SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-KSB

                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
                       THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)
[X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act
    of 1934 [Fee  Required]

For the fiscal  year  ended  December  31,  1996 or [ ]

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 [No Fee Required]

For the transition period from _______________ to ________________

Commission File No. 33-86242


                             PROTOSOURCE CORPORATION
                  --------------------------------------------
                 (Name of Small Business Issuer in its Charter)


           California                                       77-0190772
---------------------------------------------           --------------------
(State or other jurisdiction of incorporation             (I.R.S. Employer 
or organization)                                        Identification Number)


2300 Tulare Street, Suite 210
Fresno, California                                              93721
---------------------------------------------             -------------------
(Address of principal executive offices)                      (Zip Code)



Issuer's telephone number:  (209) 490-8600

Securities registered pursuant to Section 12(b) of the Act:  None

Securities registered pursuant to Section 12(g) of the Act:


                            No Par Value Common Stock
                    Redeemable Common Stock Purchase Warrants
                                (Title of Class)



<PAGE>


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

     As of February 28, 1997,  7,730,001 shares of the Registrant's no par value
Common Stock were outstanding.  As of February 28, 1997, the market value of the
Registrant's no par value Common Stock, excluding shares held by affiliates, was
$1,692,870  based upon a closing bid price of $.21 per share of Common  Stock on
the Electronic Bulletin Board of the National Association of Securities Dealers,
Inc.

     Check if there is no disclosure  contained  herein of delinquent  filers in
response to Item 405 of Regulation  S-B, and will not be contained,  to the best
of the Registrant's  knowledge,  in definitive  proxy or information  statements
incorporated  by reference  in Part III of this Form 10-KSB or any  amendment to
this Form 10-KSB. [ X ]

     The Registrant's revenues for its most recent fiscal year were $697,581.

     The following  documents are incorporated by reference into Part III, Items
9 through 12 hereof: None.



                                        2

<PAGE>

                                     PART I

ITEM 1.  DESCRIPTION OF BUSINESS
-------  -----------------------

     The following is a summary of certain information  contained in this Report
and is  qualified  in its entirety by the  detailed  information  and  financial
statements that appear elsewhere herein.  The share information  included herein
does not reflect a one share for ten shares  reverse stock split approved by the
Company's   stockholders  on  February  28,  1997.  Except  for  the  historical
information  contained  herein,  the matters  set forth in this  Report  include
forward- looking  statements within the meaning of the "safe harbor"  provisions
of the Private Securities  Litigation Reform Act of 1995. These  forward-looking
statements are subject to risks and uncertainties  that may cause actual results
to differ materially.  These risks and uncertainties are detailed throughout the
Report and will be further discussed from time to time in the Company's periodic
reports filed with the Commission.  The  forward-looking  statements included in
the Report speak only as of the date hereof.

The Company

     Operating through its ProtoSource  Network ("PSNW")  division,  the Company
provides  Internet access and related  services to individuals,  public agencies
and businesses in five small Central California cities. As of December 31, 1996,
the Company had 2,500  subscribers  for whom it provided  Internet  access.  The
Company  intends to acquire  other  small  Internet  providers  in markets  with
populations of less than 500,000 that are located  initially in various  Central
California cities between Sacramento and Bakersfield.  The Company believes that
certain of these  local  Internet  providers  currently  doing  business  in the
Company's  target markets will not be able to  effectively  manage the financial
and administrative  burdens imposed by the continuing  consumer demand for local
Internet  services,  unless these  providers are  integrated  into larger,  more
diversified  Internet products and services  companies.  The Company's long-term
plan is to target a select number of such target  markets and increase  revenues
through  acquisition in such markets.  The Company is not negotiating to acquire
nor has it entered  into any  agreement  to acquire  any such  Internet  related
companies.

History

     From July 1988 until August 1996,  the  Company's  primary  business was to
design,  develop and market  software  programs  (and related  hardware) for the
agri-business  industry  including produce broker accounting  programs,  product
tracking  programs,  crop chemical usage reports,  crop cost and billing systems
and fruit  accounting  programs.  The programs were packaged under the Company's
"Classic" line of products and were divided by function,  sophistication and the
size of the customer into  "Classic"  (appropriate  for  customers  whose annual
sales are less than $10 million), "Classic Advantage" (appropriate for customers
whose  annual  sales are  between $10 million  and $100  million)  and  "Classic
Custom"  (appropriate  for  customers  whose annual sales exceed $100  million).
Prices  ranged from  $20,000 for a "Classic"  program to $200,000 for a "Classic
Custom" program. The Company also sold customized

                                        3

<PAGE>



computer  system  configurations  designed by it which  integrated  hardware and
software.  The Classic product line together with the Company's  design services
and  hardware  and software  sales is  collectively  referred to as the "Classic
Line."

     In February 1995, the Company  completed an initial public offering ("IPO")
of its  securities,  consisting  of the sale of  690,000  Units to the public at
$5.50 per Unit.  Each Unit consisted of one share of Common Stock and one common
stock purchase  warrant (the "Public  Warrants") to purchase an additional share
of  Common  Stock at $6.50  per  share  until  February  1998.  McClurg  Capital
Corporation,  the  Representative  of the  Underwriters  of the IPO (the  "Prior
Representative")  received warrants (the "Prior Representative's Unit Warrants")
to purchase 60,000 Units at $6.60 per Unit at any time until February 2000.

     In October 1996, the Company sold 6,000,000 shares of its Common Stock to a
group of investors for $.25 per share or a total of $1,500,000.  Included in the
$1,500,000 was the conversion of $200,000 of debt to equity which was originally
represented  by a bridge loan for which the Company issued 400,000 shares of its
Common Stock to the bridge lenders as additional  consideration for the $200,000
loan. The Company also issued a total of 4,400,000 Warrants  exercisable at $.25
per share in  connection  with the bridge  loan and the private  placement.  The
6,400,000  shares,  4,400,000  Warrants  and  4,400,000  shares  underlying  the
Warrants are being registered pursuant to a Registration  Statement on Form SB-2
filed with the Commission on January 26, 1997 (the "SB-2 Filing").

     In December 1996,  the Company sold the Classic Line to a Canadian  company
for $300,000 in cash and an unsecured  promissory note which the Company has not
valued on its financial  statements.  As a part of the transaction,  the Company
received an exclusive  worldwide  license  through  December  2006 to market the
Classic Line based upon a royalty of 16% of gross sales.  In January  1997,  the
Company sold the remaining  assets of the Classic Line  (including the worldwide
license  to market  the  Classic  Line) to SSC  Technologies,  Inc.  ("SSC"),  a
privately-held  company  owned 25% by the Company and 75% by other  stockholders
including four  individuals  who were  previously  officers and directors of the
Company (the "SCC Principals"). See "Item 12."



                                        4

<PAGE>

The Internet and the World Wide Web

     The  Internet is a worldwide  network  that links  thousands  of public and
private  computer  networks.  The  Internet  began in 1969 as a  project  of the
Advanced Research Projects Agency ("ARPA") of the U.S.  Department of Defense to
connect different types of computers across geographically  disparate areas. The
ARPA network was  designed to allow any  computer on the network to  communicate
with any other computer on the network through an open  communications  protocol
known as TCP/IP.

     Initially, use of the Internet was limited to governmental, educational and
commercial  organizations  with a working knowledge of the UNIX operating system
and commands,  and the primary use made of the Internet was the communication of
information via electronic mail.  However,  there has been a rapid growth in the
use and  popularity  of the  Internet in the past  several  years.  According to
industry  sources,  users in more than 130  countries  throughout  the world are
connected to the  Internet  including 24 million  users in North  America,  17.6
million of whom use the Web.

     The dramatic  growth in the number of Internet users is  attributable  to a
number of developments  and factors.  The first was the  introduction in 1992 of
the World Wide Web ("Web"),  a  client/server  system of hyperlinked  multimedia
databases  which began to unlock the potential of the Internet as a mass medium.
The Web,  developed by the European  Laboratory for Research Physics ("CERN") in
Switzerland, advanced the potential of the Internet in several significant ways.
First, it enabled full multimedia presentation (including text, graphics,  video
and audio) over the Internet.  Second,  through the Web's system of standardized
information  protocols and a  communications  format called  HyperText  Transfer
Protocol ("HTTP"),  users were allowed access to information ("navigate") on the
Web without  entering  complex  alphanumeric  commands.  Third,  using HyperText
Markup Language  ("HTML"),  document authors were able to link text or images in
one document to other documents anywhere else on the Web. When the user selected
or, if using a mouse,  clicked on the hypertext in one document (often displayed
on the  screen  as  highlighted  words  or  images),  the  linked  document  was
automatically accessed and displayed.

     The Web is based on a  client/server  system  in  which  certain  computers
("servers"), store information in files and respond to requests issued by remote
user computers to view or download files, thus allowing multiple, geographically
dispersed users to view and use the information  stored on a single server.  The
user must use  software,  known as a browser,  that can read HTML  documents and
follow their  hypertext  links to retrieve  and display  linked  documents  from
servers such as the Company.

     An early  limitation  to  growth of the Web was that the  browser  software
initially  provided by CERN was text-based and contained  limited  retrieval and
display  capabilities.  In January 1993, the National Center for  Supercomputing
Applications   ("NCSA")  at  the  University  of  Illinois  at  Urbana-Champaign
significantly  advanced the use of Web technology with the  introduction of NCSA
Mosaic for X Window on the UNIX platform, the first graphical user interface

                                        5

<PAGE>

browser for the Web. The NCSA Mosaic  graphical user  interface  allows users to
access the diverse information archives,  data protocols and data formats of the
Internet using  point-and-click,  mouse-driven  commands.  NCSA Mosaic, which is
offered to users on a free-  with-copyright  basis  (making it available for use
without  charge and without the right to  distribute),  served as a catalyst for
increased  use of the Web.  When NCSA  released  a version  of NCSA  Mosaic  for
Windows in September 1993, the Web became  accessible to personal computer users
for the first time.

     The  increased  popularity  of the  Internet  is also  attributable  to the
proliferation of information and services available on the Internet,  as well as
the expanded use of home personal computers,  which increasingly  contain modems
as a standard feature. Among the types of publications and information available
to  Internet  users  are  newspapers,  magazines,  weather  updates,  government
documents and industry newsletters,  as well as a variety of commercial products
and services such as the Internet Waterway.

     In order to support the  continued  growth and  popularity of the Internet,
certain infrastructure elements must expand to handle the resulting increases in
Internet  demand and traffic.  These elements  include  widespread,  inexpensive
Internet access, either through Internet access providers such as the Company or
on-line services,  and widely available  high-speed  communications  channels to
accommodate the increasing number and size of files available for downloading.

     As  business  organizations  have begun to  realize  the  potential  of the
Internet as an inexpensive and effective means of offering products and services
directly to customers  and  potential  customers,  businesses  are  increasingly
advertising  and selling  such  products  and  services on the Web. For example,
business  organizations are now using the Web to provide product information and
support to existing  customers,  to advertise products and services and to offer
products and services for sale by means of on-line catalogs.  It is this market,
as well as Internet access, that the Company seeks to address.  Industry sources
have  estimated,  based on  registered  Internet  addresses,  that the number of
commercial  organizations  as a percentage of total Internet users has increased
from  approximately 30% at the beginning of 1993 to approximately 60% at the end
of 1994.

     Computer users wishing to access the vast array of information and services
available  on the Web  use a  browser  that  can  read  HTML  documents,  follow
hypertext  links and interface  with the diverse  information  archives and data
formats of the Web. The basic needs of most  individual  computer users casually
browsing the Web can be fulfilled  by a number of different  browsers  available
today, including certain browsers that are available for no charge.

Strategy

     The  Company's  strategy is to provide low cost direct  Internet  access to
subscribers  by  acquiring  small  Internet  providers  in target  markets or by
establishing  its own  marketing  operations in such  markets.  Thereafter,  the
Company  will seek to generate  additional  revenues by (i)  increasing  monthly


                                        6

<PAGE>

Internet access fees, (ii) offering monthly  community  access  services,  (iii)
providing Internet consulting  services,  and (iv) generating  marketing service
fees charged to businesses seeking a Web site on the Internet.

     Increasing  Monthly  Internet  Access  Fees.  The Web is the driving  force
behind the growth in Internet  subscribers who use the Web to access information
as well as  commerce  and  communication.  The  Company  intends to  continue to
provide    low-priced    direct    Internet   access   through   the   Company's
telecommunication  network  infrastructure  which is comprised of two high speed
dedicated data lines that connect directly to the backbone of the Internet.  The
Company  plans  to add  additional  high-speed  dedicated  data  lines,  enhance
system-wide access software,  and expand the number of points of presence (POPs)
in local  markets in order to attract and  support  additional  subscribers.  By
increasing the number of POPs,  the Company will offer  Internet  access through
local phone calls and to more geographic  areas which in turn may promote growth
in its subscriber base.

     The Company also provides  Integrated  Services  Digital Network (ISDN) and
high-speed Internet access using dedicated data lines to business customers. The
Company believes that the demand for high-speed  Internet access and the ability
to integrate Internet access into a corporate-wide  computer network is becoming
increasingly more important.

     Offering Monthly Community Access Services. Local public agencies, (such as
city  agencies,  police  departments  and  libraries),  are  seeking  to provide
information  resources  directly to their citizens through  Community Web sites.
Believing that its  subscribers  will be willing to pay a recurring fee for such
community information access, the Company intends to offer such access in 1998.

     Providing  Internet  Consulting  Services.  The Company  provides  Internet
solutions  to  assist  businesses  and  their  employees,  including  consulting
services for network setup, Internet application implementation, Intranet design
and Web site implementation.

     Generating  Marketing Service Fees. The Company will continue to design and
develop Web sites for its clients  with  sophisticated  graphics to attract user
attention.  The Company also  provides all  necessary  hardware and software and
stores its clients' Web pages on its dedicated servers,  which are monitored and
maintained 24 hours a day, 365 days a year.

Acquisition Strategies

     The Company will seek to acquire  local  Internet  access  providers in its
Central California target markets. The criteria for such acquisition  candidates
calls for  attracting  companies  that (i) are located in markets  under 500,000
population;  (ii) have been in  business  a minimum  of one year;  (iii) have at
least 300 subscribers;  (iv) have current owners and staff with strong technical
backgrounds,  (v) enjoy  strong  community  contacts,  and (vi) offer  projected
annual  growth  rates in excess of 200%.  The  Company  may also seek to acquire
other small companies that provide consulting and related Internet services. The
Company is not  negotiating  to acquire nor has it entered into any agreement to
acquire any such Internet related companies.

                                        7

<PAGE>

Marketing

     The Company primarily markets to customers who are new to the Internet, and
who  seek to  access  information  using  point-and-click  graphical  interface.
Marketing is conducted  through a small sales force which  contacts  prospective
customers  responding to advertisements  in computer,  professional and business
publications.  The Company  also seeks  customers by  participating  in industry
trade  shows and  educational  seminars  and  through  referrals  from  existing
customers.  In  addition,  the  Company  seeks  strategic  alliances  with local
computer  retailers who offer Internet  access fee discounts to their  customers
and through joint  advertising  efforts with television and radio stations.  The
Company may also distribute Internet services through retail channels.

     Direct mailings,  telemarketing programs, co-marketing agreements and joint
promotional efforts among organizations and individual users are strategies that
the  Company  may employ in the future.  Finally,  the  Company  seeks to retain
business  customers  and  individual  users  through  what  it  perceives  to be
responsive customer support and services programs.

Competition

     The  Internet  services  business is highly  competitive  and there are few
significant barriers to entry. Currently,  the Company competes with a number of
national and local California Internet service providers.  In addition, a number
of multinational  corporations,  including giant communications carriers such as
AT&T, Cable and Wireless, MCI, Sprint and the regional Bell operating companies,
are  offering,  or have  announced  plans to offer,  Internet  access or on-line
services.  The  Company  also faces  significant  competition  from the  on-line
service firms such as America Online (AOL), CompuServe, Delphi, Genie, Microsoft
and  Prodigy.  The  Company  believes  that new  competitors  which may  include
computer software and services,  telephone, media, publishing,  cable television
and other companies, are likely to enter the on-line services market.

     The ability of some of the Company's  competitors to bundle Internet access
software with other popular  products and services could give those  competitors
an advantage  over the Company.  For example,  NETCOM,  MCI and PSI offer retail
software packages and AOL and Prodigy bundle their software with new PCs.

     Many of the Company's competitors possess financial resources significantly
greater than those of the Company and,  accordingly,  could initiate and support
prolonged  price   competition  to  gain  market  share.  If  significant  price
competition  were to develop,  the Company  might be forced to lower its prices,
possibly for a protracted period,  which would have a material adverse effect on
its  financial  condition  and  results of  operations  and could  threaten  its
economic viability.  In addition, the Company believes that the Internet service
and on-line services business  are  likely  to  consolidate  in the  future,

                                        8

<PAGE>

which could result in increased price and other  competition in the industry and
consequently  adversely  impact the Company.  A number of on-line  services have
recently  lowered  their monthly  service  fees,  which may cause the Company to
lower its monthly fees in order to compete.

     The Company  believes that the primary  competitive  factors among Internet
access  providers  are  price,  customer  support,  technical  expertise,  local
presence  in a  market,  ease  of  use,  variety  of  value-added  services  and
reliability.  The  Company  believes  it is able to compete  favorably  in these
areas. The Company's success in its markets will depend heavily upon its ability
to provide high quality Internet  connectivity and value-added Internet services
targeted in select target markets.  Other factors that will affect the Company's
success in these  markets  include the  Company's  continued  ability to attract
additional experienced marketing, sales and management talent, and the expansion
of support, training and field service capabilities.

Employees

     As of February 28, 1997, the Company employed 15 full-time individuals. The
Company  believes it maintains good  relations  with its employees.  None of the
Company's  employees are represented by a labor union or covered by a collective
bargaining agreement.

ITEM 2.  DESCRIPTION OF PROPERTY
-------  -----------------------

     In September  1994, the Company  acquired,  under a 20-year  non-cancelable
capital lease, an office building,  including land and improvements at 2580 West
Shaw, Fresno,  California 93711. The lease requires initial annual minimum lease
payments  lease payments of $188,000,  increasing  every five years to a maximum
annual payment of $338,000 in 2009.  Under the lease,  the Company has an option
at any time to purchase the building and land for  $1,800,000  through April 30,
1997. Such amount  increases to $1,900,000  through April 30, 1998.  After April
30, 1998, the option amount increases annually by the percentage increase in the
Consumers Price Index, as further  described in the lease.  Upon exercise of the
purchase option, the principal portion of the lease payments made by the Company
will be applied  toward the down  payment for the  purchase  price based upon an
amortized  20-year note with interest  accrued at 9% per annum.  The Company has
leased a portion  of the  building  to the SSC  Principals  based  upon  monthly
payments to the Company of $12,000  through  February 28, 1998. The Company also
receives lease payments from another tenant in the amount of $78,000 per year.

     The Company leases 4,000 square feet of space for its corporate offices and
PSNW facilities at 2300 Tulare Street, Suite 210, Fresno,  California 93721. The
lease is for five years, ending May 2002 and requires minimum annual payments of
$40,250 increasing every year to a maximum of $55,375 in 2002.




                                        9

<PAGE>



ITEM 3.  LEGAL PROCEEDINGS
-------  -----------------

     Not applicable.

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

     Not applicable.


                                       10

<PAGE>

                                     PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
-----------------------------------------------------------------

     The Company's  Common Stock traded on the NASDAQ Small Cap Market under the
symbol  "PSCO" from  February  9, 1995 until July 10, 1996 when it was  delisted
from NASDAQ and commenced  trading on the  Electronic  Bulletin  Board under the
symbol "PSCO."

     The following table sets forth for the quarters indicated the range of high
and low closing  prices of the Company's  Common Stock as reported by NASDAQ and
the Electronic  Bulletin  Board but does not include retail markup,  markdown or
commissions.

                                                                 Price
                                                             --------------
By Quarter Ended:                                            High      Low
-----------------                                            ----      ---

March 31, 1997 (through February 28, 1997)..............    $ .31      $ .21

December 31, 1996.......................................      .75        .21
September 30, 1996......................................     1.00        .56
June 30, 1996...........................................     1.75        .56
March 31, 1996..........................................     2.13        .94

December 31, 1995.......................................     2.50       1.75
September 30, 1995......................................     4.00       1.00
June 30, 1995...........................................     4.88       3.34
March 31, 1995..........................................     5.00       4.25

     As of February  28,  1997,  the Company  had  approximately  355 record and
beneficial stockholders.

Dividend Policy

     The Company has never paid cash  dividends  on its Common Stock and intends
to retain  earnings,  if any,  for use in the  operation  and  expansion  of its
business.  The amount of future  dividends,  if any,  will be  determined by the
Board of  Directors  based upon the  Company's  earnings,  financial  condition,
capital requirements and other conditions.



                                       11

<PAGE>



ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
------------------------------------------------------------------

Background

     Operating through its ProtoSource  Network ("PSNW")  division,  the Company
provides  Internet access and related  services to individuals,  public agencies
and businesses in five small Central California cities. As of December 31, 1996,
the Company had 2,500  subscribers  for whom it provided  Internet  access.  The
Company  intends to acquire  other  small  Internet  providers  in markets  with
populations of less than 500,000 that are located  initially in various  Central
California cities between Sacramento and Bakersfield.  The Company believes that
certain of these  local  Internet  providers  currently  doing  business  in the
Company's  target markets will not be able to  effectively  manage the financial
and administrative  burdens imposed by the continuing  consumer demand for local
Internet  services,  unless these  providers are  integrated  into larger,  more
diversified  Internet products and services  companies.  The Company's long-term
plan is to target a select number of such target  markets and increase  revenues
through  acquisition in such markets.  The Company is not negotiating to acquire
nor has it entered  into any  agreement  to acquire  any such  Internet  related
companies.

Results of Operations

Year Ended December 31, 1996 vs. Year Ended December 31, 1995

     Net Sales. For fiscal 1996, Internet services revenues were $697,581 versus
$100,901 in fiscal  1995,  which  represents  a 591%  increase  in revenue.  The
increases are attributed to increases in the number of Internet users  worldwide
and increased market penetration of the Company's  ProtoSource  Network ("PSNW")
division in the  central  California  area.  PSNW only  operated  from August to
December in 1995 versus a full year in 1996.  Management  believes that the PSNW
revenues will continue to increase as the Company increases the number of Points
of Presence ("POPS") to provide Internet services to more geographic areas.

     Operating  Expenses.  Operating  expenses  were  $1,121,773  in 1996 versus
$1,079,503 in 1995. The increased  operating  expense is the result of increased
depreciation  expenses,  additional  personnel expenses and legal and accounting
expenses  related to the  Company's  restructuring  and the  divestiture  of the
Classic Line. Management believes that the operating expenses will remain at the
same level or decrease as a result of reduced personnel and facilities  expenses
after the  Classic  Line  sale.  The  decreases  may be  somewhat  offset by the
increases in operating expenses as the PSNW grows.

     Operating  Loss. For fiscal 1996, the operating loss was $424,192  compared
to an operating  loss of $978,602 in 1995 which  represents a 56% decrease.  The
decrease  in the  operating  loss  in  1996  is  attributed  to the  significant
increases in Internet  services revenues by $596,680.  Management  believes that
operating  results will  improve as revenues  increase  and  operating  expenses
decrease.


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<PAGE>

     Interest,  Net.  Net  interest  expense for 1996 was  $268,721  compared to
$109,301 in 1995.  The increase in interest  expense is primarily  attributed to
additional  interest expense related to capital leases on computer equipment and
interest  expense  related to the building  which the Company  acquired  under a
20-year  capital  lease.  The net  interest  expense  is  further  increased  by
decreases in interest income in 1996.

     Financing  Costs.  Financing costs were $126,000 in 1996 which  represented
the  commission and expenses  related to 400,000 shares of the Company's  Common
Stock issued to the  investors as additional  compensation  for the Common Stock
Placement.  The Common Stock issued was valued at $.25 per share and resulted in
a financing expense of $100,000 to the Company.

Year Ended December 31, 1995 Compared to Year Ended December 31, 1994

     Net Sales. For fiscal 1995, net sales were $1,835,000  versus $1,831,000 in
fiscal 1994.  Software  product sales  increased by 95% from $145,000 in 1994 to
$283,000 in 1995.  Hardware  equipment sales decreased slightly from $984,000 in
1994 to $942,000 in 1995 due  primarily to decreases in prices in the PC product
lines.  Professional service fees decreased from $681,000 in 1994 to $610,000 in
1995 as a result of shifting programming resources from professional services to
packaged software development.  The lower than expected sales were primarily the
results of development  difficulties  encountered in the Classic  product lines.
The  significant  increases in software  product  sales can be attributed to the
acceptance of the new PC software  products prior to the  development  obstacles
encountered.  Management  believes that focusing in PC product  development will
increase the long-term profitability of the Company.

     Gross Profit. For fiscal 1995, gross profit was $395,000 versus $557,000 in
1994,  representing  a decrease of $162,000 or 29.1%.  As a percentage of sales,
gross profit declined to 21.5% in 1995 from 30.4% in 1994. The decrease in gross
profit is attributed to the increase in investment of software development which
increases  cost  of  product  sales  and  lower  gross  margin  for PC  hardware
equipment.  Management  believes  that the gross  margin will  improve  when the
software sales increase and software development costs decrease.

     Sales and Marketing.  Sales and marketing  expenses were $641,000 in fiscal
1995 versus $275,000 in 1994. The increases in sales and marketing expenses were
caused  by  increases  in sales  personnel  and  increases  in  advertising  and
marketing  for the  introduction  of the  Classic  product  lines.  The  Company
believes  that the sales and marketing  expenses will decrease to  approximately
15% of total revenues when software sales increase.

     Research and Development.  Research and development increased from $232,000
in 1994,  to $495,000 in 1996.  The  increase in  research  and  development  is
attributable  to an increase in the number of full-time  equivalent  programmers
involved in product  development  activities  from seven  programmers in 1994 to
fifteen programmers in 1995. Management believes that the investment in research
and development will give the Company  significant  competitive  advantages over
competitors and will increase long-term profitability of the Company. Management
expects that the Classic product will be completed in early 1996.

                                       13

<PAGE>

     General  and   Administrative.   General  and  administrative   costs  were
$1,080,000  in 1995  versus  $257,000  in 1994.  The  increase  in  general  and
administrative  costs is the result of moving into a larger building,  increases
in business transactions, increases of personnel and the significant increase in
the bad debts expenses resulted from the development difficulties that have been
resolved by the  research  and  development  team in the fall of 1995 which were
encountered in the development of the Classic product line in the second quarter
of 1995.

     Operating Loss. For fiscal 1995, the operating loss was $1,820,000 compared
to an operating loss of $208,000 in 1994. The increase in operating loss in 1995
is  attributed  to the  significant  increases  in research and  development  by
$263,000 to develop the Classic  product  lines for PC,  increases  in marketing
expenses  for the  introduction  of the new PC product  lines and  increases  in
general and administrative expenses resulting from the move to larger facilities
and  the  significant  increase  of bad  debt  expenses  due to the  development
obstacles encountered in the second quarter of 1995.

Liquidity and Capital Resources

     Historically the Company required funds  principally to finance  increasing
levels of trade  receivables  which were caused by  increasing  sales volume and
business  expansion.   Those  requirements  have  been  met  through  internally
generated  funds,  bridge loans and short-term  borrowings from a revolving bank
credit line.  Funding for  expansion of property and equipment has been provided
primarily by capital leases, operating leases and term loans.

     The Company's IPO generated  gross  proceeds of $3,795,000 and net proceeds
of  $3,415,500  to the Company in 1995.  The  Company's  Common Stock  Placement
generated  gross  proceeds of  $1,500,000  and net proceeds of  $1,275,199.  The
Company also received a capital  contribution of $154,792 from officers  through
forgiveness of previously accrued salaries.

     For the year ended  December 31,  1996,  the Company  purchased  $38,421 of
property and equipment and acquired  under capital lease $90,349 of property and
equipment.  The Company's  capitalized software development costs were $442,100.
The equipment acquired was primarily used to provide Internet services to PSWN's
customers.

     For the year ended  December 31,  1995,  the Company  acquired  $404,000 of
property and equipment and capitalized  software  development costs of $593,000.
Included  in these  transactions  were the  purchase  of  computer  and  related
teaching  equipment for the expansion of the Company's  computer center facility
and  acquisition of PSNW.  The assets  acquired by the Company are primarily for
Internet access, education and computer training purposes.

     In September 1994, the Company  acquired,  under a 20-year capital lease, a
20,000 square foot office building.  The Company occupies  approximately half of
the space as its corporate  offices and subleases the other half to unrelated

                                       14

<PAGE>

third parties. The capitalized costs for the land, building and improvements was
$1,760,000.  The capital lease payments for the land,  building and improvements
was $1,760,000. The capital lease payments for the building will increase annual
cash outflows by approximately $60,000 through 2014, net of sublease income.

     At December  31,  1996,  the Company  had working  capital of $99,982.  The
limited  working  capital  may  restrict  the  ability of the Company to acquire
additional  financing.  The inability to obtain sufficient  financing to support
the  Company's  planned  growth  would have a negative  impact on its results of
operations.

     The Company  used net  proceeds  from the Common  Stock  Placement to repay
short-term  debt  and  used  additional  proceeds  to  sell  the  Classic  Line,
MarketStreet and computer training divisions.  The Company also used proceeds to
acquire  additional  equipment  for PSNW in order to expand  its  capacity.  The
Company will use the remaining  proceeds for  marketing and working  capital for
the operation of PSNW division.

     In December 1996,  the Company sold the Classic Line to a Canadian  company
for $300,000 in cash and an unsecured  promissory note which the Company has not
valued on its financial  statements.  As a part of the transaction,  the Company
received an exclusive  worldwide  license  through  December  2006 to market the
Classic Line based upon a royalty of 16% of gross sales.  In January  1997,  the
Company sold the remaining  assets of the Classic Line  (including the worldwide
license  to market  the  Classic  Line) to SSC  Technologies,  Inc.  ("SSC"),  a
privately-held  company  owned 25% by the Company and 75% by other  stockholders
including four  individuals  who were  previously  officers and directors of the
Company (the "SCC Principals"). See "Item 12."



                                       15

<PAGE>



ITEM 7.  FINANCIAL STATEMENTS
-----------------------------























                                       16
<PAGE>



                             PROTOSOURCE CORPORATION


                          INDEX TO FINANCIAL STATEMENTS



Financial Statements                                                   Page
--------------------                                                   ----

 Independent Auditors' Report                                           F-2

 Balance Sheet as of December 31, 1996                                  F-3

 Statements of Operations for the Years Ended
  December 31, 1996 and 1995                                            F-5

 Statements Of Changes in Shareholders' Equity
  for the Years Ended December 31, 1996 and 1995                        F-6

 Statements Of Cash Flows for the Years Ended
  December 31, 1996 and 1995                                            F-7

 Notes To Financial Statements                                          F-9




















                                       F-1


<PAGE>

                          INDEPENDENT AUDITORS' REPORT


To the Board of Directors
ProtoSource Corporation


We have audited the accompanying balance sheet of ProtoSource  Corporation as of
December  31,  1996  and  the  related  statements  of  operations,  changes  in
shareholders'  equity and cash flows for the years ended  December  31, 1996 and
1995.  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.

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 financial  statements  referred to above present fairly, in
all material respects,  the financial position of ProtoSource  Corporation as of
December 31, 1996 and the results of its  operations  and its cash flows for the
years ended  December 31, 1996 and 1995 in conformity  with  generally  accepted
accounting principles.


                                                  /S/  ANGELL & DEERING
                                                  -----------------------------
                                                  Angell & Deering
                                                  Certified Public Accountants

Denver, Colorado
February 28, 1997






                                       F-2


<PAGE>
                             PROTOSOURCE CORPORATION
                                  BALANCE SHEET
                                DECEMBER 31, 1996



                                     ASSETS
                                     ------

Current Assets:
  Cash and cash equivalents                                      $  482,357
  Accounts receivable:
   Trade                                                             29,156
   Employees and other                                               21,397
  Inventories                                                         8,980
  Prepaid expenses and other                                         14,587
  Current portion of note receivable                                 47,285
                                                                 ----------

          Total Current Assets                                      603,762
                                                                 ----------

Property and Equipment, at cost:
  Land                                                              411,176
  Building and improvements                                       1,381,816
  Equipment                                                         680,377
  Furniture                                                         104,375
  Vehicles                                                           10,090
                                                                 ----------
                                                                  2,587,834
  Less accumulated depreciation and amortization                    486,441
                                                                 ----------

         Net Property and Equipment                               2,101,393
                                                                 ----------

Other Assets:
  Goodwill, net of accumulated amortization
   of $2,006                                                         19,239
  Deferred tax assets                                                71,550
  Note receivable, net of current portion above                     723,565
  Deposits and other assets                                          42,346
                                                                 ----------

         Total Other Assets                                         856,700
                                                                 ----------

         Total Assets                                            $3,561,855
                                                                 ==========









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

                                       F-3


<PAGE>
                             PROTOSOURCE CORPORATION
                                  BALANCE SHEET
                                DECEMBER 31, 1996



                      LIABILITIES AND SHAREHOLDERS' EQUITY
                      ------------------------------------

Current Liabilities:
  Accounts payable                                               $   195,694
  Accrued liabilities                                                267,228
  Customer deposits                                                    1,500
  Current portion of long-term debt                                   39,358
                                                                 -----------

         Total Current Liabilities                                   503,780
                                                                 -----------

Long-Term Debt, net of current portion above:
  Bank                                                                 2,220
  Obligations under capital leases                                 1,852,083
  Less current portion above                                         (39,358)
                                                                 -----------

         Total Long-Term Debt                                      1,814,945
                                                                 -----------
Commitments and contingencies                                             --

Shareholders' Equity:
  Preferred stock, no par value; 5,000,000
   shares authorized, none issued and
   outstanding                                                            --
  Common stock, no par value; 10,000,000
   shares authorized, 773,000 shares issued
   and outstanding                                                 4,839,485
  Accumulated deficit                                             (3,596,355)
                                                                 -----------

         Total Shareholders' Equity                                1,243,130
                                                                 -----------

         Total Liabilities and Shareholders'
          Equity                                                 $ 3,561,855
                                                                 ===========









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

                                       F-4


<PAGE>
<TABLE>
<CAPTION>
                                     PROTOSOURCE CORPORATION
                                    STATEMENTS OF OPERATIONS
                          FOR THE YEARS ENDED DECEMBER 31, 1996 and 1995



                                                     1996                        1995
                                                     ----                        ----
<S>                                               <C>                          <C>  
Net Revenues:
  Internet service fees                          $   697,581                 $   100,901
                                                  -----------                 -----------

         Total Revenues                               697,581                     100,901
                                                  -----------                 -----------

Operating expenses                                  1,121,773                   1,079,503
                                                  -----------                 -----------

         Operating Loss                              (424,192)                   (978,602)
                                                  -----------                 -----------

Other Income (Expense):
  Interest income                                       3,507                      50,891
  Interest expense                                   (272,228)                   (160,192)
  Financing costs                                    (126,000)                         --
  Rent income                                         146,122                     124,356
  Other, net                                               --                     (10,231)
                                                  -----------                 -----------

         Total Other Income (Expense)                (248,599)                      4,824
                                                  -----------                 -----------
Loss From Continuing Operations
 Before Provision For Income Taxes                   (672,791)                   (973,778)

Provision for income taxes                                 --                         800
                                                  -----------                 -----------

Loss From Continuing Operations                      (672,791)                   (974,578)
                                                  -----------                 ------------

Discontinued Operations:
  Loss from discontinued
   operations (Note 2)                               (532,663)                   (841,707)
  Loss on disposal (Note 2)                          (204,346)                         --
                                                  -----------                 -----------

         Loss From Discontinued
          Operations                                 (737,009)                   (841,707)
                                                  -----------                 -----------

Net Loss                                          $(1,409,800)                $(1,816,285)
                                                  ===========                 ===========

Net Loss Per Share of Common Stock:
  Loss from continuing operations                 $     (2.46)                $     (7.88)
  Discontinued operations                               (2.70)                      (6.81)
                                                  -----------                 -----------

  Net Loss                                        $     (5.16)                $    (14.69)
                                                  ===========                 ===========

Weighted Average Number of
 Common Shares Outstanding                            273,055                     123,659
                                                  ===========                 ===========
</TABLE>







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

                                              F-5


<PAGE>
<TABLE>
<CAPTION>

                                              PROTOSOURCE CORPORATION
                                        STATEMENTS OF SHAREHOLDERS' EQUITY
                                  FOR THE YEARS ENDED DECEMBER 31, 1996 and 1995

                                                      Series A
                                                   Preferred Stock               Common Stock        
                                                   ---------------               ------------        Accumulated
                                                Shares         Amount      Shares        Amount        Deficit
                                                ------         ------      ------        ------        -------

<S>                                            <C>               <C>        <C>       <C>            <C>        
Balance at December 31, 1994                   900,000           $ --       64,000    $  303,595     $ (370,270)

Issuance of common stock and warrants
 in public offering (net of offering
 costs of $808,476)                                 --             --       69,000     2,986,524             --

Contribution of shares to the Company
 by officers and directors for issuance
 in connection with an acquisition                  --             --           --        19,375             --

Net loss                                            --             --           --            --     (1,816,285)
                                              --------           ----      -------    ----------    -----------

Balance at December 31, 1995                   900,000             --      133,000     3,309,494     (2,186,555)

Contribution of capital by officers
 through forgiveness of previously
 accrued salaries                                   --             --           --       154,792             --

Issuance of common stock in
 connection with bridge loans                       --             --       40,000       100,000             --

Issuance of common stock in private
 offering (net of offering costs of
 $224,801)                                          --             --      600,000     1,275,199             --

Cancellation of Preferred Stock in
 connection with divestiture of assets        (900,000)            --           --            --             --

Net loss                                            --             --           --            --     (1,409,800)
                                              --------           ----      -------    ----------    -----------

Balance at December 31, 1996                        --           $ --      773,000    $4,839,485    $(3,596,355)
                                              ========           ====      =======    ==========    ===========




</TABLE>










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

                                                      F-6


<PAGE>
<TABLE>
<CAPTION>
                                   PROTOSOURCE CORPORATION
                                  STATEMENTS OF CASH FLOWS
                       FOR THE YEARS ENDED DECEMBER 31, 1996 and 1995

                                                              1996                 1995
                                                              ----                 ----
<S>                                                        <C>                   <C>  
  Cash Flows From Operating Activities:
    Net loss                                              $(1,409,800)         $(1,816,285)
    Adjustments to reconcile net
     loss to net cash used by
     operating activities:
      Depreciation and amortization                           367,049              584,810
      Provision for bad debts                                      --              508,187
      Assets and liabilities disposed of
       in divestiture and note receivable
       received                                                17,176                   --
      Gain on disposal of equipment                            (4,607)                  --
      Issuance of common stock for
       costs of financing                                     100,000                   --
      Changes in operating assets
       and liabilities:
       Accounts receivable                                    163,556             (499,436)
       Inventories                                              7,079               (4,625)
       Deposits and other assets                               15,441              (18,814)
       Accounts payable                                        32,536             (150,623)
       Accrued liabilities                                    344,284              (10,618)
       Customer deposits                                       (4,000)             (12,213)
       Unearned customer support revenue                      (34,542)              (5,286)
                                                          -----------          -----------

             Net Cash (Used) By Operating
              Activities                                     (405,828)          (1,424,903)
                                                          -----------          -----------

  Cash Flows From Investing Activities:
    Purchases of property and equipment                       (38,421)            (403,591)
    Proceeds from disposal of equipment                        10,536                   --
    Software development costs capitalized                   (442,100)            (592,754)
    Receivable from shareholders                                   --              (35,000)
                                                          -----------          ------------


             Net Cash (Used) By Investing
              Activities                                     (469,985)          (1,031,345)
                                                          -----------          -----------

  Cash Flows From Financing Activities:
    Payments on notes payable                                 (55,675)            (625,998)
    Proceeds from borrowing                                   200,000               20,000
    Issuance of common stock                                1,300,000            3,795,000
    Offering costs incurred                                  (224,801)            (619,990)
                                                          -----------          -----------

             Net Cash Provided By Financing
              Activities                                    1,219,524            2,569,012
                                                          -----------          -----------



</TABLE>



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

                                       F-7


<PAGE>
<TABLE>
<CAPTION>

                             PROTOSOURCE CORPORATION
                            STATEMENTS OF CASH FLOWS
                 FOR THE YEARS ENDED DECEMBER 31, 1996 and 1995



                                                           1996               1995
                                                           ----               ----
          <S>                                             <C>                 <C>   
            Net Increase in Cash and
             Cash Equivalents                             $343,711           $112,764

            Cash and Cash Equivalents at
             Beginning of Year                             138,646             25,882
                                                          --------           --------

            Cash and Cash Equivalents at
             End of Year                                  $482,357           $138,646
                                                          ========           ========


  Supplemental Disclosure of
   Cash Flow Information:
    Cash paid during the year for:
     Interest                                             $272,228           $174,251
     Income taxes                                               --                800

  Supplemental Disclosure of Noncash
   Investing and Financing Activities:
    Acquisition of equipment
     under capital leases                                 $ 90,349           $118,701
    Common stock contributed by
     stockholders for issuance in
     acquisition by the Company                                 --             19,375
    Conversion of account payable to a
     note payable                                           32,000                 --
    Capital contribution by officers
     through forgiveness of previously
     accrued salaries                                      154,792                 --
    Conversion of note payable into
     common stock                                          200,000                 --

</TABLE>









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

                                            F-8


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies
---------------------------------------------
     Description of Business
     -----------------------
     ProtoSource  Corporation,  formerly  SHR  Corporation,  doing  business  as
     Software  Solutions  Company (the  "Company"),  was incorporated on July 1,
     1988, under the laws of the state of California. The Company is an Internet
     services provider.

     Reclassifications
     -----------------
     The former software development,  MarketStreet and computer training center
     divisions are  presented as  discontinued  operations  in  accordance  with
     Accounting  Principles  Board  (APB)  Opinion  No.  30 (Note  2).  The 1995
     operations and per share  information have been reclassified to present the
     operations of the three divisions as discontinued operations also.

     Stock Split
     -----------
     On February  28,  1997,  the  Company's  shareholders  adopted a resolution
     approving a one for ten reverse  stock split of the issued and  outstanding
     common shares, effective April 2, 1997. All share information and per share
     data have been retroactively  restated for all periods presented to reflect
     the reverse stock split.

     Revenue Recognition
     -------------------
     Product  sales  represent  sales  of  application  software  to end  users.
     Equipment  sales  represent  sales of  computer  and  peripheral  equipment
     bundled with the Company's  software.  Professional  service fees represent
     revenue from custom  programming,  post  contract  customer  support  (PCS)
     agreements and training and installation related services.  Fees associated
     with insignificant  vendor  obligations  related to installation of systems
     are deferred and recognized upon  completion of  performance.  Other income
     represents  primarily sales of promotional  brochures,  marketing materials
     and sales of miscellaneous equipment and supplies.

     Revenue from product  sales is  recognized  upon  delivery to the customer,
     provided  that  no  significant  vendor  or  PCS  obligations  remain,  and
     collection of the related  receivable is deemed probable.  Revenue from PCS
     agreements is recognized  on a  straight-line  basis over the period of the
     PCS agreement.

     Revenue from the Internet  operations  are  recognized  as the customers is
     billed for the monthly access fees.

     Cash and Cash Equivalents
     -------------------------
     For purposes of the  statements  of cash flows,  the Company  considers all
     highly  liquid  investments  with a maturity of three  months or less to be
     cash equivalents.

     Inventories
     -----------
     Inventories, consisting of computer equipment and supplies held for resale,
     are  stated at the  lower of cost  (determined  on the first in,  first out
     method) or market.

                                       F-9


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies (Continued)
---------------------------------------------------------
     Property and Equipment
     ----------------------
     Depreciation  and  amortization  of  equipment,  furniture and vehicles are
     computed  using the  straight-line  method over  estimated  useful lives of
     three  to  seven  years.  Assets  held  under  capital  lease  obligations,
     exclusive of land, are amortized  using the  straight-line  method over the
     shorter  of the  useful  lives  of the  assets  or the  term of the  lease.
     Depreciation  of property and equipment  charged to operations was $233,201
     and $171,695 for the years ended December 31, 1996 and 1995, respectively.

     Goodwill
     --------
     Goodwill  is  being  amortized  using  the  straight-line  method  over  an
     estimated useful life of 15 years.

     Investment
     ----------
     The Company has a 25% ownership interest in SSC Technologies, Inc. ("SSC").
     The Company received the equity interest in connection with the divestiture
     of three  operating  divisions  of the  Company  (Note 2).  The cost of its
     investment  is $--,  and since the  Company  does not have the  ability  to
     exercise  influence  over  operating  and  financial  policies of SSC,  the
     Company is accounting  for its  investment in SSC utilizing the cost method
     of  accounting.  Under the cost  method,  net  accumulated  earnings  of an
     investee  subsequent  to the  date  of  investment  are  recognized  by the
     investor  only to the extent  distributed  by the  investee  as  dividends.
     Dividends  received  in  excess  of  earnings  subsequent  to the  date  of
     investment  are  considered  a return of  investment  and are  recorded  as
     reductions of cost of the investment.

     Software Development Costs
     --------------------------
     Software  development  costs are capitalized with respect to those products
     for which  technological  feasibility (as defined in Statement of Financial
     Accounting Standards No. 86) has been established.  Capitalized amounts are
     reported at the lower of unamortized  cost or net realizable  value.  These
     costs are amortized into cost of goods sold on a product-by-product  basis.
     The annual amortization expense is the greater of the amount computed using
     the ratio of  current  revenue  to the total  anticipated  revenue  for the
     product or the straight-line  method over the estimated life of the product
     starting  when the product is available  for general  release to customers.
     Generally,  the Company  amortizes  these costs over three years.  Software
     development  costs  capitalized  relate primarily to product  enhancements.
     Amortization expense for capitalized software was $132,254 and $412,258 for
     the years ended December 31, 1996 and 1995, respectively.

     Deferred Offering Costs
     -----------------------
     In connection  with the Company's  public offering (Note 6), costs incurred
     to complete the  offering  have been  deferred and were offset  against the
     proceeds of the offering.

                                      F-10


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies (Continued)
---------------------------------------------------------
     Stock-Based Compensation
     ------------------------
     During the year ended December 31, 1996, the Company  adopted  Statement of
     Financial  Accounting Standard (SFAS) No. 123,  "Accounting for Stock-Based
     Compensation".  The Company will continue to measure  compensation  expense
     for its stock-based  employee  compensation plans using the intrinsic value
     method  prescribed by APB Opinion No. 25,  "Accounting  for Stock Issued to
     Employees". See Note 8 for pro forma disclosures of net income and earnings
     per share as if the fair value-  based  method  prescribed  by SFAS 123 had
     been applied in measuring compensation expense.

     Income Taxes
     ------------
     The Company adopted  Statement of Financial  Accounting  Standards No. 109,
     "Accounting  for Income  Taxes,"  in 1992.  Under the  statement,  deferred
     income taxes are provided for temporary  differences  between the financial
     reporting  and tax bases of assets and  liabilities  using enacted tax laws
     and rates for the years when the differences are expected to reverse.

     NetIncome (Loss) Per Share of Common Stock
     ------------------------------------------
     Net  income  (loss) per share of common  stock is based  upon the  weighted
     average  number  of shares of common  stock and  common  stock  equivalents
     outstanding  during  the  year.  Common  stock  equivalents  represent  the
     dilutive  effect of the  assumed  exercise  of  certain  outstanding  stock
     options and warrants.

     Estimates
     ---------
     The  preparation of the Company's  financial  statements in conformity with
     generally accepted accounting  principles requires the Company's 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 amount of revenues
     and expenses during the reporting period.  Actual results could differ from
     those estimates.

2. Discontinued Operations
--------------------------
     In  1996,  the  Company  retained  the  Kriegsman  Group  ("Kriegsman"),  a
     financial  consulting firm, to assist it with a financial  restructuring of
     its operations.  In connection with the financial restructuring the Company
     divested the software development,  MarketStreet (advertising division) and
     the computer training center  divisions.  The divisions were to be spun-off
     to a new Company owned by the former  management  of the Company  effective
     August 31, 1996. The closing for the  divestiture  occurred on December 31,
     1996. All of the assets of the three divisions and the related  liabilities
     and  facilities  leases were  assumed by the former  management  and a note
     payable was issued by the former management to the Company in the amount of
     $770,850 (Note 9). Also included in the assets of the divested divisions

                                      F-11


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


2. Discontinued Operations (Continued)
--------------------------------------
     was $500,000 in cash less approximately  $200,000 in liabilities which were
     paid by the Company which resulted in  approximately  $300,000 in cash paid
     to the divested  divisions.  The management of the divested  divisions also
     assumed all litigation  and claims related to the divisions  which includes
     one law suit in the amount of  approximately  $70,000.  The Kriegsman Group
     also  nominated new members for the Board of Directors  upon  completion of
     the divestiture of the three divisions which were approved in January 1997.
     The Company  received a 25%  ownership  interest in the common stock of the
     new  company  formed to acquire the  divested  divisions  and the  divested
     divisions will lease the principal  office from the Company for a period of
     eighteen months at the current market rate.

     Kriegsman was to use its best efforts to provide a minimum of $1,500,000 of
     financing  for the Company  through  bridge loans or equity  financing.  In
     August  1996,  a bridge  loan of $200,000  was  obtained by the Company for
     which the  Company  issued  400,000  shares of common  stock to the  bridge
     lenders as additional  consideration  for the $200,000 loan. In October and
     November 1996 the Company sold 600,000  shares of its common stock at $2.50
     per share  through an  Underwriter,  which  included the  conversion of the
     $200,000 bridge loan into common stock.  The Company paid the Underwriter a
     10% sales  commission  and a 3%  nonaccountable  expense  allowance  on the
     bridge loan and sale of common  stock.  The Company also entered into a two
     year financial consulting agreement with the Underwriter which provides for
     a monthly consulting fee of $5,000 for the two year period.

     As a part of the  financing  transaction,  the  Company  granted  both  the
     Underwriter and Kriegsman  warrants to purchase  common stock.  The Company
     granted  220,000  warrants to each which are exercisable at $2.50 per share
     for a four year period through October 31, 2001. The Company also agreed to
     use its best efforts to file a Registration Statement within 90 days of the
     closing of the  Private  Placement  to  register  the shares  issued in the
     Private  Placement  and the shares  underlying  the warrants  issued to the
     Underwriter and Kriegsman.

     Revenues applicable to the Company's discontinued  operations were $540,112
     and   $1,734,605   for  the  years  ended   December  31,  1996  and  1995,
     respectively.

3. Long-Term Debt
-----------------
     Long-term debt consists of the following:

     Bank
     ----

     10.5%  installment  note  due  in  1997  with
     monthly  principal  and interest  payments of
     $328, collateralized by an automobile.                      $    2,220



                                      F-12


<PAGE>

                            PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


3. Long-Term Debt (Continued)
-----------------------------
     Obligations Under Capital Leases
     --------------------------------

     5.7% to 25.1%  installment  notes due in 1997
     to 2001, collateralized by equipment.                         193,146

     13% capital  lease for building and land with
     a 20 year lease term, with monthly  principal
     and  interest  payments  of  $15,634  for the
     first five  years,  $19,021 for the next five
     years,  $23,142  for the next five  years and
     $28,156  for  the  next  five  years  with an
     escalating purchase option (Note 7).                       1,658,937
                                                              -----------

       Total Long-Term Debt                                     1,854,303
       Less current portion of long-term debt                     (39,358)
                                                              -----------

       Long-Term Debt                                          $1,814,945
                                                               ==========

     Installments  due on debt  principal,  including  the  capital  leases,  at
     December 31, 1996 are as follows:

                 Year Ending
                 December 31,        
                 ------------        
                    1997                                 $   39,358
                    1998                                     26,058
                    1999                                     16,325
                    2000                                     42,101
                    2001                                     10,591
                    Later years                           1,719,870
                                                         ----------

                       Total                             $1,854,303
                                                         ==========
                                                         

4. Income Taxes
---------------
     The components of the provision for income taxes are as follows:  

                                                  1996              1995
                                                  ----              ----
     Current:  
        Federal                                  $     --          $     -- 
        State                                          --               800 
                                                 --------          -------- 
          Total                                        --               800
                                                 --------          --------

     Deferred:
         Federal                                       --                --
         State                                         --                --
                                                 --------          --------
           Total                                       --                --
                                                 --------          --------

     Total Provision For Income Taxes            $     --          $    800
                                                 ========          ========


     The  provision  for  income  taxes  reconciles  to the amount  computed  by
     applying the federal  statutory  rate to income  before the  provision  for
     income taxes as follows:





                                      F-13


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


4. Income Taxes (Continued)
---------------------------
                                                   1996            1995
                                                   ----            ----

     Federal statutory rate                         (25)%           (25)%
     State franchise taxes,
      net of federal benefits                        (4)             (4)
     Valuation allowance                             29              29
                                                 ------          ------

                 Total                               -- %            -- %
                                                 ======         =======

     Significant components of deferred income taxes as of December 31, 1996 are
     as follows:

       Net operating loss carryforward                 $1,051,240
       Vacation accrual                                     2,070
                                                       ----------

       Total deferred tax asset                         1,053,310
                                                       ----------

       Accelerated depreciation                           (43,540)
       State income taxes                                  (1,520)
                                                       ----------

       Total deferred tax liability                       (45,060)
       Less valuation allowance                          (936,700)
                                                       ----------

       Net Deferred Tax Asset                          $   71,550
                                                       ==========

     The Company  has  assessed  its past  earnings  history  and trends,  sales
     backlog,  budgeted sales,  and expiration  dates of  carryforwards  and has
     determined  that it is more  likely than not that  $71,550 of deferred  tax
     assets will be realized.  The remaining  valuation allowance of $936,700 is
     maintained  on deferred tax assets which the Company has not  determined to
     be more  likely  than not  realizable  at this time.  The net change in the
     valuation  allowance  for  deferred tax assets was an increase of $406,760.
     The Company will continue to review this valuation on a quarterly basis and
     make adjustments as appropriate.

     At December 31, 1996,  the Company had federal and California net operating
     loss   carryforwards   of   approximately    $3,900,000   and   $1,900,000,
     respectively.  Such carryforwards expire in the years 2007 through 2011 and
     1997 through 2001 for federal and California purposes, respectively.

5. Acquisitions
---------------

     In July 1995, the Company purchased,  from an unrelated  individual certain
     assets of ValleyNet  Communications,  an Internet  services  provider.  The
     purchase  price was $50,000 in cash and 500 shares of the Company's  common
     stock.  The  common  stock was  issued  by the  Company's  shareholders  in
     accordance  with  their  agreement  to use  certain of their  shares  owned
     individually  in connection  with future  acquisitions of the Company (Note
     9). The assets  acquired  consists of computer  hardware and software,  and
     goodwill of $21,245 was recorded in connection  with the  acquisition.  The
     goodwill is being amortized over a fifteen year useful life. 

                                      F-14


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


6. Shareholders' Equity
-----------------------
     Incentive Stock Option Plan
     ---------------------------
     In November  1994,  the  Company's  Board of Directors  authorized  and the
     shareholders  approved, a stock option plan which provides for the grant of
     incentive and nonqualified  options to eligible  officers and key employees
     of the  Company to purchase up to 150,000  shares of the  Company's  common
     stock.  The  purchase  price of such shares  shall be at least equal to the
     fair market value at the date of grant. Such options vest at the discretion
     of the Board of Directors,  generally  over a four-year  period.  The stock
     option plan expires in 2004.  As of December 31, 1996, no options have been
     granted under the Plan.

     Preferred Stock
     ---------------

     In December  1994,  the Company  issued to six  individuals,  including the
     Company's five executive officers, for no consideration, a total of 900,000
     shares of Series A Convertible  Preferred Stock, no par value.  Such shares
     are  automatically  convertible,  in  varying  amounts  per  year,  into an
     equivalent number of shares of common stock through 2003 if certain revenue
     and net income milestones are met as follows:

          (i) an  aggregate  of 9,375  shares of Series A  Preferred  Stock will
          convert to common stock if the Company  reports gross annual  revenues
          of at least  $9,600,000  and  annual  after tax  earnings  of at least
          $1,550,000   for  the  calendar  year  ended  December  31,  1996,  an
          additional  9,375  shares per year will  convert to common  stock from
          1997 to 2002, and 121,875 shares in 2003 if the company  reports gross
          annual revenues of at least $9,600,000,  and annual after tax earnings
          of at least $1,550,000 for calendar years 1997 through 2003.

          (ii) an  aggregate  of 9,375  shares of Series A Preferred  Stock will
          convert to common stock if the Company  reports gross annual  revenues
          of at least  $15,500,000  and annual  after tax  earnings  of at least
          $3,000,000  for  the  calendar  year  ending  December  31,  1997,  an
          additional  9,375  shares per year will  convert to common  stock from
          1998 to 2002, and 131,250 shares in 2003 if the Company  reports gross
          annual revenues of at least $15,500,000, and annual after tax earnings
          of at least $3,000,000 for calendar years 1998 through 2003.

          (iii) An aggregate of 15,000  shares of Series A Preferred  Stock will
          convert to common stock if the Company  reports gross annual  revenues
          of at least  $23,800,000  and annual  after tax  earnings  of at least
          $5,100,000  for  the  calendar  year  ending  December  31,  1998,  an
          additional  5,000  shares per year will  convert to common  stock from
          1999 to 2002, and 225,000 shares in 2003 if the Company  reports gross
          annual revenues of at least $23,800,000, and annual after tax earnings
          of at least $5,100,000 for calendar years 1999 through 2003.

                                      F-15


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


6. Shareholders' Equity (Continued)
-----------------------------------
     Preferred Stock (Continued)
     ---------------------------

     The fair market value of the common stock  issued upon  conversion  will be
     charged to  operations  at that time.  Any  preferred  shares not converted
     during such period will be  canceled.  If, prior to January 1, 1999 (i) the
     Company consolidates with or merges into another corporation or entity (and
     the  Company  is not  the  survivor)  or if the  Company  sells  or  leases
     substantially  all of  its  assets  and  the  Company's  common  stock  has
     appreciated an average of 10% per annum for each 12 month period  following
     the date of the Company's Prospectus (February 9, 1995) or (ii) any person,
     entity  or  affiliated  group  or  entities  acquires  40% or  more  of the
     Company's  common stock in any 12 month period,  then all  preferred  stock
     will be automatically  converted into common stock. While outstanding,  the
     preferred  stock does not carry voting rights or dividend  rights and has a
     liquidation preference of $.01 per share.

     In connection with the  divestiture of three  operating  divisions (Note 2)
     all of the outstanding shares of Series A Preferred Stock were cancelled on
     December 31, 1996.

     Common Stock and Warrants
     -------------------------
     The closing for the  Company's  IPO  occurred on  February  17,  1995.  The
     Company sold 69,000 units at $55.00 per unit and paid the Underwriter a 10%
     commission and a 3% nonaccountable  expense allowance which resulted in net
     proceeds to the Company of  $2,986,524.  Each unit consists of one share of
     the Company's  common stock and one warrant to purchase an additional share
     of common  stock at $65.00 per share until  February 9, 1998.  The warrants
     may be redeemed by the Company at any time,  upon 30 days written notice to
     the  holders  at a price of $.01 per  warrant if the  closing  price of the
     common stock is $75.00 or more for 30  consecutive  days.  The Company also
     entered into a one year financial  consulting contract with the Underwriter
     for  $36,000  which was paid in full in  advance.  In  connection  with the
     offering,  the  Company  issued  the  Underwriter,  for $100,  a warrant to
     purchase  10% of the number of Units sold in the  offering.  The Warrant is
     exercisable  for a period of four years  beginning  February  9, 1996.  The
     Underwriter's  Warrant is  exercisable  at a price of $66.00 per Unit.  The
     Units subject to the Underwriter's  Warrant are identical to the Units sold
     to the public.

7. Commitments and Contingencies
--------------------------------
     In September  1994, the Company  acquired,  under a 20 year  noncancellable
     capital lease, an office  building,  including land and  improvements.  The
     Company  occupies  approximately  half of the space as its corporate office
     facility and has sublet the remaining space to unrelated parties. The lease
     requires  initial  annual  minimum lease  payments of $187,608,  increasing
     every five years to a maximum annual payment of $337,872 in 2009. Under the
     lease, the Company has an


                                      F-16


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


7. Commitments and Contingencies (Continued)
--------------------------------------------

     option at any time  through  April 30,  1996,  to purchase the building and
     land for $1,700,000.  Such amount increases to $1,800,000 through April 30,
     1997 and  $1,900,000  through  April 30, 1998.  After April 30,  1998,  the
     option amount increases annually by the percentage increase in the Consumer
     Price  Index,  as further  described  in the lease.  Upon  exercise  of the
     purchase  option,  all lease  payments  made by the Company will be applied
     toward the down payment for the  purchase  price based upon an amortized 20
     year note with interest accrued at 9% per annum.

     The Company  also leases  certain  computer  equipment  and  furniture  and
     fixtures  under  noncancellable  capital  leases.  The Company leases other
     facilities,  certain vehicles and computer  equipment under  noncancellable
     operating  leases.  The  Company  entered  into a  sublease  for its office
     building  described  above  in  connection  with the  divestiture  of three
     operating divisions.  The sublease rentals to be received in the future are
     approximately $168,000 and have been deducted from the future minimum lease
     payments in the table below.

     The following is a schedule of future  minimum  lease  payments at December
     31, 1996 under the  Company's  capital  leases  (together  with the present
     value of minimum lease payments) and operating  leases that have initial or
     remaining noncancellable lease terms in excess of one year:
<TABLE>
<CAPTION>


           Year Ending                       Capital           Operating
          December 31,                       Leases             Leases               Total
          ------------                       ------             ------               -----
            <S>                           <C>                   <C>               <C>                    
             1997                         $   132,142          $ 57,074           $  189,216
             1998                             235,146            53,242              288,388
             1999                             245,162            53,841              299,003
             2000                             266,169            54,918              321,087
             2001                             230,523            56,016              286,539
        Later years                         3,705,573            23,340            3,728,913
                                          -----------          --------           ----------

     Total Minimum Lease
      Payments                              4,814,715          $298,431           $5,113,146
                                                               ========           ==========

     Less amount representing
      interest                             (2,962,632)
                                          -----------

     Present Value of Net
      Minimum Lease Payments              $ 1,852,083
                                          ===========
</TABLE>

     Rent expense amounted to approximately  $120,100 and $133,600 for the years
     ended December 31, 1996 and 1995, respectively.

     Leased  equipment  under  capital  leases  as of  December  31,  1996 is as
     follows:

      Building                                           $1,348,824
      Land                                                  411,176
      Equipment                                             276,441
      Less accumulated amortization                        (252,939)
                                                         ----------
                                                 
                                      F-17


<PAGE>

                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


7. Commitments and Contingencies (Continued)
--------------------------------------------

             Net Property and Equipment Under
              Capital Leases                            $1,783,502
                                                        ==========

8. Stock Based Compensation Plans
---------------------------------

     The Company adopted Financial  Accounting Standard No. 123, "Accounting for
     Stock-Based  Compensation"  (SFAS 123) during the year ended  December  31,
     1996. In accordance with the provision of SFAS 123, the Company applies APB
     Opinion No. 25,  "Accounting  for Stock Issued to  Employees",  and related
     interpretations  in  accounting  for  its  plans  and  does  not  recognize
     compensation expense for its stock-based  compensation plans other than for
     options granted to non-employees.  If the Company had elected to recognized
     compensation expense based upon the fair value at the grant date for awards
     under these plans  consistent with the methodology  prescribed by SFAS 123,
     the  Company's  net income and  earning  per share  would be reduced to the
     following pro forma amounts:

                                                 1996             1995
                                                 ----             ----

     Net Loss:
         As reported                         $(1,409,800)      $(1,816,285)
         Pro forma                            (1,412,843)       (1,816,285)

     Net Loss Per Share of Common
      Stock:
         As reported                         $     (5.16)      $    (14.69)
         Pro forma                           $     (5.17)      $    (14.69)

     These pro forma  amounts may not be  representative  of future  disclosures
     since the  estimated  fair value of stock  options is  amortized to expense
     over the  vesting  period and  additional  options may be granted in future
     years.  The fair value for these options was estimated at the date of grant
     using the Black-Scholes option pricing model with the following assumptions
     for the year ended December 31, 1996:


                                                       1996
                                                       ----
     Risk free interest rate                            5.97%
     Expected life                                  3.5 years
     Expected volatility                               129.3%
     Expected dividend yield                               0%

     The Company did not grant any stock options in 1995.

     The  Black-Scholes   option  valuation  model  was  developed  for  use  in
     estimating  the  fair  value  of  traded  options  which  have  no  vesting
     restrictions  and are fully  transferable.  In addition,  option  valuation
     models  require the input of highly  subjective  assumptions  including the
     expected  stock price  volatility.  Because the  Company's  employee  stock
     options have characteristics  significantly  different from those of traded
     options, and because changes in subjective

                                      F-18


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


8. Stock Based Compensation Plans (Continued)
---------------------------------------------

     input  assumptions  can  materially  affect  the fair value  estimates,  in
     management's  opinion,  the existing  models do not  necessarily  provide a
     reliable  single  measure of the fair  value of its  employee  stock  based
     compensation plans.

9. Related Party Transactions
-----------------------------

     The Company has entered into  transactions with its officers and directors,
     as follows.

     The Company had a note receivable  from its former  President of $35,000 at
     December 31, 1995. Interest is payable monthly at 9% per annum and the note
     is due in April 1997. The note is secured by 50,000 shares of the Company's
     common stock which are owned by the Company's  former  President.  The note
     receivable  and  accrued   interest  were  sold  in  Connection   with  the
     divestiture of three operating divisions (Note 2).

     On November 1, 1994,  all of the Company's  shareholders  agreed in writing
     with each  other and with the  Company  to  contribute  pro rata from their
     shareholdings  up to a total of 20,000 shares of common stock to be used by
     the Company (at any time until December 31, 1999) for acquisitions of other
     companies or lines of business. The Company in its sole discretion may call
     for  such  contributions  at any  time  and  from  time to time  for  these
     purposes.  The Company will not issue any additional  equity securities for
     purposes  of  acquisition  of other  companies  or product  lines until all
     20,000 shares have been  contributed.  The shareholders did not receive any
     compensation  or  other  form  of  remuneration   for  their  agreement  to
     contribute  the shares and will have no interest in any of the companies or
     product lines which may be acquired. The shareholders agreed to provide the
     20,000 shares at the request of the  Underwriter  of the Company's  IPO, in
     order to reduce  any  dilution  to  existing  shareholders  if the  Company
     elected  to use  common  stock  for  acquisition  purposes.  In  1995,  the
     Company's  shareholders  contributed  500  shares  in  connection  with the
     acquisition of ValleyNet Communications (Note 5).

     The  Company  incurred  expenses  in  connection  with  desktop  publishing
     services provided by a Corporation  controlled by the wife of the Company's
     former Chief  Executive  Officer of $7,800 for the year ended  December 31,
     1995.

     In connection  with the divestiture of three divisions (Note 2) the Company
     received a note  receivable of $770,850 from SSC which is controlled by the
     former management of the Company.  The note bears interest at 10% per annum
     and is payable in monthly  principal and interest  installments  of $10,187
     through 2006. The note is collateralized by substantially all assets of SSC
     and is guaranteed by the former management of the Company.



                                      F-19


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


9. Related Party Transactions (Continued)
-----------------------------------------

     The  Company  issued  55,000  warrants  to its Chief  Executive  Officer in
     connection  with his  employment  agreement in November  1996. The warrants
     vest as to 20,000  warrants in December  1997,  20,000 in December 1998 and
     15,000 in December 1999. The warrants are exercisable at $2.50 per share at
     anytime through December 2001.

10. Concentration of Credit Risk and Major Customers
----------------------------------------------------
     The Company provides credit,  in the normal course of business,  to a large
     number of  companies  in the  Internet  services  industry.  The  Company's
     accounts  receivable  are due from customers  located  primarily in central
     California.  The  Company  performs  periodic  credit  evaluations  of  its
     customers'  financial  condition and generally requires no collateral.  The
     Company  maintains  reserves for potential  credit losses,  and such losses
     have not exceeded management's expectations.

11. Sale of Software
--------------------
     In  December  1995,  the  Company  entered  into an  agreement  to sell its
     "Classic"  Software to a Canadian Limited  Partnership (the  "Partnership")
     for a promissory note in the amount of $8,080,000. The Partnership acquired
     all of the Company's  interest in the Classic  Software defined as follows;
     all existing  and future  updates,  upgrades  additions,  improvements  and
     enhancements  and any new  versions of the  software.  The  Partnership  is
     selling limited partnership units in Canada and the promissory note will be
     replaced by cash and  promissory  notes as the units are sold. If all units
     are sold,  the  Company  would  receive  $1,333,200  cash at closing  (less
     expenses),  $1,333,200  cash on March 21,  1996 (less  expenses)  and notes
     receivable from the limited partners of $5,413,600. The notes bear interest
     at 8.5% per annum and are due  December  27,  2005  with  interest  payable
     annually.  The  Partnership  closed on  December  28,  1995  selling  units
     representing  18.81% of the purchase  price of the software and the Company
     received  $188,000,  net of expenses,  and  received the second  payment of
     $188,000 in March 1996. A second  partnership  was formed in 1996 in Canada
     to sell units to acquire the remaining 81.19% of the Software.  The Company
     received approximately  $150,000, net of expenses, on December 31, 1996 for
     the sale of software to the second  partnership.  The  $150,000 was paid to
     the Company that acquired the software development division pursuant to the
     terms  of the  Divestiture  Agreement.  The  Company  also  entered  into a
     Distribution  Agreement  with the  Partnership,  whereby  the  Company  was
     appointed as the exclusive  distributor of the Classic Software  throughout
     the world for a term of twenty years.  Under the terms of the  Distribution
     Agreement  the Company  will  purchase  copies of the Classic  Software for
     resale to third parties. Until December 31, 2000, the Company shall pay the
     following  prices  for  each  copy  of  the  Software  purchased  from  the
     Partnership:


                                      F-20


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


11. Sale of Software (Continued)
--------------------------------

          (a) until the Company has  purchased  $475,000 of copies in each year,
          100% of the price the Company  invoices to its customers for each copy
          of the Software; plus
<TABLE>
<CAPTION>


                                                                         Percentage of Sales
                                                                  -----------------------------------
               Until                                                Below                     Over
            December 31,                 Sales Benchmark           Benchmark                Benchmark
            ------------                 ---------------           ---------                ---------
             <S>                          <C>                         <C>                     <C>                     
               1997                        $ 8,850,000                 5%                       .1%
               1998                         10,275,000                 4                        .1
               1999                         15,150,000                 3                        .1
               2000                         34,000,000                 5                        .1
            Later Years                            -0-                 6                         6

</TABLE>

     Prior to the repayment of the Promissory Notes, payments to the Partnership
     for Software will be applied by the Partnership as follows:

               i) first,  the Partnership  shall pay to the Company on behalf of
               each  Limited  Partner,  an  amount  equal to the  interest  then
               payable in respect of the Promissory  Note issued by such Limited
               Partner;

               ii)  second,  the balance  remaining  allocable  to each  Limited
               Partner  will be paid (A) 55% to the Limited  Partner and (B) 45%
               to the  Company  for  repayment  of  the  principal  amount  then
               outstanding on the Limited Partner's Promissory Note.

     The Partnership has also entered into an Option  Agreement with the Company
     whereby the Company may  purchase the Software  from the  Partnership  upon
     certain  triggering  events.  Upon the occurrence of such triggering events
     the  Company,  at its sole  option,  may  purchase  the  software  from the
     Partnership for a purchase price based upon the following.

     The purchase  price payable by the Company for the Software  shall be equal
     to the fair market value of the Software on the Exercise Date as determined
     by a qualified arm's length  appraiser  agreed to by the parties,  provided
     that, if as a result of a Triggering  Event,  securities  are issued by the
     Company, or to the Company or its shareholders, the purchase price shall be
     satisfied by the transfer by the Company to the  Partnership of that number
     of  securities  having  a fair  market  value  equal to the  lesser  of the
     purchase price and 22.0% of the securities issued or received,  as the case
     may be, on a fully diluted basis. The Company agrees to jointly elect under
     applicable   taxing   statutes,   with  the  Partnership  to  complete  the
     transaction  on a tax  deferred  basis,  with  respect to the  issuance  of
     securities to the  Partnership by allowing the  Partnership to transfer the
     Software to a Canadian subsidiary of the Company on a tax deferred basis.



                                      F-21


<PAGE>
                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


11. Sale of Software (Continued)
--------------------------------
          In the event that sales revenue earned by the  Partnership in any year
          under the terms of the  Distribution  Agreement are less than $475,000
          in any calendar year prior to the Exercise Date, the percentage of the
          securities to be transferred by the Company to the  Partnership  shall
          be  increased  by 1% for each 10%  shortfall to a maximum of 5% in any
          calendar year,  provided that the option of the Partnership to acquire
          such  additional  shares shall not be exercisable  by the  Partnership
          until the promissory  notes issued by limited  partners to the Company
          have been paid in full and until such time,  such  additional  options
          may be  repurchased  by the  Company  for a price equal to 150% of the
          cash shortfalls for which the options were issued.

          Since the  Company  is  responsible  for  maintaining,  upgrading  and
          developing  future revisions of the Software,  the transaction has not
          been  accounted for as a sale by the Company.  In addition,  the notes
          receivable  have not been recorded by the Company as a result of their
          long-term  nature and they are primarily  expected to be repaid as the
          Company  sells  software to third  parties  and makes  payments to the
          Partnership   pursuant  to  terms  of  the   Distribution   Agreement.
          Therefore,  repayment  prior to 2005  will only  occur out of  revenue
          generated by the Company.  This  transaction has been accounted for by
          the Company on a cost  recovery  basis and the cash  received from the
          Partnership  will reduce the  capitalized  software  costs and revenue
          will be  recognized  when the  capitalized  software  costs  have been
          reduced  to  zero  since  the  Company   has,  in  essence,   retained
          substantially all rights of ownership.

          The software and all rights to the above  agreements  were sold by the
          Company in connection with the divestiture of the software development
          division (Note 2).




                                      F-22


<PAGE>

ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
         ACCOUNTING AND FINANCIAL DISCLOSURE
----------------------------------------------------------

     None.



                                       17

<PAGE>
                                    PART III

ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
         PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
--------------------------------------------------------------------

     The name, age and position of each of the Company's  executive officers and
directors are set forth below:
<TABLE>
<CAPTION>

                                                                                    Officer/Director
        Name                 Age                         Position                        Since
        ----                 ---                         --------                        -----

<S>                          <C>            <C>                                         <C>
Raymond J. Meyers            40            Chief Executive Officer                        1996
                                           and Director
Andrew Chu                   25            President, Chief Financial Officer             1995
                                           and Director
Steven A. Kriegsman          55            Director                                       1997
Howard P. Silverman          56            Director                                       1997
</TABLE>

     Directors  hold office for a period of one year from their  election at the
annual meeting of  stockholders  or until their  successors are duly elected and
qualified.  Officers of the Company are elected by, and serve at the  discretion
of, the Board of Directors.

     In January 1997 in connection with the sale of the Company's  Classic Line,
the SSC  Principals  resigned  as  officers  and  directors  and the above  four
individuals were appointed executive officers and directors of the Company.  See
"Item 12."

Background

     The  following  is a summary of the business  experience,  for at least the
last five years, of each executive officer and director of the Company:

     Raymond J. Meyers became the Company's Chief Executive  Officer in December
1996. From 1985 to 1996, he was employed by Transamerica  Corporation  holding a
variety of positions,  most recently (from 1991 to 1996) as Director of Business
Services for Transamerica Telecommunications.  Mr. Meyers graduated from Rutgers
University in 1979 with a Bachelor of Arts degree in Economics.

     Andrew Chu became the Company's Chief  Financial  Officer in April 1995 and
its President and a director in January 1997. From 1992 to 1994, he was employed
at IDS Financial Services as a Financial Planner. He was the managing partner of
The Pacific Group, a consulting firm engaged in equity financing for small firms
from January 1994 to April 1995.  Mr. Chu holds a B.S.  degree with  emphasis in
Finance from California State University of Fresno.


                                       18

<PAGE>
     Steven  A.  Kriegsman  has  been  President  of  the  Kriegsman   Group,  a
privately-held Los Angeles, California based investment banking firm since 1989.
He graduated from New York University in 1964 with a Bachelor of Science degree.

     Howard  P.  Silverman  has been an  independent  business  consultant  with
emphasis on the  financing  of public and private  companies  for more than five
years.  He earned a Bachelor of Science degree from City College of New York and
an O.D.  degree  from the  Illinois  College of  Optometry.  He is a director of
Incomnet, Inc., a publicly-held reseller of long distance services.

ITEM 10.  EXECUTIVE COMPENSATION
--------------------------------

     None of the Company's  executive  officers or directors  currently  receive
compensation  in excess of $100,000  per year except Mr.  Meyers who  receives a
salary of $130,000 per year. In connection with his  employment,  Mr. Meyers was
also granted  options to purchase  550,000 shares of Common Stock vesting over a
three-year period at $.25 per share at any time until October 2001. No executive
officers or directors as a group received compensation in excess of $100,000 for
the calendar years ended December 31, 1996, 1995 or 1994.  Compensation  for all
officers and directors as a group for the calendar year ended  December 31, 1996
aggregated $64,000.

     The following table discloses  certain  compensation  paid to the Company's
executive  officers for the  calendar  years ended  December 31, 1996,  1995 and
1994.
<TABLE>
<CAPTION>


                                            Summary Compensation Table

                                                                             Long Term Compensation
                               Annual Compensation                           Awards          Payouts
                               -------------------                           -----------------------

    (a)          (b)          (c)               (d)              (e)              (f)            (g)         (h)           (i)
Name
and
Prin-                                                           Other                                                      All
cipal                                                          Annual         Restricted                                  Other
Posi-                                                          Compen-           Stock        Options/      LTIP         Compen-
tion            Year       Salary($)         Bonus($)         sation($)       Award(s)($)      SARS(#)   Payouts($)     sation($)
----            ----       ---------         --------         ---------       -----------      -------   ----------     ---------

<S>              <C>         <C>          <C>                     <C>              <C>            <C>         <C>           <C>
James C.         1996        $61,925      $    0                  0                0              0           0             0
Robinson         1995         61,425          5,941               0                0              0           0             0
Chief Execu-     1994         57,226         25,000               0                0              0           0             0
tive Officer
</TABLE>

1995 Stock Option Plan

     In November  1994,  the Company  adopted a stock  option plan (the  "Plan")
which provides for the grant of options  intended to qualify as "incentive stock
options" and "nonqualified stock options" within the meaning of Section 422 of

                                       19

<PAGE>

the United States  Internal  Revenue Code of 1986 (the "Code").  Incentive stock
options are issuable  only to eligible  officers,  directors,  key employees and
consultants of the Company.

     The Plan is administered  by the Board of Directors.  At December 31, 1996,
the Company had reserved  150,000  shares of Common Stock for issuance under the
Plan. Under the Plan, the Board of Directors  determines which individuals shall
receive  options,  the time period  during which the options may be partially or
fully  exercised,  the number of shares of Common  Stock  that may be  purchased
under each option and the option price.

     The per share  exercise  price of the Common Stock may not be less than the
fair  market  value of the Common  Stock on the date the option is  granted.  No
person who owns,  directly  or  indirectly,  at the time of the  granting  of an
incentive stock option,  more than 10% of the total combined voting power of all
classes of stock of the Company is eligible to receive  incentive  stock options
under the Plan unless the option price is at least 110% of the fair market value
of the Common Stock subject to the option on the date of grant.

     No options may be transferred by an optionee other than by will or the laws
of descent and distribution,  and during the lifetime of an optionee, the option
may only be  exercisable  by the optionee.  Options may be exercised only if the
option holder remains continuously  associated with the Company from the date of
grant to the date of  exercise.  Options  under the Plan must be granted  within
five  years  from the  effective  date of the Plan and the  exercise  date of an
option  cannot be later than ten years from the date of grant.  Any options that
expire  unexercised or that terminate upon an optionee's  ceasing to be employed
by the Company  become  available  once again for  issuance.  Shares issued upon
exercise of an option will rank equally with other shares then outstanding.

     As of the date of this Report, no options have been granted under the Plan.



                                       20

<PAGE>

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
-----------------------------------------------------------------------

     The  following  table sets forth  information  concerning  the  holdings of
Common Stock (without  giving effect to any shares issuable upon exercise of the
Public Warrants or the Prior Representative's Unit Warrants) by each person who,
as of the date of this  Report,  holds of record or is known by the  Company  to
hold  beneficially or of record,  more than 5% of the Company's Common Stock, by
each  director,  and by all  directors and  executive  officers as a group.  All
shares are owned  beneficially and of record and all share amounts include stock
options and common stock purchase warrants  exercisable  within 60 days from the
date hereof. The address of all persons is in care of the Company at 2300 Tulare
Street, Suite 210, Fresno, California 93721.

                                        Amount of                  Percent of
Name                                    Ownership                    Class
----                                    ---------                    -----
Raymond J. Meyers(1)                       200,000                    2.5%
Andrew Chu(2)                              585,000                    7.0%
Steven A. Kriegsman(3)                   1,765,000                   18.6%
Howard P. Silverman(4)                     850,000                    9.9%
Andrew, Alexander, Wise &
  Company, Incorporated(5)               1,370,000                   15.1%
Gloria Ippolito                            600,000                    7.8%
Anaka Parkash                              700,000                    9.1%
Isaac Paschaldis                           900,000                   11.6%
John Benedetto                             700,000                    9.1%
Matthew Mulhern                            400,000                    5.2%
All officers and directors as
a group (4 persons)(1)(2)(3)(4)          3,400,000                   30.5%

----------
(1)  Represents  stock options to purchase  200,000  shares at $.25 per share at
     any time until October 2001.  Mr. Meyers holds an additional  350,000 stock
     options which vest in 1998 and 1999.
(2)  Represents  common stock  purchase  warrants to purchase  585,000 shares at
     $.25 per share at any time until October 2001  including  535,000  Warrants
     which are being registered in the SB-2 Filing.
(3)  Represents common stock purchase  warrants to purchase  1,765,000 shares at
     $.25 per share at any time until October 2001 including  1,665,000 Warrants
     which are being  registered in the SB-2 Filing.  All common stock  purchase
     warrants  are held by the  Kriegsman  Group of which Mr.  Kriegsman  is the
     President and a principal stockholder.
(4)  Represents  common stock  purchase  warrants to purchase  850,000 shares at
     $.25 per  share at any time  until  October  2001,  all of which  are being
     registered in the SB-2 Filing.

                                       21

<PAGE>

(5)  Represents common stock purchase  warrants to purchase  1,370,000 shares at
     $.25 per  share at any time  until  October  2001,  all of which  are being
     registered in the SB-2 Filing.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
-------------------------------------------------------

     Management of the Company  believes that the  transactions  described below
were no more or less fair than the terms of transactions which the Company might
otherwise have entered into with third party nonaffiliated entities. Any related
party  transactions  have been and will continue to be approved by a majority of
the disinterested members of the Company's Board of Directors.

     In February  1995,  the Company  loaned  $35,000 to Charles T. Howard,  the
Company's then President. Interest on the loan is payable monthly at the rate of
9% per annum and the promissory note evidencing the indebtedness is due in April
1997.  The promissory  note is secured by 50,000 shares of the Company's  Common
Stock  owned  by Mr.  Howard  and  was  transferred  to  SSC  as a  part  of the
Divestiture Agreement described below.

     In November 1994,  the Company  issued  857,140  shares of its  Convertible
Preferred Stock to five of the Company's then officers and directors, each share
of which  was  convertible  for no  additional  consideration  into one share of
Common Stock under certain  circumstances.  The Convertible  Preferred Stock was
cancelled and returned to the Company by the five holders in connection with the
Divestiture Agreement described below.

     In January 1997, the Company sold the remaining  assets of the Classic Line
to SSC  Technologies,  Inc. ("SSC") for $770,850  evidenced by a promissory note
bearing  interest at 10% per annum payable in January 2007 and the assumption by
SSC of all of the  liabilities  of the Classic Line,  aggregating  approximately
$500,000.  Under  the  terms of the  asset  sales  agreement  (the  "Divestiture
Agreement"), the Company acquired 25% of the outstanding common stock of SSC for
$500,000  in cash and the  remaining  75% of the  outstanding  common  stock was
issued to other stockholders  including Charles T. Howard,  David L. Green, Ding
Yang and Steven L. Wilson who were  previously  officers  and  directors  of the
Company (the "SSC Principals").  As a part of the Divestiture Agreement, the SSC
Principals also (i) cancelled 900,000 shares of Convertible Preferred Stock held
by them  which were  previously  exercisable  into an equal  number of shares of
Common Stock,  (ii) agreed not to sell an aggregate of 454,494  shares of Common
Stock owned by them until October 1999 except with the prior written  consent of
Andrew,  Alexander,  Wise &  Company,  Incorporated  ("AAWC"),  (iii)  agreed to
sublease  office space from the Company at a monthly  rental of $12,000  through
February  28,  1998,  (iv)  granted to Steven A.  Kriegsman,  a director  of the
Company,  an option to purchase up to 150,000 shares of Common Stock held by the
SSC principals at any time until October 2001, and (v) personally  guaranteed on
a joint and several basis the $770,850 promissory note and all other obligations
of SSC to the Company.

     In October 1996,  the Company  issued  2,200,000  Warrants to the Kriegsman
Group ("KG") for  consulting  services.  Steven A.  Kriegsman  who  subsequently
became a director of the Company is the President and controlling stockholder of

                                       22

<PAGE>


KG. KG subsequently assigned 535,000 of such Warrants to Andy Chu, the Company's
President  and  a  director.  The  Warrants  and  underlying  shares  are  being
registered  in the SB-2 Filing.  KG also  assigned  50,000 of the 150,000  stock
options it received from the SSC Principals to Mr. Chu.

     In  October  1996,  the  Company  issued  2,200,000  Warrants  to  AAWC  as
additional  compensation for AAWC assisting the Company in the private placement
of 6,000,000  shares of the  Company's  Common Stock to a group of investors for
$.25 per  share.  AAWC  subsequently  assigned  850,000  Warrants  to  Howard P.
Silverman,  a director of the Company.  The Warrants and  underlying  shares are
being  registered  in the SB-2  Filing.  The  Company  also  paid to AAWC a cash
commission of 10% of the gross proceeds raised  ($150,000) and a  nonaccountable
expense  allowance of 3% of such gross proceeds  ($45,000).  In September  1996,
AAWC and KG entered into an  agreement  not to sell the  2,200,000  Warrants and
underlying  shares  owned by each party for a period of three years  without the
consent of the other party.

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
-----------------------------------------

         a.  Exhibits:

    Exhibit No.                      Title
    -----------                      -----

      2.01            Restated Articles of Incorporation of the Registrant(1)

      2.02            Bylaws of the Registrant(1)

     10.01            1995 Incentive Stock Option Plan(1)

     10.02            Capitalized Lease Agreement(1)

     10.03            Employment Agreement (Mr. Howard)(1)

     10.04            Employment Agreement (Mr. Green)(1)

     10.05            Employment Agreement (Mr. Yang)(1)

     10.06            Employment Agreement (Mr. Wilson)(1)

     10.07            Real Estate Lease and Amendments thereto(1)

     10.08            Form of Bridge Loan Promissory Note(1)

     10.09            Form of Bridge Loan Subscription Agreement(1)

     10.10            Share Contribution Agreement(1)

                                          23

<PAGE>




     10.12            Divestiture Agreement(2)

     10.13            Selling Agreement with AAWC(2)

     10.14            Warrant Agreement with AAWC(2)

     10.15            Lock-up Agreement(2)

     10.16            Registration Rights Agreement(2)
----------

(1)  Incorporated  by reference to the  Registrant's  Registration  Statement on
     Form SB-2 declared  effective by the  Commission on February 9, 1995,  file
     number  33-86242.

(2)  Incorporated  by reference to the  Registrant's  Registration  Statement on
     Form SB-2, file number 333-20543, filed January 26, 1997.


                                       24

<PAGE>


                                   SIGNATURES

     In accordance  with Section 13 or 15(d) of the Exchange Act, the Registrant
has duly  caused  this  Report to be signed  on its  behalf by the  undersigned,
thereunto duly authorized, in Fresno, California, on March 28, 1997.

                                       PROTOSOURCE CORPORATION


                                       By  /S/  RAYMOND J. MEYERS
                                         --------------------------------------
                                                  Raymond J. Meyers
                                               Chief Executive Officer



      Signature                         Title                        Date
      ---------                         -----                        ----


/S/  RAYMOND J. MEYERS
--------------------------        Chief Executive Officer and     March 28, 1997
Raymond J. Meyers                 Director

/S/  ANDREW CHU
--------------------------        President, Chief Financial      March 28, 1997
Andrew Chu                        Officer, (Principal Accounting
                                  Officer) and Director
/S/  STEVEN A. KRIEGSMAN
--------------------------        Director                        March 28, 1997
Steven A. Kriegsman

/S/  HOWARD P. SILVERMAN
--------------------------        Director                        March 28, 1997
Howard P. Silverman