<PAGE>

MANAGEMENT'S  DISCUSSION  AND  ANALYSIS OF  FINANCIAL  CONDITION  AND RESULTS OF
OPERATIONS

        Except for the  historical  information  contained  herein,  the matters
discussed in this Annual  Report may contain  forward-looking  statements  which
involve risk and uncertainties. Factors that may affect the Company's results of
operations are discussed in detail in "Risks and Uncertainties" below, including
but not limited to customer delays in reengineering programs,  decreased capital
expenditures   by   several   of  the   Company's   customers,   the  impact  of
reorganizations,  restructurings  and  reductions-in-force  at  several  of  the
Company's RBOC customers;  deregulation of the telecommunications  industry; and
the highly  competitive  market  surrounding the Company's CTS and NIU products.
The Company  believes that  deregulation  and the resulting  increased number of
competitors providing  telecommunications  services could result in an expansion
of the Company's customer base and increased  competition with regard to service
levels  and costs,  ultimately  causing an  increased  demand for the  Company's
products. However, additional delays in the deployment of the Company's products
and continued uncertainty surrounding the telecommunications industry may have a
material  adverse  impact  on the  Company's  business,  operating  results  and
financial  condition.  As a result of the  uncertainties  faced by the Company's
customers,  the Company  continues  to have  limited  visibility  with regard to
future  customer  orders  and the  timing of such  orders.  Customers  have been
placing  orders  quarterly and the Company has been operating in a book and ship
mode.  With a small  customer base and  fluctuating  order size,  this trend has
resulted in quarter-to-quarter  revenue fluctuations that are likely to continue
for the foreseeable  future.  While the outlook contained in any forward-looking
statements  represents  management's current judgment on the future direction of
the business,  the risks and  uncertainties  discussed herein could cause actual
results to differ materially from any future  performance  suggested herein. The
Company  undertakes  no  obligation  to revise or update  these  forward-looking
statements to reflect events or circumstances arising after the date hereof.

OVERVIEW

        In October  1996,  the U.S.  Patent and  Trademark  Office  granted  the
Company a patent for technology used in the Company's  Remote Module product,  a
unique DS1 Network Interface Unit ("NIU"). The Remote Module, when used with the
Company's  T3AS  Performance  Monitoring  and  Test  System,  and  Sectionalizer
Operations  Systems  ("OS")  software,  enables  service  providers to determine
whether circuit troubles originated in their network or the customers'.

        On July 16, 1996,  the Company  acquired  certain  assets of MPR Teltech
Ltd., ("MPR Teltech") a subsidiary of BC TELECOM,  Inc. The assets acquired were
part of MPR  Teltech's  operating  unit commonly  known as the Special  Services
Networks  division  ("SSN").  The Company and its Canadian  subsidiary,  Applied
Digital  Access - Canada,  Inc.  ("ADA-Canada"),  acquired  the  assets for $4.2
million in cash and 150,000  shares of the  Company's  common  stock.  The total
purchase  valuation was $5.3  million.  The Company also incurred $.2 million in
related  acquisition costs. SSN was an operations  systems software  development
group with  expertise in development  of network  management  systems for public
carriers.  SSN  developed  operations  systems  ("OS")  software  primarily  for
Northern  Telecom  Limited  ("Nortel").  SSN  became  part of  ADA-Canada  which
provides  development  services  related to network  performance  management  OS
software  products  for the Company and its  customers,  including  Nortel.  The
Company incurred a $2.1 million one-time charge in the third quarter of 1996 for
purchased  research  and  development  related  to  the  asset  acquisition.  In
connection with the acquisition,  the Company also licensed  certain  technology
from Nortel for Network Performance Management applications.

        On February 29, 1996,  the Company  acquired  certain  assets of Applied
Computing  Devices,  Inc.  ("ACD"),  a company  that  developed  and marketed OS
software used  primarily by  independent  telephone  companies to manage certain
functions in their networks.  The customer set and products of ACD  complemented
those of ADA, and ADA has  continued to market and enhance these  products.  The
Company acquired the assets for $1.7 million in cash and incurred  approximately
$.2 million in related  costs.  The assets were  acquired at an auction  held in
Federal  Bankruptcy  Court,  Southern  District  of  Indiana.  After  filing for
bankruptcy in September  1995,  ACD did not generate  significant  revenue.  The
Company recorded a one-time charge of approximately $1.2 million associated with
purchased  research and  development in the first quarter of 1996 as a result of
the acquisition.


                                       1

<PAGE>

        In February 1996, the settlement of a class action lawsuit filed against
the Company and two of its  officers in March 1995 was  finalized  and  received
court  approval.  The  litigation  was  settled for $1.5  million,  of which the
Company was obligated to pay  approximately  $.4 million with the remainder paid
by the Company's  directors'  and officers'  liability  insurance  carrier.  The
costs associated with the suit were accrued in 1995.

        Taking  the  developments  discussed  above and the  elements  discussed
elsewhere,  both  individually  and in the aggregate,  there can be no assurance
that the Company will maintain  current  revenue or operating  results levels or
that revenue or operating results will increase.


                                        2


<PAGE>


 RESULTS OF OPERATIONS

        The following table sets forth certain  statements of operations data as
a percent of revenue, for the years ended December 31, 1996, 1995 and 1994.

<TABLE>
<CAPTION>

                                                YEARS ENDED DECEMBER 31,
                                             1996         1995         1994
                                             ----         ----         ----
<S>                                          <C>          <C>          <C>
Revenue................................      100%         100%         100%
Cost of revenue........................       52%          43%          42%
                                              ---          ---         ----
Gross profit...........................       48%          57%          58%

Operating Expenses:
Research and development...............       30%          28%          15%

Purchased in-process
research and
development related to                        13%           -            -
acquisitions.....
Sales and marketing....................       26%          21%           9%
General and administrative.............        5%          14%           7%
                                              ---          ---          ---
Total operating expenses...............       84%          63%          31%
                                             ----         ----         ----
Operating income (loss)................      (36)%         (6)%         27%
Other income (expense), net............        7%          10%           4%
                                              ---         ----          ---
         Income (loss) before                (29)%          4%          31%
income taxes...........................
Provision for income taxes.............        -            -           (1)%
                                              ---          ---         -----
Net income (loss)......................       (29)%         4%           30%
                                             =====          =====        ===
</TABLE>


1996 COMPARED WITH 1995

         Revenue  totaled  $24,422,000  in 1996, a 19% increase from $20,470,000
in 1995. The increase is primarily the result of revenue  generated from network
management  OS  software   design   services  and  products   acquired   through
acquisitions  during 1996. Revenue from the Company's T3AS products and services
totaled  $18,144,000  in 1996, an 11% decrease  from  $20,470,000  in 1995.  The
decrease  was the  result  of lower  T3AS  sales  compared  to last  year due to
decreased capital expenditures by several of the Company's customers, the highly
competitive  market for the Company's  CTS and NIU  products,  and the impact of
regulatory  actions on the  Company's  customers.  Revenue  from OS services and
products  totaled  $6,278,000  in 1996.  The Company did not have any OS product
revenue in 1995. In 1996, US WEST,  NYNEX,  and Northern  Telecom  accounted for
31%, 23%, and 15% of the  Company's  revenue,  respectively.  In 1995, U S WEST,
Ameritech,  NYNEX and Bell  South  accounted  for 45%,  19%,  18% and 13% of the
Company's revenue,  respectively. The Company expects that revenue from sales of
the T3AS  product  family and recently  acquired OS products  and services  will
account for a majority of the Company's revenue for the foreseeable future.

        Gross  profit  totaled  $11,813,000  in  1996,  a slight  increase  from
$11,753,000  in 1995.  Gross  profit as a  percent  of  revenue  was 48% in 1996
compared to 57% in 1995.  The  decrease in gross  profit as a percent of revenue
resulted primarily from a product mix weighted toward lower margin T3AS products
and services and  lower-margin  revenue from OS software  design  services.  The
majority of the Company's Canadian subsidiary's operations supported OS software
design services.  Since the cost of design services revenue includes both direct
and  indirect  costs of  supplying  the  services,  the majority of the Canadian
subsidiary's  operating  costs are included in cost of revenue.  There can be no
assurance  that the Company  will be able to maintain  current  gross  profit or
gross profit as a percent of revenue  levels.  Factors which may  materially and
adversely  affect the Company's  gross profit in the future include its level of
revenue,   competitive  pricing  pressures  in  the  telecommunication   network
management


                                       3

<PAGE>

market, new product  introductions by the Company or its competitors,  potential
inventory  obsolescence  and  scrap,  possible  recalls,  production  or quality
problems,  timing  of  development  expenditures,  changes  in  material  costs,
disruptions  in sources of supply,  regulatory  changes,  seasonal  patterns  of
bookings, capital spending, and changes in general economic conditions.

        Research and  development  expenses  totaled  $7,356,000  in 1996, a 27%
increase from $5,807,000 in 1995. The increase was primarily due to the addition
of research and development  personnel as a result of the ACD asset acquisition,
increases in depreciation  expense,  and increases in non-recurring  engineering
(NRE)  expenses  due to timing  of  planned  development  projects  during  1996
compared to 1995.  Research and  development  personnel  expenses  increased 26%
compared  to 1995,  mostly  related to the ACD asset  acquisition.  The  Company
believes that
 its  future  success  depends  on its  ability to  maintain  its  technological
leadership  through  enhancement  of its existing  products and  development  of
innovative new products and services that meet customer  needs.  Therefore,  the
Company  intends to continue to make  significant  investments  in research  and
product development in association with planned development projects.

        In 1996, the Company recorded  one-time  charges for purchased  research
and  development  costs related to the ACD asset  acquisition  and the SSN asset
acquisition of $1,186,000 and $2,100,000, respectively.

        Sales and marketing  expenses totaled $6,312,000 in 1996, a 49% increase
from $4,234,000 in 1995. The majority of the increase resulted from the addition
of technical  customer support  personnel,  the addition of customer support and
marketing  personnel  related  to  the  ACD  asset  acquisition,  and  increased
promotional expenses. The Company expects that sales and marketing expenses will
continue  to  increase in  absolute  dollars as the  Company  continues  to hire
additional  sales,  marketing and technical support personnel to support planned
product  introductions  in both  the  network  systems  and  network  management
business areas.

        General and  administrative  expenses totaled  $3,576,000 in 1996, a 20%
increase from $2,985,000 in 1995. The majority of the increase is the net result
of increased  expenses for the amortization of goodwill and intangibles  related
to the SSN asset  acquisition and increased  personnel  expenses related to this
year's acquisitions offset by a decrease in legal expenses compared to 1995 as a
result of greater  legal  expense in 1995  related to the suit  settlement.  The
Company  expects  that  general and  administrative  expenses  will  increase in
absolute  dollars  as the  Company  invests  in the  expansion  of its  internal
networking  capabilities  related to the ACD and SSN asset  acquisitions and the
expected need for additional support personnel.

        Interest  income  totaled  $1,673,000  in  1996,  a  17%  decrease  from
$2,023,000 in 1995. The decrease is the result of a decrease in cash investments
during 1996 compared to 1995.

        In 1996, the Company provided for income taxes related to the operations
of the Company's Canadian subsidiary, based on an effective Canadian tax rate of
46%.  The Company did not provide for U.S.  income  taxes in 1996 or 1995 due to
net losses for income tax  purposes.  At  December  31,  1996,  the  Company had
federal  income  tax-  loss  carry-forwards  of  approximately  $12,987,000  and
California state income tax-loss carry-forwards of approximately $5,835,000. The
Company's   use   of   approximately   $1,166,000   of  its   federal   tax-loss
carry-forwards,  and $408,000 of its federal and $105,000 of its  California tax
credit carryforwards are significantly  limited as a result of ownership changes
associated with equity financings in January 1989 and March 1991.  Management is
not able to  estimate  levels of tax  deductions  which will be  generated  as a
result  of  these  transactions  in  future  periods.  See  Note 11 of  Notes to
Financial Statements.

        As a result of the factors  discussed  above, the Company incurred a net
loss of  $7,120,000,  or $.59  per  share  in 1996  compared  to net  income  of
$759,000,  or $.06 per share in 1995.  Excluding  $3,286,000 in one-time charges
for purchased  research and  development  costs  associated with the ACD and SSN
asset acquisitions, the Company incurred a net loss of $3,834,000, or
$.32 per share in 1996.


                                       4

<PAGE>


1995 COMPARED WITH 1994

        Revenue totaled  $20,470,000 in 1995 a 42% decrease from  $35,597,000 in
1994.  The decrease is  attributable  to decreased  sales of the Company's  T3AS
products. In 1995, US WEST,  Ameritech,  NYNEX and Bell South accounted for 45%,
19%,  18% and 13% of the  Company's  revenue,  respectively.  In 1994, U S WEST,
Ameritech,  NYNEX and Bell  South  accounted  for 36%,  32%,  16% and 14% of the
Company's revenue,  respectively.  The majority of the Company's revenue in 1995
and 1994 was derived from the sale of T3AS products.

        Factors  which  may have  contributed  to the  decrease  in sales of the
Company's   products  during  1995  include  one  major  customer  delaying  its
reengineering program;  decreased capital spending at two of the Company's other
customers;  seasonal capital spending freezes at one of the Company's customers;
reorganizations,  restructuring  and  reductions  in  force  at  several  of the
Company's RBOC customers;  the negotiations  with labor unions  establishing new
union  contracts  at six of the seven  RBOC's  during  1995;  the  uncertainties
surrounding the telecommunications deregulation bill; and the delay in receiving
the FCC's informal assessment on the Company's Remote Module product.

        Gross  profit   totaled   $11,753,000  in  1995,  a  43%  decrease  from
$20,791,000 in 1994. The decrease in gross profit was due primarily to decreased
sales of the Company's T3AS products. As a percent of revenue,  gross profit was
57% in 1995 compared to 58% in 1994.

        Research  and  development  expenses  totaled  $5,807,000  in 1995, a 9%
increase from  $5,335,000 in 1994.  Research and development  personnel  related
expenses  increased 19% in 1995 compared to 1994.  The increases  were primarily
the result of the  addition of research  and  development  personnel,  partially
offset by decreases in  non-recurring  engineering  expenses caused by timing of
planned development projects compared to 1994.

        Sales and marketing  expenses totaled $4,234,000 in 1995, a 26% increase
from  $3,363,000  in 1994.  The  increase  in 1995 was  primarily  the result of
increases in technical support, marketing, and sales personnel, increased travel
expenses and increased promotional activity offset by lower commission

expenses owing to decreased revenue  levels.

        General and  administrative  expenses totaled  $2,985,000 in 1995, a 28%
increase  from  $2,337,000  in 1994.  The increase was primarily the result of a
non-recurring charge for the settlement of a class action law suit filed against
the Company in March 1995,  and  increased  consulting  expenses  related to the
Company's  recruiting  efforts for  additional  personnel.  The  increases  were
partially offset by decreases in travel and professional services expense.

        Interest  income  totaled  $2,023,000  in  1995,  a  67%  increase  from
$1,212,000 in 1994.  The increase was due primarily to an increase in investment
income from the  investment of cash proceeds from the Company's  initial  public
offering of common stock  completed in April 1994, as well as the  investment of
cash provided from operations.

        The Company did not provide for income tax expenses in 1995 due to a net
loss for income tax purposes.  In 1994, the Company's effective tax rate was 3%.
The Company's low effective tax rate for 1994 was a result of the utilization of
operating loss  carryforwards and tax credits and the tax benefit resulting from
the  recognition  of certain  deferred  tax  assets  which had  previously  been
reserved for in  recognition  of concerns over the Company's  ability to realize
these assets under the  Statement of  Financial  Accounting  Standards  No. 109,
"Accounting for Income Taxes" ("SFAS No. 109").  SFAS No. 109 allows the Company
to utilize available tax-loss carry-forwards as a direct reduction of its income
tax expense.  During 1994, the Company's  income taxes payable were reduced as a
result of tax deductions  generated from certain stock option transactions which
are not  reflected in the  statement of  operations.  Under  generally  accepted
accounting principles, such amounts are recorded as additional paid-in capital.

        As a result of the  factors  discussed  above,  1995 net income  totaled
$759,000,  or $.06 per share, a 93% decrease from net income of $10,620,000,  or
$.88 per share in 1994.

QUARTERLY RESULTS


                                       5


<PAGE>

        The  Company  has  experienced  significant  fluctuations  in  bookings,
revenue and operating  results from quarter to quarter due to a  combination  of
factors and expects such  fluctuations  to continue in future  periods.  Factors
that may cause the Company's  bookings,  revenue and  operating  results to vary
significantly  from quarter to quarter  include,  among others:  dependence on a
single  product  lines in the Network  Systems and Network  Management  business
units; dependence on a small group of major customers; the timing of significant
orders;   the   timing   of   shipments;   competition   and   pricing   in  the
telecommunication  network management  market; new product  introductions by the
Company or its competitors;  possible  recalls;  production or quality problems;
timing of development  expenditures;  further expansion of marketing and service
operations;  changes  in  material  costs;  disruptions  in  sources  of supply;
regulatory changes; seasonal patterns of bookings,  capital spending and payment
by customers; and changes in general economic conditions. Because of the
relatively fixed nature of most of the Company's costs,  including personnel and
facilities costs, any  unanticipated  shortfall in revenue in any fiscal quarter
would have a proportionately greater impact on the Company's operating income in
that quarter and may result in
 fluctuations in the price of the Company's Common Stock.

LIQUIDITY AND CAPITAL RESOURCES

        Cash and  investments  totaled  $21,461,000  at  December  31,  1996 and
$31,847,000  at December 31,  1995.  The 1996  decrease in cash and  investments
compared to 1995 is primarily  due to cash  payments  related to the SSN and ACD
asset acquisitions,
and 1996 operating losses.

        Net  working  capital  totaled  $31,229,000  at  December  31,  1996 and
$36,728,000 at December 31, 1995. The 1996 decrease in working capital  compared
to 1995 was  primarily  the result of cash  payments  related to the SSN and ACD
asset acquisitions.

        The  Company's  1996  operating   activities  used  $2,265,000  in  cash
primarily as a result of net operating  losses.  In 1995,  operating  activities
used  $4,384,000  in cash  due to  decreased  net  income  compared  to 1994 and
increases in accounts receivable and inventory compared to 1994.

        In 1996,  cash used for the ACD and SSN asset  acquisitions  and related
acquisition costs totaled $1,900,000 and $4,456,000,  respectively. The majority
of tangible  assets  acquired from ACD and SSN consisted of computer  equipment.
Cash used for capital expenditures totaled approximately  $1,709,000 in 1996 and
$1,948,000  in  1995.  Most of the  capital  equipment  additions  were  for the
purchase  of  computer  and lab  equipment  to support  the  Company's  expanded
research  and  development  efforts.  The  Company  did not  acquire any capital
equipment  through  capital  lease  arrangements  in 1996 or 1995.  The  Company
expects that the level of capital expenditures will increase in 1997 as a result
of planned facility moves in Vancouver,  British Columbia,  Canada,  and planned
development projects.

        Assuming no material changes in the Company's  current  operating plans,
the Company  believes that cash generated  from  operations and the total of its
cash and investments, will be sufficient to meet its working capital and capital
expenditure  requirements  for at least  the  next  twelve  months.  Significant
additional capital resources,  however,  may be required to fund acquisitions of
complementary businesses, products or technologies.  Alternatively,  the Company
may need to issue additional  shares of its capital stock or incur  indebtedness
in connection with any such acquisitions.  At present, the Company does not have
any agreements or commitments with respect to any such acquisition.

        The Company believes the impact of inflation on its business  activities
has not been significant to date.



                                        6


<PAGE>



                   APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY
                           CONSOLIDATED BALANCE SHEET

<TABLE>
<CAPTION>


       (Dollars in thousands)
YEARS ENDED DECEMBER 31,                                                      1996              1995
ASSETS
Current Assets:
<S>                                                                         <C>                <C>
     Cash and cash equivalents                                              $ 1,504            $ 1,673
     Investments                                                             19,957             25,079
     Accounts receivable, less allowance for
      doubtful accounts of $50                                                6,798              5,358
     Inventory, net                                                           7,363              6,572
     Deferred income taxes                                                      130                750
     Prepaid expenses and other current assets                                1,089              1,296
                                                                           --------            -------
              Total current assets                                           36,841             40,728

Investment - non-current                                                        ---              5,095
Property and equipment, net                                                   4,936              3,361
Intangible assets, net                                                        2,823                ---
Deferred income taxes                                                         1,372                752
          Total assets                                                     --------            -------
                                                                           $ 45,972            $49,936
                                                                           ========            =======

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
     Accounts payable                                                      $  2,120           $  1,820
     Accrued expenses                                                         1,491                843
     Accrued warranty                                                         1,398              1,305
     Current portion of obligations under capital leases                         16                 32
     Deferred revenue                                                           587                ---
                                                                           --------            -------
          Total current liabilities                                           5,612              4,000

Obligation under capital leases, net of
current portion                                                                 33                  49
                                                                           --------            -------

          Total liabilities                                                   5,645              4,049
                                                                           --------            -------
Commitments and contingency

Shareholders' equity:
   Preferred stock, no par value 7,500,000
    shares authorized, no shares issued                                        ---                ---
   Common stock, no par value, 30,000,000
    shares authorized, 11.899,216 and
    12,255,334 shares issued and outstanding
    at December 31, 1995 and
    1996, respectively                                                      50,631              49,000

     Additional paid-in capital                                              2,492               2,492
     Unrealized gain on investments                                             25                 147
     Deferred compensation                                                     (50)               (101)
     Accumulated deficit                                                   (12,771)             (5,651)
                                                                           --------            -------
          Total shareholders' equity                                         40,327             45,887
                                                                           --------            -------
          Total liabilities and shareholders' equity                       $ 45,972           $ 49,936
                                                                           ========           ========

</TABLE>



          The accompanying notes are an integral part of the financial
                                   statements



                                        7


<PAGE>




                         APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY
                            CONSOLIDATED STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>




(Dollars in thousands, except per-share date)
YEARS ENDED DECEMBER 31,                                 1996              1995              1994
<S>                                                    <C>            <C>              <C>
Revenue                                               $ 24,422        $   20,470          $ 35,597
Cost of revenue                                         12,609             8,717            14,806
                                                      --------        ----------          --------
Gross profit                                            11,813            11,753            20,791
                                                      --------        ----------          --------
Operating expenses:
     Research and development                            7,356             5,807             5,335
     In-process research and
development related to
acquisitions                                             3,286               ---               ---
     Sales and marketing                                 6,312             4,234             3,363
     General and administrative                          3,576             2,985             2,337
                                                      --------        ----------          --------
          Total operating expenses                      20,530            13,026            11,035
                                                      --------        ----------          --------
          Operating income (loss)                       (8,717)           (1,273)            9,756

Interest income                                          1,673             2,023             1,212
Other income (expenses), net                                47                 9               (32)
                                                      --------        ----------          --------
          Income (loss) before
           income taxes                                 (6,997)              759            10,936

Provision for income taxes                                 123               ---               316
                                                      --------        ----------          --------
         Net income (loss)                            $ (7,120)       $      759          $ 10,620
                                                      --------        ----------          --------
         Net income (loss) per share                  $  ( .59)       $      .06          $    .88
                                                      ========        ==========          ========
         Shares used in per-share
           computations                                 12,084            12,848            12,091
                                                      ========        ==========          ========
</TABLE>



          The accompanying notes are an integral part of the financial
                                   statements


                                        8


<PAGE>



<TABLE>
<CAPTION>


DOLLARS IN THOUSANDS

                                                       CONVERTIBLE PREFERRED STOCK

                                               SERIES A        SERIES B       SERIES C       SERIES D       SERIES E   COMMON STOCK
                                               --------        --------       --------       --------       --------   ------------
<S>                                            <C>             <C>            <C>             <C>           <C>         <C>
BALANCE, JANUARY 1, 1994                          1,000       $   5,000       $    768       $  7,773       $  4,664      $     88

Issuance of 2,590,000 shares of common stock
initial public offering, net of costs                --              --             --             --             --        28,357

Conversion of preferred stock into 7,872,199
shares of common stock upon completion of
intial public offering                           (1,000)         (5,000)          (768)        (7,773)        (4,664)       19,205

Excercise of stock options and warrants for
592,026 shares of common stock                       --             --              --             --             --            95

Issuance of 52,134 shares of common stock
under stock purchase plan                            --             --              --             --             --            536

Unrealized loss on investments                       --             --              --             --             --           --

Amoritization of deferred compensation
related to stock options                             --             --              --             --             --           --

Repayment of note receivable                         --             --              --             --             --           --

Tax effect of options excercised                     --             --              --             --             --           --

Net income                                           --             --              --             --             --           --



BALANCE, DECEMBER 31, 1994                           --             --              --             --             --        48,281

Excercise of stock options and warrants for
261,662 shares of common stock                       --             --              --             --             --            76

Issuance of 62,493 shares of common stock
under stock purchase plan                            --             --              --             --             --           643

Unrealized gain on investments                       --             --              --             --             --           --

Amoritization of deferred compensation related
to stock options                                     --             --              --             --             --           --

Net income                                           --             --              --             --             --           --



BALANCE DECEMBER 31, 1995                            --             --              --             --             --        49,000

Excercise of stock options for 149,263 shares
of common stock                                      --             --              --             --             --           115

Issuance of 56,857 shares of common stock
under stock purchase plan                            --             --              --             --             --           428

Unrealized loss on investments                       --             --              --             --             --           --

Amoritization of deferred compensation related
to stock options                                     --             --              --             --             --           --

Issuance of 150,000 shares of common stock
in connection with acquisition                       --             --              --             --             --         1,088

Net loss                                             --             --              --             --             --           --

BALANCE, DECEMBER 31, 1996                           --             --              --             --             --      $ 50,631

</TABLE>


<TABLE>

DOLLARS IN THOUSANDS
                                                                                                   NOTES
                                                                    UNREALIZED                   RECEIVABLE
                                                   ADDITIONAL     GAIN (LOSS) ON    DEFERRED     FROM COMMON    ACCUMULATED
                                                 PAID-IN CAPITAL    INVESTMENTS   COMPENSATION   SHAREHOLDERS     DEFICIT     TOTAL
                                                 ---------------    -----------   ------------   ------------     -------     -----



<S>              <C>                              <C>              <C>           <C>             <C>           <C>        <C>
BALANCE, JANUARY 1, 1994                          $    1,043       $    --       $   (205)       $  (19)       $ (17,030) $  3,082

Issuance of 2,590,000 shares of common stock
initial public offering, net of costs                     --            --             --            --               --    28,357

Conversion of preferred stock into 7,872,199
shares of common stock upon completion of
intial public offering                                    --            --             --            --               --        --

Excercise of stock options and warrants for
592,026 shares of common stock                            --            --             --            --               --        95

Issuance of 52,134 shares of common stock
under stock purchase plan                                 --            --             --            --               --       536

Unrealized loss on investments                            --          (436)            --            --               --      (436)

Amoritization of deferred compensation
related to stock options                                  --            --             52            --               --        52

Repayment of note receivable                              --            --             --            19               --        19

Tax effect of options excercised                       1,449            --             --            --               --     1,449

Net income                                                --            --             --            --           10,620    10,620



BALANCE, DECEMBER 31, 1994                             2,492          (436)           153            --           (6,410)   43,774

Excercise of stock options and warrants for
261,662 shares of common stock                            --            --             --            --               --        76

Issuance of 62,493 shares of common stock
under stock purchase plan                                 --            --             --            --               --       643

Unrealized gain on investments                            --           583             --            --               --       583

Amoritization of deferred compensation related
to stock options                                          --            --             52            --               --        52

Net income                                                --            --             --            --              759       759



BALANCE DECEMBER 31, 1995                              2,492           147           (101)           --           (5,651)    45887

Excercise of stock options for 149,263 shares
of common stock                                           --            --             --            --               --       115

Issuance of 56,857 shares of common stock
under stock purchase plan                                 --            --             --            --               --       428

Unrealized loss on investments                            --          (122)            --            --               --      (122)

Amoritization of deferred compensation related
to stock options                                          --            --             51            --               --        51

Issuance of 150,000 shares of common stock
in connection with acquisition                            --            --             --            --               --     1,088

Net loss                                                  --            --             --            --           (7,120)   (7,120)

BALANCE, DECEMBER 31, 1996                          $   2,492       $   25        $  (50)         $  --       $  (12,771)  $40,327


</TABLE>



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


                                        9


<PAGE>


                   APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                   ----------

<TABLE>
<CAPTION>

Years Ended December 31,                                            1996           1995         1994
                                                                    ----           ----         ----
<S>                                                            <C>                 <C>         <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income (loss)                                             $  (7,120)         759         10,620
  Adjustments to reconcile net income (loss) to
   net cash provided (used) by operating activities:
  In-process research and development
   related to acquisitions                                          3,286          ---            ---
  Depreciation and amortization                                     1,819          904            708
  Amortization of discount or premium on investments                   95          119           (132)
  Amortization of deferred compensation                                51           52             52
  Change in accounts receivable and
    inventory reserves                                                (68)         103            133
  Changes in operating assets and liabilities
     Accounts receivable                                           (1,440)      (2,792)          (150)
      Inventory                                                      (732)      (2,232)        (3,070)
      Deferred income taxes                                           ---          ---            (52)
      Prepaid expenses and other current assets                       207         (327)          (825)
      Accounts payable                                                300         (440)           381
      Accrued expenses                                                648         (515)           467
      Accrued warranty                                                 93          (15)           834
      Deferred revenue                                                587          ---            ---
                                                                ----------    ---------      ---------
         Net cash provided (used) by
          operating activities                                     (2,265)      (4,384)         8,966
                                                                ----------    ---------      ---------

CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchases of investments                                       (20,923)     (33,863)       (48,166)
   Maturities of investments                                       30,923       38,595         13,419
   Purchases of property and equipment                             (1,709)      (1,948)        (1,888)
   Purchase costs related to asset acquisitions                    (6,356)        ---            ---
   Purchase of license agreement                                     (350)        ---            ---
                                                                ----------    ---------      ---------
        Net cash provided (used) by
         investing activities                                       1,585        2,784        (36,635)
                                                                ----------    ---------      ---------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Principal payments on obligations under capital leases             (32)        (126)          (522)
   Proceeds from repayment of note receivable from related party       ---         ---             19
   Proceeds from exercise of stock options and warrants               115           76             95
   Proceeds from issuance of common stock, net of costs               428          643         28,893
                                                                ----------    ---------      ---------
        Net cash provided by financing activities                     511          593         28,485
                                                                ----------    ---------      ---------
        Net increase (decrease) in cash and cash equivalents         (169)      (1,007)           816

   Cash and cash equivalents at beginning of year                   1,673        2,680          1,864
                                                                ----------    ---------      ---------
   Cash and cash equivalents at end of year                     $   1,504     $  1,673       $  2,680
                                                                ==========    =========      =========

</TABLE>



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


                                       10


<PAGE>



                   APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


 1.     NATURE OF OPERATIONS:

Applied Digital Access, Inc. and subsidiary (the "Company")  designs,  engineers
and manufactures network test and performance  monitoring systems,  software and
services for the  management  and test of  telecommunication  circuits.  Current
sales are  concentrated  with "Regional Bell Operating  Companies" or affiliated
companies in the United States and Canada.

The market for the Company's  products is characterized  by rapid  technological
advances,   evolving  industry  transmission  standards,   changes  in  customer
requirements  and  frequent  new product  introductions  and  enhancements.  The
introduction  of telephone  network  test and  performance  monitoring  products
involving superior technologies or the evolution of alternative  technologies or
new  industry  transmission   standards  could  render  the  Company's  existing
products,  as  well  as  products  currently  under  development,  obsolete  and
unmarketable.

 2.     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

PRINCIPLES OF CONSOLIDATION
The consolidated  financial  statements  include the accounts of the Company and
its  wholly-owned  subsidiary,  Applied  Digital Access - Holding,  Inc. and its
wholly-owned  subsidiary,  Applied Digital Access - Canada, Inc. ("ADA-Canada").
All intercompany transactions and balances have been eliminated.

CASH AND CASH EQUIVALENTS
Cash and  cash  equivalents  consist  of cash and  short-term  investments  with
original maturities of 90 days or less when purchased.

INVENTORY
Inventory is stated at the lower of cost or market using the first-in, first-out
method. The Company currently buys certain key components of its products from a
limited number of suppliers. Although there are a limited number of suppliers of
the components,  management  believes that other suppliers could provide similar
key components on comparable terms. A change in suppliers,  however, could cause
a delay in  manufacturing  and a possible loss of sales,  which would  adversely
affect operating results.

INVESTMENTS
The Company determines the appropriate  classification of its debt securities at
the time of purchase and  re-evaluates  such  designations at each balance sheet
date.  Investments  are  classified as  "available  for sale" and are carried at
their fair value.  Realized gains and losses are  determined  using the specific
identification method and are included in other income. Gross unrealized holding
gains or losses are excluded from earnings and reported,  net of the related tax
effect, as a separate  component of shareholders'  equity. The amortized cost of
debt  securities is adjusted for the  amortization  of premiums and accretion of
discounts to maturity.  Such  amortization is included in interest income.  Fair
value is determined based on quoted market prices.

PROPERTY AND EQUIPMENT
Property and  equipment  is stated at cost and  depreciated  over the  estimated
useful lives of the assets (3 to 7 years) using the straight-line method. Leased
property  meeting  certain  criteria is capitalized and the present value of the
related lease payments is recorded as an obligation. Amortization of capitalized
leased  assets is computed on the  straight-line  method over the shorter of the
lease term or the assets'  estimated  useful lives.  Maintenance and repairs are
charged to expense as incurred.  Upon the retirement or other  disposition,  the
property and related  accumulated  depreciation or amortization are removed from
the accounts and any resulting profit or loss is reflected in income.

                                       11
<PAGE>


2.      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:

INTANGIBLE ASSETS
The Company  amortizes costs in excess of fair value of net assets of businesses
acquired using the  straight-line  method over 3 to 5 years.  Recoverability  is
reviewed annually or sooner if events or changes in circumstances  indicate that
the carrying value may exceed fair value.

REVENUE RECOGNITION
Revenue is generally  recognized  at the time of shipment or delivery,  based on
specified  shipping terms,  or when services have been performed.  When customer
acceptance criteria are specified in the customer order,  revenue recognition is
deferred until the acceptance criteria are met.

INCOME TAXES
Deferred  income taxes are recognized for the tax  consequences  in future years
for  differences  between  the tax basis of assets and  liabilities  ("temporary
differences")  and their financial  reporting  amounts at each year end based on
enacted  tax laws and  statutory  rates  applicable  to the periods in which the
temporary   differences  are  expected  to  affect  taxable  income.   Valuation
allowances are  established  when necessary to reduce deferred tax assets to the
amount  expected to be  realized.  Income tax expense is the tax payable for the
period and the change during the period in deferred tax assets and liabilities.

ADVERTISING COSTS
Advertising  costs are  expensed  as  incurred.  Total  advertising  expense was
approximately  $88,000,  $141,000 and $217,000 for the years ended  December 31,
1994, 1995 and 1996, respectively.

STOCK-BASED COMPENSATION
Statement of Financial  Accounting  Standards  ("SFAS") No. 123,  ACCOUNTING FOR
STOCK-BASED COMPENSATION,  encourages, but does not require, companies to record
compensation cost for stock-based employee compensation plans at fair value. The
Company has chosen to continue to account for stock-based compensation using the
intrinsic value method prescribed in Accounting Principles Board Opinion No. 25,
ACCOUNTING   FOR  STOCK  ISSUED  TO  EMPLOYEES   and  related   interpretations.
Accordingly,  options  granted at below fair  market  value  result in  deferred
compensation  to the extent of the  difference  between the fair market value at
the date of grant and the exercise price.  The deferred  compensation is charged
to earnings ratably over the vesting period.  During the three year period ended
December 31, 1996, no options were granted at below fair market value.

PER SHARE INFORMATION
Net income  (loss) per share is computed  using the weighted  average  number of
common shares and common equivalent shares (when the effect is dilutive)


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 estimates.


                                       12


<PAGE>


 3.     STATEMENTS OF CASH FLOWS:
<TABLE>
<CAPTION>

Non-cash investing and financing activities are as follows:

                                                   Years Ended December 31,
                                                   ------------------------
        (Dollars in thousands)               1994            1995             1996
        ----------------------               ----            ----             ----
<S>                                        <C>               <C>              <C>
Property and equipment acquired with
     capital lease financing               $  189            $-               $ -
Conversion of preferred stock
     upon completion
     of initial public offering            19,205             -                 -
Issuance of stock in connection
     with acquisition                          -              -             1,088

Cash payments for interest and income taxes are as follows:

                                                    Years Ended December 31,
                                                    ------------------------
        (Dollars in thousands)               1994            1995             1996
        ----------------------               ----            ----             ----
<S>                                        <C>               <C>              <C>
               Interest                     $ 53           $ 13              $  7
               Income taxes                  144            506                 -

</TABLE>

 4.     INVESTMENTS:

Marketable  securities at December 31, 1995 and 1996 consist of  obligations  of
the U.S. Government and its agencies and are summarized as follows:

<TABLE>
<CAPTION>

                                         Years Ended December 31,
                                         ------------------------
        (Dollars in thousands)             1995            1996
                                           ----            ----
<S>                                  <C>             <C>
        Cost                         $  30,027       $   19,936
        Gross unrealized gains             148               57
        Gross unrealized losses             (1)             (36)
                                     ---------          -------
               Estimated fair value  $  30,174          $19,957
                                     =========          =======
</TABLE>


 5.     INVENTORY:
Inventory at December 31, 1995 and 1996 consists of the following:
<TABLE>
<CAPTION>

          (Dollars in thousands)          1995             1996
          ----------------------          ----             ----
<S>                                     <C>              <C>
        Raw materials                   $3,483           $4,211
        Work-in-process                  2,314            2,558
        Finished goods                   1,313            1,063
                                        ------           ------
                                        7,110             7,832
        Less inventory reserve           (538)             (469)
                                        ------            ------
                                       $6,572             $7,363
                                       ======             ======

</TABLE>


                                       13
<PAGE>

 6.     PROPERTY AND EQUIPMENT:
Property and equipment at December 31, 1995 and 1996 consists of the following:

<TABLE>
<CAPTION>


        (Dollars in thousands)                   1995             1996
        ----------------------                   ----             ----
<S>                                             <C>              <C>
        Computers                               $2,500           $4,254
        Machinery, furniture and equipment       2,716            3,614
        Purchased computer software                729              894
        Leasehold improvements                     640              766
                                                ------            ------
                                                 6,585            9,528
        Less accumulated depreciation
          and amortization                      (3,224)          (4,592)
                                                ------            ------

                                                $3,361            $4,936
                                                ======            ======
</TABLE>

Property and equipment  acquired  under  capital  leases  totaled  approximately
$444,000 and $216,000 at December 31, 1995 and 1996,  respectively.  Accumulated
amortization  related  to assets  under  capital  leases  totaled  approximately
$299,000 and $106,000 as of December 31, 1995 and 1996, respectively.



 7.     INTANGIBLE ASSETS:
Intangible assets at December 31,1996 consist of the following:

<TABLE>
<CAPTION>

             (Dollars in thousands)                  1996

<S>                                                <C>
        Goodwill and know-how                      $2,588
        Purchased technology, customer contracts      337
        License agreement                             350
                                                   ------
                                                    3,275
        Less accumulated amortization                (452)
                                                   ------
                                                   $2,823
                                                   ======

</TABLE>

 8.     ACCRUED EXPENSES:
     Accrued expenses at December 31, 1995 and 1996 consist of the following:
<TABLE>
<CAPTION>

               (Dollars in thousands)                1995                 1996
               ----------------------                ----                 ----
<S>                                                 <C>                <C>
        Accrued payroll and related costs           $ 489               $  443
        Income taxes                                   -                   444
        Accrued vacation                              316                  431
        Other                                          38                  173
                                                    -----               ------
                                                    $ 843               $1,491
                                                    =====               ======
</TABLE>

                                       14
<PAGE>

 9.     COMMITMENTS AND CONTINGENCY:

LEASES
The Company leases office space and equipment under operating leases. Certain of
these leases include renewal or purchase options.  Rent expense related to these
leases was  approximately  $288,000,  $386,000  and $613,000 for the years ended
December 31, 1994, 1995 and 1996, respectively.

The Company also leases certain property and equipment under capital leases.

Minimum commitments under these leases are as follows:
<TABLE>
<CAPTION>

        (Dollars in thousands)

                                         Operating       Capital
         Year ending December 31,         Leases          Lease
         ------------------------         ------          -----
            <S>                          <C>               <C>
                1997                     $   788           $20
                1998                       1,064            20
                1999                       1,049            15
                2000                         732             -
                2001                         756             -
                Thereafter                 1,392             -
                                         --------        ------

                 Total minimum
                 lease payments           $5,781            55
                                         ========        ======

                 Less amounts representing interest         (6)
                                                         ------
                 Obligations under capital leases           49
                 Less current portion                      (16)
                                                         ------
                                                           $33
                                                         ======
</TABLE>

PURCHASE COMMITMENTS
At December 31, 1996, the Company has open purchase commitments of approximately
$3,731,000  which  include  approximately   $2,264,000  of  cancelable  purchase
commitments.

LEGAL PROCEEDING
In March 1995, a class action  lawsuit was filed  against the Company and two of
its  officers,  one of whom is  also a  director  of the  Company,  in the  U.S.
District  Court for the  Southern  District  of  Southern  California.  The suit
alleged  violations of Section 10(b) and Rule 10b-5 of the  Securities  Exchange
Act of 1934, as amended (the "Act"),  arising out of alleged  misrepresentations
and omissions made by the Company and the named officers.  The suit also alleged
violation  of Section  20(a) of the Act arising out of alleged  "control" of the
Company by the officer defendants.  The suit was brought on behalf of purchasers
of the Company's securities during the period October 10, 1994 through March 29,
1995, and sought unspecified damages. In December 1995, the Company entered into
a  settlement  agreement  pursuant  to which  all  claims  were  dismissed  with
prejudice.  The total settlement amount was approximately  $1,500,000,  of which
the Company paid  approximately  $446,000 with the remaining  amount paid by the
Company's Directors' and Officers' liability insurance carriers.  Obligations of
the  Company  with  respect to this matter were  provided  for in the  financial
statements  during the year ended  December  31,  1995 and paid  during the year
ended December 31, 1996.

10.     SHAREHOLDERS' EQUITY:

In April 1994, the Company  completed the initial public  offering of its shares
of common stock, at a price of $12.00 per share  including  2,200,000 which were
sold by the  Company and 400,000  which were sold by existing  shareholders.  In
addition,  the Company's  underwriters  also  exercised an option to purchase an
additional 390,000

                                       15
<PAGE>

shares to cover  over-allotments.  The net proceeds realized by the Company from
this offering were $28.4 million after deducting the  underwriting  discount and
expenses payable by the Company related to the offering.

Effective upon the closing of the offering, 55,105,577 shares of preferred stock
were converted into 7,872,199  shares of common stock after giving effect to the
1-for-7 reverse stock split.

In March 1994, the Company's Articles of Incorporation were amended  authorizing
30,000,000  shares  of common  stock,  no par  value,  and  7,500,000  shares of
preferred  stock,  no par value.  The preferred stock may be issued from time to
time in one or more  series  with the Board of  Directors  authorized  to fix or
alter the  designation,  powers,  preferences  and  rights of the shares of each
series.

STOCK COMPENSATION PLANS
At December 31, 1996, the Company has stock-based  compensation  plans which are
described below. The Company applies Accounting Principles Board Opinion No. 25,
ACCOUNTING  FOR STOCK  ISSUED  TO  EMPLOYEES,  and  related  interpretations  in
accounting for its plans. Accordingly,  no compensation cost has been recognized
for its fixed stock option plans and its stock purchase  plan. Had  compensation
costs for the Company's stock-based  compensation plans been determined based on
the fair value at the grant  dates for awards in 1995 and 1996 under those plans
consistent with the methods of SFAS No. 123, the Company's net income (loss) and
earnings  per share would have been reduced to the pro forma  amounts  indicated
below:

<TABLE>
<CAPTION>

        (Dollars in thousands)                       1995                        1996
<S>                                                  <C>                       <C>
        Net income (loss):
               As reported                          $ 759                     $(7,120)
               Pro forma                             (195)                     (8,352)

        Net income (loss) per common share:
               As reported                           $.06                       $(.59)
               Pro forma                             (.02)                       (.69)

</TABLE>

FIXED STOCK OPTION PLANS
In May 1996, the Company adopted the 1996  Non-Qualified  Stock Option Plan (the
"1996 Plan").  The 1996 Plan does not affect the 1994 Plan. Under the 1996 Plan,
the Company is authorized to issue 400,000 shares of common stock. The 1996 Plan
is intended to promote the interests of the Company or its parents or subsidiary
corporations.  Under the 1996 Plan, eligible  individuals may be granted options
to purchase  shares of the  Company's  common  stock at not less than 85% of the
fair market  value of such shares on the date of grant.  Such  options  shall be
exercisable in one or more  installments as specified in the Notice of Grant and
have a maximum term of 10 years. Persons eligible to receive stock options under
the 1996 Plan are key  employees  of the  Company  other than  officers  who are
responsible for the growth and financial  success of the Company and consultants
and other independent contractors who provide valuable services to the Company.

In February 1994, the Company adopted the 1994 Stock Option/Stock  Issuance Plan
(the "1994 Plan").  The 1994 Plan  supersedes  and  consolidates  the 1988 Stock
Option Plan and Restricted  Stock  Purchase Plan (the "1988 Plan").  Outstanding
stock options and unvested share issuances under the 1988 Plan were incorporated
into and  assumed  in the 1994  Plan.  In May of 1996,  the  Board of  Directors
received  shareholder  approval to increase the  authorized  shares to 3,800,000
under the 1994 Plan.  The 1994 Plan is divided into three  separate  components:
the  Discretionary  Option Grant  Program  (the  "Discretionary  Program");  the
Automatic Option Grant Program (the "Automatic  Program") and the Stock Issuance
Program (the "Issuance  Program").  Under the  Discretionary  Program,  eligible
individuals  may be granted options to purchase shares of the Company's stock at
not less than 85% of the fair market  value of such shares on the date of grant.
Under the  Automatic  Program,  non-employee  Directors  will  automatically  be
granted options to purchase common stock at 100% of the fair market value on the
grant date. Under the Issuance Program,  eligible  individuals may be allowed to
purchase shares of the Company's  common stock at discounts from the fair market
value of such  shares of up to 15%.  Such  shares may be issued as  fully-vested
shares or as  shares  to vest  over time and have a maximum  term of 10 years (5
years for options  granted to a 10%  shareholder).  Persons  eligible to receive
stock  issuances  under the  Issuance  Program  and/or  option  grants under the
Discretionary  Program are officers  and other key  employees of the Company and
certain  consultants or other

                                       16


<PAGE>

independent  contractors,  as defined in the plan. The  individuals  eligible to
receive  option  grants  under the  Automatic  Program are  individuals  who are
elected, re-elected or appointed as non-employee Board members.


The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes   option-pricing   model  with  the   following   weighted-average
assumptions  used for  grants  in 1995 and 1996:  no  dividend  yield;  expected
volatility;  risk-free  interest rates on or about the date of grant represented
by the interest rate on U.S. Treasury Bills with a term of maturity equal to the
vesting period of the options, and expected lives of 5 years.

The following table summarizes  stock option  transactions for each of the three
years in the period ended December 31, 1996:

<TABLE>
<CAPTION>

                                                  Weighted                           Weighted
                                                   Average                            Average
                                                  Exercise                           Exercise
                               Shares               Price              Shares          Price
<S>                          <C>                     <C>                <C>           <C>
Outstanding at
January 1, 1994              1,711,492               $.39              44,587           $.14
  Granted                      319,665             $17.36               ---              ---
  Exercised                   (509,029)              $.18             (17,000)          $.14
  Canceled                     (82,384)              $.43               ---              ---
                               -------------                        ------------

Outstanding at
December 31, 1994            1,439,744              $4.22              27,587           $.14
  Granted                      737,025             $12.30                ---             ---
  Exercised                   (205,068)              $.35             (10,500)          $.14
  Canceled                    (300,392)            $18.30                ---             ---
                              --------             ------             -------           ------

Outstanding at
December 31,  1995           1,671,309              $5.63              17,087           $.14
  Granted                      874,887              $9.01                ---             ---
  Exercised                   (149,261)              $.77                ---             ---
  Canceled                    (598,732)            $12.01                ---             ---
                              --------             ------              ------          ------

Outstanding at
December 31, 1996            1,798,203              $5.54              17,087           $.14
                             =========                                 ======
</TABLE>


The range of exercise  prices of stock options  outstanding at December 31, 1996
is as follows:

<TABLE>
<CAPTION>

                                            Options Outstanding                    Options Exercisable
                                             -------------------                   -------------------
                                            Weighted
                                             Average             Weighted                              Weighted
     Range of                               Remaining            Average                               Average
     Exercise                Number        Contractual           Exercise            Number            Exercise
      Prices              Outstanding         Life                Price            Exercisable          Price
<S>                         <C>              <C>                 <C>               <C>                  <C>
        $.14 - $.28          366,413          4.81                $.16              362,585              $.16
       $.42 - $1.05          325,590          6.57                $.46              268,798              $.45
      $2.80 - $6.50          304,142          8.85               $5.67               53,374             $3.07
      $6.63 - $8.40          460,504          9.54               $8.05               14,005             $7.35
     $11.25 - $16.13         341,554          8.72              $12.65              132,264            $12.29
      --------------         -------         ------             ---------           --------           -------
       $.14 - $16.13       1,798,203          7.77               $5.54              831,026             $2.49
       ====   ======       =========          ====               =====              =======             =====


</TABLE>

                                       17

<PAGE>

At December 31, 1995 and 1996, 571,106 and 1,191,381 shares,  respectively,  are
available for granting of options under the 1994 and 1996 Plans.

STOCK PURCHASE PLAN The Amended 1994 Employee  Stock  Purchase Plan,  originally
adopted in February 1994 (the "Stock Purchase Plan"),  authorizes the Company to
issue up to 300,000 shares of common stock to participating employees. The Stock
Purchase Plan is intended to provide  qualifying  employees with the opportunity
to acquire an interest in the Company by accumulating amounts for the employees'
account through payroll deductions and the periodic  application of such amounts
to the purchase of shares of the Company's common stock.  Under the terms of the
Stock Purchase Plan,  qualified employees can choose each year to have up to 15%
of their annual base earnings  withheld to purchase the Company's  common stock.
The  purchase  price of the stock will be equal to 85% of the lower fair  market
value of the common stock on (i) the commencement date of the offering period or
(ii) the purchase date. The Stock Purchase Plan terminates on December 31, 2003.
Under the Stock  Purchase  Plan,  the Company  sold 62,493 and 56,857  shares to
employees  in 1995 and 1996,  respectively.  There are 128,516  shares of common
stock available for purchase under the Stock Purchase Plan at December 31, 1996.

In order to disclose the pro forma net income and earnings per share as required
by SFAS No.  123 (see Stock  Compensation  Plans  above),  the fair value of the
employees'  purchase rights is estimated using the Black-Scholes  model with the
following  assumptions for 1995 and 1996: no dividend yield, expected volatility
risk-free  interest rates on the date of grant  represented by the interest rate
on U.S.  treasury  bills with a term of  maturity  equal to the period  from the
subscription date to the purchase date. The weighted-average fair value of those
purchase rights granted in 1995 and 1996 was $13.89 and $9.56, respectively.


11.     INCOME TAXES:

The provision for income taxes for the years ended December 31, 1994, 1995 and
1996 are as follows:

<TABLE>
<CAPTION>

        (Dollars in Thousands)                     1994         1995       1996
        ----------------------                     ----         ----       ----

       Current:
<S>                                             <C>            <C>        <C>
                Federal                         $   897        $  -       $  -
                State                               320           -          -
                Foreign                              -            -         123
                                                   ----         ----       ----

                                                  1,217           -         123
                                                  -----         ----       ----
       Deferred:
                Federal                            (786)          -          -
                State                              (115)          -          -
                Foreign                              -            -          -
                                                  ------        ----       ----

                                                   (901)          -          -
                                                  ------        ----       ----

                                                 $  316        $  -         $123
                                                 =======        ====        ====
 </TABLE>


                                       18

<PAGE>

Differences  between the statutory  rate and the effective tax rate for the year
ended December 31, 1994, 1995 and 1996 are as follows:

<TABLE>
<CAPTION>


                                                                    1994        1995      1996
                                                                    ---------------------------

<S>                                                                <C>          <C>      <C>
           Taxes at federal statutory rate                         34.0%        34.0%    (34.0%)
           Foreign income taxes                                      - %         -  %      1.8%
           Net operating loss carryforwards and research and
                development tax credits (utilized) not utilized   (23.4%)      (33.0%)    33.0%
           Change in valuation allowance                          (13.6%)      (33.0%)     -  %
           Other                                                    5.9%        (1.0%)     1.0%
                                                                  -------      -------    ------

                Provision for income taxes                         12.9%         -  %      1.8%
                                                                   ====        ======     =====
</TABLE>


The  components  of the deferred tax assets at December 31, 1995 and 1996 are as
follows:

<TABLE>
<CAPTION>

        (Dollars in thousands)                                     1995                     1996
        ----------------------                                     ----                     ----

<S>                                                              <C>                      <C>
        Allowances and reserves                                  $  760                   $  773
        Vacation accrual                                            128                      146
        Capitalized research and development                        723                    2,211
        Net operating loss carryforwards                          2,819                    4,774
        Tax credits                                               1,200                    1,429
        Accelerated depreciation                                   (164)                    (252)
        Other                                                         8                       10
                                                                  -------                  ------

               Total gross deferred tax asset                     5,474                    9,091

        Less valuation allowance                                 (3,972)                  (7,589)

               Net deferred tax asset                            $1,502                   $1,502
                                                                  =====                    =====
</TABLE>



The Company has recorded a net deferred tax asset of  $1,502,000  as of December
31, 1996.  Realizability  is dependent on generating  sufficient  taxable income
prior  to  expiration  of  the  net  operating  loss   carryforwards.   Although
realization is not assured,  management believes it is more likely than not that
the net  deferred  tax asset will be  realized.  The amount of the  deferred tax
asset  considered  realizable,  however,  could be  reduced  in the near term if
estimates of future taxable income during the carryforward period are reduced.

At December 31,  1996,  the Company has net  operating  loss  carryforwards  for
federal income tax purposes of approximately $12,987,000, of which $5,161,000 is
attributable to  disqualifying  dispositions of stock options.  The Company also
has  net  operating   loss   carryforwards   for   California  tax  purposes  of
approximately   $5,835,000  at  December  31,  1996,  of  which   $2,508,000  is
attributable  to  disqualifying   dispositions  of  stock  options.  The  amount
attributable  to the  disposition of stock options will not impact the Company's
effective  tax rate in future  periods  as the  impact  will be  reflected  as a
component of equity when recognized.

The Company  also has  research  and  development  tax credit  carryforwards  of
approximately $1,087,000 for federal and $255,000 for California tax purposes at
December 31, 1996. These carryforwards will begin expiring, if unused, in 2003.

The Internal Revenue Code (the "Code") imposes limits on the availability of net
operating loss carryforwards and certain tax credits that arose prior to certain
cumulative changes in a corporation's ownership resulting in a change of control
of the Company. The Company's use of approximately $1,166,000 of its federal net
operating loss carryforwards and $408,000 of its federal and $105,000 of its
California  tax credit  carryforwards  are  significantly  limited  because  the
Company  underwent  "ownership-changes"  in January 1989 and March 1991. In each
year following the change,  the Company will be able to offset taxable income by
a limited amount of the pre-ownership

                                       19

<PAGE>

change carryforwards.  This limitation is determined by the value of the Company
immediately prior to the ownership change multiplied by the long-term tax-exempt
rate. Net operating losses and tax credits that are unavailable in any year as a
consequence of this  limitation may be carried forward for future use subject to
certain restrictions.

12.  EMPLOYEE  BENEFITS:  The Company  has a 401(k)  defined  contribution  plan
available  to all  employees  who have been with the  Company  for more than one
month.  Employees  may  contribute  up to 15% of their  salary each year and the
Company may elect to make a discretionary  contribution to the plan once a year.
All plan  participants  who are  employed  at the end of the plan  year and have
completed  1,000  hours of service in that plan year are  eligible  to receive a
share  of the  employer  contribution.  Participant's  rights  to  the  employer
contributions  vest 25% per year of service  with the  participant  being  fully
vested at the end of the fourth  year of  service.  The  Company  did not make a
discretionary contribution in 1994, 1995 or 1996.

In 1995,  the Company  adopted a profit sharing plan available to all employees.
The plan  provides  financial  benefits to  employees  when the Company  exceeds
certain  targeted  objectives.  The  Compensation  Committee  of  the  Board  of
Directors annually  determines the maximum amount that is allocated to the plan.
Employees  are eligible to  participate  in the plan at the start of the quarter
following  their  employment  at the  Company.  The  Company  did not  make  any
allocation to the profit sharing plan in 1995 or 1996.

13.  CONCENTRATION  OF CREDIT  RISK:
Financial instruments which potentially subject the Company to concentrations of
credit risk consist  principally of cash and cash  equivalents,  investments and
trade receivables.

The Company has approximately $858,000 of cash and cash equivalents in excess of
FDIC insured  limits at two  financial  institutions  at December 31, 1996.  The
Company has not experienced any losses on its cash and cash equivalents.

All  of  the  Company's  investments,  all  of  which  mature  in  1997,  are in
obligations of the U.S. Government and its agencies at December 31, 1996.

At December 31, 1995 and 1996, the Company's trade  receivables are concentrated
with "Regional Bell Operating  Companies" or affiliated  companies in the United
States,  all of which  management  believes are large companies with substantial
financial  resources.  Sales are typically made on credit,  with terms that vary
depending upon the customer and the nature of the product.  The Company does not
hold collateral to secure payment.  Although the Company maintains a reserve for
uncollectible  receivables that it believes to be adequate, a payment default on
a significant sale or customer  receivable could materially and adversely affect
its operating results and financial condition.


      Sales to major customers for each year are as follows (% of revenue):

<TABLE>
<CAPTION>


                                                    1994       1995     1996
                                                    ------------------------

<S>                                                  <C>        <C>      <C>
                      Nynex                          16%        18%      23%
                      Bell South                     14%        13%       7%
                      US West                        36%        45%      31%
                      Ameritech                      32%        19%       9%
                      Nortel                          -          -       15%

</TABLE>

Sales to an affiliate of a shareholder during the years ended December 31, 1994,
1995  and  1996  were  approximately  $11,320,000,  $3,836,000  and  $2,263,000,
respectively, of which $186,000 and $140,000 are included in accounts receivable
at December 31, 1995 and 1996, respectively.


                                       20

<PAGE>


14.     ACQUISITIONS:
In February  1996,  the Company  acquired  certain  assets of Applied  Computing
Devices,  Inc. ("ACD"), a company that developed and marketed operations systems
software used  primarily by  independent  telephone  companies to manage certain
functions in their  networks.  The  customer set and products of ACD  complement
those of the Company  and the Company  intends to continue to market and enhance
these  products.  The Company  acquired  the assets for  $1,700,000  in cash and
incurred approximately $200,000 in related costs. The assets were acquired at an
auction held in Federal  Bankruptcy  Court,  Southern  District of Indiana.  The
transaction,  which was accounted for as a purchase, included the acquisition of
in-process research and development valued at approximately $1,200,000, property
and equipment valued at approximately  $377,000 and purchased  technology valued
at approximately  $337,000.  The Company recorded a one-time charge in the first
quarter  of 1996 for the  $1,200,000  associated  with  purchased  research  and
development costs.

In July 1996, the Company acquired  certain assets of MPR Teltech,  a subsidiary
of BC TELCOM, Inc. The assets acquired were part of MPR Teltech's operating unit
commonly known as the Special Services Network division ("SSN"). The Company and
its Canadian subsidiary,  ADA-Canada, acquired the assets for $4,200,000 million
in  cash  and  150,000  shares  of the  Company's  common  stock,  and  incurred
approximately  $200,000 in related costs. SSN was an operations systems software
development  group with expertise in development of network  management  systems
for public carriers.  SSN developed  operations  systems software  primarily for
Northern Telecom ("Nortel").  SSN has become part of ADA-Canada and will develop
network  performance  management  operations  systems software  products for the
Company  and  its  customers,  including  Nortel.  The  transaction,  which  was
accounted for as a purchase, included the acquisition of in-process research and
development valued at approximately $2,100,000, property and equipment valued at
approximately  $900,000  and  goodwill  and  know-how  valued  at  approximately
$2,588,000.  The Company recorded a one-time charge in the third quarter of 1996
for the $2,100,000 associated with purchased research and development costs.

       The following condensed pro forma results of operations information
        has been presented to give effect to the acquisitions as if such
        transactions had occurred at the beginning of each of the periods
      presented. The historical results of operations have been adjusted to
       reflect additional depreciation and amortization expense based upon
            the value allocated to assets acquired in the purchases.
        The pro forma results of operations information is presented for
       information purposes only and is not necessarily indicative of the
      operating results that would have occurred had the acquisitions been
        consummated as of the beginning of the periods presented, nor is
             it necessarily indicative of future operating results.

<TABLE>
<CAPTION>

                    CONDENSED PRO FORMA RESULTS OF OPERATIONS
                    -----------------------------------------
                  (AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
                                   (UNAUDITED)

      Years Ended  December 31,                             1995                     1996
      ------------------------------------------------------------------------------------

<S>                                                       <C>                      <C>
           Revenue                                        $38,747                  $29,660
           Net loss                                        (8,521)                  (7,474)
           Net loss per share                                (.71)                    (.61)
           Weighted average shares used in computation     11,956                   12,165

</TABLE>


Sales to Canadian customers, generated from both the Company's United States and
Canadian operations in fiscal 1997 were $4,351,000,  from which operating income
of $434,000 was  derived.  The  identifiable  assets of the  Company's  Canadian
operations at December 31, 1997 were $970,000


                                       21

<PAGE>

                  APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY

                       VALLUATION AND QUALIFYING ACCOUNTS
              For the Years Ended December 31, 1994, 1995 and 1996
                                   ----------
<TABLE>
<CAPTION>


                                             Balance at
                                              Beginning                                    Balance at
           Description              Year      of Year        Additions      Deductions    End of Year
           -------------------------------------------------------------------------------------------

<S>                                <C>       <C>            <C>            <C>            <C>
Allowance for doubtful accounts    1994      $  50,000      $    --        $    --        $  50,000
                                   1995         50,000           --             --           50,000
                                   1996         50,000           --             --           50,000

Inventory reserve                  1994        301,476       247,661       (114,520)        434,617
                                   1995        434,617       150,000        (47,055)        537,562
                                   1996        537,562           --         (68,092)        469,470
</TABLE>


                        REPORT OF INDEPENDENT ACCOUNTANTS
                        ---------------------------------


TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF
  APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY


We have audited the accompanying  consolidated balance sheets of Applied Digital
Access,  Inc.  and  subsidiary  as of December 31, 1995 and 1996 and the related
consolidated  statements of operations,  shareholders' equity and cash flows for
each of the three years in the period ended December 31, 1996.  These  financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is to express an opinion on these financial  statements based on
our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Applied
Digital  Access,  Inc. and  subsidiary  as of December 31, 1995 and 1996 and the
consolidated  results of their  operations  and their cash flows for each of the
three years in the period ended December 31, 1996, in conformity  with generally
accepted accounting principles.




/s/ Coppers & Lybrand

San Diego, California
January 18, 1997


                                       22