
financial position or results of operation, and therefore the Company believes
that its potential foreign currency exchange rate exposure is not material.

The forgoing risk management discussion and the effects thereof are
forward-looking statements. Actual results in the future may differ materially
from these projected results due to actual developments in global financial
markets. The analytical methods used by the Company to assess and mitigate risk
discussed above should not be considered projections of future events or losses.

<PAGE>   14
26

Independent Auditors' Report

[Deloitte &
Touche LLP LOGO]



To the Board of Directors and Stockholders of
Security Dynamics Technologies, Inc. and Subsidiaries:

We have audited the accompanying consolidated balance sheets of Security
Dynamics Technologies, Inc. (the "Company") and subsidiaries as of December 31,
1997 and 1998, and the related consolidated statements of income, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits. The consolidated financial statements give
retroactive effect to the acquisition of Intrusion Detection, Inc., which has
been accounted for as a pooling of interests as described in Note 2 of notes to
the consolidated financial statements.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Security Dynamics
Technologies, Inc. and subsidiaries as of December 31, 1997 and 1998, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1998 in conformity with generally accepted
accounting principles.

As discussed in Note 4 of the notes to the consolidated financial statements, in
1996 the Company changed its method of accounting for option grants requiring
stockholder approval in 1996.


/s/ DELOITTE + TOUCHE LLP


Boston, Massachusetts

January 27, 1999

<PAGE>   15
                                                                              27

Consolidated Balance Sheets
SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES

(In thousands, except share and per share data)
<TABLE>
<CAPTION>

                                                       DECEMBER 31,
ASSETS                                              1997         1998
-----------------------------------------------------------------------
<S>                                              <C>          <C>      
CURRENT ASSETS
 Cash and cash equivalents                       $  96,595    $  33,178
 Marketable securities                              68,064      125,058
 Accounts receivable                                27,551       36,712
   (less allowance for doubtful accounts
    of $852 in 1997 and $710 in 1998)
 Inventory                                           3,035        7,025
 Prepaid expenses and other                          9,338       10,596
 Prepaid income taxes                                2,562        3,930
  Deferred taxes                                     1,426           --
                                                 ----------------------
    TOTAL CURRENT ASSETS                           208,571      216,499
                                                 ----------------------
PROPERTY AND EQUIPMENT
 Furniture and equipment                            20,909       37,269
 Leasehold improvements                              4,528        6,486
                                                 ----------------------
    TOTAL PROPERTY AND EQUIPMENT                    25,437       43,755

Less accumulated depreciation and amortization      (7,922)     (14,187)
                                                 ----------------------
    PROPERTY AND EQUIPMENT NET                      17,515       29,568
                                                 ----------------------
OTHER ASSETS
 Investments                                         3,699       14,248
 Deferred taxes                                      3,371       19,285
 Other                                                 819        1,255
                                                 ----------------------
    TOTAL OTHER ASSETS                               7,889       34,788
                                                 
TOTAL                                            $ 233,975    $ 280,855
                                                 ====================== 
</TABLE>

See notes to consolidated financial statements 

<PAGE>   16
28

Consolidated Balance Sheets
continued
<TABLE>
<CAPTION>
                                                       DECEMBER 31,

LIABILITIES AND STOCKHOLDERS' EQUITY                1997         1998
-----------------------------------------------------------------------
<S>                                              <C>          <C>      
CURRENT LIABILITIES
 Accounts payable                                $  11,137    $   8,169
 Accrued payroll and related benefits                5,254        9,695
 Accrued expenses and other                          4,071        4,659
 Income taxes payable                                  159           --
 Deferred revenue                                    9,602       10,971
 Deferred taxes                                         --        2,120
                                                 ----------------------   
   TOTAL CURRENT LIABILITIES                        30,223       35,614
                                                 ----------------------
MINORITY INTERESTS                                   3,099        2,521
                                                 ----------------------
COMMITMENTS AND CONTINGENCIES (Notes 7 and 9)

STOCKHOLDERS' EQUITY
 Common stock, $.01 par value; authorized,
 80,000,000 shares; issued, 40,467,118
 shares in 1997 and 41,534,359 shares in 1998;
 outstanding, 40,466,609 shares in 1997 and
 40,475,850 shares in 1998                             405          415
 Additional paid-in capital                        165,751      191,185
 Retained earnings                                  35,284       64,302
 Deferred stock compensation                          (116)         (74)
 Treasury stock, common, at cost, 509 shares
 in 1997 and 1,058,509 shares in 1998                   --      (12,135)
 Accumulated other comprehensive income               (671)        (973)
                                                 ----------------------
   TOTAL STOCKHOLDERS' EQUITY                      200,653      242,720
                                                 ----------------------
TOTAL                                            $ 233,975    $ 280,855
                                                 ======================
</TABLE>
See notes to consolidated financial statements

<PAGE>   17
                                                                              29

Consolidated Statements of Income
SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES 
(In thousands, except per share data)

<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,     
                                                         1996        1997         1998
----------------------------------------------------------------------------------------
<S>                                                   <C>         <C>          <C>      
REVENUE                                                 $86,417    $140,630     $171,334
                                                                                        
Cost of revenue                                          18,431      28,704       40,781
                                                        --------------------------------
GROSS PROFIT                                             67,986     111,926      130,553
                                                        --------------------------------
COSTS AND EXPENSES                                                                      
 Research and development                                13,682      27,180       31,981
 Marketing and selling                                   24,829      41,926       66,788
 General and administrative                              14,603      17,171       19,007
 Legal settlement                                            --          --        1,872
 Merger and integration                                   6,100       5,700        2,600
                                                        --------------------------------
   Total                                                 59,214      91,977      122,248
                                                        --------------------------------

INCOME FROM OPERATIONS                                    8,772      19,949        8,305
                                                                                        
Interest income and other                                 4,889       6,273        8,676
Gain on sale of marketable securities                    11,027       4,264           --
Gain on sale of VeriSign common stock                        --          --       31,285
Gain from increase in investment value                       --          --       11,976
Equity in loss from operations of equity investment          --          --       (4,187)
Investment valuation adjustment                              --          --       (3,647)
Income before provision for income taxes                 24,688      30,486       52,408
Provision for income taxes                               11,003      13,324       23,571
Minority interests                                           --        (114)         578
                                                        --------------------------------
NET INCOME                                              $13,685    $ 17,048     $ 29,415
                                                        --------------------------------
BASIC EARNINGS PER SHARE                                                                
 Per share amount                                       $  0.37    $   0.44     $   0.72
                                                        --------------------------------
 Weighted average shares                                 37,165      38,956       40,909
                                                        --------------------------------
DILUTED EARNINGS PER SHARE                                                              
 Per share amount                                       $  0.35    $   0.42     $   0.69
                                                        --------------------------------
   Weighted average shares                               37,165      38,956       40,909
   Effect of dilutive options                             2,533       1,692        1,588
                                                        --------------------------------
 Adjusted weighted average shares                        39,698      40,648       42,497
                                                        ================================
</TABLE>                                                                     

See notes to consolidated financial statements 

<PAGE>   18


30

Consolidated Statements of Stockholders' Equity
SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES

(In thousands, except share data)
<TABLE>
<CAPTION>

                                            COMMON STOCK                                                      TREASURY STOCK        
                                        -------------------     ADDITIONAL      RETAINED   DEFERRED STOCK    ----------------       
                                        SHARES       AMOUNT   PAID-IN CAPITAL   EARNINGS    COMPENSATION     SHARES    AMOUNT       
------------------------------------------------------------------------------------------------------------------------------------

<S>                                     <C>           <C>        <C>             <C>           <C>            <C>         <C>       
BALANCE, JANUARY 1, 1996                35,922,113    $359       $ 94,593        $ 4,777       $(292)         296          --       

Exercise of stock options
  and purchase plans                       817,123       8          2,598             --          --           --          --       
Tax benefit arising from
  exercise of stock options                     --      --          3,702             --          --           --          --       
Compensation expense and amortization
  of deferred stock compensation                --      --          1,409             --         118           --          --       
Issuance of common stock                 1,265,999      13            521             --          --           --          --       
Comprehensive income: 
   Translation adjustment                       --      --             --             --          --           --          --       
   Unrealized (loss) on marketable
     securities, net                            --      --             --             --          --           --          --       
Net income                                      --      --             --         13,685          --           --          --       
------------------------------------------------------------------------------------------------------------------------------------
Total comprehensive income                      --      --             --             --          --           --          --       
------------------------------------------------------------------------------------------------------------------------------------

BALANCE, DECEMBER 31, 1996              38,005,235     380        102,463         18,462        (174)         296          --       
                                                                                        
Settlement of RSA escrow                   (36,037)     --             --             --          --          213          --       
Exercise of stock options               
 and purchase plans                      1,031,322      10          5,485             --          --           --          --       
Other                                           --      --             --           (226)         --           --          --       
Tax benefit arising from
 exercise of stock options                      --      --          2,012             --          --           --          --       
Payments to Acquisition shareholders      (159,402)     (1)        (6,037)            --          --           --          --       
Issuance of common stock                 1,626,000      16         61,092             --          --           --          --       
Compensation expense and amortization
    of deferred stock compensation              --      --            736             --          58           --          --       
Comprehensive income:
 Translation adjustment                         --      --             --             --          --           --          --       
 Unrealized (loss) on marketable
  securities, net                               --      --             --             --          --           --          --       
 Net income                                     --      --             --         17,048          --           --          --       
------------------------------------------------------------------------------------------------------------------------------------
 Total comprehensive income                     --      --             --             --          --           --          --       
------------------------------------------------------------------------------------------------------------------------------------

BALANCE, DECEMBER 31, 1997              40,467,118     405        165,751         35,284        (116)         509          --       

Exercise of stock options
 and purchase plans                      1,067,241      10          3,354             --          --           --          --       
Tax benefit arising from                                                                                    
exercise of stock options                       --      --          4,482             --          --           --          --       
Compensation expense and amortization                                                                          --          --       
 of deferred stock compensation                 --      --          1,941             --          42                                
Tax benefit arising from foreign                                                                                                    
 acquisition net assets                         --      --         13,835             --          --           --          --       
Legal settlement                                --      --          1,872             --          --           --          --       
Other                                           --      --            (50)          (397)         --           --          --       
Share repurchase program                        --      --             --             --          --    1,058,000    $(12,135)      
Comprehensive income:                                                                                       
 Translation adjustment                         --      --             --             --          --           --          --       
 Unrealized gain on marketable                                                                              
  securities, net                               --      --             --             --          --           --          --       
 Net income                                     --      --             --         29,415          --           --          --       
------------------------------------------------------------------------------------------------------------------------------------
 Total comprehensive income                     --      --             --             --          --           --          --       
------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1998              41,534,539    $415       $191,185        $64,302       $(74)   $1,058,509    $(12,135)      
                                        ============================================================================================
</TABLE>                                                                      
<TABLE>

                                           ACCUMULATED OTHER    TOTAL
                                            COMPREHENSIVE    STOCKHOLDERS'
                                                INCOME          EQUITY
--------------------------------------------------------------------------

<S>                                            <C>             <C>     
BALANCE, JANUARY 1, 1996                       $10,005         $109,442

Exercise of stock options
  and purchase plans                                --            2,606
Tax benefit arising from
  exercise of stock options                         --            3,702
Compensation expense and amortization
  of deferred stock compensation                    --            1,167
Issuance of common stock                            --              534
Comprehensive income: 
   Translation adjustment                           --              398
   Unrealized (loss) on marketable
     securities, net                            (6,430)          (6,430)
Net income                                          --           13,685
-------------------------------------------------------------------------
Total comprehensive income                          --            7,653
-------------------------------------------------------------------------

BALANCE, DECEMBER 31, 1996                       3,973          125,104
                                        
Settlement of RSA escrow                            --               --
Exercise of stock options               
 and purchase plans                                 --            5,495
Other                                               --             (226)
Tax benefit arising from
 exercise of stock options                          --            2,012
Payments to Acquisition shareholders                --           (6,038)
Issuance of common stock                            --           61,108
(Compensation expense and amortization
    of deferred stock compensation                  --              794
Comprehensive income:
 Translation adjustment                         (1,243)          (1,243)
 Unrealized (loss) on marketable
  securities, net                               (3,401)          (3,401)
 Net income                                         --           17,048
------------------------------------------------------------------------
 Total comprehensive income                         --           12,404
------------------------------------------------------------------------

BALANCE, DECEMBER 31, 1997                        (671)         200,653

Exercise of stock options
 and purchase plans                                 --            3,364
Tax benefit arising from                
exercise of stock options                           --            4,482
Compensation expense and amortization               --            1,983
 of deferred stock compensation                                   
Tax benefit arising from foreign                                       
 acquisition net assets                             --           13,835
Legal settlement                                                  1,872
Other                                               --             (447)
Share repurchase program                            --          (12,135)
Comprehensive income:                   
 Translation adjustment                           (425)            (425)
 Unrealized gain on marketable          
  securities, net                                  123              123
 Net income                                         --           29,415
------------------------------------------------------------------------
 Total comprehensive income                         --           29,113
------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1998                     $  (973)        $242,720
                                        ================================
</TABLE>                                


See notes to consolidated financial statements



<PAGE>   19
                                                                              31

Consolidated Statements of Cash Flows
SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES

(In Thousands)
<TABLE>
<CAPTION>
                                                                  YEARS ENDED DECEMBER 31,

                                                             1996         1997         1998
---------------------------------------------------------------------------------------------
<S>                                                       <C>          <C>          <C>      
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income                                                $  13,685    $  17,048    $  29,415
Adjustments to reconcile net income to net cash                 
 provided by (used for) operating activities:
   Legal settlement                                              --           --        1,872
   Gain on sale of VeriSign common stock                         --           --      (31,285)
   Gain from increase in investment value                        --           --      (11,976)
   Equity in loss from operations of equity investment           --           --        4,187
   Investment valuation adjustment                               --           --        3,647
   Non cash investment                                           --           --       (2,000)
   Gain on sale of marketable securities                    (11,027)      (4,264)          --
   Deferred taxes                                            (1,393)      (2,337)       1,366
   Depreciation and amortization                              1,824        4,353        6,845
   Stock compensation                                         1,167          794        1,983
   Minority interests                                            --         (114)        (578)
   Increase (decrease) in cash from changes in:
     Accounts receivable                                     (8,459)     (10,946)      (9,074)
     Inventory                                               (1,161)       (,429)      (3,993)
     Prepaid expenses and other                              (2,672)      (5,167)      (7,529)
     Accounts payable                                         2,379        1,627       (5,874)
     Accrued payroll and related benefits                     1,659          471        4,370
     Accrued expenses and other                               2,943        6,225        3,593
     Prepaid and income taxes payable                          (459)      (4,685)       4,828
     Deferred revenue                                         1,105        3,983        1,356
                                                          -----------------------------------
       NET CASH PROVIDED BY (USED FOR) OPERATING
       ACTIVITIES                                              (409)       6,559       (8,858)
                                                          -----------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchase of marketable securities                       (119,619)    (104,172)    (211,393)
   Sales and maturities of marketable securities             85,975      133,804      154,399
   Purchases of property and equipment                       (9,434)     (10,896)     (18,850)
   Capitalized software costs and purchased
    technology                                               (1,061)      (1,410)          --
   Investments and other                                     (3,224)      (1,616)      26,328
                                                          -----------------------------------
       NET CASH PROVIDED BY (USED FOR) INVESTING
       ACTIVITIES                                           (47,363)      15,710      (49,516)
                                                          -----------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from sale of common stock, net of
    issuance costs                                              534       61,108           --
   Payments to Acquisition shareholders                          --       (6,038)          --
   Proceeds from exercise of stock options and
    purchase plans                                            2,606        5,269        3,364
   Tax benefit from exercise of stock options                 3,702        2,012        4,482
   Minority interests                                         1,213        1,905           --
   Share repurchase program                                      --           --      (12,135)
   Other                                                        537           --         (447)
                                                          -----------------------------------
       NET CASH PROVIDED BY (USED FOR) FINANCING
       ACTIVITIES                                             8,592       64,256       (4,736)
                                                          -----------------------------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND EQUIVALENTS        (138)      (1,618)        (307)
                                                          -----------------------------------

NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS             (39,318)      84,907      (63,417)

CASH AND EQUIVALENTS, BEGINNING OF YEAR                      51,006       11,688       96,595
                                                          -----------------------------------
CASH AND EQUIVALENTS, END OF YEAR                         $  11,688    $  96,595    $  33,178
                                                          ===================================
</TABLE>

See notes to consolidated financial statements 


<PAGE>   20
32

Notes to Consolidated Financial Statements
SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES


(In thousands, except lease, share, and per share data)

1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES NATURE OF
BUSINESS -- Security Dynamics Technologies, Inc. ("SDI," which, together with
its subsidiaries, is referred to as the "Company") is a leading provider of
enterprise network and data security solutions to corporate end user
("Enterprise") and original equipment manufacturer ("OEM") customers. The
Company helps enable electronic business by providing technologies, products and
services that secure the access to and protect the information in networks,
systems, applications and Internet commerce initiatives. Leveraging its
expertise in authentication management, public key encryption and access
control, the Company helps organizations in a range of industries conduct
business securely, protect corporate information assets and facilitate
business-to-business and electronic commerce. The Company's products include its
SecurID "tokens" and ACE/Server software, which authenticate the identity of
users accessing networked or stand-alone computer resources, RSA developer
toolkits and other products used to implement cryptographic data security
applications, and the Keon product family, which provides a broad range of
application security solutions, including secure single sign-on solutions. The
Keon family includes the products formerly known as "BoKS" and acquired by the
Company as part of the acquisition of DynaSoft AB in July 1997.

The Company's principal markets for its products are, in order of significance,
the United States, Europe, Canada, Asia/Pacific and Latin America.

RECLASSIFICATION -- Certain prior year amounts have been reclassified to conform
to the 1998 presentation.

BASIS OF PRESENTATION -- The consolidated financial statements have been
prepared to give retroactive effect to the acquisitions of Intrusion Detection,
Inc. ("IDI") on March 26, 1998, DynaSoft AB ("DynaSoft") on July 14, 1997 and
RSA Data Security ("RSA") on July 26, 1996 (see Note 2), which have been
accounted for as poolings of interests.

PRINCIPLES OF CONSOLIDATION -- The consolidated financial statements include all
accounts of SDI and its subsidiaries. Strategic equity investments are accounted
for using the equity method in situations where the Company has the ability to
exercise significant influence over the investee's business. All other strategic
investments are accounted for using the cost method (See Note 3).

In 1996 and 1997, RSA sold minority interests, aggregating 26% in its Japanese
subsidiary to third parties for $1,213 and $1,905, respectively. The minority
interest in the subsidiaries' profits and losses is separately presented in the
accompanying consolidated income statements.

REVENUE RECOGNITION -- Revenues are recognized when software and hardware
products are shipped, no significant obligations remain and collection is
considered probable. Revenue from shipments to distributors are recognized upon
receipt of evidence of sale to end users by the distributors. Revenues from
licensing intellectual property such as patents and cryptographic data security
applications are recognized when contracts are entered into, no significant
obligations remain and collection is considered probable. Maintenance services
revenues are deferred and recognized ratably over the maintenance period,
generally twelve months. Professional services revenues are recognized as
services are provided. No customer accounted for 10% or more of the Company's
revenue in any period reported.

WARRANTY POLICY -- The Company provides warranties on SecurID tokens for the
customer-selected programmed life of the token and replaces damaged tokens
(other than tokens damaged by a user's negligence or alteration) free of charge.
The Company generally sells its other products to customers with warranties for
specified periods. The Company provides a reserve for warranties based upon
historical experience.

INVENTORY -- Inventory consists primarily of SecurID tokens and is stated at the
lower of cost (first-in, first-out method) or market.

PROPERTY AND EQUIPMENT -- Property and equipment are stated at cost. 
Depreciation is computed using the straight-line method over the estimated 
useful lives of the related assets (two to ten years).

RESEARCH AND DEVELOPMENT, CAPITALIZED SOFTWARE AND PURCHASED TECHNOLOGY COSTS --
Research and development costs, including purchased research and development,
are expensed as incurred. The Company capitalizes certain software costs after
technological feasibility has been established. Capitalized amounts are reported
at the lower of unamortized cost or net realizable value and are amortized to
cost of revenue over the estimated useful lives (two to three years) starting at
the general release of the software product to customers. Purchased technology
consists of acquired software and is recorded at cost. Amortization is provided
over estimated lives of two years. Purchased technology and capitalized software
costs, net of accumulated amortization, were $86 as of December 31, 1997 and $14
as of December 31, 1998 and are included in Other Assets. Amortization expense
for capitalized software and purchased technology approximated $330, $111 and
$73 for 1996, 1997 and 1998, respectively.

CASH EQUIVALENTS -- The Company considers all highly liquid investments
purchased with a remaining maturity of three months or less to be cash
equivalents.

<PAGE>   21
                                                                              33

MARKETABLE SECURITIES -- The Company classifies its marketable securities as
"available for sale," and carries them at aggregate fair value. Unrealized gains
and losses are included as a component of stockholders' equity, net of tax
effect. Realized gains are determined based on the specific identified cost of
the securities. The Company's marketable securities have various contractual
maturities through 2008. Unrealized gross gains were $132 at December 31, 1997
and $500 at December 31, 1998.

Marketable securities were as follows:
<TABLE>
<CAPTION>

                                                                             December 31,
                                                                      1997                       1998
---------------------------------------------------------------------------------------------------------------
                                                           AGGREGATE                  AGGREGATE
                                                           FAIR VALUE        COST     FAIR VALUE         COST
                                                           ----------------------------------------------------
<S>                                                         <C>            <C>         <C>            <C>      
U.S. Government and Federal Agency obligations              $ 67,582       $ 67,510    $  32,370      $  32,193
State and municipal government tax-exempt obligations            482            422       34,920         35,002
Corporate obligations                                             --             --       57,768         57,526
                                                           ----------------------------------------------------
      Total                                                 $ 68,064       $ 67,932    $ 125,058      $ 124,721
                                                           ==================================================== 
</TABLE>

ADVERTISING -- Advertising costs are expensed as incurred. Advertising expense
was approximately $632 in 1996, $850 in 1997 and $837 in 1998.

INCOME TAXES -- The Company uses the liability method of accounting for income
taxes. Deferred taxes are determined based on the estimated future tax effects
of differences between the financial statement and tax bases of assets and
liabilities given the provisions of the enacted tax laws. The Company provides
for taxes on the undistributed earnings of foreign subsidiaries which are
ultimately expected to be remitted to the parent company. Unrecognized
provisions for taxes on undistributed earnings of foreign subsidiaries which are
considered permanently invested are not material to the Company's consolidated
financial position or results of operations.

In accordance with Statement of Financial Accounting Standards ("SFAS") No. 109
the Company records valuation allowances against net deferred tax assets, if
based upon the available evidence, it is more likely than not that some or all
of the deferred tax assets will not be realized. In assessing the realizability
of deferred assets, management considers whether it is more likely than not that
some or all of the deferred tax assets will not be realized. The ultimate
realization of deferred tax assets is dependent upon the generation of future
taxable income and when temporary differences become deductible. The Company
considers, among other available information, uncertainties surrounding the
recoverability of deferred tax assets, scheduled reversals of deferred tax
liabilities, projected future taxable income, and other matters in making this
assessment.

FOREIGN CURRENCY -- The Company considers the local currencies of the countries
in which the Company's branches and subsidiaries are domiciled to be the
functional currencies. Translation adjustments are accumulated in a separate
component of equity.

EARNINGS PER SHARE -- In the fourth quarter of 1997, the Company adopted the
provisions of SFAS No. 128 "Earnings per Share." The Company changed the method
used to compute earnings per share and restated all prior periods in accordance
with SFAS No. 128. SFAS No. 128 supersedes Accounting Principles Board Opinion
No. 15 and is intended to simplify the computation of earnings per share and to
make the U.S. computations more comparable with international computations by
requiring the presentation of basic and fully diluted earnings per share. The
Company's only dilutive stock equivalents are stock options.

FINANCIAL INSTRUMENTS -- The carrying values of cash and equivalents, accounts
receivable and accounts payable approximate fair value due to the short-term
nature of these instruments. Marketable securities are carried at aggregate fair
value. The Company's interest in VeriSign (Note 3) is accounted for under the
equity method. Other investments represent strategic equity positions in
companies and are stated at cost (Note 3). It is not practicable to measure the
estimated fair value of such investments.

USE OF ESTIMATES -- The preparation of the Company's consolidated financial
statements in conformity with generally accepted accounting principles
necessarily requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting periods. Actual results
could differ from those estimates.

CONCENTRATION OF CREDIT RISK -- The Company licenses its ACE/Server and Keon
software and token technology to various customers in a diverse industry range.
Toolkit and patent licenses are issued primarily to companies in the computer
and software industries. The Company performs ongoing credit evaluations of its
customers and maintains allowances for potential credit losses. The Company
generally requires no collateral from its customers.

<PAGE>   22
34

Notes to Consolidated Financial Statements
continued


STOCK-BASED COMPENSATION -- The Company applies Accounting Principles Board
Opinion No. 25 and related interpretations in accounting for stock option grants
to employees (and non-employees prior to January 1, 1996). Since January 1,
1996, the Company applies SFAS No. 123, "Accounting for Stock-Based
Compensation" and related interpretations for accounting for stock option grants
to non-employees.

LONG-LIVED ASSETS -- Effective January 1, 1996, the Company adopted the
provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of," for 1996. The adoption of SFAS No.
121 did not have an impact on the Company's consolidated financial statements.

RECENT ACCOUNTING PRONOUNCEMENTS -- In October 1997, the American Institute of
Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") No.
97-2, "Software Revenue Recognition," which supersedes SOP No. 91-1. The Company
adopted SOP No. 97-2, as amended, prospectively on January 1, 1998. SOP No. 97-2
generally requires revenue earned on software arrangements involving multiple
elements to be allocated to each element based on the relative fair values of
the elements.

2. MERGER AND ACQUISITIONS 
On July 26, 1996, SDI completed a merger with RSA Data Security, Inc. (the
"Merger" and "RSA," respectively). On July 15, 1997, SDI acquired DynaSoft AB
(the "DynaSoft Acquisition" and "DynaSoft," respectively). On March 26, 1998,
SDI acquired IDI (the "IDI Acquisition") (collectively, the "Acquisitions"). The
Acquisitions and the Merger have been accounted for as poolings of interests and
therefore the consolidated financial statements for all periods prior to the
Acquisitions and the Merger have been restated to include the accounts and
operations of RSA, DynaSoft and IDI with those of SDI. Expenses related to these
transactions for investment banking, professional fees and other direct expenses
are recorded at the respective dates of the Acquisitions and the Merger.

Under the terms of the Merger, each share of RSA common stock was exchanged for
1.66112 shares of the Company's common stock and the Company issued a total of
6,683,078 shares of its common stock to RSA stockholders and options to purchase
a total of 1,316,922 shares of the Company's common stock to option holders of
RSA.

Under the terms of the DynaSoft Acquisition, the Company issued approximately
2.7 million shares of common stock in exchange for approximately 95% of the
outstanding shares and certain of the outstanding options to acquire shares of
DynaSoft. The Company paid $6,038 to certain stockholders of DynaSoft in
exchange for the remaining outstanding shares and options.

Under the terms of the IDI Acquisition, the Company issued 784,342 shares of
common stock in exchange for all of the outstanding shares of IDI.

Investment banking, professional fees and other direct expenses incurred in
connection with the Merger were approximately $6,100 in 1996. In the third
quarter of 1997, the Company accrued a charge of $7,000 representing the
estimated direct costs of the DynaSoft Acquisition. In the fourth quarter, the
Company's actual direct costs were determined to be approximately $5,400, a
difference of $1,600. The difference came from lower than expected legal and
other professional fees and from a change in the planned use of the DynaSoft
facilities. As a result, the Company reversed $1,600 of the original accrual in
the fourth quarter of 1997.

In December 1997, the Company committed to a plan to integrate the DynaSoft
operations into its worldwide structure. The plan of integration encompasses the
severing of nine DynaSoft employees and consultants, all of whom were notified
of their pending termination from the Company prior to December 31, 1997. In
connection with this plan, the Company accrued for severance and other related
costs of $300 in the fourth quarter of 1997. As of December 31, 1997, four of
the employees were terminated, whereby the Company paid severance of $49. The
remaining five employees/consultants were terminated in early 1998, at which
time the Company paid the remaining amounts contemplated under the plan.

Investment banking, professional fees and other direct expenses incurred in
connection with the IDI acquisition and charged to operations in the first
quarter of 1998 were approximately $2.6 million.

No adjustments to conform accounting policies of the Company, RSA and IDI were
required. Adjustments to conform accounting policies of DynaSoft to those of the
Company were not material.

Revenues and net income (loss) for previously separate Companies for the periods
before the acquisitions follow. IDI revenues and net income (loss) were $2,600
and $510, respectively, in 1996, $4,700 and $ 680, respectively, in 1997 and
$900 and $(137), respectively for the period January 1, 1998 to March 26, 1998,
the date Security Dynamics acquired IDI. DynaSoft revenues and net income (loss)
were $7,669 and $130, respectively, in 1996 and $5,277 and $(155), respectively,
for the period January 1, 1997 to July 15, 1997, the date Security Dynamics
acquired DynaSoft. RSA revenues and net (loss) were $6,043 and $(383),
respectively, for the period January 1, 1996 to July 26, 1996, the date Security
Dynamics merged with RSA.

Pursuant to escrow agreements entered into with the Company by certain of the
stockholders of DynaSoft, RSA, and IDI in connection with the DynaSoft
Acquisition, the Merger, and the IDI Acquisition, respectively, 10.0% of the
shares of the

<PAGE>   23
                                                                              35


Company's common stock issued to holders of DynaSoft's stock and 12.5% of the
shares of the Company's common stock issued to holders of RSA stock and issuable
to holders of RSA options and 10% of the shares of the Company's common stock
issued to holders of IDI's stock were placed in escrow, pending settlement of
any breaches of representations, warranties or covenants to the DynaSoft
Acquisition, the Merger and the IDI Acquisition agreements. In June 1997, the
Company and the holders of the RSA shares reached a settlement with respect to
claims against the escrow shares and 36,250 shares were distributed to the
Company and 837,957 shares were distributed to the holders of the RSA stock. Of
the shares received by the Company, 213 shares were accounted for as treasury
stock and the remainder were canceled. In July 1998, the shares held in escrow
in connection with the DynaSoft Acquisition were released and in September 1998,
the shares held in escrow in connection with the IDI Acquisition were released.

3. INVESTMENTS
VERISIGN, INC. -- In January 1998, VeriSign had an initial public offering of
three million shares of its common stock. The VeriSign series A and B
convertible preferred stock held by the Company converted to common stock in
connection with the offering. The offering diluted the Company's ownership but
increased the value of the Company's equity in VeriSign.

As a result of VeriSign's initial public offering, in accordance with the equity
method of accounting, the Company recognized as a gain the increase in the
amount of its investment in VeriSign of $12.0 million, representing its
proportionate share of VeriSign's equity as of December 31, 1997, after
considering VeriSign's net proceeds from the offering. The Company sold 895,500
shares of its VeriSign common stock for a gain of $31.3 million in 1998. As of
December 31, 1998 the Company owned approximately 3.6 million shares of VeriSign
common stock, an approximate ownership percentage of 16%, with a market value of
approximately $213.0 million. In January 1999 VeriSign completed a secondary
offering of 3.2 million shares of its common stock, including the sale of 1.0
million shares held by the Company. The Company realized a gain of $74.7 million
on the sale in January 1999. In the second quarter of 1999, the Company will
recognize as a gain the increase in the amount of its investment in VeriSign of
$12.6 million, representing its proportionate share of VeriSign's net increase
in equity from this offering.

The Company recognizes its proportionate interest in VeriSign's operating
results one quarter in arrears. The Company's proportionate share of VeriSign's
net loss was $4.2 million in 1998. On January 25, 1999, VeriSign announced it
had incurred a net loss of $19.7 million for the year ended December 31, 1998
and $2.5 million for the three months ended December 31, 1998 and at December
31, 1998 had total assets and liabilities of $64.3 million and $22.6 million
respectively. A Director of the Company serves as Chairman of the Board of
VeriSign.

VPNET TECHNOLOGIES, INC. -- In December 1996, the Company purchased 250,000
shares of Series B Preferred Stock of VPNet Technologies, Inc. ("VPNet") of San
Jose, California, for an aggregate purchase price of $1,500. VPNet was organized
to develop and market products and technologies for implementing
high-performance virtual private networks. In January 1998, the Company
purchased $120 of VPNet 8% convertible debt. The debt is convertible into
preferred stock which is convertible into common stock. The Company also
received a warrant to purchase VPNet Common Stock. The Company's investment in
VPNet represents a minority interest of less than 10% of VPNet's capitalization.
A Director of the Company serves as a director of VPNet.

TRINTECH GROUP -- In March 1998 the Company purchased, in a non-cash
transaction, 482,756 ordinary shares of Trintech Group ("Trintech") valued at
$2,000. Trintech is an Irish development company organized to develop and market
software products designed to enable secure payment in the electronic
marketplace. In June 1998, the Company purchased 500,000 shares of Trintech's
Series A Convertible Preferred Shares for $3,000 cash. The Company's investment
represents a minority interest of less than 10% of Trintech's capitalization.

NCIPHER CORPORATION LIMITED -- In October 1997, the Company purchased 175,285
ordinary shares of nCipher Corporation Limited ("nCipher") for an aggregate
purchase price of $512. nCipher is located in the United Kingdom and develops
products designed to accelerate cryptographic processes in Internet security,
electronic commerce and other applications. In January and July 1998, the
Company purchased 93,896 and 563,910 ordinary shares of nCipher for aggregate
purchase price of $336 and $2,460, respectively. The Company's investment in
nCipher represents a minority interest of less than 20% of nCipher's
capitalization.

C2NET, INC. -- In June 1998, the Company made a one-year bridge loan to C2Net,
Inc. ("C2Net") in the amount of $200. The debt is convertible at the Company's
option into equity of C2Net or may be used to offset any financial obligation
which may arise from future licensing agreements between the Company and C2Net.
C2Net is located in California and was organized to develop commercial Internet
security software.

FINJAN SOFTWARE LTD. -- In August 1997, the Company purchased 877,193 Series C
Preferred Shares of Finjan Software Ltd. ("Finjan") for an aggregate purchase
price of $1,000. Finjan is an Israeli software company organized to develop and
market products for the Java Internet security market. The Company's investment
in Finjan represents a minority interest of less than 5% of Finjan's
capitalization.

INVESTMENT VALUATION ADJUSTMENT -- The Company routinely evaluates the
realizable value of its investments using qualitative and quantitative factors
including discounted cash flow analysis and liquidation value assessments. Based
on these evaluations the Company reduced investments by $3.6 million in December
1998.
<PAGE>   24
36

continued

4. STOCK OPTION AND PURCHASE PLANS 1994 STOCK OPTION PLAN ("1994 PLAN") -- In
October 1994, the Board of Directors adopted the Company's 1994 Plan. The 1994
Plan authorizes (i) the grant of options to purchase common stock intended to
qualify as incentive stock options and (ii) the grant of options that do not so
qualify (non-statutory options) to employees, officers, directors and
consultants of the Company. Option exercise prices for incentive stock options
granted under the 1994 Plan may not be less than 100% of the fair market value
of the shares. In general, 1994 Plan option grants become exercisable as to 25%
on the first anniversary of the grant date, and in equal quarterly amounts
thereafter for three years. Options generally expire eight years from the grant
date. On April 30, 1998, at the Annual Meeting of Stockholders of the Company,
the stockholders adopted an amendment and restatement of the 1994 Plan which,
among other things, increased the number of shares authorized for issuance under
the 1994 Plan from 6,570,000 to 9,570,000. Shares of common stock available for
option grants were 567,390 at December 31, 1998. On January 6, 1999, the Board
of Directors adopted, subject to stockholder approval, an amendment to the 1994
Plan which, among other things, increases the number of shares of common stock
authorized for issuance from 9,570,000 to 11,570,000 shares in the aggregate.

1994 DIRECTOR STOCK OPTION PLAN ("DIRECTOR PLAN") -- In October 1994, the Board
of Directors adopted the Company's Director Plan. The Director Plan permits the
granting of options to purchase up to a maximum of 300,000 shares of common
stock to non-employee members of the Board of Directors. The exercise price of
the options may not be less than 100% of the fair market value on the date of
the grant. Options granted under the Director Plan become exercisable at the
earlier of the date of the next Annual Meeting of Stockholders or one year from
the date of grant and expire up to ten years from the date of grant. Shares of
common stock available for option grant were 55,000 at December 31, 1998. On
January 6, 1999, the Board of Directors adopted, subject to stockholder
approval, an amendment to the Director Plan increasing the number of shares of
common stock authorized for issuance from 300,000 to 500,000 shares in the
aggregate.

1994 EMPLOYEE STOCK PURCHASE PLAN ("PURCHASE PLAN") -- In October 1994, the
Board of Directors adopted the Company's Purchase Plan. The Purchase Plan
provides for sales to participating employees of up to 400,000 shares of common
stock, at prices of not less than 85% of the closing price on either the first
day or the last day of the offering period, whichever is lower. Shares purchased
under the Plan were 91,408 in 1996, 145,203 in 1997 and 100,997 in 1998.

1998 NON-OFFICER EMPLOYEE STOCK INCENTIVE PLAN ("1998 PLAN") -- In December
1998, the Board of Directors adopted the Company's 1998 Plan. The 1998 Plan, as
amended, authorizes the grant of non-statutory stock options, restricted stock
awards, and other stock-based awards covering up to an aggregate of 625,750
shares of Common Stock to employees, consultants and advisors of the Company,
other than those who are also officers (within the meaning of Section 16 of the
Exchange Act). In general, stock options granted under the 1998 Plan become
exercisable as to 25% of the shares covered thereby on the first anniversary of
the grant date and in equal quarterly installments thereafter for three years.
Options generally expire eight years from the grant date. No shares of Common
Stock were available for awards under the 1998 Plan as of December 31, 1998.

RSA OPTIONS -- At the effective date of the Merger, the then-outstanding options
to purchase shares of RSA common stock, issued under RSA's 1987 Stock Option
Plan were exchanged for options to purchase an aggregate of 1,316,922 shares of
the Company's common stock. All option activity data has been retroactively
adjusted to the earliest period presented to give effect to the conversion of
the RSA options. Incentive stock options and non-statutory stock options were
awarded to employees, officers, directors, consultants and independent
contractors and were generally immediately exercisable for a term of five years.
In the event of termination of employment or consulting services, the Company
had the option to repurchase at the original exercise price any unvested shares.
No options were subject to repurchase rights as of December 31, 1998.

<PAGE>   25
                                                                              37

A summary of stock option activity under all plans follows:

<TABLE>
<CAPTION>

                                                   WEIGHTED AVERAGE 
                                                      EXERCISE
                                          SHARES   PRICES PER SHARE
-------------------------------------------------------------------
<S>                                      <C>           <C>    
Outstanding at January 1, 1996           3,179,195     $  2.69
 Granted                                 2,332,212       29.12
 Exercised                                (761,633)       2.33
 Canceled                                  (27,317)      21.57
Outstanding at December 31, 1996         4,722,457       15.71
 Granted                                 2,437,383       34.29
 Exercised                                (959,143)       3.58
 Canceled                                 (147,056)      26.43
Outstanding at December 31, 1997         6,053,641       24.87
 Granted                                 9,125,937       15.09
 Exercised                                (972,740)       1.85
 Canceled                               (6,178,366)      32.59
                                         --------------------------
Outstanding at December 31, 1998         8,028,472     $ 13.35
                                         ==========================
 Exercisable at December 31, 1996        2,127,928     $  1.69
                                         ==========================
 Exercisable at December 31, 1997        2,120,841     $ 11.45
                                         ==========================
 Exercisable at December 31, 1998        2,629,914     $ 13.63
                                         ==========================
</TABLE>

The following table sets forth information regarding stock options outstanding
at December 31, 1998 under all plans:
<TABLE>
<CAPTION>
                                                          WEIGHTED AVERAGE                          
       RANGE                                WEIGHTED         REMAINING          NUMBER         WEIGHTED AVERAGE
     EXERCISE          NUMBER OF             AVERAGE      CONTRACTUAL LIFE     CURRENTLY      EXERCISE PRICE FOR                 
      PRICES            OPTIONS           EXERCISE PRICE      (YEARS)         EXERCISABLE    CURRENTLY EXERCISABLE
------------------------------------------------------------------------------------------------------------------
<C>                      <C>                <C>                <C>              <C>               <C>    
$      0.10              52,000             $  0.10            1.3              52,000            $  0.10
       0.45              22,397                0.45            4.9              22,397               0.45
   0.76 -  0.90         145,085                0.90            1.2             144,828               0.90
   1.75 -  2.55          21,663                2.36            5.7              21,663               2.36
   2.95 -  3.31         109,262                3.27            2.7             107,431               3.27
       6.62               4,959                6.62            2.3               4,959               6.62
   9.97 - 14.31       6,523,957               11.95            7.6           1,829,732              11.70
  16.00 - 19.00         417,339               16.73            7.7                  --                 --         
  24.13 - 35.63         638,250               28.95            7.7             382,748              29.22
  37.59 - 44.21          93,500               40.70            8.1              64,156              41.66
-------------------------------------------------------------------------------------------------------------------
$  0.10 - 44.21       8,028,472             $ 13.35            7.3           2,629,914            $ 13.63            
===================================================================================================================
</TABLE>

ACCOUNTING FOR STOCK OPTIONS
For certain options and stock awards granted in 1996, 1997 and 1998, the Company
is recognizing compensation expense based on the excess of fair market value
over the option exercise or award prices at dates of grant. Compensation is
being recognized ratably over the vesting periods.

On April 1, 1996 and April 24, 1996, options to purchase 200,000 shares and
38,900 shares of common stock were granted at exercise prices of $24.30 and
$38.20, respectively, subject to stockholder approval of an amendment to the
1994 Plan increasing the number of shares available for grant to 4,820,000
shares. On May 22, 1996, the stockholders approved the amendment to the 1994
Plan.

For options granted subsequent to April 1, 1996, the Company changed its
accounting policy on options requiring stockholder approval to measure
compensation expense on the approval date. This change resulted in an aggregate
compensation expense of approximately $4,500 relating to the April 1, 1996 and
April 24, 1996 option grants, which the Company is recognizing over the
remainder of the four-year vesting period of the options from May 22, 1996. The
effect of this change was to reduce income from operations by $667 in 1996.
Total compensation expense relating to certain options and stock awards amounted
to $1,167 in 1996, $1,205 in 1997 and $1,982 in 1998.

<PAGE>   26
38


On July 24, 1998 and August 6, 1998, the Board of Directors of the Company
approved a stock option repricing program pursuant to which each holder (other
than certain executive officers and the directors of the Company) of an
outstanding stock option granted under the Plan during the period commencing on
January 1, 1996 and ending on June 30, 1998 (collectively, the "Old Options"),
could elect to receive a new stock option (collectively, "New Options") granted
on August 12, 1998 under the Plan in exchange for cancellation of each Old
Option. The Company repriced the options because the exercise prices of such
options were significantly higher than the fair market value of the Company's
Common Stock, and therefore did not provide the desired incentive to employees.
The Company believes that stock options are a valuable tool in retaining
employees. Each New Option is, among other things,(i) exercisable for the number
of shares of the Company's Common Stock covered by the outstanding unexercised
portion of the Old Option canceled in exchange therefore; (ii) has an exercise
price of $12.0625 (equal to the closing price of the Common Stock on the Nasdaq
National Market on August 12, 1998 and the fair market value of the Common Stock
on such date); and (iii) has the identical vesting schedule as the Old Option,
provided, however, that each such New Option shall not be exercisable prior to
February 12, 1999, with such prohibition on exercise expiring at a rate of 25%
at the end of each three-month period thereafter. New Options to purchase an
aggregate of approximately 5.3 million shares of Common Stock were granted in
exchange for Old Options with exercise prices ranging from $19.00 to $44.125.

PRO FORMA DISCLOSURE -- Had the Company recognized compensation costs for its
stock option and purchase plans based on the fair value for awards under those
plans after January 1, 1996, in accordance with SFAS No. 123 "Accounting for
Stock Based Compensation," pro forma net income and pro forma net income per
share would have been as follows: 

<TABLE>
<CAPTION>

                                  YEARS ENDED DECEMBER 31, 
                               -------------------------------
                                 1996         1997       1998
--------------------------------------------------------------
<S>                            <C>           <C>       <C>    
Pro forma net income           $ 11,255      $ 5,697   $ 4,598
Pro forma net income         
 per share
 -- basic                      $   0.30      $  0.15   $  0.11
 -- diluted                    $   0.28      $  0.14   $  0.11
</TABLE>

The fair values used to compute pro forma net income and net income per share
were estimated fair value at grant date using the Black-Scholes option-pricing
model with the following weighted average assumptions:

<TABLE>
<CAPTION>                                       YEARS ENDED DECEMBER 31,
                                            -----------------------------      
                                            1996        1997         1998
-------------------------------------------------------------------------
<S>                                          <C>         <C>         <C>
STOCK OPTION PLANS
 Risk-free interest rate                     6.0%        6.1%        5.2%
 Expected life of option grants (years)      4.4         4.3         4.1
 Expected volatility of underlying stock    57.5%       57.5%       70.0%
 Expected dividend payment rate              0.0%        0.0%        0.0%
 Expected forfeiture rate                    4.1%        4.1%        7.5%

EMPLOYEE STOCK PURCHASE PLAN
 Risk-free interest rate                     5.2%        5.2%        5.2%
 Expected life of option grants (years)      0.5         0.5         0.5
 Expected volatility of underlying stock    57.5%       57.5%       70.0%
 Expected dividend payment rate              0.0%        0.0%        0.0%
</TABLE>

The weighted average fair value of stock options granted, calculated using the
Black-Scholes option-pricing model, was $17.36 in 1996, $19.64 in 1997 and $6.50
in 1998. The weighted fair value of stock options granted under the Purchase
Plan, calculated using the Black-Scholes option-pricing model was $8.81 in 1996,
$10.82 in 1997 and $5.58 in 1998.

<PAGE>   27
                                                                             39

5. INCOME TAXES
The provision for income taxes consisted of the following:

<TABLE>
<CAPTION>
                                YEARS ENDED DECEMBER 31,

                            1996         1997          1998
------------------------------------------------------------
<S>                      <C>          <C>           <C> 
Current:
 Federal                 $  7,359     $ 11,459      $ 14,583
 State                        936        1,759         2,342
 Foreign                      399          431           798
                         -----------------------------------
   Total                    8,694       13,649        17,723

Deferred:
 Federal                   (1,219)      (2,179)         (387)
 State                       (174)        (158)        2,050
 Foreign                       --           --          (297)
                         -----------------------------------
   Total                   (1,393)      (2,337)        1,366

Tax benefit from exercise  
of stock options:
 Federal                    3,452        1,878         4,137
 State                        250          134           345
                         -----------------------------------
   Total                    3,702        2,012         4,482
                         -----------------------------------
Total                    $ 11,003     $ 13,324      $ 23,571
                         ===================================
</TABLE>

Significant components of the Company's deferred tax assets and liabilities at
December 31 were as follows:

<TABLE>
<CAPTION>
                                                1997         1998
-------------------------------------------------------------------
<S>                                           <C>         <C>
Deferred tax assets (liabilities)  current
 Marketable securities                        $  (846)    $  (5,760)
 Deferred revenue                                 942         1,107
 Royalty valuation                                 --           920
 Merger and integration                           196            --
 Sales returns                                    524           605
 Allowance for doubtful accounts                  267           284
 Compensation                                     185           237
 Inventory reserves                                67           225
 Warranty obligation                               42            42
 Commissions                                       22            95
 Other                                             27           195
                                              ---------------------
Net deferred tax asset (liability)  current   $ 1,426     $  (2,120)
                                              =====================
Deferred tax assets (liabilities)  non current:
 Foreign acquisition asset                    $    --     $  39,333
 Purchased research and 
 development                                    2,907         2,642
 Compensation                                     575         2,269
 Investment valuation                              --         1,459
 Capitalized software development costs 
 and other                                       (111)         (920)
 Valuation allowance                               --       (25,498)
                                              ---------------------
Net deferred tax assets -- non current        $ 3,371     $  19,285
                                              =====================
</TABLE>
<PAGE>   28
40

Notes to Consolidated Financial Statements
continued


A reconciliation between the statutory and effective income tax rates follows:

<TABLE>
<CAPTION>

                                                       YEARS ENDED DECEMBER 31,

                                                  1996            1997          1998
-------------------------------------------------------------------------------------
<S>                                               <C>             <C>           <C>  
Statutory tax rate                                35.0%           35.0%         35.0%
State income taxes net of federal benefit          2.3             3.7           7.0      
Merger expenses                                    8.3             6.7           0.1      
Other                                             (1.0)           (1.7)          2.9

Effective income tax rate                         44.6%           43.7%         45.0%
                                                  ===================================
</TABLE>

In the fourth quarter of 1998, the Company made certain elections for U.S. tax
reporting purposes that resulted in a deferred tax asset of approximately $39.3
million relating to the DynaSoft Acquisition, a taxable business combination in
1997 which was accounted for as a pooling of interests. In accordance with
provisions of SFAS No. 109, the Company simultaneously recorded a $25.5 million
valuation allowance, reducing the deferred tax asset to an amount that
management believes is more likely than not to be realized. The net deferred tax
asset of $13.8 million was recorded with a corresponding increase to additional
paid in capital.

Cash payments for income taxes were approximately $8,390 in 1996, $15,542 in
1997 and $18,249 in 1998.

6. RETIREMENT AND SAVINGS PLAN 
The Company has a 401(k) retirement and savings plan (the "Plan") established in
1986 covering substantially all domestic employees. The Plan allows each
participant to defer up to 20% of annual earnings up to an amount not to exceed
an annual statutory maximum. Subject to the approval of the Board of Directors
on an annual basis, the Company may make, at its discretion, profit-sharing
contributions and/or match employee deferrals. Profit-sharing contributions were
$305 in 1996, $400 in 1997 and $336 in 1998. The Board of Directors also
approved for 1996, 1997 and 1998 matching contributions in an amount equal to
one-third of the employee deferrals up to 6% of annual earnings (or a total of
2%), subject to certain eligibility requirements. Matching contributions were
$261 in 1996, $367 in 1997 and $582 in 1998.

7. COMMITMENTS 
The Company leases office facilities and automobiles under non-cancelable
operating leases expiring through 2009. Future minimum rental payments are as
follows:


                            YEARS ENDED DECEMBER 31,

                              1999      $ 6,354
                              2000        6,820
                              2001        6,809
                              2002        6,891
                              2003        6,843        


Net rent expense was approximately $2,069 in 1996, $3,437 in 1997 and $4,884 in
1998. Rent collected from subleases of the Company's former headquarters was
$108 in 1996, $527 in 1997 and $81 in 1998.

During 1996, the Company issued an unsecured irrevocable standby letter of
credit in the amount of $750 to the landlord of its corporate headquarters in
lieu of a security deposit.

As of December 31, 1996 and 1997, the Company had approximately $673 due to a
bank plus interest at 13%. The amount, included in accrued expenses and other,
was repaid in 1998.

The Company has an agreement with Progress Software Corporation ("Progress
Software") for the right to use certain of its software to enhance the
functionality of the Company's ACE/Server and Keon software. The agreement has
been amended several times. In order to obtain favorable pricing, the Company
has, from time to time, prepaid Progress Software royalties due under the
agreement. In the first quarter of 1997 the Company prepaid $2.5 million and in
1998 the Company prepaid an aggregate of $6.0 million in three installments. The
prepaid royalty is recorded as a component of cost of revenue as the related
products are sold. Unamortized prepaid royalties were $4.5 million at December
31, 1997 and $4.8 million at December 31, 1998. 


<PAGE>   29
                                                                              41


In connection with refinements of its product offering strategy, the Company
determined it will no longer actively market certain secure VPN and secure email
products obtained from third parties under license agreements. Fees prepaid
under the license agreements of $4.1 million were determined to have no future
value and were charged to cost of revenue in 1998.

The Company has a license for cryptographic communication technology and devices
from the Massachusetts Institute of Technology ("MIT") which granted, through
September 2000, an exclusive right to use, lease or sell technology, subject to
payment of royalties.

Royalty expense was $2,009 in 1996, $6,061 in 1997 and $6,235 in 1998.

As of April 14, 1996 and November 1, 1997, the Company entered into 
employment agreements with two of its executive officers, which require total 
annual minimum salaries of $500 and expire in July 1998 and November 1999, 
respectively. One of the agreements includes a post retirement benefit, to be 
paid by the Company for the executive. The Company is recognizing the present 
value of the benefit over the applicable service period.

During September 1998, the Company entered into Employment Agreements with
substantially all of the Company's management team, including most of the
Company's executive officers. The Board of Directors determined that such
Employment Agreements were necessary to effectively incent and retain key
management team members in a competitive employment marketplace. The Employment
Agreements generally provide for minimum annual salaries aggregating $1.9
million, and, among other things, that during the period commencing on
September 1, 1998 and ending on March 1, 2000, the Company may terminate the
employee only for nonperformance of his or her duties, or for cause, subject to
criteria and definitions set forth therein.

In the first quarter of 1999, the Company entered into an agreement with a
former officer, who is a director, for consulting services for a 2 year term at
$120 per year.

8. SEGMENT INFORMATION
The following is presented in accordance with SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information." This statement establishes
new standards for defining and disclosing information about a company's business
segments and requires a company to define its segments along its internal
structure and reporting methodology. The Company has identified only one
distinct and reportable segment: enterprise network and data security solutions.
The segment generates revenue from two distinct product lines: Enterpise
Solutions (which include sales of SecurID tokens, licensing of ACE/Server, Keon
(formerly known as BoKS), Kane Security Analyst and Kane Security Monitor and
RSA SecurPC software) and OEM Solutions (which include licensing of BSAFE,
TIPEM, SSL encryption engines and protocol products). The Company determined
that it has only one reportable segment meeting the criteria established under
SFAS No. 131. The Company's chief operating decision maker, as defined,
(determined to be the Chief Executive Officer and the President) and the Board
of Directors do not manage any part of the Company separately, and the
allocation of resources and assessment of performance is based solely on the
Company's consolidated operations and operating results. As there is only
segment, refer Note 1 for the significant accounting policies.

The Company's operations are conducted throughout the world. Operations in the
United States represent individually more than 10% of revenues or income from
operations. The Company's operations in other countries are individually
insignificant and have been included in "Rest of world" below. The following
table presents information about the Company's operating segments:
<TABLE>
<CAPTION>
                                               YEARS ENDED DECEMBER 31,
                                        ----------------------------------
PRODUCTS AND SERVICES                      1996        1997        1998
--------------------------------------------------------------------------
<S>                                     <C>         <C>          <C>      
Securid Tokens                          $ 34,826    $  57,028    $  72,328
Encryption Engine Licenses                16,781       30,765       38,205
Ace/Server Licenses                       16,297       26,378       34,344
Maintenance and Professional Services      5,729       10,468       14,573
Other Software, Hardware                  12,784       15,991       11,920
                                        ==================================
Total                                   $ 86,417   $  140,630    $ 171,334
                                        ==================================
</TABLE>

<TABLE>
<CAPTION>
GEOGRAPHIC AREAS
                                              YEARS ENDED DECEMBER 31,
                                        ----------------------------------
REVENUES                                  1996          1997        1998
--------------------------------------------------------------------------
<S>                                     <C>          <C>          <C>
United States                           $62,587      $ 97,162     $112,042
Rest of World                            23,830        43,468       59,292
                                        ----------------------------------
Total                                   $86,417      $140,630     $171,334
                                        ==================================
</TABLE>


<PAGE>   30
42

Notes to Consolidated Financial Statements
continued


9. LITIGATION
In September 1998, the Company granted options to purchase an aggregate of
325,000 shares of common stock in connection with the settlement of threatened
litigation arising out of the IDI Acquisition. The value of the options was
determined, using the Black-Scholes option-pricing model, to be $1,872, based on
an expected life of 2.5 years, a risk-free interest rate of 6% and expected
volatility of the underlying stock of 75%.

On December 11, 1998, a purported class action lawsuit was filed against the
Company and certain of its officers and directors in the United States District
Court for the District of Massachusetts. The plaintiff claims to represent all
purchasers of the Company's common stock during the period from September 30,
1997 through July 15, 1998, and seeks unspecified damages on their behalf. The
plaintiff alleges that the defendants misled the investing public concerning
demand for the Company's products, the strengths of its technologies, and
certain trends in the Company's business. The company is vigorously contesting
the suit and believes the plaintiff's allegations are without merit.

On November 2, 1998 the company commenced litigation in a patent infringement
lawsuit filed in the United States District court for the District of
Massachusetts against VASCO Data Security, Inc. ("VASCO"). The suit alleges that
VASCO's Digipass token products infringe certain of the Company's patents. The
company seeks monetary damages for such infringement and injunctive relief. In
connection with this litigation, VASCO has filed counterclaims against the
Company seeking a declaratory judgement of noninfringement and invalidation of
the Company's patents at issue and alleging that the Company's infringement suit
against VASCO represents a breach of contract between the parties.

On January 6, 1999, the Company commenced litigation in a patent infringement
lawsuit filed in the United States District Court for the District of
Massachusetts against VASCO. The suit alleges that VASCO's RSA cards and RSA
chips products infringe the RSA patent. The Company seeks monetary damages for
such infringement and injunctive relief. In connection with this litigation,
VASCO has filed counterclaims against the Company seeking a declaratory
judgement of non-infringement and invalidation of the patent at issue, and
alleging that the Company's suit against VASCO represents a violation of
antitrust laws.

The Company has been named as a defendant in other legal actions arising from
its normal business activities, none of which it believes could have a material
adverse effect on the Company or its business.

10. RELATED PARTY TRANSACTIONS
VERISIGN
The Company has a Master Development and License Agreement (the "Development
Agreement") and an RSA BSAFE /TIPEM OEM Master License Agreement (the "OEM
Agreement") with VeriSign (Note 3). Pursuant to the terms of the Development
Agreement, VeriSign developed certain technology for the Company in exchange for
an initial license fee of $2.7 million. In December 1998, the Company and
VeriSign amended the Development Agreement (the "Amendment") to appoint the
Company the exclusive distributor of VeriSign's certificate authority software.
The Amendment provides, among other things, that each year during the first five
years following the date of the Amendment, the Company may elect to retain its
exclusive status, subject to payment by the Company of certain prepaid license
fees each year during that five year period. In addition to $.5 million paid at
the execution of the agreement, prepaid license fees are due in minimum
quarterly installments and aggregate $1.1 million in 1999, $2.3 million in 2000,
$3.0 million in 2001, $4.0 million in 2002, and $4.0 million in 2003.

In December 1998, the Company and VeriSign also amended OEM Agreement to
provide, among other things, that VeriSign will execute RSA's support and
maintenance agreement in order to receive upgrades and updates to RSA's BSAFE
software.

From September 1996 to March 1998, the Company sublet its former headquarters in
Cambridge, Massachusetts, to VeriSign in exchange for lease payments from
VeriSign of $18 in 1996, $105 in 1997 and $81 in 1998. A Company director serves
as VeriSign's (Note 3) Chairman of the Board of Directors.

OTHER
A stockholder, who owns less than 5% of the Company's common stock, provides
consulting services to the Company and received $97 in 1996, $104 in 1997 and
$82 in 1998. The Company has approximately $25 payable on demand to a less than
5% stockholder as of December 31, 1997 and 1998.

<PAGE>   31
                                                                              43

11. COMPREHENSIVE INCOME
The Company adopted the provisions of SFAS No. 130, "Reporting Comprehensive
Income" effective January 1, 1998. Accumulated other comprehensive income was:

<TABLE>
<CAPTION>
                                                                 UNREALIZED
                                               FOREIGN          HOLDING GAIN     ACCUMULATED
                                               CURRENCY          (LOSS) ON          OTHER
                                              TRANSLATION        MARKETABLE     COMPREHENSIVE
ACCUMULATED OTHER COMPREHENSIVE INCOME        ADJUSTMENTS        SECURITIES         INCOME
---------------------------------------------------------------------------------------------
  <S>                                          <C>                 <C>             <C>
  Balance, January 1, 1997                     $   493             $3,480          $3,973
  Period change                                 (1,243)            (3,401)         (4,644)
                                               -------------------------------------------
  Balance, December 31, 1997                      (750)                79            (671)
  Period change                                   (425)               123            (302)
                                               -------------------------------------------
  Balance, December 31, 1998                   $(1,175)            $  202          $ (973)
                                               ===========================================
</TABLE>

<TABLE>
<CAPTION>
                                                           
                                                            YEARS ENDED DECEMBER 31,
UNREALIZED GAINS (LOSSES) ON MARKETABLE              -------------------------------------
SECURITIES, NET:                                        1996          1997         1998
------------------------------------------------------------------------------------------
<S>                                                   <C>           <C>            <C>
Unrealized holding gains (losses) arising
  during year, net of tax (expense) benefit                                               
  of ($329), $442 and ($82), respectively             $   572       $  (736)       $123
Less; reclassification adjustment for gains
  included in net income, net of tax (expense)
  benefit of $4,025, $1,599 and $0 respectively        (7,002)       (2,665)         --
Unrealized gains (losses) on marketable              -------------------------------------
  securities, net                                     $(6,430)      $(3,401)       $123
                                                     =====================================
</TABLE>

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12. SUBSEQUENT EVENTS (UNAUDITED)
In the first quarter of 1999, the Company commenced consolidation of certain
operations in order to promote operational efficiency. The Company expects to
incur costs, primarily severance and facilities exit costs, of between $5.0
million and $7.0 million in connection with this effort.

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