<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

                                   FORM 10-K


[x]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the Fiscal Year  Ended December 31, 1998

OR

[_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the Transition Period from __________ to __________.

Commission File Number 000-21559

                           VIISAGE TECHNOLOGY, INC.
                       --------------------------------
            (Exact name of registrant as specified in its charter)


Delaware                                                     04-3320515
---------------------------------                            -------------------
(State or other jurisdiction of                              (I.R.S. Employer
incorporation or organization)                               Identification No.)
                                                             
30 Porter Road,  Littleton,  MA                              01460
----------------------------------------                     -------------------
(Address of principal executive offices)                     (Zip Code)
 
Registrant's telephone number, including area code           (978)-952-2200
                                                             -------------- 

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

      Title of each Class                  Name of exchange on which registered
      -------------------                  ------------------------------------
  Common Stock $.001 par value                     NASDAQ National Market

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K  is not contained herein, and will not be contained to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference into Part III of this Form 10-K or any
amendment to this Form 10-K.[X]

The aggregate market value of the voting stock held by nonaffiliates of the
registrant as of March 15, 1999, was approximately $4 million.

As of March 15, 1999, the registrant had 8,392,168 shares of Common Stock
outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement for the Annual Meeting
of Shareholders to be held on May 28, 1999, are incorporated by reference into
Part III.
<PAGE>
 
                                    PART I

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

  (a) General Development of Business
      -------------------------------

     Viisage Technology, Inc. (Viisage or the Company), is a leader in the
  emerging field of biometrics technology and in providing digital
  identification systems and solutions.  The Company focuses on identification
  solutions that improve personal convenience and security, deter fraud and
  reduce identification program costs.  Viisage combines its systems integration
  and software design capabilities with its proprietary software and hardware
  products and other industry standard products to create complete customized
  solutions.  These turnkey solutions integrate image and data capture, create
  relational databases, incorporate multiple biometrics and improve customers'
  ability to move and manage information.  Applications can include driver's
  licenses, voter registration, national ID's, law enforcement, social services,
  access control and PC network and internet access security.  To date,
  Viisage's primary customers have been government agencies with particular
  emphasis on U.S. drivers licensing agencies.  Since its inception in 1993, the
  Company has captured approximately 30% of the domestic driver's license
  market. Viisage products annually produce more than 20 million identification
  documents at more than 1,000 locations in 11 states.  The Company has also
  provided services under subcontracts for projects in Jamaica, the Philippines
  and for the U.S. Immigration and Naturalization Service.

     The Company began operations in 1993 as a division of Lau Technologies
  (Lau), a provider of systems integration services and products for
  sophisticated electronic systems.  In November 1996, Lau transferred
  substantially all of the assets, liabilities and operations of the division to
  the Company and the Company completed its initial public offering.  The
  Company is currently a 65% owned subsidiary of Lau.

     On November 3, 1998, the Company's Board of Directors appointed Thomas J.
  Colatosti, formerly the Company's Chief Operating Officer, President and Chief
  Executive Officer.

     During 1997 and 1998, the Company's revenue growth slowed significantly due
  primarily to lengthening procurement delays in its principal markets and a
  strong competitive market place.  The Company believes that the acceptance of
  digital identification technology in recent years, its commitment to providing
  customized solutions for its customers needs, its expertise in facial imaging
  and biometric solutions and its proprietary software and hardware products
  will continue to contribute to its growth.

     Effective June 1, 1998, the Company reorganized its operations to create a
  separate biometrics division to respond to the growing market interest in
  biometric solutions.  The biometrics division is focused on product, market
  and channel development activities in three principal areas: facility access
  control; PC network and internet access security; and real-time large database
  identification and verification of individuals.  The systems integration and
  identification card division (SI division) focuses on Viisage's public sector
  markets and serves as a channel to existing customers and the public sector
  for the Company's biometric 

                                       1
<PAGE>
 
  technologies. The Company believes that it is in the early stages of an
  emerging and high growth market for biometric identification solutions,
  particularly facial recognition solutions in the government and commercial
  markets. In September 1998, the Company's technology partner and principal
  shareholder, Lau, was awarded a $2.8 million development contract for facial
  recognition systems by the U.S. Department of Defense which involved Viisage
  as a subcontractor. The Company believes that the leadership from the Federal
  Government in using facial biometrics as well as other recent awards and OEM
  arrangements validates the Company's technology and helps create credibility
  for the emerging global market.

     The SI division provides systems and services principally under contracts
  that generally have five to seven year terms and provide for several annual
  renewals after the initial contract term.  Contracts generally provide for a
  fixed price for the system and/or for each card produced.  Contract prices
  vary depending on, among other things, design and integration complexities,
  the nature and number of workstations and sites, the projected number of cards
  to be produced, the size of the database, the level of post-installation
  support and the competitive environment.  Substantially all of the Company's
  revenues are currently derived from SI division public sector customers and
  contractors to such customers.  The Company believes for the foreseeable
  future that it will continue to derive a significant portion of its revenues
  from a limited number of large contracts.

  (b) Financial Information about Industry Segments
      ---------------------------------------------

     The Company is engaged in one business, the development and implementation
  of digital identification systems and solutions.  The Company has two
  reportable business segments represented by its SI division and biometrics
  division discussed in item (a).  For financial information about industry
  segments see Note 11 of Notes to Financial Statements.

  (c) Description of Business
      ------------------------

  (i) Principal Products and Services
      -------------------------------

  Industry Background

     The need for proper identification impacts most people every day.  The
  desire for personal convenience, the significant and increasing costs of fraud
  and the growing concern over declining personal security have become driving
  forces behind the global need for effective identification solutions.
  Starting with only a fake driver's license, an individual is able to create
  multiple identities, commit fraud, evade law enforcement and engage in other
  criminal activities that have significant financial and societal implications.
  Password security and identity card systems can also be compromised if someone
  obtains a password or identity card and uses this information to gain
  unauthorized access to facilities, networks or information.

    In an effort to combat fraud and tampering, photographic identification
  cards encapsulated within laminated pouches were developed. However,
  photographic identification cards can be replicated using widely available
  advanced color copiers and 

                                       2
<PAGE>
 
  printers, and laminated pouches have proven easy to delaminate. Advances in
  and the acceptance of digital technology have led to an increasing demand for
  digital identification systems to replace existing systems. Digital systems
  enable information and images to be captured and imbedded within the fabric of
  the card through the use of dye-sublimation techniques, making digital cards
  more resistant to tampering than laminated pouches. Information can be stored
  in and later accessed from the card itself through the use of bar codes,
  magnetic stripes and "smart" cards (cards which contain computer chips).
  Digital systems also facilitate the storage of information in computer
  databases, thereby reducing the need for manual record-keeping, file cabinets,
  and cumbersome indexing systems. Finally, digital systems can be networked to
  enable up-to-date information to be shared and distributed across geographic
  and organizational boundaries. This ability to move and manage information
  helps to increase personal convenience for system users.

    As an additional means of improving personal convenience and security and
  deterring fraud, identification systems have increasingly used biometrics
  (unique biological characteristics) to verify personal identities. Biometric
  identifiers include facial images, fingerprints, iris scans, retinal scans,
  voice data, hand geometry and others, with fingerprints enjoying wide usage in
  law enforcement. However, unlike other biometrics, a facial image can be
  easily verified visually and can be captured in an unobtrusive manner via a
  photograph, making it a practical means of identification. When two or more
  biometric identifiers are used together, the statistical probability of
  properly identifying an individual increases.  The Company generally advocates
  the use of multiple biometrics and can incorporate these technologies into its
  solutions.

    Applications for digital identification systems and biometrics are
  increasing as they become more sophisticated and easier to use. For example,
  the typical U.S. state has multiple licensing or other agencies, including its
  department of motor vehicles, which require the verification of personal
  identity. The public sector is also focusing on the value of sharing databases
  to avoid redundant data gathering efforts, distribute information in a timely
  manner, increase efficiency and deter fraud. The Company believes that public
  and commercial sector applications for digital identification systems and
  biometrics will include national ID's, driver's licenses, law enforcement,
  voter registration, social services, access control, PC network and internet
  access security, ATMs, retail point-of-sale transaction processing and
  administration of health care benefits.

    The emergence of digital identification systems and biometrics present
  significant challenges for integrating these systems with customers' existing
  software, hardware and computing environments. Consequently, customers are
  seeking complete, integrated solutions to overcome these issues.

  Products and Services

  Digital Identification Systems

    The Company's SI division develops and implements digital identification
  systems and solutions and serves as a channel to the public sector for the
  biometrics division.  The SI 

                                       3
<PAGE>
 
  division's systems can produce identification cards that are virtually tamper
  proof and utilize facial recognition and other biometrics with or without
  cards for the real-time identification (one-to-many) and verification (one-to-
  one) of individuals.

     Depending on the customer's needs, the SI division offers ''instant issue''
  systems which produce identification cards on location in minutes, and central
  production systems which receive the information electronically from the point
  of capture and produce cards from a secure off-site processing location which
  are later mailed to recipients in several days. The facial images captured by
  the SI division's card systems can provide the content (face bases) for
  identification and verification applications.

    In a Viisage card system the facial image and other information are captured
  in digital format at the SI division's PC-based Image Capture Workstation
  which usually incorporates the SI division's proprietary SensorMast.  Compact
  and self-contained, Viisage workstations can easily be linked to a central
  image storage device, central card production unit and other remote devices
  using an existing network, custom designed data communications or the World
  Wide Web.  This flexibility makes the Image Capture Workstation ideal for
  instant issue, central production, mobile use and multiple site systems. The
  Viisage Quality Advisor can be used to assess image quality at the point of
  capture.  With an instant issue system, a commercially available dye-
  sublimation printer produces single-piece, tamper-resistant identification
  cards. Alternatively, with a central production system, a high speed
  manufacturing unit produces the cards, and an integrated card delivery unit
  prepares the cards for mailing.  When central production is selected, such
  systems incorporate the SI division's proprietary Visual Inspection System for
  quality control of all cards produced. Every system delivers top quality,
  tamper-resistant identification cards customized to meet the customer's
  information, delivery and security needs.  A wide range of optional features
  are available including bar codes, holographic overlays, ghost imaging,
  ultraviolet or micro preprinting, smart cards and a number of other features.

    Systems Integration and Software Design Capabilities. In addition to the SI
  division's systems integration capabilities, an important aspect of its
  services and ability to deliver turnkey solutions for its customers involves
  the design of customized software. Viisage's proprietary software controls the
  system and integrates the system components, including the SensorMast and
  Visual Inspection System and a variety of third party components and
  technologies used by its customers. The SI division has designed software to
  support all current industry standard operating systems (e.g., Windows NT,
  Windows 95, Unix and OS/2), network protocols (e.g., Novell Netware, TCP/IP
  and SNA), database products (e.g., Sybase or Oracle) and client/server
  architectures. The SI division's software design and systems integration
  capabilities enable it to accommodate most computing environments and
  customers with special requirements.

    Proprietary Products.  The SI division's proprietary products and related
  software are described below:

    .  The SensorMast is a fully-integrated, secure tower unit which
       incorporates computer-controlled image capture equipment. This equipment
       includes commercially available

                                       4
<PAGE>
 
       digital cameras, adjustable lighting, frame grabbers, step motors,
       fingerprint and signature capture devices and barcode readers. An
       integrated version of the SensorMast also includes the computer in the
       SensorMast.

    .  The Visual Inspection System automatically evaluates cards produced by
       the SI division's central production systems to determine whether the
       image and data on a person's identification card correspond to the
       information about that person in the system database. If the information
       does not match, the Visual Inspection System rejects the printed card and
       identifies the defect for immediate corrective action. This system, which
       incorporates robotics, high-speed cameras and sophisticated software,
       automates an activity which is otherwise performed manually and is a
       potential source of cost savings for customers.

    .  The Viisage Quality Advisor can be used by customers to ensure proper
       image quality. This software product instantly and precisely assesses
       image quality against desired standards. Images that fail to meet such
       standards are immediately rejected.

    Customer Service and Support. Following the installation of its digital
  identification systems, the SI division offers extensive customer training and
  help desk telephone support as well as ongoing maintenance services. The SI
  division's service and support teams, which vary depending on the customer and
  contract, are able to draw extensively upon the expertise of the Company's
  software and hardware engineers. For some contracts, the SI division has
  contracted with third party service organizations for maintenance support.

  Facial Recognition Systems

    The Company's biometrics division is developing the Company's biometric
  technologies in cooperation with its principal shareholder and technology
  partner Lau, with a particular emphasis on facial recognition.  The group has
  focused on the facial image as a key biometric because the human face is a
  unique and prominent feature that can be easily captured (in image) by a
  digital camera and verified visually in most cases by an individual with no
  special training. The biometrics division is concentrating on three principal
  areas: facility access control; PC network and internet access security; and
  real-time large database products.  The Company has several on-going facial
  recognition identification projects, including projects with the Massachusetts
  Department of Transitional Assistance and the Illinois Secretary of State.

    Over the last five years, Viisage and Lau have enhanced technology
  initially developed by Professor Alex Pentland of the Massachusetts Institute
  of Technology (MIT) and have developed products for access control,
  surveillance, and real-time large database identification and verification of
  individuals.  Viisage and Lau each license the underlying MIT technology for
  their respective markets through Facia Reco Associates Limited Partnership
  (Facia Reco), an entity formed by Dr. Pentland. While Dr. Pentland's software
  forms the basis of the Company's facial recognition technologies, the Company
  believes that the proprietary software developed over the last five years is
  integral to making these technologies commercially viable.

                                       5
<PAGE>
 
     Viisage's patented facial recognition software offers organizations the
  ability to create unique identification solutions and both enhances existing
  identification solutions and offers opportunities for new applications.  Using
  a sophisticated algorithm, the software translates the characteristics of a
  face into a unique number or eigenface.  The eigenface is used by the system
  for identification, a one-to-many search of a database, and verification, a
  one-to-one match to a specific stored image.  The Company's facial recognition
  products are unique because they are scalable to databases of millions of
  faces. Viisage generally advocates the use of multiple biometrics and can
  integrate other biometrics such as iris, voice, signature and fingerprint
  technology into its solutions.

     Viisage offers several facial recognition software systems that can be
  utilized in virtually any solution requiring identification or verification of
  an individual. The Company's identification software instantly calculates an
  individual's eigenface identifier and can search an existing database of
  millions of records in less than 10 seconds for images similar to the image
  being searched. Viisage's Face in the Crowd technology can find and identify
  specific individuals in a crowd.  The system searches real-time for a match
  between individuals in the field and images in a database.  When a match is
  located, the system tracks the individual and reports to the user. Early
  adopters are using the software for access control, fraud reduction,
  surveillance and law enforcement applications.  The software can also be
  utilized with other biometrics, PIN's and identification cards or on a stand-
  alone basis for a variety of applications such as PC network and internet
  access security, ATMs, retail point-of-use and administration of health care
  benefits.  The Company envisions a day when society could be free from cards,
  keys, PIN's and signatures.  One's face will be the private, secure and
  convenient password of choice.

  Sales and Marketing

     The SI division markets its products directly through its internal sales
  force, and continues to ally strategically with prominent vendors, systems
  integrators and service organizations, particularly in international markets,
  in order to gain access to such organizations' existing relationships,
  marketing resources and credibility in new markets.  The Company's engineering
  department supports the direct sales staff by providing pre- and post-sale
  technical support. This support entails traveling with sales representatives
  to help explain the systems, defining solutions for customers, designing
  systems for proposal activity, supporting the implementation process and
  providing post-implementation support.  The SI division also uses its program
  management group to identify opportunities with existing customers and
  coordinate related selling efforts.

     The SI division's systems are generally provided to public sector customers
  through a formal bidding process. The sales and marketing personnel regularly
  conduct visits and attend industry trade shows to identify bid opportunities
  and particular customer preferences and to establish and cultivate
  relationships in advance of any bid. Once a request for proposal is issued, a
  six-to-twelve month proposal and award process usually ensues, followed by (if
  the bid is successful) a six-to-twelve month implementation and installation
  phase. In the aggregate, the time needed for agencies to secure funding for
  systems, the request for 

                                       6
<PAGE>
 
  proposal and bid process, the execution of actual contracts and the
  installation of a system can extend over several years. The Company believes
  that long sales cycles in its public sector markets will continue. Further,
  customers may seek to modify the system either during or after the
  implementation of the system. While this long sales and implementation cycle
  requires the commitment of marketing resources and investments of working
  capital, the Company believes that it also serves as a barrier to entry for
  smaller companies and as an early indicator of potential competitors for
  particular projects. For existing customers, a considerably shorter sales and
  implementation cycle may be involved.

    The biometrics division is a software content provider.  Its sales force and
  business development activities are focused on establishing OEM and other
  distribution arrangements with vendors, systems integrators and service
  organizations serving its principal market areas.  The SI division and Lau are
  also serving as channels for the division's products.  The division's
  engineering department provides technical support for the division's selling
  and channel development activities.

  (ii) and (xi) Product Development
                ------------------- 

    In prior years, the Company developed proprietary software that supports all
  current industry standard operating systems and networking environments, and
  proprietary image capture and inspection products for its card-based
  identification systems. The Company believes that these products will support
  its card-based identification system offerings for the foreseeable future.
  Development costs that benefited specific projects were recorded as project
  costs and costs that did not benefit specific projects were recorded as
  research and development expenses.  The Company has not capitalized any
  software development costs because costs incurred subsequent to achieving
  technological feasibility have not been material. The Company's current
  development activities are focused on its facial recognition products and the
  further commercialization of its facial recognition technology.  In addition
  to its own development efforts, the Company has benefited and expects to
  continue to benefit from on-going research and development conducted by Lau
  and, through its license with Facia Reco, from certain research activities at
  MIT.  The Company also benefits from research and development activities
  conducted by the manufacturers of the components integrated into the Company's
  systems such as PC's, printers, etc.

    For the years ended December 31, 1998, 1997 and 1996, research and
  development expense was $358,000, $152,000 and $235,000, respectively.  Such
  amounts do not include amounts for specific projects that are allocated to
  project costs or the benefits from the other research and development
  activities referred to above.

  (iii) Manufacturing and Sources of Supply
        -----------------------------------

    Proprietary subsystems and assemblies are made to the Company's
  specifications by contract manufacturers, including Lau Technologies. Other
  non-proprietary system components, such as personal computers, printers and
  related components, are purchased from third-party vendors.  The Company
  generally purchases major contracted assemblies from single vendors to help
  ensure high quality, prompt delivery and low cost. The Company 

                                       7
<PAGE>
 
  does, however, qualify second sources for most components, contracted
  assemblies and purchased subsystems, or at least identifies alternative
  sources of supply. The Company believes that the open architecture of its
  systems facilitates substitution of components or software when this becomes
  necessary or desirable. The Company has from time to time experienced delays
  as a result of the availability of component parts and assemblies.



  (iv)  Patents, Trademarks and Licenses
        --------------------------------

     In addition to customized technology developed by the Company to meet
  customer requirements, the Company utilizes patented technology and trade
  secrets developed by its principal shareholder and technology partner, Lau.
  The Company has an exclusive, perpetual, irrevocable, paid-up royalty-free,
  worldwide license to use all of the technology owned or controlled by Lau
  relating to the Company's business except for controlling human entry through
  doorways, gates, turnstiles, or similar thresholds in and to buildings or
  facilities located on properties owned or controlled by the United States
  federal government, or any other national government, using apparatus at the
  entry point (federal access control).  Lau has a U.S. patent which runs to
  2014 on a card production system used by the Company, has a number of  U.S.
  patent applications in process for facial recognition technologies, has
  copyrighted the SensorMast and has made a copyright filing for the Company's
  Visual Inspection System and related proprietary software.  Lau has also filed
  foreign patent applications, which correspond to three of these domestic
  patent applications.

     The Company also makes use of patented technology and trade secrets owned
  or controlled by Facia Reco in the field that relates to de-duplicating or
  querying databases created, controlled and/or managed by the Company or its
  sublicensees and/or utilizing, directly or indirectly, personal identification
  cards but does not extend to federal access control.  This license extends
  until the expiration of the final patent included in the license and includes
  Facia Reco's rights to use patented facial recognition technology of MIT,
  which rights are exclusive through June 1, 2001, except for certain rights
  granted to sponsors of the MIT Media Lab and certain research rights.
  Thereafter, Facia Reco's patent license with MIT extends to 2010 on a non-
  exclusive basis.  MIT has applied to extend its patent rights to certain
  jurisdictions in Europe and in Singapore.  Further, at Lau's request and
  expense, broadened claims for the MIT patent have been allowed by the U.S.
  Patent and Trademark Office.  The Company's license agreement with Facia Reco
  provides for a royalty of $350 per machine copy incorporating the licensed
  technology.  Until June 1, 2001, a minimum annual royalty applies of,
  generally, $21,000 for the U.S. rights and an amount ranging from $21,000 to
  $42,000 for the non-U.S. rights.
 
     The Company has registered its "Viisage" trademark with the U.S. Patent and
  Trademark Office.

     There can be no assurance that the Company's efforts to prevent the
  misappropriation of the intellectual property used in its business will be
  successful.  Further, there can be no assurance that any of the additional
  U.S. or foreign patents applied for by Lau or the foreign 

                                       8
<PAGE>
 
  patents applied for by MIT will be issued or that, if issued, they will
  provide protection against competitive technologies or will be held valid and
  enforceable if challenged. Finally, there can be no assurance that the
  Company's competitors would not be able to design around any such proprietary
  right or obtain rights that the Company would need to license or circumvent in
  order to practice under these patent and copyrights.



  (v) Seasonality
      -----------

    The Company's SI division operations are not seasonal since contracts are
  awarded and performed throughout the year.  However, the Company believes its
  public sector business is subject to cyclical procurement delays that may be
  related to state-wide election cycles.  Biometric division revenues have not
  been material to date and operations are not expected to be seasonal.

  (vi) Working Capital Requirements
       ----------------------------

    The Company is generally required to fund the development and implementation
  of large digital identification system projects for public sector customers.
  Historically, the Company has utilized bank borrowings and project lease
  financing to meet these needs.  There are no special requirements or customer
  terms that are expected to have a material adverse effect on the Company's
  working capital.  As discussed more fully in Management's Discussion and
  Analysis of Financial Condition and Results of Operations, the Company plans
  to raise capital, as needed, to fund biometric division activities.

  (vii)  Customers and End Users
         -----------------------

    The following lists and categorizes the Company's customers and end users as
  of December 31, 1998:

<TABLE> 
<CAPTION> 
  STATE DEPARTMENTS OF MOTOR VEHICLES             OTHER STATE AND LOCAL AGENCIES
  <S>                                             <C> 
  Arizona Department of Transportation            Connecticut Department of Social Services
  Arkansas Office of Driver Services              Massachusetts Department of Transitional
  Florida Department of Highway Safety             Assistance
   and Motor Vehicles*                            New York Department of Social Services*
  Illinois Secretary of State                     Ohio Department of Public Safety
  Massachusetts Registry of Motor Vehicles        Wisconsin Department of Corrections
  New Mexico Department of Taxation and
    Revenue
  North Carolina Department of Transportation
  Ohio Bureau of Motor Vehicles
  Wisconsin Department of Transportation
</TABLE> 

                                       9
<PAGE>
 
<TABLE> 
<CAPTION> 
  FEDERAL AGENCIES                                FOREIGN CONTRACTS
  <S>                                             <C> 
  U.S. Immigration and Naturalization Service *   Commission on Elections of the Republic of
                                                    the Philippines*
</TABLE> 

  * By subcontract.
 
    For 1996, two customers (New York Department of Social Services and North
  Carolina Department of Transportation) each accounted for over 10% of Company
  revenues and an aggregate of 50% of revenues for the year. For 1997, one
  customer (Illinois Secretary of State) accounted for an aggregate of 46% of
  revenues. For 1998, three customers (Arkansas Office of Driver Services,
  Florida Department of Highway Safety and Motor Vehicles and Illinois Secretary
  of State) each accounted for over 10% of Company revenues and an aggregate of
  40% of revenues for the year.  The loss of any such customers could have a
  material adverse impact on the Company's business, operating results and
  financial condition.  Since inception in June 1998, revenues for the
  biometrics division related solely to a subcontract with Lau and were not
  material.  However, the SI division has on-going facial recognition projects
  (Massachusetts Department of Transitional Assistance, Illinois Secretary of
  State and Wisconsin Department of Corrections).

  (viii) Backlog
         -------

    The Company measures backlog based on signed contracts, subcontracts and
  customer commitments for which revenue has not yet been recognized. Backlog
  does not include amounts for phase-outs or other extension opportunities
  included in such contracts.  Accordingly, backlog is not necessarily
  indicative of future revenue. Backlog amounts relate solely to SI division
  contracts.  A substantial amount of the such backlog can be cancelled at any
  time without penalty, except, in some cases, for the recovery of the Company's
  actual committed costs and profit on work performed through the date of
  cancellation. Any failure of the Company to meet an agreed-upon schedule could
  lead to the cancellation of the related order. The timing of award and
  performance on contracts as well as variations in size, complexity and
  requirements of the customer and modifications to contract awards may result
  in substantial fluctuations in backlog from period to period. Therefore, the
  Company believes that backlog cannot be considered a meaningful indicator of
  future financial performance.

    At December 31, 1998, the Company's backlog was approximately $59 million,
  compared to approximately $61 million at December 31, 1997. Approximately 28%
  of the Company's backlog as of December 31, 1998, is expected to be earned
  during the current fiscal year.

  (ix) Government Contacts
       -------------------

    Government contracts are generally subject to termination for convenience or
  lack of appropriation at the election of the subject agency.  At December 31,
  1998, amounts subject to future negotiation are not material.

                                       10
<PAGE>
 
     (x)   Competition
           -----------

           The market for the Company's products and services is extremely
     competitive and management expects this competition to intensify as the
     markets in which the Company's products and services are sold continue to
     develop.

           The SI division faces competition in the identification systems
     market (for both digital and conventional systems) from technologically
     sophisticated companies, including Polaroid Corporation and De La Rue,
     which, in some cases, have greater technical, financial, and marketing
     resources than the Company. A former competitor, NBS Imaging Systems, Inc.,
     was acquired by Polaroid during 1998. In some cases, the Company may be
     competing with an entity which has a pre-existing relationship with a
     potential customer which could put the Company at a significant competitive
     disadvantage. As the digital identification market expands, additional
     competitors may seek to enter the market.

           The Company believes that competition in the digital identification
     systems market is based primarily upon the following factors: systems and
     product performance; price; flexibility in terms of accommodating customer
     needs, architectures, platforms, systems and networks; and service support.
     The relative importance of each of these and other factors depends upon the
     specific customer and situation involved. Substantially all of the SI
     division's sales to new customers have been the result of competitive
     bidding for contracts pursuant to public sector procurement rules, which
     generally increases the importance of price as a competitive factor. The
     Company believes that its competitive strength lies primarily in its
     systems integration and software design capabilities, with additional
     strengths including system performance and proprietary technologies, system
     configuration flexibility, price, and relative ease of use.

           In the field of biometric identification technology, the Company
     competes with other facial recognition providers as well as other providers
     of biometric solutions. Fingerprint recognition solutions have a long
     history of use, particularly in law enforcement applications. Other current
     suppliers of facial recognition solutions are software development firms.
     The Company expects that as the market for biometric solutions develops,
     companies with significant resources and capabilities may enter the market
     and competition will intensify.

     (xi)  Research and Development
           ------------------------

           See Product Development Section

     (xii) Environmental Protection Regulations
           ------------------------------------

           The Company believes that compliance by the Company with federal,
     state and local environmental regulations will not have a material adverse
     effect on its financial position or results of operations.

                                       11
<PAGE>
 
     (xiii) Employees
            ---------

            As of December 31, 1998, the Company had 59 employees. The Company
     from time-to-time supplements its employee forces with independent
     contractors. As of December 31, 1998, the Company had 7 such contractors.
     During 1998, the Company reduced headcount by 8 employees and 10
     contractors to reflect the 1998 business plan and reduced headcount by 6
     employees in 1999 in connection with the 1999 business plan. None of the
     Company's employees is represented by a labor union, and the Company
     considers its relationship with its employees to be good.

     (d)    Financial Information about Foreign and Domestic Operations and
            ---------------------------------------------------------------
            Export Sales
            ------------

            The Company's foreign operations and export sales are currently not
     material.

Item 2.     Properties
            ----------

            In February 1997, the Company moved to facilities located in
     Littleton, Massachusetts. The Company currently uses approximately 15,000
     square feet of space and has access to common areas under the terms of a
     Use and Occupancy Agreement with Lau Technologies through February 2002.
     The Company believes that its facilities are in good condition and are
     suitable and adequate for its present operations and that suitable space is
     available if such lease is not extended.

Item 3.     Legal Proceedings
            -----------------

            The Company does not believe that there are any legal matters that
     would have a material adverse effect on its business, financial condition
     or results of operations.

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

            None.

                                       12
<PAGE>
 
                                    PART II

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

          The Company's common stock is traded on the NASDAQ National Market
     under the symbol VISG. On March 15, 1999, the closing price of the common
     stock was $1.50 per share and there were approximately 36 holders of record
     of the Company's common stock. The quarterly high and low closing prices,
     as reported by NASDAQ, of Viisage's common stock in 1998 and 1997 were as
     follows: 

<TABLE>
<CAPTION>
                                                1998                 1997
                                             ---------             ---------
              QUARTER                    HIGH        LOW        HIGH        LOW
              -------                  ---------  ----------  ---------  ---------
             <S>                       <C>        <C>         <C>        <C>
              First Quarter                7-3/8       4-7/8     14-3/4      9-1/8
              Second Quarter               5-3/8     1-15/16     18-1/4      7-7/8
              Third Quarter                3-1/2       1-1/4     20-1/2      9-7/8
              Fourth Quarter               2-1/4         5/8     12-1/4      5-1/2
</TABLE>

     DIVIDEND POLICY

          The Company presently intends to retain earnings for use in the
     operation and expansion of its business and, therefore, does not anticipate
     paying any cash dividends in the foreseeable future.

                                       13
<PAGE>
 
Item 6.  Selected Financial Data
         -----------------------

         The financial data set forth below should be read in conjunction with
     Management's Discussion and Analysis of Financial Condition and Results of
     Operations and the Financial Statements of the Company and related notes
     thereto included elsewhere in this Form 10-K.

<TABLE>
<CAPTION>
                                                                                Years Ended December 31,                            
                                                ----------------------------------------------------------------------------------- 
                                                   1998 (1)             1997 (2)           1996              1995              1994 
                                                   ----                 ----               ----              ----              ---- 
                                                                      (in thousands, except per share amounts)                      
<S>                                             <C>                  <C>            <C>               <C>               <C>         
     STATEMENT OF OPERATIONS DATA:                                                                                                  
     Revenues.................................      $   16,259       $    29,388    $    24,971       $    11,221       $     1,257 
     Project costs............................          15,957            26,122         19,484            10,361             1,140 
                                                    ----------       -----------    -----------       -----------       ----------- 
     Project margin...........................             302             3,266          5,487               860               117 
                                                    ----------       -----------    -----------       -----------       ----------- 

     Operating expenses:                                                                                                            
     Sales and marketing......................           2,195             4,930          1,852               999             1,596 
     Research and development.................             358               152            235             1,089               201 
     General and administrative...............           2,247             2,105          1,880             1,204               681 
                                                    ----------       -----------    -----------       -----------       ----------- 
     Total operating expenses.................           4,800             7,187          3,967             3,292             2,478 
                                                    ----------       -----------    -----------       -----------       ----------- 

     Operating income (loss)..................          (4,498)           (3,921)         1,520            (2,432)           (2,361)
     Interest expense, net....................           1,667               441            714               515                40 
                                                    ----------       -----------    -----------       -----------       ----------- 

     Income (loss) before income taxes and                                                                                          
     cumulative effect of accounting change             (6,165)           (4,362)           806            (2,947)           (2,401)
     Income taxes.............................               -                 -            205                 -                 - 
                                                    ----------       -----------    -----------       -----------       ----------- 
                                                                                                                                    
     Income (loss) before cumulative effect of                                                                                  
     accounting change                                  (6,165)           (4,362)           601            (2,947)           (2,401)
     Cumulative effect of accounting change             (1,038)                -              -                 -                 - 
                                                    ----------       -----------    -----------       -----------       -----------
     Net income (loss)........................      $   (7,203)      $    (4,362)   $       601       $    (2,947)      $    (2,401)
                                                    ==========       ===========    ===========       ===========       =========== 

     Basic net income (loss) per share before                                                                                   
     cumulative effect of accounting change         $    (0.75)      $     (0.54)   $      0.10       $     (0.52)      $     (0.42)
     Basic net income (loss) per share (3)....      $    (0.88)      $     (0.54)   $      0.10       $     (0.52)      $     (0.42)
                                                    ==========       ===========    ===========       ===========       =========== 
     Weighted average common shares...........           8,175             8,060          6,022             5,680             5,680 
                                                    ==========       ===========    ===========       ===========       =========== 

     Diluted net income (loss) per share before                                                                                 
     cumulative effect of accounting change         $    (0.75)         $  (0.54)   $      0.09       $     (0.52)      $     (0.42)
     Diluted net income (loss) per share (3)..      $    (0.88)         $  (0.54)   $      0.09       $     (0.52)      $     (0.42)
                                                    ==========      ============    ===========       ===========       =========== 
     Weighted average common shares                      8,175             8,060          6,537             5,680             5,680
                                                    ===========     ============    ===========       ===========       =========== 
</TABLE>

                                       14
<PAGE>
 
<TABLE>
<CAPTION>
                                                                              December 31,
                                          ------------------------------------------------------------------------------------------
                                              1998 (1)           1997 (2)            1996               1995               1994
                                              ----               ----                ----               ----               ----     
<S>                                        <C>                <C>                <C>               <C>                <C>
     BALANCE SHEET DATA:
     Working Capital.....................  $    11,089        $    15,261        $ 20,676          $   7,413          $   2,509 
     Total assets........................       46,444             47,463          36,119             11,285              3,999
     Long-term obligations...............       18,058             13,300           4,420              8,319                955
     Shareholders' equity................       12,618             18,736          23,020                  -                  -
     Net assets(4).......................            -                  -               -              1,323              1,554
</TABLE> 
                                         
     (1)  1998 amounts reflect the impact of charges of $230 for restructuring,
          $1,321 for the early adoption of SOP 98-5, Reporting on the Costs of
          Start-Up Activities, and $2,322 to revise project margins and contract
          cost-to-complete estimates.
     (2)  1997 amounts reflect the impact of charges of $7.6 million for
          investments in technology, services and markets.
     (3)  See note 2 of Notes to Financial Statements for information concerning
          the computation of basic and diluted net income (loss) per share.
     (4)  Net assets represents divisional investment during the time the
          Company operated as a division of Lau Technologies.

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

          The following discussion and analysis contains forward-looking
     statements that involve risks and uncertainties. The Company's actual
     results could differ materially from those discussed herein. Factors that
     could cause or contribute to such differences include, but are not limited
     to, those discussed in the section below entitled "Certain Factors that may
     Affect Future Results." The cautionary statements made herein should be
     read as being applicable to all related forward-looking statements in this
     Form 10-K.

     OVERVIEW

          Viisage is a leader in the emerging field of biometrics technology and
     in providing digital identification systems and solutions. The Company
     focuses on identification solutions that improve personal convenience and
     security, deter fraud and reduce identification program costs. Viisage
     combines its systems integration and software design capabilities with its
     proprietary software and hardware products and other industry standard
     products to create complete customized solutions. These turnkey solutions
     integrate image and data capture, create relational databases, incorporate
     multiple biometrics and improve customers' ability to move and manage
     information. Applications can include driver's licenses, voter
     registration, national ID's, law enforcement, social services, access
     control and PC network and internet access security. To date, Viisage's
     primary customers have been government agencies with particular emphasis on
     U.S. drivers licensing agencies. Since its inception in 1993, the Company
     has captured approximately 30% of the domestic driver's license market.
     Viisage products annually produce more than 20 million identification
     documents at more than 1,000 locations in 11 states. The Company has also
     provided services under subcontracts for projects in Jamaica, the
     Philippines and for the U.S. Immigration and Naturalization Service.

                                       15
<PAGE>
 
          The Company began operations in 1993 as a division of Lau Technologies
     (Lau), a provider of systems integration services and products for
     sophisticated electronic systems. In November 1996, Lau transferred
     substantially all of the assets, liabilities and operations of the division
     to the Company and the Company completed its initial public offering. The
     Company is currently a 65% owned subsidiary of Lau.

          On November 3, 1998, the Company's Board of Directors appointed Thomas
     J. Colatosti, formerly the Company's Chief Operating Officer, President and
     Chief Executive Officer.

          During 1997 and 1998, the Company's revenue growth slowed
     significantly due primarily to lengthening procurement delays in its
     principal markets and a strong competitive market place. The Company
     believes that the acceptance of digital identification technology in recent
     years, its commitment to providing customized solutions for its customers
     needs, its expertise in facial imaging and biometric solutions and its
     proprietary software and hardware products will continue to contribute to
     its growth.

          Effective June 1, 1998, the Company reorganized its operations to
     create a separate biometrics division to respond to the growing market
     interest in biometric solutions. The biometrics division is focused on
     product, market and channel development activities in three principal
     areas: facility access control; PC network and internet access security;
     and real-time large database identification and verification of
     individuals. The systems integration and identification card division (SI
     division) focuses on Viisage's public sector markets and serves as a
     channel to existing customers and the public sector for the Company's
     biometric technologies. The Company believes that it is in the early stages
     of an emerging and high growth market for biometric identification
     solutions, particularly facial recognition solutions in the government and
     commercial markets. In September 1998, the Company's technology partner and
     principal shareholder, Lau, was awarded a $2.8 million development contract
     for facial recognition systems by the U.S. Department of Defense which
     involved Viisage as a subcontractor. The Company believes that the
     leadership from the Federal Government in using facial biometrics as well
     as other recent awards and OEM arrangements validates the Company's
     technology and helps create credibility for the emerging global market.

          The Company is engaged in one business, the development and
     implementation of digital identification systems and solutions. As
     discussed above, since June 1, 1998, the Company has operated in two
     segments. Amounts for the biometrics division prior to the reorganization
     are not material or meaningful.

          The SI division provides systems and services principally under
     contracts that have five to seven year terms and provide for several annual
     renewals after the initial contract term. Contracts generally provide for a
     fixed price for the system and/or for each card produced. Contract prices
     vary depending on, among other things, design and integration complexities,
     the nature and number of workstations and sites, the projected number of
     cards to be produced, the size of the database, the level of post-
     installation support and the competitive environment. Substantially all of
     the Company's revenues are currently derived from the SI division's public
     sector customers and contractors to such customers. The Company believes
     for the foreseeable future that it will continue to derive a significant
     portion of its revenues

                                       16
<PAGE>
 
     from a limited number of large contracts. For the years ended December 31,
     1998, 1997 and 1996, three customers, one customer and two customers,
     respectively, each accounted for more than 10% of the Company's revenues
     and an aggregate of 40%, 46% and 50% of revenues for each of the years,
     respectively.

          The Company's results of operations are significantly affected by,
     among other things, the timing of award and performance on contracts. As a
     result, the Company's revenues and income may fluctuate from quarter to
     quarter, and comparisons over longer periods of time may be more
     meaningful. The Company's results of operations are not seasonal since
     contracts are awarded and performed throughout the year. However, the
     Company believes its public sector business is subject to cyclical
     procurement delays that may be related to state-wide election cycles.
     Biometric division revenues have not been material to date and operations
     are not expected to be seasonal.

     RESULTS OF OPERATIONS

     YEAR ENDED DECEMBER 31, 1998 AND 1997

     Charges and Accounting Change. During the first quarter of 1998, the
     Company recorded charges of approximately $230,000 related to a
     restructuring to reduce expenses in line with the Company's revised plan
     for 1998. Approximately $50,000 of such charges are included in project
     costs, $170,000 are included in sales and marketing expenses and $10,000
     are included in general and administrative expenses in the statement of
     operations. During the third and fourth quarters of 1998, the Company
     recorded charges of $472,000 and $1,850,000, respectively, to revise
     project margins and contract cost-to-complete estimates. Approximately
     $2,222,000 of such charges are included in project costs and $100,000 are
     included in general and administrative expenses in the statement of
     operations.

          The Company elected early adoption of Statement of Position No. 98-5
     (SOP 98-5), Reporting on the Costs of Start-Up Activities, which requires
     start-up costs to be expensed as incurred rather than capitalized. The
     Company previously capitalized certain start-up costs as pre-contract costs
     under SOP 81-1, Accounting for Performance of Construction-Type and Certain
     Production-Type Contracts, and charged such costs to contracts upon award.
     As required, the adoption of SOP 98-5 has been made effective as of the
     beginning of the year. The cumulative effect of the change in accounting
     principle of $1,038,000 was recorded as a one-time charge in the Company's
     results for the year. Project costs also include start-up costs of $283,000
     which were incurred in the first quarter of 1998.

     Revenues. SI division revenues are derived principally from systems
     implementation, card production and related services under multi-year
     contracts. Biometrics division revenues are derived principally from
     software development services. Revenues decreased 45% to $16.3 million for
     1998 from $29.4 million in 1997. This decrease reflects the slowdown in new
     business awards during 1997 and 1998. Biometrics division revenues for the
     period were approximately $500,000, all of which were earned under a 
     subcontract from Lau.

     Project Costs and Margin. SI division project costs consist primarily of
     hardware, consumables (printer ribbons, cards, holographic overlays, etc.),
     system design, software

                                       17
<PAGE>
 
     development and implementation labor, maintenance and overhead. Biometrics
     division project costs consist primarily of labor and related overhead. As
     a percentage of revenues, project costs, excluding charges and accounting
     change, increased to 82% for 1998 from 71% for 1997. This increase reflects
     the impact of lower margin contracts in the overall revenue mix and
     overhead variances resulting from lower than anticipated 1998 revenues.
     Including charges and accounting change, project costs increased to 98% for
     1998 compared to 89% for 1997. This increase reflects the charges discussed
     above which are due in part to enhancements to central production
     operations and technology and transitioning to an in-house maintenance
     organization during 1998. Project margin, excluding charges and accounting
     change, decreased 66% to $2.9 million (18% of revenues) for 1998 from $8.5
     million (29% of revenues) for 1997. This decrease reflects lower revenues
     in 1998 and the increases in project costs discussed above. Including
     charges and accounting change, project margin decreased 91% to $302,000 (2%
     of revenues) compared to $3.3 million (11% of revenues) for 1997.
     Biometrics division project costs for 1998 were $516,000, including a
     portion of the overhead variances discussed above.

     Sales and Marketing. Sales and marketing expenses consist primarily of
     compensation and professional service fees for marketing, bid and proposal
     and customer support activities. Sales and marketing expenses, excluding
     charges, decreased 23% to $2.0 million from $2.6 million for 1997. This
     decrease reflects the reduction in headcount and related expenses in
     connection with the restructuring mentioned above. Including charges, sales
     and marketing expenses decreased 55% to $2.2 million for 1998 compared to
     $4.9 million for 1997. As a percentage of revenues, sales and marketing
     expenses, excluding charges, increased to 12% for 1998 from 9% for 1997 due
     to the decrease in 1998 revenues discussed above. Including charges, sales
     and marketing expenses were 14% for 1998 compared to 17% for 1997. Sales
     and marketing expenses since the reorganization for the biometrics division
     were $380,000.

     Research and Development. Research and development expenses consist
     principally of compensation, outside services and materials utilized for
     product and software development activities that are not related to
     specific projects. Research and development expenses increased 135% to
     $358,000 for 1998 from $152,000 for 1997. Expenditures for 1998 and 1997
     relate primarily to the Company's facial recognition products. Such amounts
     do not include amounts for specific projects that are allocated to project
     costs and do not reflect the benefits to the Company under license
     arrangements from the research and development efforts of Lau Technologies
     and the Massachusetts Institute of Technology for projects that are not
     directly related to the Company.

                                       18
<PAGE>
 
     General and Administrative. General and administrative expenses consist
     principally of compensation for executive management, finance and
     administrative personnel and outside professional fees and are shared by
     the Company's two divisions. General and administrative expenses, excluding
     charges, remained constant at approximately $2.1 million for 1998 and 1997.
     Amounts for 1998 reflect the restructuring and reorganization charges
     discussed above and the related transfer of certain management expenses to
     general and administrative expenses. Including charges, general and
     administrative costs increased 7% to $2.3 million. As a percentage of
     revenues, general and administrative expenses, excluding charges, increased
     to 13% for 1998 compared to 7% for 1997 due primarily to lower revenues in
     1998. Including charges, general and administrative costs were 14% of
     revenues.

     Interest Expense. The increase in net interest expense to $1.7 million for
     1998 from $441,000 for 1997 reflects increased borrowings during 1998 and a
     reduction in interest earned on cash equivalents in 1998.

     Income Taxes. The Company did not record any tax benefit for the 1998 or
     1997 losses due to the uncertainty of whether such benefit will be
     realized.

     YEAR ENDED DECEMBER 31, 1997 AND 1996

          Fourth Quarter Charge. During the fourth quarter of 1997, the Company
     recorded charges of approximately $7.6 million related to investments in
     technology, services and markets that are expected to benefit current and
     future customers and result in future revenues. These investments relate
     principally to upgrades and enhancements to older systems, enhancements to
     central production and data management capabilities and enhancements to
     certain systems to facilitate the future use of facial recognition
     technologies. These investments demonstrate the Company's commitment to its
     customers and to being a leading provider of biometric identification
     solutions. Approximately $5.3 million of such charges are included in
     project costs and $2.3 million are included in sales and marketing expenses
     in the statement of operations.

          Revenues. Revenues are derived principally from systems
     implementation, card production and related services under multi-year
     contracts. Revenues increased 18% to $29.4 million in 1997 from $25.0
     million in 1996. This increase was due to an increase in the number of
     contracts being performed during 1997.

          Project Costs and Margin. Project costs consist primarily of hardware,
     consumables (printer ribbons, cards, holographic overlays, etc.), system
     design, software development and implementation labor, maintenance and
     overhead. As a percentage of revenues, project costs, excluding charges,
     decreased to 71% for 1997 from 78% for 1996. This decrease reflects cost
     savings on design, development and implementation activities related to new
     contracts. Including charges, project costs increased to 89% for 1997.
     Project margin, excluding charges, increased 56% to $8.5 million (29% of
     revenues) from $5.5 million (22% of revenues) for 1996, reflecting the
     impact of newer contracts on the overall revenue mix for 1997. Including
     charges, project margin decreased 40% to $3.3 million (11% of revenues).

                                       19
<PAGE>
 
          Sales and Marketing. Sales and marketing expenses consist primarily of
     compensation and professional service fees for marketing, bid and proposal
     and customer support activities. Sales and marketing expenses, excluding
     charges, increased 43% to $2.6 million from $1.9 million in 1996. This
     increase principally reflects the addition of marketing personnel during
     the second half of 1996 and the first half of 1997. Including charges,
     sales and marketing expenses increased 166% to $4.9 million in 1997. As a
     percentage of revenues, sales and marketing expenses, excluding charges,
     increased to 9% from 7% for 1996 due to such expenses increasing at a
     greater rate than revenues during 1997. Including charges, sales and
     marketing expenses increased to 17% for 1997.

          Research and Development. Research and development expenses consist
     principally of compensation, outside services and materials utilized for
     product and software development activities that are not related to
     specific projects. Research and development expenses decreased 35% to
     $152,000 in 1997 from $235,000 in 1996, and remained constant as a
     percentage of revenues at approximately 1% each year. Expenditures for 1997
     and 1996 relate primarily to the Company's facial recognition products.
     Such amounts do not include amounts for specific projects that are
     allocated to project costs and do not reflect the benefits to the Company
     under license arrangements from the research and development efforts of Lau
     Technologies and MIT for projects that are not directly related to the
     Company.

          General and Administrative. General and Administrative expenses
     consist principally of compensation for executive management, finance and
     administrative personnel and outside professional fees. General and
     administrative expenses increased 12% to $2.1 million in 1997 from $1.9
     million in 1996. The increase in expenses was due primarily to public
     company expenses for a full year in 1997 and additional personnel added in
     1997. As a percentage of revenues, general and administrative expenses
     decreased to 7% in 1997 from 8% in 1996 due to revenues increasing at a
     greater rate than such expenses in 1997.

          Interest Expense. The decrease in net interest expense to $441,000 in
     1997 from $714,000 in 1996 principally reflects the interest earned on cash
     equivalents during 1997 as well as the reduced level of borrowings during
     the first half of 1997 compared to the first half of 1996.

          Income Taxes. The Company did not record any tax benefit for the loss
     in 1997 due to the uncertainty of when such benefit will be realized.
     Income tax expense for 1996 related principally to corporate taxes for the
     period following the transfer discussed above and a deferred tax charge of
     $110,000 relating to the cumulative differences between the financial
     reporting and income tax bases of certain assets and liabilities as of the
     transfer date.


     LIQUIDITY AND CAPITAL RESOURCES

          At December 31, 1998, working capital was $11.1 million compared to
     $15.3 million at December 31, 1997. The decrease in working capital is due
     primarily to the charges and accounting change discussed above.

                                       20
<PAGE>
 
          For the year ended December 31, 1998, operations and investing
     activities utilized cash of approximately $3.8 million and $5.4 million,
     respectively, principally to fund operating losses and increases in project
     assets. Financing was provided primarily by long-term borrowings and the
     project lease financing arrangement referred to below.

          At December 31, 1998, the Company was not in compliance with certain
     covenants included in its revolving credit and project lease financing
     facilities. The Company has received waivers of such violations from its
     lenders and commitments from its lenders to modify the Company's covenants
     in line with its current operating plan. In connection with the bank's
     commitment, the revolving credit facility will be amended to provide for
     borrowings of up to $10 million through September 30, 1999, $9 million
     through December 31, 1999, and $6.5 million through June 30, 2000 at the
     prime rate plus 1%. The revolving credit facility is secured by
     substantially all of the Company's assets and requires the Company to
     maintain certain financial ratios and minimum levels of earnings and
     tangible capital funds, as defined. The revolving credit facility also
     requires the Company to raise funds, as needed, from other sources to cover
     biometrics division expenses. These sources are expected to include a
     combination of biometrics division revenues, subordinated debt and equity
     capital.

          The Company also has a system project lease financing arrangement with
     a commercial leasing organization. Pursuant to this arrangement, the lessor
     purchases certain of the Company's digital identification systems and
     leases them back to Viisage for deployment with identified and contracted
     customers approved by the lessor. The lessor retains title to systems and
     has an assignment of Viisage's rights under the related customer contracts,
     including rights to use the software and technology underlying the related
     systems. Under this arrangement, the lessor bears the credit risk
     associated with payments by Viisage's customers, but Viisage bears
     performance and appropriation risk and is generally required to repurchase
     a system in the event of a termination by a customer for any reason except
     credit default. The Company is also required to maintain certain financial
     ratios and minimum levels of tangible capital funds, as defined. As
     discussed above, the Company was not in compliance with certain covenants,
     but has received waivers and a commitment to amend the covenants to be
     consistent with the Company's current operating plan. These project lease
     arrangements are accounted for as capital leases. The current arrangement
     provides for project financing of up to $15.0 million, which has been
     reduced from $25 million to reflect the Company's current operations. At
     December 31, 1998, the Company had approximately $14.8 million outstanding
     under the lease financing arrangement, and is currently seeking additional
     project financing arrangements. Lau has agreed to provide up to 
     $3.1 million of capital lease financing in 1999.

          The Company believes that it will meet its revised debt covenants.
     However, this expectation is dependent in part on achieving business
     forecasts and raising funds to cover biometrics division expenses. If the
     Company does not meet such covenants, the bank and the lessor could require
     immediate repayment of amounts outstanding.

          During the third quarter, the Company issued 300,000 shares of Common
     Stock to Lau Technologies (Lau), its majority shareholder, for $2.00 per
     share or $600,000. The Company 

                                       21
<PAGE>
 
     also issued 509,091 options to Lau during the third quarter as a financing
     fee for Lau's guarantee of certain capital lease financing drawdowns. The
     options are exercisable through August 2001 at $2.75 per share. In November
     1998, the Company also issued an $800,000, 4% convertible subordinated note
     to Lau. The note and related accrued interest are convertible into the
     Company's common stock at any time prior to October 15, 1999 at $1.58 per
     share.

          The Company has historically not made substantial capital expenditures
     for facilities, office and computer equipment and has satisfied its needs
     in these areas principally through leasing.

          The Company believes that it will require at least $2 million of
     additional funding in order to comply with certain covenants in its lending
     agreements. The Company has a commitment from Lau for up to $2 million of
     additional funding which can be drawn, under certain conditions defined in
     the commitment, at various times through February 2000 and plans to raise
     additional funding, as needed, from other sources. The Company believes
     that if it meets its business forecast for 1999, cash flows from available
     borrowings, project leasing, operations and capital raising will be
     sufficient to meet the Company's working capital and capital expenditure
     needs for the foreseeable future. There can be no assurance, however, that
     additional capital will be available on favorable terms or at all. If the
     Company is unable to obtain additional capital, as needed, on acceptable
     terms the Company may be unable to take full advantage of future
     opportunities or respond to competitive pressures, which could adversely
     affect the Company's business, financial condition and results of
     operations. Failure to obtain additional capital could also result in
     violation of debt and project lease financing covenants.

     INFLATION

          Although certain of the Company's expenses increase with general
     inflation in the economy, inflation has not had a material impact on the
     Company's financial results to date.

     ACCOUNTING PRONOUNCEMENTS

          In February 1997, the FASB issued SFAS No. 129, Disclosure of
     Information about Capital Structure, which establishes standards for
     disclosing information about an entity's capital structure. In June 1997,
     the FASB issued SFAS No. 130, Reporting Comprehensive Income, which
     establishes standards for reporting and disclosure of comprehensive income
     and its components (revenues, expenses, gains and losses) in a full set of
     general-purpose financial statements. These statements are effective for
     fiscal years beginning after December 15, 1997 and require certain
     additional disclosures. The adoption of these statements did not have a
     significant impact on the Company's current disclosures.

          In June 1997, the FASB issued SFAS No. 131, Disclosures About Segments
     of an Enterprise and Related Information, which establishes standards for
     reporting and disclosure of information about operating segments as well as
     disclosures about products and services, geographic areas and major
     customers. As required, the Company adopted SFAS No. 131 in 

                                       22
<PAGE>
 
     the fourth quarter and has provided the required financial disclosures for
     the systems integration and identification card and biometrics divisions.


     MARKET RISK

          Except for the Company's revolving credit facility, which has a
     variable interest rate, the Company has no material exposure to market risk
     that could affect its future results of operations and financial condition.

     YEAR 2000

          The Company continues to assess the potential impact of the year 2000
     on the Company's internal business systems, products, and operations. The
     Company's year 2000 initiatives include (i) testing and upgrading internal
     business systems and facilities; (ii) testing and developing necessary
     upgrades for the Company's current products and certain discontinued
     products; (iii) contacting key suppliers, vendors, and customers to
     determine their year 2000 compliance status; and (iv) developing
     contingency plans.

          The Company's accounting and information systems provider, Lau, has
     advised the Company that its internal business systems are year 2000
     compliant. The Company expects that its facilities will be year 2000
     compliant by the end of 1999 and problems encountered, if any, will be
     remedied by the owners of such facilities.

          The Company believes that all of the material products that it
     currently sells are year 2000 compliant or can be made compliant with minor
     modifications. However, as many of the Company's products are complex,
     interact with third-party products, and operate on computer systems that
     are not under the Company's control, there can be no assurance that the
     Company has identified all of the year 2000 issues with its current
     products. The Company is continuing to test and evaluate such products and
     may offer upgrades to alternative products where reasonably practicable.

          The Company is in the process of identifying and contacting suppliers,
     vendors, and customers that are believed to be significant to the Company's
     business operations in order to assess their year 2000 readiness. As part
     of this effort, the Company is developing questionnaires relating to year
     2000 compliance for distribution to its significant suppliers, vendors, and
     customers. The Company intends to follow-up and monitor the year 2000
     compliant progress of significant suppliers, vendors, and customers that
     indicate that they are not year 2000 compliant or that do not respond to
     the Company's questionnaires. The Company intends to develop a contingency
     plan that will allow its primary business operations to continue despite
     disruptions due to year 2000 issues. These plans may include identifying
     and securing other suppliers, increasing inventories, and modifying
     production facilities and schedules. As the Company continues to evaluate
     the year 2000 readiness of its products and significant suppliers, vendors,
     and customers, it will modify and adjust its contingency plan as may be
     required.

                                       23
<PAGE>
 
          To date, costs incurred in connection with the year 2000 issue have
     not been material. The Company does not expect total year 2000 remediation
     costs to be material, but there can be no assurance that the Company will
     not encounter unexpected costs or delays in achieving year 2000 compliance.
     If any of the Company's material suppliers, vendors, or customers
     experience business disruptions due to year 2000 issues, the Company might
     also be materially adversely affected. While the Company is attempting to
     minimize any negative consequences arising from the year 2000 issue, there
     can be no assurance that year 2000 issues will not have a material adverse
     impact on the Company's business, operations, or financial condition.

     CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS

          The Company operates in an environment that involves a number of
     risks, some of which are beyond the Company's control. Forward-looking
     statements in this document and those made from time to time by the Company
     through its senior management are made pursuant to the safe harbor
     provisions of the Private Securities Litigation Reform Act of 1995. 
     Forward-looking statements concerning future plans or results are
     necessarily only estimates and actual results could differ materially from
     expectations. Certain factors that could cause or contribute to such
     differences include, among other things, potential fluctuations in
     quarterly results, the size and timing of award and performance on
     contracts, dependence on large contracts and a limited number of customers,
     lengthy sales and implementation cycles, changes in management estimates
     incident to accounting for contracts, availability and cost of key
     components, market acceptance of new or enhanced products and services,
     proprietary technology and changing technology, competitive conditions,
     system performance, management of growth, dependence on key personnel,
     risks of year 2000 issues, and general economic and political conditions
     and other factors affecting spending by customers.

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

     Information required by this item is included on pages F-1 through F-23 of
this Form 10K.

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

                              Not applicable.

                                       24
<PAGE>
 
                                   PART III
                                        
Item 10.  Directors and Executive Officers of the Registrant
          --------------------------------------------------

          The information concerning directors required under this item is
     incorporated herein by reference from the material contained under the
     caption "Election of Directors" in the registrant's definitive proxy
     statement to be filed with the Securities and Exchange Commission pursuant
     to Regulation 14A, not later than 120 days after the close of the fiscal
     year. The information concerning delinquent filers pursuant to Item 405 of
     Regulation S-K is incorporated herein by reference from the material
     contained under the heading "Compliance with Section 16(a)" in the
     registrant's definitive proxy statement to be filed with the Securities and
     Exchange Commission pursuant to Regulation 14A, not later than 120 days
     after the close of the fiscal year.

Item 11. Executive Compensation
         ----------------------

          The information required under this item is incorporated herein by
     reference from the material contained under the caption "Executive
     Compensation" in the registrant's definitive proxy statement to be filed
     with the Securities and Exchange Commission pursuant to Regulation 14A, not
     later than 120 days after the close of the fiscal year.

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

          The information required under this item is incorporated herein by
     reference from the material contained under the caption "Security
     Ownership" in the registrant's definitive proxy statement to be filed with
     the Securities and Exchange Commission pursuant to Regulation 14A, not
     later than 120 days after the close of the fiscal year.

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

          The information required under this item is incorporated herein by
     reference from the material contained under the caption "Certain
     Relationships and Related Transactions" in the registrant's definitive
     proxy statement to be filed with the Securities and Exchange Commission
     pursuant to Regulation 14A, not later than 120 days after the close of the
     fiscal year.

                                       25
<PAGE>
 
                                    PART IV
                                        
Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K
          ----------------------------------------------------------------

     (a), (d)  Financial Statements and Schedules
               ----------------------------------
 
               For a list of financial statements included herein see Index on
          page F-1.

               All schedules are omitted because they are not applicable or not
          required, or because the required information is shown either in the
          financial statements or in the notes thereto.

     (b)  Reports on Form 8-K
          -------------------
 
               None.

     (c)  Exhibits
          --------

               See Exhibit Index on pages 28 and 29.

                                       26
<PAGE>
 
                                  SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized on this 26th day of
April, 1999.


                                        Viisage Technology, Inc.

 
                                   By:  /s/  Thomas J. Colatost
                                      -----------------------------------
                                             Thomas J. Colatosti
                                      President and Chief Executive Officer

     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities indicated on the 31st day of  March, 1999:

<TABLE> 
<CAPTION> 
                  Signature                           Title
                  ---------                           ----- 
                     *
<S>                                        <C> 
By:_________________________________       Chairman of the Board of Directors
               Denis K. Berube             
                     *                     
By:_________________________________       President and Chief Executive Officer (Principal     
              Thomas J. Colatosti          Executive Officer)                
                     *                 
By:________________________________        Vice President, Chief Financial Officer and Treasurer 
              William A. Marshall          (Principal Financial and Accounting Officer)         
                     *                                                       
By:_________________________________       Secretary and Director            
              Charles J. Johnson                                             
                     *                                                       
By:_________________________________       Director                          
               Charles E. Levine                                             
                     *                                                       
By:_________________________________       Director                          
             Harriet Mouchly-Weiss                                           
                     *                                                       
By:_________________________________       Director                          
                Peter Nessen                                                 
                     *                                                       
By:_________________________________       Director                          
              Thomas J. Reilly
                     *
* By: /s/ Thomas J. Colatosti
     --------------------------------
          Thomas J. Colatosti
           Attorney-in-fact
</TABLE> 
                                     

                                       27
<PAGE>
 
                                 EXHIBIT INDEX

Exhibit
-------
No.                DESCRIPTION
---                -----------

2.1*      Amended and Restated Asset Transfer Agreement, dated as of August 20,
          1996, between the Registrant and Lau Technologies.

3.1*      Restated  Certificate of Incorporation of the Registrant.

3.2*      By-Laws of the Registrant.

4.1*      Specimen certificates for shares of the Registrant's Common Stock.

10.1*     Amended and Restated License Agreement, dated as of August 20, 1996,
          between the Registrant and Lau Technologies.

10.2*     Form of Administration and Services Agreement between the Registrant
          and Lau Technologies.

10.3*     Form of Use and Occupancy Agreement between the Registrant and Lau
          Technologies.

10.4*     License Agreement, dated as of August 20, 1996, between the Registrant
          and Facia Reco Associates, Limited Partnership.

10.5*     Employment Agreement, dated as of November 3, 1998, between the
          Registrant and Robert C. Hughes, as amended.

10.6*     Employment Agreement, dated as of February 1, 1996, between the
          Registrant and William A. Marshall.

10.7*     Employment Agreement, dated as of July 1, 1996, between the Registrant
          and Yona Wieder.

10.8      1996 Management Stock Option Plan, as amended (filed as appendix to
          October 10, 1997 Schedule 14C Information Statement

10.9      1996 Director Stock Option Plan, as amended (filed as appendix to 1997
          proxy statement).

10.10*    Form of Option Agreement for the 1996 Management Stock Option Plan.

10.11*    Form of Option Agreement for the 1996 Director Stock Option Plan.

10.12**   Amended and Restated Credit Agreement between the Registrant and State
          Street Bank and Trust Company, dated December 7, 1998.

10.13*    Subcontract between the Registrant and Information Spectrum, Inc.
          (relating to the U.S. Immigration & Naturalization Service), dated as
          of October 19, 1995.

10.14*    Contract between the Registrant and the North Carolina Department of
          Transportation, dated as of April 26, 1996.

10.15***  Purchase Agreement (Project Finance Facility) between the Registrant
          and Sanwa Business Credit Corporation, dated as of November 20, 1998,
          as amended.

10.16*    Contract between the Registrant and Transactive, Inc. (relating to the
          New York Department of Social Services), dated as of December 8, 1994,
          as amended.

                                       28
<PAGE>
 
                                 EXHIBIT INDEX

Exhibit
-------
No.                DESCRIPTION
---                -----------

10.17**** Contract between the Registrant and the Illinois Secretary of State,
          dated June 2, 1997, as amended.

10.18     1997 Employee Stock Purchase Plan, filed as appendix to October 10,
          1997 Schedule 14C Information Statement

10.19     Employment Agreement, dated as of November 3, 1998, between the
          Registrant and Thomas J. Colatosti.

23.1      Consent of Arthur Andersen LLP.

24.1      Power of Attorney.

27.1      Financial Data Schedule.


*    Filed as an exhibit to the registrant's Form S-1 Registration Statement
        dated November 8, 1996 (File No. 333-10649)
**   Filed as an exhibit to the registrant's Quarterly Report on Form 10-Q for
        the quarter ended September 29, 1996 (File No. 000-21559)
***  Original agreement filed as an exhibit to the Registrant's Form S-1
        Registration Statement dated November 8, 1996 (File No. 333-10649).
        Amendment filed as an exhibit to the Registrant's Report on Form 10-K
        for the year ended December 31, 1997.
**** Amendment filed as an exhibit to the Registrant's Report on Form 10-K for
        the year ended December 31, 1997.

                                       29
<PAGE>
 
                                                                    EXHIBIT 23.1


                           Viisage Technology, Inc.

                   Consent of Independent Public Accountants
                   -----------------------------------------

As independent public accountants, we hereby consent to the incorporation of our
report included in this Form 10-K, into the Company's previously filed
registration statements on Form S-8 (No.'s 333-28695 and 333-42485)

                                                             Arthur Andersen LLP



Boston, Massachusetts
April 26, 1999

                                       30
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.

                                     INDEX
 
                                                                            PAGE
                                                                            ----
 
Report of Independent Public Accountants                                    F-2
 
Balance Sheets as of December 31, 1998 and 1997                             F-3
 
Statements of Operations for the years ended December 31,
    1998, 1997 and 1996                                                     F-4
 
Statements of Changes in Shareholders' Equity/Net Assets
   for the years ended December 31, 1998, 1997 and 1996                     F-5
 
Statements of Cash Flows for years ended December 31, 1998, 1997 and 1996   F-6
 
Notes to Financial Statements                                               F-7
 

                                      F-1
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
                                        


To Viisage Technology, Inc.:

We have audited the accompanying balance sheets of Viisage Technology, Inc. as
of December 31, 1998 and 1997, and the related statements of operations, changes
in shareholders' equity/net assets and cash flows for each of the years in the
three year period ended December 31, 1998.  These financial statements are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial statements based on our audits.

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 Viisage Technology, Inc. as of
December 31, 1998 and 1997, and the results of its operations and its cash flows
for each of the years in the three year period ended December 31, 1998, in
conformity with generally accepted accounting principles.



                                                 ARTHUR ANDERSEN LLP



Boston, Massachusetts
March 19, 1999 (except for note 6 for which
                the date is April 26, 1999)


                                      F-2
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.
                                BALANCE SHEETS
                     (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE> 
<CAPTION> 
                                                                                     DECEMBER 31,
                                                                           ------------------------------
                                                                                1998              1997
                                                                           -------------   --------------
<S>                                                                        <C>             <C>     
ASSETS
Current Assets:
    Cash and cash equivalents (note 2)                                     $      166       $    1,611
    Accounts receivable                                                         4,285            3,171
    Costs and estimated earnings in excess of billings (note 2)                21,723           25,483
    Other current assets (note 3)                                                 683              423
                                                                           -------------   --------------                    
          Total current assets                                                 26,857           30,688
Property and equipment, net (note 4)                                           18,513           16,046
Other assets (note 3)                                                           1,074              729
                                                                           -------------   --------------
                                                                           $   46,444       $   47,463
                                                                           =============   ============== 

LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
    Accounts payable and accrued expenses (note 5)                         $    9,090       $   12,253
    Accrued and deferred income taxes (notes 2 and 9)                              27               16
    Subordinated debt (note 3)                                                    800                -
    Current portion of long-term debt (note 6)                                  2,054              549
    Obligations under capital leases (notes 6 and 7)                            3,797            2,609
                                                                           -------------   --------------     
          Total current liabilities                                            15,768           15,427
Long-term debt (note 6)                                                         6,500            3,505
Obligations under capital leases (notes 6 and 7)                               11,558            9,795
                                                                           -------------   --------------
                                                                               33,826           28,727
                                                                           -------------   --------------

Commitments and contingencies (note 7)
 Shareholders' Equity (notes 1 and 10):
    Preferred stock, $.001 par value;
     2,000,000 shares authorized; none issued                                       -                -
    Common stock, $.001 par value;
     20,000,000 shares authorized; issued and outstanding
     8,383,000 in 1998 and 8,066,000 in 1997                                        8                8
    Additional paid-in capital                                                 24,157           23,072
    Retained earnings (deficit)                                               (11,547)          (4,344)
                                                                           -------------   --------------
          Total shareholders' equity                                           12,618           18,736
                                                                           -------------   --------------
                                                                           $   46,444       $   47,463
                                                                           =============   ==============
</TABLE> 


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

                                      F-3
<PAGE>
 
                            VIISAGE TECHNOLOGY, INC.
                           STATEMENTS OF OPERATIONS
                   (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE> 
<CAPTION> 
                                                                                 YEAR ENDED DECEMBER 31,
                                                                       ------------------------------------------------
                                                                             1998            1997             1996
                                                                       -------------    --------------   --------------
<S>                                                                    <C>              <C>              <C>       
Revenues                                                               $     16,259     $     29,388     $     24,971
Project costs (note 2)                                                       15,957           26,122           19,484
                                                                       ------------     ------------     ------------      
          Project Margin                                                        302            3,266            5,487
                                                                       ------------     ------------     ------------   
Operating expenses:
    Sales and marketing (note 2)                                              2,195            4,930            1,852
    Research and development                                                    358              152              235
    General and administrative (note 2)                                       2,247            2,105            1,880
                                                                       ------------     ------------     ------------   
          Total operating expenses                                            4,800            7,187            3,967
                                                                       ------------     ------------     ------------   
          Operating income (loss)                                            (4,498)          (3,921)           1,520
Interest expense, net                                                         1,667              441              714
                                                                       ------------     ------------     ------------   
          Income (loss) before income taxes and cumulative
            effect of change in accounting principle                         (6,165)          (4,362)             806
Income taxes (notes 2 and 9)                                                      -                -              205
                                                                       ------------     ------------     ------------   
          Income (loss) before cumulative effect of change
            in accounting principle                                          (6,165)          (4,362)             601
Cumulative effect of change in accounting principle (note 2)                 (1,038)               -                -
                                                                       ------------     ------------     ------------   
          Net income (loss)                                            $     (7,203)    $     (4,362)    $        601
                                                                       ============     ============    =============

Basic net income (loss) per share before cumulative
    effect of change in accounting principle                           $      (0.75)    $      (0.54)   $        0.10
Basic net income (loss) per share                                      $      (0.88)    $      (0.54)   $        0.10
                                                                       ============     =============   =============
Weighted average common shares                                                8,175            8,060            6,022
                                                                       ============     =============   =============

Diluted net income (loss) per share before cumulative
    effect of change in accounting principle                           $      (0.75)    $      (0.54)   $        0.09
Diluted net income (loss) per share                                    $      (0.88)    $      (0.54)   $        0.09
                                                                       ============     ============    =============
Weighted average common shares                                                8,175            8,060            6,537
                                                                       ============     ============    =============
</TABLE> 

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


                                      F-4
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.
           STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY/NET ASSETS
                                (IN THOUSANDS)

<TABLE> 
<CAPTION> 
                                                                             ADDITIONAL       RETAINED
                                              PREFERRED        COMMON          PAID-IN        EARNINGS
                                                STOCK           STOCK          CAPITAL        (DEFICIT)      NET ASSETS     TOTAL
                                           ------------  ------------  ---------------  ----------------   ------------  ----------
<S>                                        <C>           <C>           <C>              <C>                <C>           <C>      
Balance, December 31, 1995                 $       -     $         -   $           -    $          -       $   1,323     $   1,323
    Net income                                     -               -               -               -             583           583
    Stock compensation expense                     -               -               -               -             166           166
    Net transactions with parent                   -               -               -               -          (1,372)       (1,372)
                                           ------------  ------------  --------------  ---------------     ----------    ----------
Balance, November 6, 1996                          -               -               -               -             700           700
    Issuance of common stock in
       exchange for net assets (note 1)            -               6             694               -            (700)            -
    Issuance of common stock in
       initial public offering (notes 1
       and 10)                                     -               2          22,228               -               -        22,230
    Net income                                     -               -               -              18               -            18
    Stock compensation expense                     -               -              72               -               -            72
                                           ------------  ------------  --------------  ---------------     ----------    ----------
Balance, December 31, 1996                         -               8          22,994              18               -        23,020
    Exercise of stock options (note 10)            -               -              78               -               -            78
    Net loss                                       -               -               -          (4,362)              -        (4,362)
                                           ------------  ------------  --------------  ---------------     ----------    ----------
Balance, December 31, 1997                 $       -     $         8   $      23,072    $     (4,344)      $       -     $  18,736
                                           ============  ============  ==============  ===============     ==========    ==========
    Issuance of stock options (note 3)             -               -             444               -               -           444
    Issuance of common stock (note 3)              -               -             600               -               -           600
    Exercise of stock options (note 10)            -               -              41               -               -            41
    Net loss                                       -               -               -          (7,203)              -        (7,203)
                                           ------------  ------------  --------------  ---------------     ----------    ----------
Balance, December 31, 1998                 $       -     $         8   $      24,157    $    (11,547)      $       -     $  12,618
                                           ============  ===========   ==============  ===============     ==========    ==========
</TABLE> 

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

                                      F-5
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.
                           STATEMENTS OF CASH FLOWS
                                (IN THOUSANDS)

<TABLE> 
<CAPTION> 
                                                                                     YEAR ENDED DECEMBER 31,
                                                                          --------------------------------------------------
                                                                                1998              1997              1996
                                                                          -------------   --------------   -----------------
<S>                                                                       <C>             <C>              <C>     
CASH FLOWS FROM OPERATING ACTIVITIES:
    Net income (loss)                                                      $   (7,203)    $      (4,362)    $        601
    Adjustments to reconcile net income (loss) to net cash
    (used for) provided by operating activities:
       Depreciation and amortization                                            3,022             1,964              612
       Cumulative effect of change in accounting principle                      1,038                 -                -
       Stock compensation expense                                                   -                 -              238
       Changes in operating assets and liabilities:
           Accounts receivable                                                 (1,114)           (1,672)          (1,121)
           Costs and estimated earnings in excess of billings                   2,722            (9,038)          (7,767)
           Other current assets                                                  (260)              (85)            (338)
           Accounts payable and accrued expenses                               (2,005)            5,259            6,135
           Accrued and deferred taxes                                              11              (174)             190
                                                                          -------------   --------------   -----------------
                Net cash used for operating activities                         (3,789)           (8,108)          (1,450)
                                                                          -------------   --------------   -----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
    Purchase of contract equipment converted to capital leases                 (5,244)           (7,800)          (3,965)
    Purchase of system assets                                                    (100)           (3,900)               -
    Additions to property and equipment                                          (145)             (453)            (275)
    Decrease (increase) in other assets                                            99               178             (907)
                                                                          -------------   --------------   -----------------
                Net cash used for investing activities                         (5,390)          (11,975)          (5,147)
                                                                          -------------   --------------   -----------------

CASH FLOWS FROM FINANCING ACTIVITIES:
    Net revolving credit (repayments) borrowings                                8,554                 -           (6,656)
    Proceeds from long-term borrowings                                              -             4,100                -
    Proceeds from sale/leaseback of equipment                                   5,244             7,800            3,965
    Principal payments on long-term borrowings                                 (4,054)              (46)               -
    Principal payments on obligations under capital leases                     (2,651)           (1,311)            (497)
    Net proceeds from issuance of common stock                                    641                78           22,230
    Net transactions with parent                                                    -                 -           (1,372)
                                                                          -------------   --------------   -----------------
                Net cash provided by financing activities                       7,734            10,621           17,670
                                                                          -------------   --------------   -----------------

(Decrease) increase in cash and cash equilvalents                              (1,445)           (9,462)          11,073
Cash and cash equivalents, beginning of year                                    1,611            11,073                -
                                                                          -------------   --------------   ----------------- 
Cash and cash equivalents, end of year                                    $       166     $       1,611     $     11,073
                                                                          =============   ==============   =================
SUPPLEMENTAL CASH FLOW INFORMATION:
    Cash paid during the year for interest                                $     1,416     $         832     $        781
                                                                          =============   ==============   =================
    Cash paid during the year for income taxes                            $        68     $         122     $          -
                                                                          =============   ==============   =================
NON CASH ACTIVITIES:
    Issuance of stock options (note 3)                                    $       444     $           -     $          -
                                                                          =============   ==============   ================= 
    Issuance of subordinated debt in exchange for
       reduction of accounts payable                                      $       800     $           -     $          -
                                                                          =============   ==============   =================
</TABLE> 
 
                       The  accompanying  notes  are an  integral  part of these
financial statements.

                                       F-6
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.
                                        
                         NOTES TO FINANCIAL STATEMENTS


(1)  Business and Basis of Presentation

     Viisage Technology, Inc. (Viisage or the Company) is a leader in the
     emerging field of biometrics technology and in providing digital
     identification systems and solutions. The Company focuses on identification
     solutions that improve personal convenience and security, deter fraud and
     reduce identification program costs. Viisage combines its systems
     integration and software design capabilities with its proprietary software
     and hardware products and other industry standard products to create
     complete customized solutions. These turnkey solutions integrate image and
     data capture, create relational databases, incorporate multiple biometrics
     and improve customers' ability to move and manage information. Applications
     can include drivers licenses, voter registration, national ID's, law
     enforcement, social services, access control and PC network and internet
     access security.

     The Company is engaged in one business, the development and implementation
     of digital identification systems and solutions. Effective June 1, 1998,
     the Company reorganized its operations to create a separate biometrics
     division to respond to the growing market interest in biometric solutions.
     The biometrics division is focused on product, market and channel
     development activities in three principal areas: facility access control;
     PC network and internet access security; and real-time large database
     identification and verification of individuals. The systems integration and
     identification card division (SI division) focuses on Viisage's public
     sector markets and serves as a channel to existing customers and the public
     sector for the Company's biometric technologies. Since June 1, 1998, the
     Company has operated in two segments. Amounts for the biometrics division
     prior to the reorganization are not material.

     Viisage was incorporated in Delaware on May 23, 1996 as part of a planned
     reorganization of Lau Acquisition Corp. (Lau Technologies or Lau). On
     November 6, 1996, Lau Technologies completed the transfer of substantially
     all of the assets, liabilities and operations of its Viisage Technology
     Division to the Company in exchange for 5,680,000 shares of the Company's
     common stock (the Transfer) and, as discussed more fully in note 10, the
     Company completed its initial public offering in November 1996. The Company
     is currently an approximately 65% owned subsidiary of Lau Technologies.
     These transactions were between entities under common control and were
     accounted for using historical amounts in a manner similar to a pooling of
     interests. The financial statements for all periods presented prior to the
     Transfer reflect the financial position, results of operations and cash
     flows of the Viisage Technology Division business that comprise the
     Company. All changes in the Company's equity prior to the Transfer are
     reflected in net assets, which represent the net investment of Lau
     Technologies in the Company.


                                      F-7
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.
                                        
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


(1)  Business and Basis of Presentation (Continued)

     The statement of operations for 1996 reflects allocations for the costs of
     shared facilities and certain administrative services. Such costs and
     expenses were allocated to the Company based on actual usage or other
     methods that approximate actual usage. Management believes that the
     allocation methods were reasonable and that allocated costs and expenses
     approximate what such amounts would have been if the Company had operated
     on a stand-alone basis. As discussed more fully in note 3, the Company has
     agreements with Lau Technologies covering certain facilities, equipment and
     administrative services after the Transfer. Although the Company has not
     filed separate income tax returns for periods prior to the Transfer, income
     taxes presented in the financial statements for periods prior to the
     Transfer are computed on a separate return basis taking into consideration
     the tax-sharing arrangement with Lau Technologies described in note 2.

     The financial information included herein may not necessarily reflect the
     financial position, results of operations and cash flows of the Company in
     the future or what the financial position, results of operations and cash
     flows would have been had it been a separate, stand-alone company for the
     periods prior to the Transfer.


(2)  Summary of Significant Accounting Policies

     Use of Estimates

     The preparation of financial statements in conformity with generally
     accepted accounting principles requires management to make estimates and
     assumptions that affect the reported amounts of assets and liabilities and
     disclosure of contingent assets and liabilities at the date of the
     financial statements and the reported amounts of revenues and expenses
     during the reporting period. Actual results could differ from those
     estimates.

     Contract Revenue and Cost Recognition

     The Company provides services principally under contracts that provide for
     a fixed price for the system and/or for each card produced. Revenue is
     recognized using the percentage of completion method based on labor costs
     incurred and/or cards produced. Contract losses, if any, are recognized in
     the period in which they become determinable. Costs and estimated earnings
     in excess of billings are recorded as a current asset. Billings in excess
     of costs and estimated earnings and accrued contract costs are recorded as
     current liabilities. Generally, contracts provide for billing when contract
     milestones are met and/or cards are produced. Retainages and amounts
     subject to future negotiation are not material. Costs and estimated
     earnings in excess of billings include approximately $8 million expected to
     be billed and collected after December 31, 1999.

                                      F-8
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.
                                        
                  NOTES TO FINANCIAL STATEMENTS (CONTINUED) 


(2)  Summary of Significant Accounting Policies (Continued) 

     Charges and Accounting Change

     During the first quarter of 1998, the Company recorded charges of
     approximately $230,000 related to a restructuring to reduce expenses in
     line with the Company's revised plan for 1998. Approximately $50,000 of
     such charges are included in project costs, $170,000 are included in sales
     and marketing expenses and $10,000 are included in general and
     administrative expenses in the statement of operations. During the third
     and fourth quarters of 1998, the Company recorded charges of $472,000 and
     $1,850,000, respectively, to revise project margins and contract cost-to-
     complete estimates. Approximately $2,222,000 of such charges are included
     in project costs and $100,000 are included in general and administrative
     expenses in the statement of operations.

     The Company elected early adoption of Statement of Position No. 98-5 (SOP
     98-5), Reporting on the Costs of Start-Up Activities, which requires start-
     up costs to be expensed as incurred rather than capitalized. The Company
     previously capitalized certain start-up costs as pre-contract costs under
     SOP 81-1, Accounting for Performance of Construction-Type and Certain
     Production-Type Contracts, and charged such costs to contracts upon award.
     As required, the adoption of SOP 98-5 has been made effective as of the
     beginning of the year. The cumulative effect of the change in accounting
     principle of $1,038,000 was recorded as a one-time charge in the Company's
     results for the year. Project costs also include start-up costs of
     $283,000, which were incurred in the first quarter of 1998.

     During the fourth quarter of 1997, the Company recorded non-recurring
     charges of approximately $7.6 million related to investments in technology,
     services and markets that are expected to benefit current and future
     customers and result in future revenues. These investments relate
     principally to upgrades and enhancements to older systems, enhancements to
     central production and data management capabilities and enhancements to
     certain systems to facilitate the future use of facial recognition
     technologies. Approximately $5.3 million of such charges are included in
     project costs and $2.3 million are included in sales and marketing expenses
     in the statement of operations.

     Fair Value of Financial Instruments

     The carrying amounts of the Company's financial instruments, including cash
     and cash equivalents, accounts receivable and payable and short- and long-
     term borrowings, approximate fair values.

     Cash and Cash Equivalents

     The Company considers all highly liquid investments with original
     maturities of three months or less to be cash equivalents. At December 31,
     1997, cash equivalents consisted of short-term repurchase agreements of
     $1,229,000 with a commercial bank. These investments are carried at cost,
     which approximates market value. At December 31, 1998, there were no 
     short-term repurchase agreements.

                                      F-9
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.
                                        
                  NOTES TO FINANCIAL STATEMENTS (CONTINUED) 


(2)  Summary of Significant Accounting Policies (Continued)

     Accounts Receivable

     Accounts receivable are due principally from government agencies and
     contractors to government agencies. Management periodically reviews
     accounts receivable for possible uncollectible amounts. In the event
     management determines a specific need for an allowance, a provision for
     doubtful accounts is provided. Based on management's review, a $100,000
     allowance for doubtful accounts has been recorded for 1998. No amount was
     recorded for 1997.

     For 1998, 1997 and 1996, three customers, one customer, and two customers,
     respectively, each accounted for more than 10% of revenues individually,
     and approximately 40%, 46% and 50% in the aggregate of the Company's
     revenues, respectively.

     At December 31, 1998, 49% of accounts receivable and costs and estimated
     earnings in excess of billings related to two customers.

     Property and Equipment

     Property and equipment are recorded at cost or the lesser of fair value or
     the present value of minimum lease payments for items acquired under
     capital leases. Depreciation and amortization are calculated using the
     straight-line or usage-based methods over the estimated useful lives of the
     related assets that approximate five to seven years or the lease term,
     whichever is shorter.

     Research and Development

     Research and development costs are charged to expense as incurred.

     Software Development

     The Company reviews software development costs incurred in accordance with
     the provisions of Statement of Financial Accounting Standards (SFAS) No.
     86, Accounting for the Costs of Computer Software to be Sold, Leased, or
     Otherwise Marketed, which requires that certain costs incurred in the
     development of computer software to be sold or leased be capitalized once
     technological feasibility is reached. The Company has not capitalized any
     software development costs because development costs incurred subsequent to
     the establishment of technological feasibility have not been material.

     Costs related to software developed for internal use are expensed as
     incurred, except for externally purchased software which is capitalized and
     depreciated over its estimated useful life not to exceed five years.


                                     F-10
<PAGE>
 
                           VIISAGE TECHNOLOGY, INC.
                                        
                  NOTES TO FINANCIAL STATEMENTS (CONTINUED) 


(2)  Summary of Significant Accounting Policies (Continued)

     Income Taxes

     The Company's operations prior to the Transfer discussed in note 1 were
     included in the income tax returns of Lau Technologies, an S corporation.
     Income tax allocations for such periods have been calculated as if the
     Company were filing separate income tax returns taking into consideration
     that operating losses and tax credits have been utilized by the
     shareholders of Lau Technologies. Subsequent to the Transfer, the Company
     files separate tax returns. Any tax liability or refund that may arise for
     periods when the Company was a division of Lau Technologies is covered by a
     tax indemnification arrangement contained in the Asset Transfer Agreement
     executed in connection with the Transfer. The indemnification provides for
     Lau Technologies to pay or receive reimbursement from the Company for any
     tax adjustment relating to the Viisage Technology Division for all periods
     prior to the effective date of the Transfer if such adjustments will result
     in tax expense or tax benefit, as the case may be, to the Company.

     The Company accounts for income taxes under SFAS No. 109, Accounting for
     Income Taxes. Deferred tax assets and liabilities are recognized for the
     estimated future tax consequences attributable to differences between the
     financial statement carrying amounts of existing assets and liabilities and
     their respective tax bases. Deferred income tax assets and liabilities are
     measured using currently enacted tax rates. The effect on deferred tax
     assets and liabilities of a change in tax rates is recognized in income in
     the period that includes the enactment date.

     Net Income (Loss) Per Share

     Basic net income (loss) per share is computed based on the weighted average
     common shares outstanding during the period.  Diluted net income (loss) per
     share includes the dilutive impact of potential common stock.

     For 1998 and 1997, the diluted per share amounts do not reflect the impact
     of convertible debt or options outstanding for 2,784,531 and 1,770,550
     shares, respectively, because their effect is antidilutive. For 1996,
     diluted net income per share reflects the 515,000 share dilutive effect of
     common stock options outstanding during 1996 using the treasury stock
     method. Except for the convertible debt and options referred to above, the
     Company does not have any other potential common stock.

     Stock-Based Compensation

     The Company accounts for its stock-based compensation plans under
     Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
     Employees. SFAS No. 123, Accounting for Stock-Based Compensation,
     establishes a fair value based method of accounting for stock-based
     compensation plans. The Company has adopted the disclosure only alternative
     under SFAS No. 123, which requires disclosure of the pro forma effects on
     earnings and earnings per share as if SFAS No. 123 had been adopted as well
     as certain other information. See note 10 for required disclosures .


                                      F-11
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)


(2)  Summary of Significant Accounting Policies (Continued)

     Other Accounting Pronouncements 

     In February 1997, the FASB issued SFAS No. 129, Disclosure of Information
     about Capital Structure, which establishes standards for disclosing
     information about an entity's capital structure. In June 1997, the FASB
     issued SFAS No. 130, Reporting Comprehensive Income, which establishes
     standards for reporting and disclosure of comprehensive income and its
     components (revenues, expenses, gains and losses) in a full set of general-
     purpose financial statements. These statements are effective for fiscal
     years beginning after December 15, 1997 and require certain additional
     disclosures. The adoption of these statements did not have a significant
     impact on the Company's current disclosures.

(3)  Other Related Party Transactions

     In connection with the Transfer discussed in note 1, the Company and Lau
     Technologies entered into an Administration and Services Agreement, a Use
     and Occupancy Agreement and a License Agreement.

     Under the Administration and Services Agreement, Lau Technologies provides
     general accounting, data processing, payroll, certain human resources,
     employee benefits administration and certain executive services to the
     Company. The agreement requires the Company to pay a monthly fee based on
     the estimated actual cost of such services and permits the Company to
     terminate selected services upon 30 days written notice. The annual fee for
     services is revised if the level of services is changed. The Company
     utilized the same allocation methods for prior periods. Amounts for 1997
     reflect the use of additional services. The amounts for such services were
     approximately $636,000 in 1998, $864,000 in 1997 and $660,000 in 1996,
     respectively.

     The Use and Occupancy Agreement requires the Company to pay its
     proportionate share of the cost of shared facilities and office services
     including rent, insurance, property taxes, utilities and other operating
     expenses, based on square footage or equipment utilized. The annual fee for
     facilities and services is revised for changes in space utilized and in
     operating expenses. The amounts for facilities and services were
     approximately $550,000 in 1998, $512,000 in 1997 and $220,000 in 1996,
     respectively. Amounts for 1998 and 1997 reflect the use of additional
     space. See note 7 for lease information.

     Company employees participate in various Lau Technologies employee benefit
     plans. The Company pays its proportionate share of the costs of such plans
     based on the number of participating employees.

     Management believes the methods for allocating expenses and those costs
     related to shared facilities and equipment are reasonable and approximate
     what these costs would be on a stand-alone basis.

     The License Agreement grants the Company an exclusive, worldwide, royalty-
     free, paid-up, perpetual, irrevocable license to use proprietary technology
     used by the Viisage Technology Division at the time of the Transfer and
     improvements thereto. The license excludes the use of such technology for
     federal access control as defined in the License Agreement.

                                      F-12
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)

(3)  Other Related Party Transactions (Continued)

     The Company purchases certain system components and technical personnel
     from Lau Technologies. The amounts for such components and services were
     approximately $1.0 million in 1998, $1.9 million in 1997 and $1.7 million
     in 1996. During 1998, the Company provided software development services as
     a subcontractor to Lau amounting to $500,000.

     At December 31, 1998 and 1997, the Company had approximately $596,000 and
     $23,000 of accounts receivable due from Lau Technologies, respectively, and
     approximately $906,000 and $713,000 of accounts payable due to Lau
     Technologies, respectively. The Company also has a 9% note receivable from
     Lau Technologies due in monthly installments of principal and interest of
     approximately $21,000 through February 28, 2002. At December 31, 1998 and
     1997, approximately $197,000 and $194,000 of the note was included in other
     current assets, respectively, and the remaining balance of approximately
     $472,000 and $664,000 was included in other assets, respectively, in the
     accompanying balance sheet.

     During the third quarter of 1998, the Company issued 300,000 shares of
     Common Stock to Lau, its majority shareholder, for $2.00 per share or
     $600,000. The Company also issued to Lau options to purchase 509,091 shares
     of common stock during the year as a financing fee for certain guarantees
     of capital lease financing drawdowns. The options are exercisable at $2.75
     per share through August 2001. The fair market value of the options was
     recorded as an addition to deferred financing costs and additional paid-in-
     capital.

     In November 1998, the Company issued an $800,000, 4% convertible
     subordinated note to Lau in exchange for amounts payable to Lau. The note
     and related accrued interest are convertible into the Company's common
     stock at any time prior to October 15, 1999 at $1.58 per share.

     The Company has a commitment from Lau for up to $2 million of additional
     funding which can be drawn, under certain conditions defined in the
     commitment, at various times through February 2000. In addition, Lau has
     agreed to provide up to $3.1 million of capital lease financing in 1999
     for a certain contract.

     The Company has employment and noncompetition agreements with certain
     officers. Such agreements provide for employment and related compensation,
     and restrict the individuals from competing, as defined, with the Company
     during the terms of their respective agreements and for up to two years
     thereafter. The agreements also provide for stock options under the
     Company's stock option plan and for severance payments upon termination
     under circumstances defined in such agreements.

                                     F-13
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)


 (4) Property and Equipment

     Property and equipment are summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                        1998        1997
 
               <S>                                  <C>             <C>
               Assets held under capital lease      $19,225         $13,981
               System assets                          4,000           3,900
               Computer equipment                       974             829
                                                    -------         -------
                                                     24,199          18,710
               Less--Accumulated depreciation         5,686           2,664
                                                    -------         -------
                                                    $18,513         $16,046
                                                    =======         =======
</TABLE>

     During 1998 and 1997, the Company sold and leased back under capital leases
     approximately $5.2 million and $7.8 million, respectively, of system
     equipment used to produce identification cards for certain contracts.

     In October 1997, Viisage completed a System Sale, License and Subcontract
     Agreement (the Agreement) with Unisys Corporation (Unisys). Under the
     Agreement, Viisage purchased and licensed certain assets from Unisys and
     agreed to perform certain services as Unisys' subcontractor relating to a
     digital imaging system for the Florida Department of Highway Safety and
     Motor Vehicles. The purchase price was $4 million, consisting of $3.8
     million paid in 1997 and two payments of $100,000 each, one made in
     December 1998 and the other to be made on October 1, 2000. In addition,
     Viisage agreed to additional contingent payments of up to $754,000
     depending largely on Unisys' support of Viisage's efforts to generate
     incremental revenues from Florida state agencies. The purchase, including
     approximately $100,000 of transaction costs, was recorded using the
     purchase method of accounting and has been allocated to system assets which
     are being amortized over the estimated remaining useful life of the system.

(5)  Accounts Payable and Accrued Expenses

    Accounts payable and accrued expenses consist of the following (in
    thousands):

<TABLE>
<CAPTION>
                                                         DECEMBER 31,
                                                      1998          1997
               <S>                                   <C>            <C> 
               Accounts payable                      $3,112         $ 4,483
               Accrued contract costs                 5,235           6,700
               Accrued payroll and related taxes        138             170
               Accrued vacation                         219             285
               Other accrued expenses                   386             615
                                                     ------         -------
                                                     $9,090         $12,253
                                                     ======         =======
</TABLE>

                                     F-14
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)


(5)  Accounts Payable and Accrued Expenses (Continued)

     During 1998 and 1997, accrued capital lease interest of approximately
     $358,000 and $294,000, respectively, has been transferred from accounts
     payable and accrued expenses to obligations under capital leases.

(6)  Long-term Debt and Project Lease Arrangements

     In December 1998, the Company executed an amended and restated agreement
     with a commercial bank to provide a new revolving credit facility to the
     Company through June 2000. Outstanding term and revolving credit borrowings
     were repaid with funds from the new agreement at closing. At December 31,
     1998 the Company was not in compliance with certain covenants included in
     its revolving credit and project lease financing facilities. The Company
     has received waivers of such violations from its lenders and commitments
     from its lenders to modify the Company's covenants in line with its current
     operating plan. In connection with the bank's commitment, the revolving
     credit facility will be amended to provide for borrowings of up to $10
     million through June 30, 1999, $9 million through September 30, 1999, $8
     million through December 31, 1999 and $6.5 million through June 30, 2000 at
     the prime rate plus 1%. The facility is secured by substantially all of the
     Company's assets and requires the Company to maintain certain financial
     ratios and minimum levels of earnings and tangible capital funds, as
     defined. The revolving credit facility also requires the Company to raise
     funds, as needed, from other sources to cover biometrics division expenses.
     These sources are expected to include a combination of biometrics division
     revenues, subordinated debt and equity capital.

     Prior to December 1998, borrowings under the credit facility were unsecured
     and had interest rates ranging from prime to 8.1%.

     The Company also has a system project lease financing arrangement with a
     commercial leasing organization. Pursuant to this arrangement, the lessor
     purchases certain of the Company's digital identification systems and
     leases them back to Viisage for deployment with identified and contracted
     customers approved by the lessor. The lessor retains title to systems and
     has an assignment of Viisage's rights under the related customer contracts,
     including rights to use the software and technology underlying the related
     systems. Under this arrangement, the lessor bears the credit risk
     associated with payments by Viisage's customers, but Viisage bears
     performance and appropriation risk and is generally required to repurchase
     a system in the event of a termination by a customer for any reason except
     credit default. The Company is also required to maintain certain financial
     ratios and minimum levels of tangible capital funds, as defined. As
     discussed above, at year-end the Company was not in compliance with certain
     covenants, but has received waivers and a commitment to amend the covenants
     to be consistent with the Company's current operating plan. These project
     lease arrangements are accounted for as capital leases. The current
     arrangement provides for project financing of up to $15.0 million, which
     has been reduced from $25 million to reflect the Company's current
     operations. At December 31, 1998, the Company had approximately $14.8
     million outstanding under the lease financing arrangement, and is currently
     negotiating additional project financing arrangements. Lau has agreed to
     provide up to $3.1 million of capital lease financing in 1999.

                                     F-15
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)


(6)  Long-term Debt and Project Lease Arrangements (Continued)

     The Company believes that it will continue to meet its debt covenants.
     However, this expectation is dependent in part on achieving business
     forecasts and raising funds to cover biometrics division expenses. If the
     Company does not meet such covenants, the bank and the lessor could require
     immediate repayment of amounts outstanding. As discussed in note 3, the
     Company has a commitment from Lau for up to $2 million of additional
     funding.

(7)  Commitments and Contingencies

     Leases

     The Company leases certain equipment and facilities used in its operations
     and the shared facilities discussed in note 3. Rental expense for operating
     leases was approximately $212,000 in 1998, $212,000 in 1997 and $130,000 in
     1996.

     At December 31, 1998, approximate future minimum rentals under the lease
     for shared facilities and capital leases are as follows (in thousands):

<TABLE>
<CAPTION>
                                                     CAPITAL    OPERATING     
                                                     LEASES       LEASE       
             <S>                                     <C>        <C>           
             Year Ending:                                                     
              1999                                   $ 4,726        $131      
              2000                                     4,447         131      
              2001                                     3,820         131      
              2002                                     2,483          12      
              2003                                     1,943           -      
              Thereafter                               1,134           -      
                                                     -------        ----      
                  Total minimum lease payments        18,553        $405      
                                                                    ====      
             Less--Interest portion                    3,198                    
                                                     -------                    
                  Present value of net                                          
                  minimum lease payments              15,355                    
             Less--Current portion                     3,797                    
                                                     -------                    
                                                     $11,558                    
                                                     =======                    
</TABLE>


     Litigation

     The Company does not believe that there are any legal matters that would
     have a material adverse effect on its business, financial condition or
     results of operations.

                                     F-16
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)
   
(8)  Retirement Plans

     The Company participates in the Lau Technologies 401(k) plan and pays its
     proportionate share of plan expenses based on the number of participants.
     The plan permits pretax contributions by participants of up to 15% of base
     compensation. The Company may make discretionary matching contributions of
     up to 3% of base compensation. Participants are fully vested in their
     contributions and vest 20% per year in employer contributions. The
     Company's costs for this plan amounted to approximately $67,000, $95,000
     and $70,000 for the years ended December 31, 1998, 1997 and 1996,
     respectively.

     The Company does not offer any postretirement benefits.

(9)  Income Taxes

     As discussed in notes 1 and 2, the Company was treated as an S corporation
     prior to the Transfer and operating losses and tax credits for prior
     periods have been utilized by the shareholders of Lau Technologies. In
     connection with the Transfer, the Company changed its tax status and
     recorded a deferred tax provision of $110,000 relating to the cumulative
     differences between the financial reporting and income tax bases of certain
     assets and liabilities as of the Transfer date.

     The provision for income taxes for the year ended December 31, 1996
     consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                    CURRENT       DEFERRED       TOTAL
                     <S>            <C>           <C>            <C>
                     Federal           $ 7          $132          $139
                     State              25            41            66
                                       ---          ----          ----
                                       $32          $173          $205
                                       ===          ====          ====
</TABLE>


     There was no provision for income taxes for the years ended December 31,
     1998 and 1997.

     A reconciliation of the federal statutory rate to the Company's effective
     tax rate for the years ended December 31, 1998, 1997 and 1996 is as
     follows:

<TABLE>
<CAPTION>
                                                     1998      1997      1996
          <S>                                       <C>       <C>       <C>
          Federal statutory rate                    (34.0)%   (34.0)%     4.0 %
          State taxes, net of federal benefit        (6.0)     (6.0)      6.0 
          Valuation allowance recorded               40.0      40.0         - 
          Subchapter S earnings not taxed               -         -     (28.0)
          Deferred taxes related to Transfer            -         -      14.0 
          Other, net                                    -         -      (1.0)
                                                    -----     -----     ----- 
                                                        - %       - %    25.0 %
                                                    =====     =====     ===== 
</TABLE>

                                      F-17
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)
   

(9)  Income Taxes (Continued)

     The components and approximate tax effects of the Company's deferred tax
     assets and liabilities as of December 31, 1998, 1997 and 1996 are as
     follows (in thousands):

<TABLE>
<CAPTION>
                                                                    1998         1997    
          <S>                                                     <C>          <C>      
          Deferred tax assets (liabilities):                                                           
             Net operating loss carryforwards for tax purposes    $ 4,363      $ 1,058    
             Bases differences related to contract assets            (859)          33    
             Property, plant and equipment                            (19)         245    
             Accruals and other reserves                              242          228    
             Other                                                      -            -    
                                                                  -------      -------    
          Net deferred tax asset before valuation allowance         3,727        1,564    
          Valuation allowance                                      (3,727)      (1,564)   
                                                                  -------      -------    
          Net deferred tax asset                                  $     -      $     -    
                                                                  =======      =======    
</TABLE>

     Due to the uncertainty surrounding the realization of the Company's net
     deferred tax asset, the Company has provided a full valuation allowance
     against this amount.

     At December 31, 1998, the Company had available estimated net operating
     loss carryforwards for federal tax purposes of approximately $10.9 million
     to reduce, subject to certain limitations, future income taxes. These
     carryforwards expire from 2111 to 2114 and are subject to review and
     possible adjustment by the Internal Revenue Service.

                                     F-18
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)
   
(10) Shareholders' Equity

     Stock Option Plans

     Under the 1996 Management Stock Option Plan and the 1996 Director Stock
     Option Plan (the Plans), the Board of Directors may grant incentive and
     nonqualified stock options to employees and officers and nonqualified stock
     options to directors. Generally, incentive stock options are granted at
     fair value and are subject to the requirements of Section 422 of the
     Internal Revenue Code of 1986, as amended. Nonqualified options are granted
     at exercise prices determined by the Board of Directors. Options granted to
     date to directors vest over three years from the date of grant. Options
     granted to management and employees vest at various rates over periods
     ranging from three to seven years or, in some cases, earlier if certain
     performance measures are met. The performance measures are based on each $1
     million increase in Company value up to approximately $500 million, as
     adjusted. All options granted under the Plans expire ten years from the
     date of grant.

     At December 31, 1998, the Company has reserved 2,057,100 shares of common
     stock for issuance under the management plan of which 456,696 shares are
     available for future grants, and 176,620 shares of common stock under the
     director plan which have all been granted.

     In connection with such options, the Company is recognizing compensation
     expense of approximately $700,000 over the estimated vesting period. The
     amount of compensation is calculated as the difference between the exercise
     price and the fair value of the Company's business on the grant dates based
     on an independent third-party appraisal. No stock compensation expense was
     recorded in 1998 or 1997 and $238,000 was recorded in 1996. During 1998,
     the Company adjusted the exercise price from $13.00 to $2.25 on 177,000
     employee options and from $6.25 to $2.25 on 21,000 options granted to
     certain management personnel. These options were treated as cancelled and
     reissued in the table that follows.

                                     F-19
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)
   

(10) Shareholders' Equity (Continued)

     A summary of stock option activity under the Plans is as follows:

<TABLE>
<CAPTION>
                                                                                                    WEIGHTED       
                                                                                                    AVERAGE        
                                                              SHARES         OPTION PRICE         OPTION PRICE     
       <S>                                                  <C>            <C>                    <C>        
       Options outstanding, December 31, 1996               1,427,100      $   2.96 - $4.86             $ 3.20     
          Granted                                             362,000          6.25 - 13.00              12.50     
          Exercised                                           (10,732)                 2.96               2.96     
          Cancelled                                            (7,818)                 2.96               2.96     
                                                            ---------      ----------------             ------     
       Options outstanding, December 31, 1997               1,770,550      $  2.96 - $13.00             $ 5.07     
          Granted                                           1,109,077        0.625 - 4.4375               1.63     
          Exercised                                            (1,465)                 2.96               2.96     
          Cancelled                                        (1,113,335)         2.96 - 13.00               5.68     
                                                            ---------      ----------------             ------     
       Options outstanding, December 31, 1998               1,764,827         0.625 - 12.50             $ 2.53     
                                                            =========      ================             ======     
                                                                                                                   
       Options exercisable, December 31, 1998                 550,715      $0.9375 - $12.50             $ 3.17     
                                                            =========      ================             ======     
                                                                                                                   
       Options available for grant                            456,696                                              
                                                            =========                                               
</TABLE>
                                                                                
     The following table summarizes information about outstanding options as of
     December 31, 1998:

<TABLE> 
<CAPTION> 
                                         OPTIONS OUTSTANDING                        OPTIONS EXERCISABLE        
                                         -------------------                        -------------------        
                                                      WEIGHTED        WEIGHTED                         WEIGHTED     
                                                      AVERAGE         AVERAGE                          AVERAGE      
                 RANGE OF                            REMAINING        EXERCISE                         EXERCISE      
              EXERCISE PRICES        NUMBER         CONTRACTUAL      PRICE PER        NUMBER           PRICE PER      
                                   OUTSTANDING         LIFE            SHARE        EXERCISABLE          SHARE       
              <S>                  <C>             <C>               <C>            <C>                <C>            
              $0.625 - $0.9375          656,837        9.8 years        $ 0.93            58,303          $ 0.94   
                   2.00 - 2.96        1,013,020        7.5 years          2.79           467,412            2.95   
                        4.4375           19,970        9.4 years          4.44                 -               -   
                         12.50           75,000        8.4 years         12.50            25,000           12.50   
                                      ---------                                          -------             
                                      1,764,827                                          550,715             
                                      =========                                          =======              
</TABLE>
                                                                                
     The Company has computed the pro forma disclosures required under SFAS No.
     123 for options granted using the Black-Scholes option pricing model
     prescribed by SFAS No. 123.  The weighted average assumptions used are:

<TABLE>
<CAPTION>
                                        1998            1997           1996
       <S>                           <C>               <C>           <C>
       Risk free interest rate        4.63 - 5.7%           6%           6%
       Expected dividend yield             -              -             -   
       Expected lives                8 - 10 years      10 years      10 years   
       Expected volatility                    74%          76%          66% 
</TABLE>

                                     F-20
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)


(10) Shareholders' Equity (Continued)

     The total value of options granted from the Company's plans was computed as
     approximately $1.1 million for 1998, $3.7 million for 1997 and $4.2 million
     for prior periods, respectively. Of these amounts, approximately $1.4
     million, $434,000 and $1.4 million would have been charged to operations
     for the years ended December 31, 1998, 1997 and 1996, respectively, for
     currently vested options and the remaining amounts, $5.8 million, $6.1
     million and $2.8 million, would be amortized over the related vesting
     periods. The pro forma effect of SFAS No. 123 is as follows:

<TABLE>
<CAPTION>
                                                                 1998              1997              1996
     <S>                                                      <C>               <C>                 <C>
     Net income (loss), as reported                           $(7,203,000)      $(4,362,000)        $ 601,000
     Pro forma net loss                                        (8,566,000)       (4,796,000)         (225,000)
     Basic net income (loss) per share, as reported                 (0.88)            (0.54)             0.10
     Pro forma basic net loss per share                             (1.05)            (0.60)            (0.04)
     Diluted net income (loss) per share, as reported               (0.88)            (0.54)             0.09
     Pro forma diluted net loss per share                           (1.05)            (0.60)            (0.04)
</TABLE>

     Employee Stock Purchase Plan

     In 1997, the Company adopted the 1997 Employee Stock Purchase Plan and
     reserved 70,000 shares of common stock for issuance under such plan.
     Purchase price is determined by taking the lower of 85% of the closing
     price on the first or last day of periods defined in the plan. As of
     December 31, 1998, 15,500 shares have been issued and options to purchase
     9,471 shares of common stock at $1.06 per share were vested under the plan.
     These shares were issued in 1999.

(11) Business Segments, Geographical Information, and Concentration of Risk

     The Company is engaged in one business, the development and implementation
     of digital identification systems and solutions. Effective June 1, 1998,
     the Company reorganized its operations to create two separate divisions,
     a biometrics division and a systems integration and identification card
     division. Since June 1, 1998, the Company has operated in two segments.
     Amounts for the biometrics division prior to the reorganization are not
     material. The costs of shared facilities and certain administrative
     services have been allocated to each business based on actual usage or
     other methods that approximate actual usage. All other costs and expenses
     have been allocated to each business based on actual usage. The Company's
     accounting policies for its segments are the same as disclosed in Note 2.
     Management evaluates segment performance based on operating income.

     Substantially all of the Company's revenues are currently derived from the
     SI division's public sector customers and contractors to such customers.
     The Company believes for the foreseeable future that it will continue to
     derive a significant portion of its revenues from a limited number of large
     contracts. For the years ended December 31, 1998, 1997 and 1996, three
     customers, one customer and two customers, respectively, each accounted for
     more than 10% of the Company's revenues and an aggregate of 40%, 46% and
     50% of revenues for each of the years, respectively.

                                     F-21
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)


(11) Business Segments, Geographical Information, and Concentration of Risk
     (Continued)

<TABLE>
<CAPTION>
                                                          1998         1997         1996
      <S>                                           <C>                <C>          <C>           
      BUSINESS SEGMENT INFORMATION                                                           
      Revenues:                                                                              
          Systems integration division                    15,759       29,388       24,971   
          Biometrics division                                500           --           --   
                                                    --------------------------------------   
                                                          16,259       29,388       24,971   
                                                    ======================================   
      Operating Income (Loss):                                                               
          Systems integration division                    (3,141)      (3,921)       1,520   
          Biometrics division                             (1,357)          --           --   
                                                    --------------------------------------   
                                                          (4,498)      (3,921)       1,520   
                                                    ======================================   
      Total Assets:                                                                          
          Systems integration division                    45,881       47,463       36,119   
          Biometrics division                                563           --           --   
                                                    --------------------------------------   
                                                          46,444       47,463       36,119   
                                                    ======================================   
      Depreciation and Amortization:                                                         
          Systems integration division                     2,996        1,964          612   
          Biometrics division                                 26           --           --   
                                                    --------------------------------------   
                                                           3,022        1,964          612   
                                                    ======================================   
      Capital Expenditures:                                                                  
          Systems integration division                     5,480       12,153        4,240   
          Biometrics division                                  9           --           --   
                                                    --------------------------------------   
                                                           5,489       12,153        4,240   
                                                    ======================================   
      GEOGRAPHIC INFORMATION:                                                                
      Revenues:                                                                              
          United States                                   15,644       28,149       23,113   
          International                                      615        1,239        1,858   
                                                    --------------------------------------   
                                                          16,259       29,388       24,971   
                                                    ======================================    
</TABLE>


                                     F-22
<PAGE>
 
                            VIISAGE TECHNONOGY, INC.

                   NOTES TO FINANCIAL STATEMNETS (CONTINUED)


(12) Quarterly Financial Data (Unaudited)

     The following table sets forth selected quarterly financial data for 1998
     and 1997 (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                       1ST              2ND              3RD              4TH
                                                     QUARTER          QUARTER          QUARTER          QUARTER
     <S>                                             <C>              <C>              <C>              <C>
     1998                                 
       Revenues                                       $ 4,629          $ 2,965          $ 4,242          $ 4,423
       Project margin (loss)                              633              343              185             (859)
       Net loss                                        (1,864)          (1,568)          (1,286)          (2,485)
       Basic net loss per share                         (0.23)           (0.19)           (0.16)           (0.30)
       Diluted net loss per share                       (0.23)           (0.19)           (0.16)           (0.30)
                                          
     1997                                 
       Revenues                                       $ 7,178          $ 8,554          $ 6,026          $ 7,630
       Project margin (loss)                            2,029            2,474            1,608           (2,845)
       Net income (loss)                                  569              690              107           (5,728)
       Basic net income (loss) per share                 0.07             0.09             0.01            (0.71)
       Diluted net income (loss) per share               0.07             0.08             0.01            (0.71)
</TABLE>

     Net income (loss) per share amounts for the first quarter of 1998 have been
     restated to reflect the Company's early adoption of SOP 98-5.

     The 1998 results reflect the impact of charges and the accounting change
     discussed in note 2.

     The 1997 fourth quarter amounts reflect the impact of charges for certain
     investments in technology, services and markets discussed in note 2.

                                      F-23