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, 1997 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                          I.R. S. Employer 
incorporation or organization)                       Identification Number)


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



Issuer's telephone number:  (310) 314-9801

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, 1998,  665,333 shares of the  Registrant's  no par value
Common Stock were outstanding.  As of February 28, 1998, the market value of the
Registrant's no par value Common Stock, excluding shares held by affiliates, was
$3,171,663  based upon a closing bid price of $5.50 per share of Common Stock on
the Electronic Bulletin Board.

     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 $749,796.

     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.  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.

Introduction

     The Company  provides  Internet access and related services to individuals,
public  agencies and businesses in six small central  California  cities.  As of
December 31, 1997, the Company had  approximately  2,700 subscribers for whom it
provided  Internet  access up from 250  subscribers  in July 1995.  The  Company
intends to acquire other small  Internet  providers in markets with  populations
less than 500,000 that are located 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 has addressed these kinds of financial and
administrative  burdens  by (i)  expanding  its  operations  throughout  Central
California,   (ii)  developing   diversified  services  similar  to  its  larger
competitors,  such as hourly-based  access services,  special access to packages
for business and high speed access, and (iii) investing in automated billing and
administrative systems. The Company believes these resources will not only allow
it to compete  effectively  with larger  access  firms  entering  the  Company's
markets,  but also will  facilitate  the  Company's  efforts  to  attract  small
Internet providers. The Company's long-term plan is to target a select number of
such markets and increase  revenues  through  acquisition in these markets.  The
Company is not  currently  negotiating  to acquire  nor has it entered  into any
agreement to acquire any other 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


                                        3

<PAGE>


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 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  46,000  Units to the  public at
$82.50 per Unit. Each Unit consisted of one share of Common Stock and one common
stock purchase warrant (the "Prior Warrants") to purchase an additional share of
Common  Stock  at  $97.50  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 4,000 Units at $99.00 per Unit until February 2000. In May 1997, the
Company  registered 186,666 Common Stock Purchase Warrants and 186,666 shares of
Common Stock  underlying  these Warrants  together with 426,667 shares of Common
Stock (collectively the "May 1997 Securities").

     In July 1995, the Company acquired ValleyNet Communications  ("ValleyNet"),
a small  Internet  access  provider  for $50,000 in cash and the issuance of 334
shares of the Company's Common Stock. At the time of its acquisition,  ValleyNet
operated  out of one  location in Fresno,  California  and had 250  subscribers.
Since that time,  the Company has increased  its Internet  locations to six, and
increased its subscribers to 2700 at December 31, 1997.

     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
carried  as an asset on its  financial  statements,  due to the high  degree  of
uncertainty  as to  the  payment  of  the  promissory  note.  As a  part  of the
transaction,  the  Company  received  an  exclusive  worldwide  license  through
December 2006, to market the Classic Line subject to the payment of a royalty of
16% of gross  sales  to the  Canadian  company.  To date,  the  Company  has not
incurred any liability to pay royalties.

     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 the  liabilities  of the Classic Line and certain other  liabilities,
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 (less  $200,000 of  liabilities  which
were paid by the Company and deducted  from the  $500,000) 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 part
of the  Divestiture  Agreement,  the SSC  Principals  also (i) canceled  900,000
shares of Convertible  Preferred  Stock held by them (and one other  individual)
which were previously  exercisable  into shares of Common Stock on a fifteen for
one basis, (ii) agreed not to sell an aggregate of 30,300 shares of Common Stock
owned by them until October 1999, except with the prior  written consent  of the


                                        4

<PAGE>


Prior Representative,  (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 former director of the Company, an option to purchase up to 10,000
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.  The value of
the Classic Line assets were determined as a result of negotiations  between the
Company and the SSC Principals. See "Item 12."

     In October 1996,  the Company sold 400,000  shares of its Common Stock to a
group of  investors  for $3.75 per share or a total of  $1,500,000  (the "Common
Stock Placement").  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  26,667  shares of its  Common  Stock to the  bridge  lenders as
additional  consideration for the $200,000 loan. The Company also issued 186,666
Warrants  exercisable at $3.75 per share in connection  with the bridge loan and
the private placement.  The 426,667 shares,  186,666 Warrants and 186,666 shares
underlying the Warrants were registered with the Commission in May 1997.

     Between June and September  1997,  the Company issued 150,000 shares of its
Common Stock as additional consideration for a $750,000 bridge loan (the "Bridge
Loan") advanced to it by eight bridge lenders.

     The Company was  incorporated in the State of California as SHR Corporation
on July 1, 1988, and changed its name to  "ProtoSource  Corporation"  in October
1994.  The  Company's  principal  executive  offices  are located at 2300 Tulare
Street, Suite 210, Fresno, California 93721, telephone (310) 314-9801.

Strategy

     The Company's  strategy is to provide low cost direct  Internet  access and
other  Internet  related  products and services to  subscribers  or customers in
target  markets.  The Company will seek to effectuate this strategy by acquiring
small  Internet  providers,  by expanding  marketing  operations in its existing
markets,  by offering  Internet  related  products and services and by acquiring
other  computer  oriented  companies.  The  Company  will also seek to  generate
additional  revenues  by (i)  increasing  monthly  Internet  access  fees  while
offering  additional  Internet  products and  services,  (ii)  offering  monthly
community access services,  (iii) providing Internet  consulting  services,  and
(iv) generating marketing service fees from businesses seeking a Web site on the
Internet.  The Company  believes that it can increase the  profitability  of its
monthly  access fees by developing  economies of scale as a result of increasing
total access subscribers and earning  additional  revenues from such subscribers
by providing additional access services.

     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 to engage in  commerce  and  communication.  The  Company  intends to


                                        5

<PAGE>



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 in order to offer additional  Internet products and
services, and expand the number of POPs in local markets in order to attract and
support  additional  subscribers.  By increasing the number of POPs, the Company
will offer more users access to the Internet  through  local phone calls 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 its customers
with a number of  Internet  services  such as  consulting  services  for network
setup,  Internet  application  implementation,  Intranet  design,  and Web  site
implementation.

     Generating  Marketing  Service Fees.  The Company  designs and develops 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 to assure subscriber access.

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 with a population
under 500,000;  (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  computer  oriented  companies.  The Company is not  negotiating  to
acquire, nor has it entered into any agreement to acquire, any such companies.

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


                                        6

<PAGE>


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,  MCI,  Sprint  and some of 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 Internet access consolidates
such as Verio, Inc. and from on-line service firms such as America Online (AOL),
CompuServe,  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  service  businesses will further  consolidate in the future,  which
could  result in  increased  price and other  competition  in the  industry  and
consequently adversely impact the Company. In the last year, a number of on-line
services have 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


                                        7

<PAGE>


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 December 31, 1997, the Company  employed twelve  full-time  employees
and two part time  employees.  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  located at
2580 West Shaw,  Fresno,  California  93711.  The lease requires  initial annual
minimum  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
to purchase the building and land for $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  accruing at 9% per annum.  The
Company does not occupy any space in the building,  although it leased a portion
of it to SSC and the SSC Principals  based upon monthly  payments to the Company
of $12,000 through February 1998. See "Certain Transactions".  In May 1997, as a
result of the  Company's  default on the  lease,  the  Company  agreed to return
possession  of the office  building to the landlord.  Accordingly,  the landlord
collects rents directly from the tenants of the office  building and the Company
is responsible for the difference between such aggregate rents and the Company's
lease payment to the landlord. As of the date hereof, the landlord is collecting
monthly  rents  aggregating  approximately  $9,200  and  the  Company's  monthly
leasehold obligation is approximately $15,600 leaving a monthly balance due from
the Company to the landlord of approximately $6,400.

     The Company leases 4,000 square feet of space for its offices and operating
facilities at 2300 Tulare Street, Suite 210, Fresno, California 93721. The lease
term is five years,  ending May 2002 and  requires  minimum  annual  payments of
$40,250  increasing every year to a maximum of $55,375 in 2002. The Company also
leases  approximately  250 square feet for its  corporate  office space in Santa
Monica, California on a month-to-month lease for $600 per month.

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

     As a result of the  failure of SSC and the SSC  Principals  to pay  certain
trade  account  payables  and  certain  office  rent under a  sublease  from the
Company,  the  Company  has been  threatened  with  litigation  from such  trade


                                        8

<PAGE>


creditors (currently aggregating approximately $25,000) and has been required to
return  possession of the SSC subleased office space to the Company's  landlord.
The  Company  believes  that the total  contingent  liability  to trade  account
creditors  arising from defaults by SSC and the SSC  Principals  does not exceed
$100,000.  Additionally,  the total  amount due from SSC and the SSC  Principals
under the Company's office sublease aggregates approximately $100,000.

     In May 1997,  the SSC  Principals  brought an  administrative  labor  claim
against the Company before the California  office of the State Labor  Commission
seeking  unpaid  wages in the  amount of  approximately  $160,000.  The case was
dismissed by the Labor Commission in December 1997 but may be refiled as a civil
action  if the  claimants  elect to do so. As of this date the case has not been
refiled. This Company believes the claim to be without merit.

     The Company is a defendant in a civil action entitled "P/K Associates, Inc.
et al. v. Fresno  Business  Journal,  Inc., et al" civil action  number  97-5546
filed in the United State District Court for the Eastern  District of California
in May 1997. The suit alleges certain  copyright  violations  against the Fresno
Business Journal and the Company.  The Company settled the case in December 1997
for a payment of $5,000 to the plaintiffs.

     In February 1997, three of the Company's  former employees  brought a civil
action against the Company in the California  Municipal Court entitled "David J.
Dague,  et  al.  v.  ProtoSource   Corporation"   for  back  wages   aggregating
approximately  $45,000.  In March 1998,  the Company paid $23,000 to settle this
matter.

     Payment of any judgments or settlements in connection with these litigation
matters,  together  with the costs of defending  such matters,  could  adversely
affect the Company's results of operations and financial condition.

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

     Not applicable.


                                        9

<PAGE>




                                     PART II

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

     The Company's  Common Stock traded on the NASDAQ  SmallCap 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, 1998 (through February 28, 1998)...................  $5.75      $5.25

December 31, 1997............................................   6.50       5.00
September 30, 1997...........................................   6.30       5.25
June 30, 1997................................................   5.50       3.15
March 31, 1997...............................................   4.65       3.15

December 31, 1996......................................... .   11.25       3.15
September 30, 1996...........................................  15.00       8.40
June 30, 1996................................................  26.25       8.40
March 31, 1996...............................................  31.95      14.10

     As of February  28,  1998,  the Company  had  approximately  365 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.



                                       10

<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, 1997,
the Company had 2,700  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, 1997 vs. Year Ended December 31, 1996

     Net Sales

     For calendar 1997, Internet services revenues were $749,796 versus $697,581
in calendar  1996, an increase of 7.5%. The increase in revenue is primarily due
to an  increase  in the  subscriber  base.  Management  believes  revenues  will
continue to increase as the Company  implements  marketing  programs focusing on
increasing  name brand  recognition  and  differentiation  of service  offerings
(i.e., Internet access, web site development and electronic commerce).

     Operating Expenses

     1997 operating  expenses totaled $1,818,698 versus $1,121,773 in 1996. This
increase of $696,925  was  primarily  attributed  to costs  associated  with the
Company's  May 1997  Registration  Statement  covering  the May 1997  Securities
including $102,971 of legal and accounting fees, increased rent expense,  higher
salary  expense,   and  increased  bad  debt  expense.   Bad  debt  expense  was
approximately  $132,000 and is comprised of write-offs of accounts receivable of
approximately  $25,000,  establishment of a reserve for  uncollectible  accounts
receivable  of  $7,500  and for the  uncollectability  of a note  receivable  of
$100,000. Management has implemented several cost reduction or containment steps
but believes that  operating  expenses will increase as revenues  increase.  The
Company  will  also  seek to  reduce  operating  expenses  by  renegotiating  or
canceling its Shaw Avenue Capital lease and its Visalia, California lease.


                                       11

<PAGE>



     Operating Loss

     The Company's  1997 operating loss totaled  $1,068,902  versus  $424,192 in
1996. This increase in operating loss of $644,710 is attributed to a significant
rise in 1997  operating  expenses  coupled with less than  anticipated  Internet
service revenue growth.  Management believes that operating results will improve
as revenues increase.

     Interest Expense (Net)

     Net interest expense for 1997 totaled $546,607 versus $268,721 in 1996. The
increase of $277,886 is attributable  to obtaining  bridge loan financing in the
amount of $750,000.  This net interest expense includes the amortization of debt
issuance costs of $320,167 in connection  with the issuance of 150,000 shares of
Common  Stock in the Bridge  Loan and  commissions  of $97,500  and Bridge  Loan
interest  expense of $45,049.  The interest  expense was somewhat  offset by the
interest earned on cash and short term investments of $77,399.

     Other Income

     1997 net other income  increased to $218,959  from  $146,122 in 1996.  This
increase of $72,837 is a result of the rental income  generated by the Company's
Shaw Avenue office building and  miscellaneous  sales. Net other income for 1997
is comprised  entirely of rental income on the sublease of the Company's  office
building.  Rental income  recognized from SSC totals $144,000,  all of which was
collected in 1997.


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 Central California area. PSNW
only  operated  from  August  to  December  in 1995  versus a full year in 1996.
Management  believes that the Company's revenues will continue to increase as it
increases the number of points of presence ("POPS") through which it markets its
Internet  services.  The number of POPS to be developed in any given  geographic
area depends upon the Company's estimate of "demand" in such geographic area. In
turn,  demand is based upon the  population and rate of population  growth,  the
number of existing access  providers,  the number of access  subscribers and the
growth rate of such access subscribers in the particular area.

     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  expense,  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 Company's Internet business grows.

                                       12

<PAGE>


     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.

     Interest  Expenses.  Net interest expense for 1996 was $268,721 compared to
$109,301 in 1995.  The increase in interest  expense is primarily  attributed to
the building which the Company  acquired under a 20-year capital lease.  The net
interest  expense is further  increased  as a result of a decrease  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 $3.75 per share and resulted in
a financing expense of $100,000 to the Company.

Liquidity and Capital Resources

     For the year ended December 31, 1997, the Company used cash of $995,736 for
operating  activities.  The Company had a working capital deficiency of $795,657
at December 31, 1997 which is primarily  attributed to the short term  liability
treatment of the Bridge Loan. The Company  intends to reduce the working capital
deficit by (i) increasing sales, (ii) reducing certain low margin operations and
(iii) obtaining long-term financing.  There can be no assurance that the Company
will be  successful  in these  actions and if  unsuccessful,  the Company may be
required to substantially reduce its operations.

     Capital  expenditures  relating  primarily  to  the  purchase  of  computer
equipment,  furniture  and  fixtures,  and other assets  amounted to $77,552 and
$38,421  for the  years  ended  December  31,  1997 and 1996,  respectively.  In
addition,  the Company acquired through lease $69,959 of computer  equipment for
its Internet operations during the year ended December 31, 1997.

     Between  June and  September  1997,  the  Company  received  $750,000  from
proceeds  of the Bridge  Loan,  which was used for  working  capital,  marketing
expenses and the purchase of capital  equipment.  In connection  with the Bridge
Loan, the Company agreed to issue 150,000 restricted shares of its Common Stock,
subject to certain  piggy-back and demand  registration  rights at the Company's
expense.  The fair  market  value of the  Common  Stock  ($750,000)  issued  and
commission  paid on the Bridge Loan ($97,500) were  capitalized as debt issuance
costs and are being amortized over the 15 month loan as interest expense.


                                       13

<PAGE>



     In June 1996 the  Company's  Common  Stock  was  delisted  from the  NASDAQ
SmallCap Market as a result of the Company's  shareholders' equity falling below
the NASDAQ SmallCap Market maintenance requirements.



                                       14

<PAGE>



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




                                       15

<PAGE>

                             PROTOSOURCE CORPORATION


                          INDEX TO FINANCIAL STATEMENTS



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

 Independent Auditors' Report                                                F-2

 Balance Sheet as of December 31, 1997                                       F-3

 Statements of Operations for the years ended
  December 31, 1997 and 1996                                                 F-5

 Statements of Changes in Shareholders' Equity for the
  years ended December 31, 1997 and 1996                                     F-6

 Statements of Cash Flows for the years ended
  December 31, 1997 and 1996                                                 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,  1997  and  the  related  statements  of  operations,  changes  in
shareholders'  equity and cash flows for the years ended  December  31, 1997 and
1996.  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, 1997 and the results of its  operations  and its cash flows for the
years ended  December 31, 1997 and 1996 in conformity  with  generally  accepted
accounting principles.

The  accompanying  financial  statements  have been  prepared  assuming that the
Company will continue as a going concern. As shown in the financial  statements,
the Company incurred a net loss of $1,470,550 during the year ended December 31,
1997,  and, as of that date had a working  capital  deficiency  of $795,657.  As
discussed  in Note 1 to the  financial  statements,  the  Company's  significant
operating losses and working capital  deficiency raise  substantial  doubt about
its  ability to  continue as a going  concern.  Management's  plans in regard to
these  matters are also  discussed in Note 1. The  financial  statements  do not
include any adjustments that might result from the outcome of this uncertainty.



                                            Angell & Deering
                                            Certified Public Accountants

Denver, Colorado
February 13, 1998








                                       F-2


<PAGE>



                             PROTOSOURCE CORPORATION
                                  BALANCE SHEET
                                DECEMBER 31, 1997




                                     ASSETS
                                     ------

Current Assets:
  Cash and cash equivalents                                         $    98,148
  Accounts receivable - trade net of allowance
   for doubtful accounts of $7,500                                       22,490
  Current portion of note receivable                                     67,000
                                                                    -----------

         Total Current Assets                                           187,638
                                                                    -----------

Property and Equipment, at cost:
  Land                                                                  411,176
  Building and improvements                                           1,381,816
  Equipment                                                             821,876
  Furniture                                                             110,387
                                                                    -----------
                                                                      2,725,255
  Less accumulated depreciation and amortization                       (701,455)
                                                                    -----------

         Net Property and Equipment                                   2,023,800
                                                                    -----------

Other Assets:
  Goodwill, net of accumulated amortization
   of $3,423                                                             17,822
  Debt issuance costs, net of accumulated amortization
   of $320,167                                                          527,333
  Note receivable, net of allowance for uncollectibility
   of $100,000 and net of current portion above                         396,271
  Deposits and other assets                                              44,347
  Deferred offering costs                                                98,523
                                                                    -----------

         Total Other Assets                                           1,084,296
                                                                    -----------

         Total Assets                                               $ 3,295,734
                                                                    ===========




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

                                       F-3


<PAGE>



                             PROTOSOURCE CORPORATION
                                  BALANCE SHEET
                                DECEMBER 31, 1997




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

Current Liabilities:
  Accounts payable                                                  $    96,107
  Accrued expenses:
    Payroll taxes, wages and other                                       30,213
    Interest                                                             45,049
  Current portion of long-term debt                                     811,926
                                                                    -----------

         Total Current Liabilities                                      983,295
                                                                    -----------

Long-Term Debt, net of current portion above:
  Individuals and other                                                 750,000
  Obligations under capital leases                                    1,850,815
  Less current portion above                                           (811,926)
                                                                    -----------

         Total Long-Term Debt                                         1,788,889
                                                                    -----------

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, 665,333 shares issued and outstanding                  5,590,455
  Accumulated deficit                                                (5,066,905)
                                                                    -----------

         Total Shareholders' Equity                                     523,550
                                                                    -----------

         Total Liabilities and Shareholders' Equity                 $ 3,295,734
                                                                    ===========





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

                                       F-4


<PAGE>



                             PROTOSOURCE CORPORATION
                            STATEMENTS OF OPERATIONS
                 FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1996



                                                        1997            1996
                                                        ----            ----
Net Revenues:
 Internet service fees                              $   749,796     $   697,581
                                                    -----------     -----------

       Total Revenues                                   749,796         697,581

Operating expenses                                    1,818,698       1,121,773
                                                    -----------     -----------

       Operating Loss                                (1,068,902)       (424,192)
                                                    -----------     -----------

Other Income (Expense):
 Interest income                                         77,399           3,507
 Interest expense                                      (624,006)       (272,228)
 Financing costs                                           --          (126,000)
 Rent and other income                                  218,959         146,122
 Loss on disposal of assets                              (2,018)           --
 Other, net                                                 368            --
                                                    -----------     -----------

       Total Other Income (Expense)                    (329,298)       (248,599)
                                                    -----------     -----------

Loss From Continuing Operations Before
 Provision For Income Taxes                          (1,398,200)       (672,791)

Provision for income taxes                               72,350            --
                                                    -----------     -----------

Loss From Continuing Operations                      (1,470,550)       (672,791)
                                                    -----------     -----------

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

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

Net Loss                                            $(1,470,550)    $(1,409,800)
                                                    ===========     ===========

Net Loss Per Share of Common Stock:
  Basic:
   Loss from continuing operations                  $     (2.49)    $     (3.69)
   Discontinued operations                                 --             (4.05)
                                                    -----------     -----------

   Net Loss                                         $     (2.49)    $     (7.74)
                                                    ===========     ===========

  Diluted:
   Loss from continuing operations                  $     (2.49)    $     (3.69)
   Discontinued operations                                 --             (4.05)
                                                    -----------     -----------

   Net Loss                                         $     (2.49)    $     (7.74)
                                                    ===========     ===========

Weighted Average Number of
 Common Shares Outstanding:
  Basic                                                 589,702         182,037
  Diluted                                               589,702         182,037



                     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, 1997 AND 1996



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

<S>                                              <C>           <C>             <C>         <C>              <C>         
Balance at December 31, 1995                     900,000       $--             88,666      $ 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                       --          --             26,667          100,000             --

Issuance of common stock in private
 offering (net of offering costs of
 $224,801)                                          --          --            400,000        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                        --          --            515,333        4,839,485       (3,596,355)

Issuance of common stock                            --          --               --                970             --

Issuance of common stock in connection
 with bridge loans                                  --          --            150,000          750,000             --

Net loss                                            --          --               --               --         (1,470,550)
                                             -----------       -----      -----------      -----------      -----------

Balance at December 31, 1997                        --         $--            665,333      $ 5,590,455      $(5,066,905)
                                             ===========       =====      ===========      ===========      ===========





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

                                                        F-6

</TABLE>

<PAGE>



                             PROTOSOURCE CORPORATION
                            STATEMENTS OF CASH FLOWS
                 FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1996



                                                         1997           1996
                                                         ----           ----
Cash Flows From Operating Activities:
  Net loss                                           $(1,470,550)   $(1,409,800)
  Adjustments to reconcile net loss to net cash
   provided (used) by operating activities:
    Depreciation and amortization                        544,670        367,049
    Provision for bad debts                              107,500           --
    Deferred income taxes                                 71,550           --
    Assets and liabilities disposed of in
     divestiture and note receivable received               --           17,176
    (Gain) loss  on disposal of equipment                  2,018         (4,607)
    Issuance of common stock for costs of financing         --          100,000
    Changes in operating assets and liabilities:
     Accounts receivable                                  20,563        163,556
     Inventories                                           8,980          7,079
     Deposits and other assets                            12,586         15,441
     Accounts payable                                    (99,587)        32,536
     Accrued liabilities                                (191,966)       344,284
     Customer deposits                                    (1,500)        (4,000)
     Unearned customer support revenue                      --          (34,542)
                                                     -----------    -----------

Net Cash (Used) By Operating Activities                 (995,736)      (405,828)
                                                     -----------    -----------

Cash Flows From Investing Activities:
  Purchase of property and equipment                     (77,552)       (38,421)
  Proceeds from disposal of equipment                       --           10,536
  Software development costs capitalized                    --         (442,100)
  Receipt of principal on notes receivable               207,579           --
                                                     -----------    -----------

Net Cash Provided (Used) By Investing Activities         130,027       (469,985)
                                                     -----------    -----------

Cash Flows From Financing Activities:
  Payments on notes payable                              (73,447)       (55,675)
  Proceeds from borrowing                                750,000        200,000
  Issuance of common stock                                   970      1,300,000
  Offering costs incurred                                (98,523)      (224,801)
  Debt issuance costs incurred                           (97,500)          --
                                                     -----------    -----------

Net Cash Provided By Financing Activities                481,500      1,219,524
                                                     -----------    -----------






                     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, 1997 AND 1996



                                                                  1997               1996
                                                                  ----               ----

<S>                                                            <C>                <C>      
Net Increase (Decrease) in Cash and Cash Equivalents           $(384,209)         $ 343,711

Cash and Cash Equivalents at Beginning of Year                   482,357            138,646
                                                               ---------          ---------

Cash and Cash Equivalents at End of Year                       $  98,148          $ 482,357
                                                               =========          =========

Supplemental Disclosure of Cash Flow Information:
 Cash paid during the year for:
  Interest                                                     $ 258,790          $ 272,228
  Income taxes                                                       800               --

Supplemental Disclosure of Noncash
 Investing and Financing Activities:
  Acquisition of equipment under capital leases                $  69,959          $  90,349
  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
  Issuance of common stock in connection with financing          750,000               --








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

                                       F-8

</TABLE>

<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 service provider.

     Basis of Presentation
     ---------------------
          The  accompanying  financial  statements have been prepared on a going
          concern basis,  which  contemplates  the realization of assets and the
          satisfaction  of  liabilities  in the normal  course of business.  The
          financial  statements do not include any  adjustments  relating to the
          recoverability  and  classification  of recorded  asset amounts or the
          amount and  classification  of  liabilities  that  might be  necessary
          should  the  Company be unable to  continue  as a going  concern.  The
          Company's  continuation  as a going  concern  is  dependent  upon  its
          ability to generate  sufficient cash flow to meet its obligations on a
          timely basis, to obtain additional  financing as may be required,  and
          to increase  sales to a level where the  Company  becomes  profitable.
          Additionally,  the  Company has  experienced  extreme  cash  liquidity
          shortfalls from operations.

          The  Company's  continued  existence is dependent  upon its ability to
          achieve  its  operating  plan.   Management's   plan  consist  of  the
          following:

          1.   In 1996,  the Company  restructured  its  operations and divested
               three divisions (Note 2). The Company  currently  operates solely
               as an  Internet  service  provider.  The  Company has reduced its
               general and administrative  expenses and continues to consolidate
               its operations and reduce its operating costs.

          2.   Obtaining  additional  equity through the sale of securities in a
               secondary stock offering (the  "Offering")  (Note 6). The Company
               has a letter of intent with an Underwriter  for the offering on a
               firm  commitment  basis.  The  Company  has filed a  Registration
               Statement  with the  Securities  and Exchange  Commission for the
               Offering.  The  Offering is  expected to raise gross  proceeds of
               approximately  $6,000,000,  which would result in net proceeds to
               the  Company  of  approximately  $5,100,000.   There  can  be  no
               assurance that the Offering will be successfully completed.

          3.   Sale of certain assets of the Company.

          If  management  cannot  achieve its  operating  plan  because of sales
          shortfalls,  lack of  ability  to  complete  the  Offering,  or  other
          unfavorable  events,  the Company may find it  necessary to dispose of
          assets, or undertake other actions as may be appropriate.

     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.

          On April 25, 1997,  the  Company's  shareholders  adopted a resolution
          approving  a three  for two  reverse  stock  split of the  issued  and
          outstanding  common  shares,  effective  April  25,  1997.  All  share
          information  and per share data have been  retroactively  restated for
          all periods presented to reflect the reverse stock splits.


                                       F-9


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies (Continued)
   ------------------------------------------------------
     Revenue Recognition
     -------------------
          Revenue from the Internet operations is recognized over the period the
          services are provided.  Deferred revenue consists primarily of monthly
          subscription fees billed in advance.

     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
          at the date of purchase to be cash equivalents.

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

     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 $223,086  and  $233,201 for the years ended  December 31, 1997 and
          1996, respectively.

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

          Debt issuance costs are being amortized using the straight-line method
          over the fifteen month term of the loans.

     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 $-0-,  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 the cost of the
          investment.

     Deferred Offering Costs
     -----------------------
          In connection  with the Company's  proposed  public offering (Note 6),
          costs incurred to complete the offering have been deferred and will be
          offset  against the proceeds of the offering if completed,  or charged
          to expense if the offering is not completed.

     Stock-Based Compensation
     ------------------------
          During the year ended December 31, 1996, the Company adopted Statement
          of Financial  Accounting  Standards  (SFAS) No. 123,  "Accounting  for
          Stock-Based  Compensation".  The  Company  will  continue  to  measure
          compensation expense for its stock-based  employee  compensation plans
          

                                      F-10


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies (Continued)
   ------------------------------------------------------
     Stock-Based Compensation (Continued)
     ------------------------------------
          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 No.  123 had been  applied in
          measuring compensation expense.

     Long-Lived Assets
     -----------------
          In accordance with Statement of Financial  Accounting Standards (SFAS)
          No. 121,  "Accounting for the Impairment of Long-Lived  Assets and for
          Long-Lived  Assets to be Disposed  Of",  the  Company  reviews for the
          impairment of long-lived assets, certain identifiable intangibles, and
          associated  goodwill,  whenever  events or  changes  in  circumstances
          indicate that the carrying  value of an asset may not be  recoverable.
          An impairment loss would be recognized when the estimated  future cash
          flows is less than the  carrying  amount of the asset.  No  impairment
          losses have been identified by the Company.

     Income Taxes
     ------------
          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.

     Net Income (Loss) Per Share of Common Stock
     -------------------------------------------
          As of December 31, 1997,  the Company  adopted  Statement of Financial
          Accounting  Standards  (SFAS) No. 128,  "Earnings  Per  Share",  which
          specifies the method of computation,  presentation  and disclosure for
          earnings  per share.  SFAS No. 128 requires  the  presentation  of two
          earnings per share amounts, basic and diluted.

          Basic  earnings per share is  calculated  using the average  number of
          common shares  outstanding.  Diluted earnings per share is computed on
          the basis of the average number of common shares  outstanding plus the
          dilutive  effect of  outstanding  stock  options  using the  "treasury
          stock" method.

     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  (Notes 9
          and 12).

                                      F-11


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


2. Discontinued Operations (Continued)
   -----------------------------------
          Also included in the assets of the divested  divisions 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
          included  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 office
          space from the Company for a period of fourteen  months at the rate of
          $12,000 per month through February 1998.

          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 26,667 shares of common stock
          to the bridge  lenders as  additional  consideration  for the $200,000
          loan. In October and November 1996 the Company sold 400,000  shares of
          its  common  stock at $3.75 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  146,667  warrants to each which are  exercisable  at
          $3.75 per share for a four year period  through  October 31, 2001.  In
          June 1997, the Underwriter  returned  106,667  warrants to the Company
          without consideration. 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.  The  Registration  Statement was filed and
          declared effective in May 1997.

          Revenues  applicable to the  Company's  discontinued  operations  were
          $540,112 for the year ended December 31, 1996.

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

     Individuals and Other
     ---------------------
          12%  unsecured  Bridge  Loans  from a  group  of  eight
          lenders  due on the  earlier of the closing of a public
          or private offering of securities by the Company for at
          least $1,000,000 or fifteen months from the date of the
          Bridge Loans. As additional compensation for the Bridge
          Loans,  the  Company  issued an  aggregate  of  150,000
          shares of common  stock to the  lenders,  one share for
          each $5 loaned to the Company.                               $750,000

     Obligations Under Capital Leases
     --------------------------------
          11.1% to 25.1%  installment  notes due in 1998 to 2001,
          collateralized by equipment.                                  172,882


                                      F-12


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


3. Long-Term Debt (Continued)
   --------------------------
     Obligations Under Capital Leases (Continued)
     --------------------------------------------
          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).                        1,677,933
                                                                     ----------

               Total Long-Term Debt                                   2,600,815
               Less current portion of long-term debt                  (811,926)
                                                                     ---------- 

               Long-Term Debt                                        $1,788,889
                                                                     ==========

          Installments due on debt principal,  including the capital leases,  at
          December 31, 1997 are as follows:

               Year Ending
               December 31,
               ------------
                  1998                                               $  811,926
                  1999                                                   19,902
                  2000                                                   42,023
                  2001                                                   10,504
                  2002                                                    9,382
                  Later years                                         1,707,078
                                                                     ----------

                  Total                                              $2,600,815
                                                                     ==========

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

                                                      1997              1996
                                                      ----              ----
          Current:
              Federal                                $    --          $    --
              State                                      800               --
                                                     -------          -------
                Total                                    800               --
                                                     -------          -------

          Deferred:
              Federal                                 60,635               --
              State                                   10,915               --
                                                     -------          -------
                Total                                 71,550               --
                                                     -------          -------

          Total Provision For Income Taxes           $72,350          $    --
                                                     =======          =======


          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)
   ------------------------
                                                          1997           1996
                                                          ----           ----
          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,
          1997 are as follows:

          Net operating loss carryforward              $ 1,413,700
          Vacation accrual                                   2,070
          Allowance for bad debts                           36,870
                                                       -----------

          Total deferred tax asset                       1,452,640
                                                       -----------

          Accelerated depreciation                         (21,760)
                                                       -----------

          Total deferred tax liability                     (21,760)
          Less valuation allowance                      (1,430,880)
                                                       -----------

          Net Deferred Tax Asset                       $      --
                                                       ===========

          The  Company  has  assessed  its past  earnings  history  and  trends,
          budgeted  sales,  and  expiration  dates  of  carryforwards   and  has
          determined that it is more likely than not that no deferred tax assets
          will be realized.  The valuation allowance of $1,430,880 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
          $494,180.  The Company  will  continue to review this  valuation  on a
          quarterly basis and make adjustments as appropriate.

          At December  31,  1997,  the Company  had federal and  California  net
          operating  loss   carryforwards   of   approximately   $5,000,000  and
          $2,500,000,  respectively. Such carryforwards expire in the years 2007
          through  2012  and  1998  through  2002  for  federal  and  California
          purposes, respectively.

5. 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, 1997, no options have been granted under the Plan.





                                      F-14


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


5. Shareholders' Equity (Continued)
   --------------------------------
     Preferred Stock
     ---------------
          In December 1994, the Company issued to six individuals, including the
          Company's five former  executive  officers,  for no  consideration,  a
          total of 900,000 shares of Series A Convertible  Preferred  Stock,  no
          par value.  Such shares  were  automatically  convertible,  in varying
          amounts  per year,  into  shares of common  stock on a fifteen for one
          basis through 2003 if certain  revenue and net income  milestones were
          met.

          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 46,000 units at $82.50 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
          consisted of one share of the  Company's  common stock and one warrant
          to purchase an  additional  share of common  stock at $97.50 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 $112.50
          or more for 30  consecutive  days. The warrants were not exercised and
          all 46,000  warrants  expired on  February 9, 1998.  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 $99.00 per Unit. The Units subject to the  Underwriter's
          Warrant are identical to the Units sold to the public.

6. Proposed Public Stock Offering
   ------------------------------
          The Company has  executed a letter of intent  with an  Underwriter  to
          offer 900,000 units of the Company's securities,  each unit consisting
          of one share of the Company's  common stock and one redeemable  common
          stock  purchase  warrant.  The  offering  price  per unit  will be the
          average bid price of the common stock in the  over-the-counter  market
          for the common stock on the day prior to the Offering. Each warrant is
          exercisable  to  purchase  one  share of  common  stock at the  public
          offering  price of the  Units  for a  period  of five  years  from the
          effective  date of the  Company's  Registration  Statement  and may be
          redeemed by the Company.  The Company will also grant the  Underwriter
          an option to purchase an additional  135,000 units from the Company to
          cover  over-allotments  for a period of thirty days from the effective
          date of the Registration Statement.

          The Company will pay the Underwriter a commission equal to ten percent
          of the gross  proceeds of the offering and a  non-accountable  expense
          allowance  equal  to  three  percent  of  the  gross  proceeds  of the
          offering.  In connection with the offering,  the Company has agreed to
          issue the  Underwriter  a warrant,  for $100, to purchase up to 90,000
          units which shall be  exercisable at a price per unit equal to 165% of
          the public offering price of the Units. The  Underwriter's  warrant is
          exercisable  for a period of four  years  beginning  one year from the
          effective date of the Registration Statement. The units subject to the
          Underwriter's  warrant  will be  identical  to the  units  sold to the
          public. The Company has also agreed upon completion of the Offering to
          retain the  Underwriter as a financial  consultant for a period of one
          year at a monthly fee of $5,000 (a total of  $60,000)  payable in full
          upon  completion of the Offering.  There can be no assurance  that the
          Offering will be successfully completed.


                                      F-15


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


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 previously  occupied  approximately half of
          the space as its  corporate  office  facility and 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 option at any time through April 30, 1998, to purchase the building
          and land for  $1,900,000.  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  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  $24,000 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, 1997 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:

          Year Ending                     Capital        Operating
          December 31,                    Leases          Leases         Total
          ------------                    ------          ------         -----
             1998                      $   273,922      $  52,785     $  326,707
             1999                          252,176         53,841        306,017
             2000                          265,984         54,918        320,902
             2001                          230,047         56,016        286,063
             2002                          228,252         23,340        251,592
          Later years                    3,477,321             --      3,477,321
                                       -----------      ---------     ----------

          Total Minimum Lease
           Payments                      4,727,702      $ 240,900     $4,968,602
                                                        =========     ==========

          Less amount representing 
           interest                     (2,876,887)
                                       ----------- 

          Present Value of Net Minimum
           Lease Payments              $ 1,850,815
                                       ===========

          Rent expense  amounted to  approximately  $69,806 and $120,100 for the
          years ended December 31, 1997 and 1996, respectively.

          Leased  equipment  under capital  leases as of December 31, 1997 is as
          follows:





                                      F-16


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


7. Commitments and Contingencies (Continued)
   -----------------------------------------
          Building                                                  $1,348,824
          Land                                                         411,176
          Equipment                                                    346,398
          Less accumulated amortization                               (386,417)
                                                                    ----------

          Net Property and Equipment Under Capital Leases           $1,719,981
                                                                    ==========

          In May  1997,  as a result of the  Company's  default  on its  capital
          lease,  the Company  agreed to return legal  possession  of the office
          building to the landlord. The Company does not occupy any space in the
          building,  although  it  leased  a  portion  of it to SSC  and the SSC
          Principals  based  upon  monthly  payments  to the  Company of $12,000
          through  February  1998.  Accordingly,  the  landlord  collects  rents
          directly  from the tenants of the office  building  and the Company is
          responsible  for the difference  between such aggregate  rents and the
          Company's  lease  payment to the  landlord.  The landlord is currently
          collecting  monthly  rents  aggregating  approximately  $9,200 and the
          Company's  monthly  leasehold  obligation  is  approximately   $15,600
          leaving a monthly  balance  due from the  Company to the  landlord  of
          approximately $6,400.

8. Stock Based Compensation Plans
   ------------------------------
          The Company  adopted  SFAS No. 123 during the year ended  December 31,
          1996. In accordance  with the  provisions of SFAS No. 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 recognize  compensation  expense based upon
          the fair  value  at the  grant  date  for  awards  under  these  plans
          consistent  with  the  methodology  prescribed  by SFAS No.  123,  the
          Company's  net income and  earnings  per share would be reduced to the
          following pro forma amounts:

                                                       1997             1996
                                                       ----             ----
          Net Loss:
              As reported                         $(1,470,550)      $(1,409,800)
              Pro forma                            (1,507,063)       (1,412,843)

          Net Loss Per Share of Common Stock:
              As reported                         $     (2.49)     $      (7.74)
              Pro forma                           $     (2.56)     $      (7.76)

          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 1997.

                                      F-17


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


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

          On November 1, 1994, all of the Company's former  shareholders  agreed
          in writing with each other and with the Company to contribute pro rata
          from  their  shareholdings  up to a total of  13,334  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  13,334  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
          13,334 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 334 shares in connection with
          the acquisition of ValleyNet Communications.

          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.  SSC was behind on the payments
          under  the  terms of the note and the  Company  has  withheld  certain
          payments  it received  from the sale of software  (Note 11) which were
          owed to SSC and reduced the note receivable by such amounts (Note 12).

          The Company issued 36,667 warrants to its Chief  Executive  Officer in
          connection  with  his  employment  agreement  in  November  1996.  The
          warrants  vest as to 13,333  warrants  on January  1, 1997,  13,334 on
          January  1, 1998 and  10,000 on January  1,  1999.  The  warrants  are
          exercisable at $3.75 per share at anytime through October 2001.

10. Concentration of Credit Risk
    ----------------------------
          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.


                                      F-18


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


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, 1996 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 various
          percentage of sales for each copy of the Software  purchased  from the
          Partnership.

          Since the Company  was  responsible  for  maintaining,  upgrading  and
          developing  future revisions of the Software,  the transaction was not
          been  accounted for as a sale by the Company.  In addition,  the notes
          receivable  were not  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  was accounted for by the
          Company  on a cost  recovery  basis  and the  cash  received  from the
          Partnership reduced 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).

12. Litigation
    ----------
          As a  result  of the  failure  of SSC and the  SSC  Principals  to pay
          certain  trade  account  payables  and  certain  office  rent  under a
          sublease  from the  Company,  the  Company  has been  threatened  with
          litigation  from such trade  creditors and has been required to return
          possession of the SSC subleased office space to the Company's landlord
          (Note 7). The Company believes that the total contingent  liability to
          trade  account  creditors  arising  from  defaults  by SSC and the SSC
          Principals does not exceed $100,000.



                                      F-19


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


12. Litigation (Continued)
    ----------------------
          The Company has paid certain  amounts to trade  creditors of SSC which
          arose prior to the divestiture of three of the Company's  divisions to
          SSC in 1996. The Company filed suit against SSC and the SSC Principals
          in  December  1997 to recover  the  amounts it paid and to  accelerate
          payment of the Company's note receivable from SSC.

          In February 1997, three of the Company's  former  employees  brought a
          civil   action   against  the  Company  for  back  wages   aggregating
          approximately  $45,000 which was incurred prior to the  divestiture of
          the three divisions.  The Company alleges that these amounts,  if due,
          are  the  responsibility  of SSC  and the  SSC  Principals  under  the
          Divestiture Agreement. The Company is unable to predict the outcome to
          the litigation.

          Payment of any  judgements or  settlements  in  connection  with these
          litigation matters, together with the costs of defending such matters,
          could  adversely  affect  the  Company's  results  of  operations  and
          financial condition.

13. Employee Benefit Plan
    ---------------------
          Effective May 29, 1997, the Company  adopted a 401(K) savings plan for
          employees who are not covered by any collective  bargaining agreement,
          have attained age 21 and have completed one year of service.  Employee
          and Company matching contributions are discretionary. The Company made
          matching contributions of $1,799 for the year ended December 31, 1997.
          Company contributions vest as follows:

                   Years of Service                    Percent Vested
                   ----------------                    --------------
                           1                                 33%
                           2                                 66%
                           3                                100%

14. Fair Value of Financial Instruments
    -----------------------------------
          Disclosures  about  Fair  Value  of  Financial   Instruments  for  the
          Company's  financial  instruments  are  presented  in the table below.
          These calculations are subjective in nature and involve  uncertainties
          and  significant  matters of judgment  and do not  include  income tax
          considerations.  Therefore,  the  results  cannot be  determined  with
          precision and cannot be  substantiated  by  comparison to  independent
          market  values and may not be realized in actual sale or settlement of
          the instruments.  There may be inherent  weaknesses in any calculation
          technique,  and  changes  in the  underlying  assumptions  used  could
          significantly  affect the  results.  The  following  table  presents a
          summary of the  Company's  financial  instruments  as of December  31,
          1997:

                                                               1997
                                                  -----------------------------
                                                    Carrying         Estimated
                                                     Amount          Fair Value
                                                  -----------        ----------

          Financial Assets:
          Cash and cash equivalents               $   98,148         $   98,148
          Note receivable                            463,271            463,271

          Financial Liabilities:
          Long-term debt                           2,600,815          2,600,815




                                      F-20


<PAGE>


                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


14. Fair Value of Financial Instruments (Continued)
    -----------------------------------------------
          The  carrying  amounts  for cash and  cash  equivalents,  receivables,
          accounts payable and accrued  expenses  approximate fair value because
          of the  short  maturities  of these  instruments.  The  fair  value of
          long-term debt, including the current portion, approximates fair value
          because of the market rate of interest on the  long-term  debt and the
          interest rate implicit in the obligations under capital leases.












                                      F-21







<PAGE>




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

     None.



                                       16

<PAGE>



                                    PART III

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

Officers and Directors

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

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

 Raymond J. Meyers           41        Chief Executive Officer       1996
                                       and Director

 David A. Appell             34        Director                      1997

 Dickon Pownall-Gray (1)     43        Director                      1997

----------

(1) Mr.  Pownall-Gray  has agreed to become a director of the Company  following
completion of a public  offering of the Company's  securities  (the  "Offering")
which is  currently  the  subject  of a  Registration  Statement  filed with the
Securities and Exchange Commission.

     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 Raymond J. Meyers,  Andrew Chu,  Steven A. Kriegsman and Howard P. Silverman
were elected as officers and directors.  In May 1997 Mr. Kriegsman  resigned and
in August 1997 Messrs. Chu and Silverman  resigned.  The Company  established an
audit  committee in January 1998  composed of all three  members of its Board of
Directors.

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.

                                       17

<PAGE>


     David A. Appell became a Director of the Company in September  1997.  Since
January  1997, he has served as an investment  banker for the  Underwriter,  and
since  February  1992,  he has been engaged in the private  practice of law. Mr.
Appell also serves as a director of Allied Capital  Services,  LLC, a consulting
firm which provides financing and real estate development  services.  From April
1996 to January 1997 he served as Managing  Director of  Investment  Banking for
R.D.  White & Co., Inc. Mr. Appell is the General  Partner of HPH Capital Growth
L.P.,  a New York  Limited  Partnership  created to raise and  manage  funds for
equity  investments.  From  December  1993 through April 1996 he served as house
counsel for Comart,  Inc., an introducing broker registered with the commodities
futures trading commission. Mr. Appell received a Judicial Doctorate degree from
Cardozo Law School and holds a BBA in Accounting from Pace  University.  He is a
Member of the New York State Bar and New Jersey  State Bar.  He is a  registered
options principal,  general securities representative,  uniform securities agent
and general securities  principal.  He is also registered as a commodity trading
advisor and commodity pool operator.

     Dickon  Pownall-Gray  has agreed to become a director of the Company at the
closing of the Offering.  Since 1994 he has acted as an  independent  consultant
and an  investment  manager for his own  account.  Since 1995 he has also been a
stockholder  and a  director  of  Infosis,  Inc.  From 1992 to 1993 he served as
Senior Vice President in charge of acquisitions  for Preferred Health Care, Inc.
From 1988 to 1991 he was Chief Executive Officer and a founder of CareSys, Inc.,
a medical  monitoring  and database cost  containment  company.  In 1991 he sold
CareSys,  Inc. to  Preferred  Health Care,  Inc.  From 1985 to 1987 he served as
Chief  Executive  Officer  of Health  Care  Systems.  From 1982 to 1984 he was a
senior consultant for Bain & Co. in its London office. Mr. Pownall-Gray holds an
MBA from the London Business School, an MA in Sports Science from the University
of  California  Berkeley,  a BA (Honors  History  and Sports  Science)  from the
University of Birmingham.

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,  the  Company's
Chief Executive Officer,  who receives a salary of $130,000 per year pursuant to
an Employment  Agreement which expires in January 1999. The Employment Agreement
also  provides  for cash bonuses  ranging from $25,000 (if the Company  earns at
least  $500,000  before  taxes in any year) to $75,000 (if the Company  earns at
least  $1,250,000  before taxes in any year). In connection with his employment,
Mr.  Meyers was also granted  options to purchase  36,667 shares of Common Stock
vesting  over a three  year  period at $3.75 per share  exercisable  at any time
until October 2001. No executive  officer or director  received  compensation in
excess of $100,000 for the calendar years ended December 31, 1997, 1996 or 1995.
Compensation  for all  officers and  directors as a group for the calendar  year
ended December 31, 1997, aggregated $130,008.


                                       18

<PAGE>



     The following table discloses  certain  compensation  paid to the Company's
Chief Executive Officer for the calendar years ended December 31, 1997, 1996 and
1995.
<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(#)       Payout      sation($)
---------      ----   ---------    --------      ---------     -----------     -------      -------      ---------

<S>            <C>    <C>          <C>           <C>           <C>             <C>          <C>          <C>
Raymond J.
Meyers         1997   $130.008     $    0            0              0           36,667          0            0
James C.       1996     61,925          0            0              0              0            0            0
Robinson       1995     61,425        5,941          0              0              0            0            0


</TABLE>

Option Grants in Last Year and Stock Option Grant

     The following  table provides  information on option grants during the year
ended December 31, 1997 to the named executive officers:

                                Individual Grants

                             % of Total Options
                                 Granted to
                     Options     Employees
       Name          Granted      in Year       Exercise Price   Expiration Date
       ----          -------      -------       --------------   ---------------

Raymond J. Meyers    36,667        100%             $3.75         October 2001



                                       19

<PAGE>




Aggregate Option Exercise of Last Fiscal year and Fiscal Year-End Option Values

     The  following  table  provides  information  on the  value  of  the  named
executive  officers'  unexercised  options at December  31,  1997.  No shares of
Common Stock were acquired upon exercise of options during the fiscal year ended
December 31, 1997.

                                                             Value of
                       Number of Unexercised          Unexercised In-The-Money
                      Options at Year End (1)          Options at Year End (1)
      Name          Exerciable    Unexercisable      Exercisable   Unexercisable
      ----          ---------------------------      ---------------------------

Raymond J. Meyers     13,333          23,334            20,000         35,001

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

(1)  The closing  price of the Common  Stock on December 31, 1997 as reported by
     on the Electronic Bulletin Board was $5.25.

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
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  and  terminates  in
November 2004. At December 31, 1997, 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


                                       20

<PAGE>



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.

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)                 13,333                         2.0%
Andrew Chu(2)                         38,999                         5.5%
David A. Appell                         0                              0%
Dickon Pownall-Gray                     0                              0%
Steven A. Kriegsman(3)               117,667                        15.0%
Anaka Prakash                         38,667                         5.8%
World Spirit, Inc.                    50,000                         7.5%
All officers and
directors as  a
group (3 persons)(1)                  13,333                         2.0%
----------

(1) Represents stock options to purchase 13,333 shares at $3.75 per share at any
time until  October 2001.  Mr.  Meyers holds an additional  23,334 stock options
which vest in 1998 and 1999.

(2) Represents common stock purchase warrants to purchase 38,999 shares at $3.75
per share at any time until October 2001.

(3)  Represents  common stock  purchase  warrants to purchase  117,667 shares at
$3.75 per share at any time  until  October  2001.  All  common  stock  purchase
warrants are held by the  Kriegsman  Group ("KG") of which Mr.  Kriegsman is the
President and a principal stockholder.  KG originally received 146,666 Warrants,
but assigned 38,999 of such Warrants to Mr. Chu. See "Item 12".

                                       21

<PAGE>


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 November 1994,  the Company  issued  857,140  shares of its  Convertible
Preferred  Stock to five of the  Company's  then  officers and  directors,  (and
42,860 to another  individual  not otherwise  affiliated  with the Company) each
share of which was convertible for no additional consideration into one share of
Common Stock for each fifteen shares of Preferred  Stock.  All 900,000 shares of
Convertible  Preferred  Stock were  canceled  and returned to the Company by the
five holders in connection with the Divestiture Agreement described below.

     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  was due in
April 1997 and remains unpaid. The promissory note is secured by 3,333 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 October 1996, the Company issued 146,666 common stock purchase  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 KG. KG subsequently assigned 35,666 of such warrants to Andy Chu,
the  Company's  President and a director.  KG also assigned  3,333 of the 10,000
stock options it received from the SSC Principals to Mr. Chu to provide him with
an equity  stake in the  Company.  KG believed  that the  Company's  success and
therefore the economic success of its investment in the Company depended in part
upon the participation of Mr. Chu as the Company's then President.

     In October 1996, the Company issued 146,667 common stock purchase  warrants
to Andrew,  Alexander,  Wise & Company, Inc. (the "Underwriter") as compensation
for it assisting the Company in the private  placement of 400,000  shares of the
Company's  Common  Stock  to a group of  investors  for  $3.75  per  share.  The
Underwriter   subsequently  assigned  56,667  of  such  warrants  to  Howard  P.
Silverman,  a  former  director  of  the  Company,  for  his  assistance  to the
Underwriter in connection  with the private  placement.  At the time the subject
Warrants were  assigned,  Mr.  Silverman was not a director of the Company.  The
Company  also  paid to the  Underwriter  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 June 1997,  the  Underwriter  and Mr.  Silverman
returned 106,667 warrants to the Company without consideration.


                                       22

<PAGE>



     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 the  liabilities  of the Classic Line and certain other  liabilities,
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 (less  $200,000 of  liabilities  which
were paid by the Company and deducted  from the  $500,000) 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 part
of the  Divestiture  Agreement,  the SSC  Principals  also (i) canceled  900,000
shares  of  Convertible  Preferred  Stock  held by them  which  were  previously
exercisable into shares of Common Stock on a fifteen for one basis,  (ii) agreed
to refrain from the sale of an aggregate of 30,300  shares of Common Stock owned
by them  until  October  1999,  except  with the prior  written  consent  of the
Underwriter, (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,  then a director of the  Company,  an option to purchase up to 10,000
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.  The Classic
Line assets were valued as a result of negotiations  between the Company and the
SSC Principals.

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)

  10.12            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)


                                    23

<PAGE>




  10.17            Employment Agreement with Mr. Meyers (3)

  10.18            Bridge Loan Agreement (3)

---------

(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, declared effective on May 14, 1997.

(3) Incorporated by reference to the Registrant's Registration Statement on Form
SB-2, file number 333-40743, filed February 10, 1998.


                                       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 26, 1998.

                                           PROTOSOURCE CORPORATION



                                           By  /s/ Raymond J. Meyers
                                             -----------------------------------
                                             Raymond J. Meyers
                                             Chief Executive Officer


     Pursuant to the  requirements  of the  Securities  Exchange Act of 1934, as
amended, this Report has been signed below by the following persons on the dates
indicated.

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


/s/ Raymond J. Meyers       Chief Executive Officer, Chief        March 24, 1998
------------------------    Financial Officer (Principal      
Raymond J. Meyers           Accounting Officer), and Director 
                            


/s/ David A. Appell         Director                              March 24, 1998
------------------------
David A. Appell



                                       25