<PAGE>   1
 
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
 
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
 
                            ------------------------
 
                                   FORM 10-K
        ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
 
                              EXCHANGE ACT OF 1934
 
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
 
                           COMMISSION FILE NO. 1-9767
 
                              INTERNATIONAL REMOTE
                             IMAGING SYSTEMS, INC.
 
<TABLE>
<S>                                            <C>
                   DELAWARE                                      94-2579751
       (STATE OR OTHER JURISDICTION OF                        (I.R.S. EMPLOYER
        INCORPORATION OR ORGANIZATION)                      IDENTIFICATION NO.)
</TABLE>
 
                 9162 ETON AVENUE, CHATSWORTH, CALIFORNIA 91311
              (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
 
                        TELEPHONE NUMBER: (818) 709-1244
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
                     COMMON STOCK (AMERICAN STOCK EXCHANGE)
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                                      NONE
 
     Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [ ]
 
     On March 12, 1999, the aggregate market value of the shares of Common Stock
held by non-affiliates of the Registrant was approximately $4.9 million based
upon the closing price of $ 7/8 per share of Common Stock as reported on the
American Stock Exchange. Solely for the purpose of determining "non-affiliates"
in this context, shares of Common Stock held by each officer and director and by
each person who owns 5% or more of the outstanding Common Stock have been
excluded. This determination of affiliate status is not necessarily a
determination for other purposes.
 
     The Registrant had 6,432,875 shares of Common Stock outstanding on March
12, 1999.
 
     Part III incorporates information by reference from the Proxy Statement for
the Registrant's 1999 Annual Meeting of Stockholders.
 
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE>   2
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
                            FORM 10-K ANNUAL REPORT
                      FISCAL YEAR ENDED DECEMBER 31, 1998
 
<TABLE>
<CAPTION>
                                                                        PAGE
                                                                        ----
<S>       <C>                                                           <C>
PART I
Item 1.   Business....................................................     1
Item 2.   Properties..................................................    16
Item 3.   Legal Proceedings...........................................    16
Item 4.   Submission of Matters to a Vote of Security Holders.........    16
 
PART II
Item 5.   Market for the Registrant's Common Stock and Related
          Stockholder Matters.........................................    17
Item 6.   Selected Financial Data.....................................    18
Item 7.   Management's Discussion and Analysis of Financial Condition
          and Results of Operations...................................    18
Item 7A.  Quantitative and Qualitative Disclosures About Market
          Risk........................................................    28
Item 8.   Financial Statements and Supplementary Data.................    28
Item 9.   Changes in and Disagreements with Accountants on Accounting
          and Financial Disclosure....................................    28
 
PART III
Item 10.  Directors and Executive Officers of the Registrant..........    29
Item 11.  Executive Compensation......................................    29
Item 12.  Security Ownership of Certain Beneficial Owners and
          Management..................................................    29
Item 13.  Certain Relationships and Related Transactions..............    29
 
PART IV
Item 14.  Exhibits, Financial Statements Schedules, and Reports on
          Form 8-K....................................................    29
</TABLE>
 
                                        i
<PAGE>   3
 
                                     PART I
 
ITEM 1. BUSINESS
 
     A glossary of selected technical terms is included at the end of this
section, and stockholders are encouraged to review the glossary before reading
the description of business.
 
OVERVIEW
 
     International Remote Imaging Systems, Inc. and its subsidiaries ("IRIS" or
the "Company") design, develop, manufacture and market in vitro diagnostic
("IVD") imaging systems based on patented and proprietary automated intelligent
microscopy ("AIM") technology for automating microscopic procedures performed in
clinical laboratories as well as special purpose centrifuges and other small
instruments. AIM combines the Company's capabilities in automated specimen
presentation, including its patented slideless microscope, and proprietary
high-speed digital processing hardware and software to classify and present
images of microscopic particles in easy-to-view displays. The Company's IVD
imaging systems are designed to provide customers with better and more rapid
results and labor cost-savings over manual methods of performing microscopy. The
Company's products are sold directly and through distributors primarily to
hospital and reference clinical laboratories, as well as veterinary, physician
office and research laboratories.
 
     The Company pioneered its first IVD imaging system application in 1983 with
its introduction of The Yellow IRIS family of workstations for urinalysis. The
Company believes that it is still the only supplier of laboratory systems which
fully automate a complete urinalysis, and it introduced its fourth generation
models in 1996 which incorporate significant advancements in speed, utility and
ease of use. In 1996, the Company also received Food and Drug Administration
("FDA") clearance and began to market the Model 900UDx urine pathology system
designed especially for the high-volume testing requirements of larger
laboratories. The Company also provides ongoing sales of supplies and service
necessary for operation of The Yellow IRIS workstations. Most supplies are
purchased under standing orders and, following an initial one-year warranty
period, the majority of customers purchase annual service contracts.
 
     In July 1996, the Company entered the field of genetics with the
acquisition (the "PSI Acquisition") of the digital imaging business of
Perceptive Scientific Instruments, Inc. ("PSI"). PSI's principal product line is
the PowerGene family of genetic analyzers -- IVD imaging systems for
karyotyping, DNA probe analysis and comparative genomic hybridization. The
Company also acquired international operations from PSI.
 
     In February 1996, the Company acquired StatSpin, Inc. ("StatSpin"), in a
pooling-of-interests transaction. Through StatSpin, the Company manufactures and
markets a variety of benchtop centrifuges, small instruments and supplies for
the laboratory market. These products are used primarily for manual specimen
preparation and dedicated applications in cytology, hematology and urinalysis.
They appeal to laboratories and physician offices performing too few tests to
justify the cost of an automated IVD imaging system.
 
     In December 1997, the Company began distributing the IRIS/Sysmex UF-100
urine cell analyzer in the United States under an existing agreement with its
manufacturer, Sysmex Corporation. Sysmex initiated contractual procedures in
September 1998 for terminating the exclusive nature of the Company's
distribution rights to the UF-100 based on allegations of inadequate
performance. The Company disputed these allegations and entered into discussions
with Sysmex about the pricing and marketing of the UF-100. Those discussions did
not resolve the matter. Sysmex is now asserting that it has the right to appoint
additional distributors for the UF-100 in North America. The Company disputes
that Sysmex has this right but expects that Sysmex will attempt to appoint at
least one additional distributor for North America in the near future. The
Company is presently evaluating its alternatives and may take legal action if
Sysmex does in fact appoint an additional distributor. The Company cannot
presently predict the impact of any attempt by Sysmex to appoint an additional
distributor or any resulting legal action taken by the Company.
 
     The Company has had a major program over a number of years to develop The
White IRIS leukocyte differential analyzer. The FDA cleared The White IRIS in
May 1996, but its commercial release was
 
                                        1
<PAGE>   4
 
subsequently delayed by other priorities such as the introductions of the Model
900UDx urine pathology system and the UF-100 urine cell analyzer. The Company
has elected not to launch The White IRIS at the present time due to limited
resources and the potential impact of product launch costs on near-term
profitability. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources."
 
THE INDUSTRY
 
     As a result of cost containment pressures from third-party payors,
healthcare providers are focusing on the most efficient use of their resources.
This goal is driving them to reduce costs while simultaneously improving the
outcome potential of patient care. Meeting this goal depends to a large degree
on reducing the cost and improving the accuracy of medical tests for diagnosing
and monitoring diseases, as well as reporting the results of these tests in
timely and useful ways.
 
     Medical tests are performed either on the patient or on a specimen removed
from the patient. IVD testing refers to analysis of a specimen -- a sample of
blood ("hematology"), urine ("urinalysis"), chromosomes ("genetics") or other
tissue or material removed from the patient -- usually in the clinical
laboratory. Many IVD tests rely on chemical or simple physical measures of
specific characteristics of the specimen. Over the past five decades, the
chemical and particle-counting aspects of these tests have been largely
converted from manual methods to automated instruments, such as clinical
chemistry analyzers and blood cell counters.
 
     However, many other IVD tests require visual examination of the specimen
through a microscope ("microscopy"). Manual microscopy requires numerous steps
from specimen preparation to visual examination, making the method
labor-intensive, cumbersome, biohazardous, inefficient and imprecise. More labor
time is spent in performing manual microscopy, collectively, than in any other
IVD testing procedure in the clinical laboratory. Nonetheless, the vast majority
of microscopic procedures are still performed manually.
 
     The pressure to reduce the costs and improve the accuracy of IVD tests,
together with recent technological developments, have created an opportunity for
automating microscopic procedures. Advances in image processing software,
computer hardware and solid-state cameras have made it possible to capture
digital images of microscopic specimens in a uniform manner and perform
sophisticated analysis and classification of these images. The test results can
then be electronically transmitted to the central computer system of the
hospital or reference laboratory for clinical use and billing. The digital
images of the specimen can also be stored in electronic format for future review
and, theoretically, transmitted to remote locations for review by other
technologists or specialists.
 
THE COMPANY'S STRATEGY
 
     The Company's objectives are to maintain its technological leadership,
develop new products, continue market penetration of existing products, expand
the geographic markets for existing products and increase sales of supplies and
service. The Company is pursuing these objectives through the following
strategies:
 
     - Adding New IVD Imaging Applications. The Company believes automated
       microscopy has a number of potential applications in the clinical
       laboratory beyond the field of urinalysis. In July of 1996, the Company
       strategically expanded into the field of genetics through the PSI
       Acquisition, which included the acquisition of the PowerGene family of
       IVD imaging systems. The Company completed development of The White IRIS
       leukocyte differential analyzer for hematology in 1997, but it has
       elected not to launch The White IRIS at the present time due to limited
       resources and the potential impact of product launch costs on near-term
       profitability. See "Overview."
 
     - Continuing Market Penetration for Current Applications of IVD Imaging
       Technology. The Company plans to continue penetrating the urinalysis
       segment of the IVD testing market with additional sales of its newest
       generation models of The Yellow IRIS family, including the Model 900UDx
       Urine Pathology System which was designed especially for the high-volume
       testing requirements of larger laboratories.
 
                                        2
<PAGE>   5
 
     - Expanding in New Geographic Markets. The Company's growth strategy also
       calls for the successful penetration of overseas markets, where its
       PowerGene systems have already achieved a strong market presence with
       sales in more than 40 countries. Until recently, neither The Yellow IRIS
       line nor the StatSpin products have been marketed to a significant degree
       outside the United States. International markets have witnessed the same
       trend toward consolidation and emphasis on labor productivity that has
       characterized the US market for the past 15 years. From a strategic
       standpoint, management intends to proceed with the introduction of The
       Yellow IRIS in selected markets where consolidation has already been a
       factor by developing relationships with distributors in those countries
       capable of selling both its clinical systems and small instruments.
 
     - Increasing Sales of Supplies and Service. Once an IVD imaging system is
       installed, the Company generates significant recurring revenue from sales
       of supplies and service for its operation. The Company seeks to enhance
       this revenue stream by installing more systems as well as increasing its
       product offering of supplies for each system. For example, the Company
       began selling the CHEMSTRIP/IRIStrip urine test strips for The Yellow
       IRIS systems at the end of 1994. The Company also hopes to introduce
       specific DNA probe kits and other consumables for chromosome analysis to
       its PowerGene line.
 
     - Maintaining Technological Edge. The Company maintains an active research
       and development program to continually enhance its IVD imaging systems
       and explore other potential IVD imaging applications for its AIM
       technology.
 
     - Adding Complementary Product Lines. In the past, the Company has also
       added several complementary lines of small instruments and supplies which
       appeal to smaller laboratories and respond to the desire of integrated
       healthcare providers to purchase systems and supplies for a variety of
       clinical settings from one supplier. The Company also added the UF-100 to
       its urinalysis instrument line which appeals more to reference
       laboratories which desire to minimize the number of microscopic
       examinations. While it continues to consider complementary product line
       acquisitions from time to time, the Company does not presently believe
       that such acquisitions are likely in the near term.
 
AIM TECHNOLOGY
 
     An effective system for automated microscopy in most applications requires
technology for fast, consistent and easily discernable presentation of the
specimen to the microscope ("front end processing") and for rapidly capturing,
analyzing, classifying, enhancing, arranging and displaying images of the
specimen ("back end imaging"). The Company has over the past twenty years
created and developed its patented and proprietary AIM technology to address
both of these requirements.
 
     The Company's AIM technology automates all or most of the front end
processing in its IVD imaging systems. For example, traditional urine sediment
analysis requires manual preparation of a slide from the specimen requiring
several steps, including centrifugation followed by carefully positioning,
staining and coverslipping a sample extracted from the specimen. The slide is
then placed under the microscope and manually manipulated and scanned by a
technologist. This procedure is often time-consuming, imprecise and carries the
potential for human exposure to biohazards. In contrast, the Company's patented
slideless microscope used in The Yellow IRIS allows microscopic examination of a
moving specimen precisely positioned in a stream of fluid and eliminates the
need for manual slide preparation, manipulation and scanning. The slideless
microscope precisely positions the specimen to within microns in a thin layer
for proper focusing as it flows past the microscope at high-speed ensheathed in
a larger stream of fluid. The method of ensuring proper alignment, particle
orientation, focus and measurement, called "imaging flow cytometry," is
patented, and the Company is unaware of any other company which has developed
similar technology. For those IVD tests where imaging flow cytometry is not
optimal or possible, AIM technology automates the slide manipulation and
scanning process.
 
     Once the specimen is located and presented to the microscope, AIM's back
end imaging automatically captures, digitizes, classifies, organizes and
presents the microscopic images displayed on a video monitor for review by the
medical specialist. These digital images of the specimen can then be stored on
magnetic or optical media for later retrieval, even years later.
 
                                        3
<PAGE>   6
 
PRODUCTS
 
  AIM Systems
 
     The Company currently markets two families of AIM systems -- The Yellow
IRIS and the PowerGene. They require customers to make substantial capital
investments and are designed for sale to clinical laboratories performing a
relatively large number of IVD tests.
 
     The Yellow IRIS family of urinalysis workstations are widely used
nationwide, including hospitals affiliated with over 75% of all United States
medical schools. This family of IVD imaging systems currently consists of three
models. Two models can also perform IVD imaging tests on a number of body fluids
other than urine, including cerebrospinal, peritoneal, pleural, pericardial,
synovial and seminal fluids as well as peritoneal dialyzates and lavages. The
third model, the Model 900UDx, is designed for laboratories testing high numbers
of urine specimens. The Yellow IRIS family of IVD imaging systems currently has
list prices ranging from $100,000 to $195,000.
 
     The PowerGene family of genetic analyzers performs certain chromosome tests
such as karyotyping, DNA probe analysis in FISH and M-FISH procedures and
comparative genomic hybridization. These tests are typically used for analyzing
genetic abnormalities for both clinical uses (e.g. prenatal screening) and
research applications (e.g. cancer studies). The Company purchased this family
of analyzers in July 1996 in conjunction with the PSI Acquisition. The PowerGene
analyzers currently have list prices ranging from $10,000 to over $100,000
depending upon the range of functionality, selected options and configuration.
 
  Other Systems
 
     In the fourth quarter of 1997, the Company began marketing the IRIS/Sysmex
UF-100 urine cell analyzer in the United States. The UF-100, developed in Japan
by Sysmex Corporation, formerly TOA Medical Electronics Co., Ltd. ("Sysmex"),
utilizes flow cytometric laser scanning principles to screen large volumes of
urine specimens for the presence of abnormal sediment compositions. The Company
is the exclusive distributor for the UF-100 in North America and receives
royalties from Sysmex on sales of the UF-100 outside of North America. The
UF-100 currently has a list price in the United States of $125,000. It provides
only the sediment portion of a complete urinalysis.
 
     Sysmex initiated contractual procedures in September 1998 for terminating
the exclusive nature of the Company's distribution rights to the UF-100 based on
allegations of inadequate performance. The Company disputed these allegations
and entered into discussions with Sysmex about the pricing and marketing of the
UF-100. Those discussions did not resolve the matter. Sysmex is now asserting
that it has the right to appoint additional distributors for the UF-100 in North
America. The Company disputes that Sysmex has this right but expects that Sysmex
will attempt to appoint at least one additional distributor for North America in
the near future. The Company is presently evaluating its alternatives and may
take legal action if Sysmex does in fact appoint an additional distributor. The
Company cannot presently predict the impact of any attempt by Sysmex to appoint
an additional distributor or any resulting legal action taken by the Company.
 
  System Supplies and Service
 
     In addition to sales of IVD imaging systems and the UF-100, the Company
obtains significant recurring revenue from sales of supplies used in the
operation of these systems and from their service and repair. Supplies for The
Yellow IRIS family include the sheath fluid used to position the particles and
cleanse the system in slideless microscopy and "controls" used in calibrating
and monitoring the performance quality of the systems. The Company also sells
the CHEMSTRIP/IRIStrip for testing urine chemistry on The Yellow IRIS. The
Company introduced the CHEMSTRIP/IRIStrip urine test strips in late 1994 and has
converted over 95% of the installed base of systems to these new test strips.
CHEMSTRIP/IRIStrips urine test strips are produced through an agreement with the
Boehringer Mannheim Group of companies, recently bought by Hoffman-LaRoche,
reorganized and now operated as Roche Diagnostics. The Company is currently
seeking to add DNA probe kits for chromosome analysis to the PowerGene product
line.
 
                                        4
<PAGE>   7
 
  Small Instruments and Supplies
 
     The Company also manufactures and markets a variety of small instruments
and supplies for the clinical laboratory market. These products complement the
Company's line of IVD imaging systems because they appeal to smaller
laboratories and physician offices performing an insufficient number of tests to
justify the capital cost of an IVD imaging system. StatSpin's
technologically-advanced small benchtop centrifuges are designed to prepare
certain biological specimens for instrumental or microscopic examination in a
fraction of the time required by larger, common laboratory centrifuges. They
have proven ideal for on-demand, point-of-use testing in hospitals, physician's
offices and veterinary laboratories. The basic StatSpin centrifuge unit is
adaptable to a variety of uses by means of application-specific rotors and
consumables. Noted for their compact design and simple, quiet and unobtrusive
operation, they are particularly well-suited to laboratories in which
technicians are located in close proximity to the equipment. These products also
take advantage of the Company's reputation and expertise in urinalysis and
respond to the desire of integrated healthcare providers to purchase systems and
supplies for a variety of clinical settings (both large and small) from one
supplier. This category of products includes special-purpose centrifuges,
digital refractometers for measuring the specific gravity of urine, the CenSlide
System for manual microscopic examination of urine and other supplies intended
primarily for specimen preparation.
 
  Summary of Revenues by Product Line for Each Segment
 
     The following tables present a summary of revenues for each segment by
product line for the three years ended December 31, 1998:
 
<TABLE>
<CAPTION>
                                                                          SMALL
                                                           GENETIC      LABORATORY
                                          URINALYSIS     ANALYSIS(1)     DEVICES         TOTAL
                                          -----------    -----------    ----------    -----------
<S>                                       <C>            <C>            <C>           <C>
For the Year Ended December 31, 1996
Sales of IVD systems....................  $ 4,189,663    $2,180,683     $       --    $ 6,370,346
Sales of IVD system supplies and
  service...............................    8,831,516       285,977             --      9,117,493
Sales of small instruments and
  supplies..............................           --            --      5,066,292      5,066,292
Royalty and license revenues............       42,923            --             --         42,923
                                          -----------    ----------     ----------    -----------
Total...................................  $13,064,102    $2,466,660     $5,066,292    $20,597,054
                                          ===========    ==========     ==========    ===========
</TABLE>
 
<TABLE>
<CAPTION>
                                                                         SMALL
                                                          GENETIC      LABORATORY
                                          URINALYSIS      ANALYSIS      DEVICES         TOTAL
                                          -----------    ----------    ----------    -----------
<S>                                       <C>            <C>           <C>           <C>
For the Year Ended December 31, 1997
Sales of IVD systems....................  $ 5,612,308    $6,211,135    $       --    $11,823,443
Sales of IVD system supplies and
  service...............................   10,061,314       559,897            --     10,621,211
Sales of small instruments and
  supplies..............................           --            --     4,447,418      4,447,418
Royalty and license revenues............      510,920            --        92,156        603,076
                                          -----------    ----------    ----------    -----------
Total...................................  $16,184,542    $6,771,032    $4,539,574    $27,495,148
                                          ===========    ==========    ==========    ===========
</TABLE>
 
<TABLE>
<CAPTION>
                                                                         SMALL
                                                          GENETIC      LABORATORY
                                          URINALYSIS      ANALYSIS      DEVICES         TOTAL
                                          -----------    ----------    ----------    -----------
<S>                                       <C>            <C>           <C>           <C>
For the Year Ended December 31, 1998
Sales of IVD systems....................  $ 4,985,717    $5,374,212    $       --    $10,359,929
Sales of IVD system supplies and
  service...............................   11,785,185       562,089            --     12,347,274
Sales of small instruments and
  supplies..............................           --            --     4,345,304      4,345,304
Royalty and license revenues............      229,972            --       235,000        464,972
                                          -----------    ----------    ----------    -----------
Total...................................  $17,000,874    $5,936,301    $4,580,304    $27,517,479
                                          ===========    ==========    ==========    ===========
</TABLE>
 
---------------
 
(1) Includes only revenues from July 31, 1996, the date of acquisition of the
    genetic analysis segment.
 
                                        5
<PAGE>   8
 
     In the second quarter of 1998, the Company adopted Statement of Financial
Accounting Standards (SFAS) 131, "Disclosures about Segments of an Enterprise
and Related Information". SFAS 131 supersedes SFAS 14, "Financial Reporting for
Segments of a Business Enterprise", replacing the "industry segment" approach
with the "management" approach. The management approach designates the internal
organization that is used by management for making operating decisions and
assessing performance as the source of the Company's reportable segments. The
Company operated in one industry segment under SFAS 14. Since the Company is
organized on the basis of products and related services, it operates in three
segments under SFAS 131: (1) urinalysis, (2) genetic analysis and (3) small
laboratory devices. See Note 19 to the Consolidated Financial Statements,
"Segment and Geographic Information".
 
  Backlog
 
     The sales backlog for IVD imaging systems was approximately $700,000 at
December 31, 1997 and $221,000 at December 31, 1998. The Company believes the
amount of backlog at a given date is not necessarily indicative of sales for any
succeeding period.
 
RESEARCH AND DEVELOPMENT
 
     The Company maintains an active research and development program to
continually enhance its existing IVD imaging systems and explore other IVD
imaging applications for its AIM technology. In 1996, 1997 and 1998, the Company
focused its research and development efforts on the following major projects, as
well as numerous other smaller projects:
 
     - Developing the Model 900UDx. The Company completed development of its
       newest model in The Yellow IRIS family, the Model 900UDx, in 1996. The
       Model 900UDx is the industry's first and only fully-automated walkaway
       system for performing complete macroscopic, chemical and microscopic
       urinalysis profiles. During 1998, the Company upgraded the installed base
       of Model 900UDx systems to increase reliability and enhance overall
       performance.
 
     - Upgrading The Yellow IRIS. The Company conducts an ongoing process of
       refining its AIM technology and the cost-effectiveness of its systems.
       During 1998, the Company completed work on software updates to make The
       Yellow IRIS family of workstations Y2K compliant. See "Management's
       Discussion and Analysis of Financial Condition and Results of
       Operations -- Year 2000 Problem."
 
     - Expanding PowerGene. The Company has dedicated significant research and
       development efforts toward fluorescent in-situ hybridization ("FISH")
       analysis. FISH is providing new tools for direct and specific evaluation,
       and prediction of human genetic disease. Utilizing multi-spectral
       fluorescent chemical probes, Multiplex-FISH ("M-FISH") methods enhance
       the sensitivity of classical karyotyping and provide easier
       interpretation of chromosome abnormalities permitting such procedures to
       be performed rapidly on uncultured amniotic or cancer cells. During 1998,
       the Company conducted research and development on DNA probe kits for the
       PowerGene product line.
 
     - Developing The White IRIS. The Company has had a major program over a
       number of years, under sponsorship of the National Institutes of Health
       and later in conjunction with a Company-sponsored research and
       development entity, to develop The White IRIS leukocyte differential
       analyzer. The White IRIS is an automated high-speed workstation used to
       classify normal, as well as immature and other abnormal white blood
       cells. The White IRIS performs a differential analysis which includes
       identifying the five types of normally occurring white blood cells plus a
       number of abnormally occurring immature white blood cells, variant
       lymphocytes and other cells. The Company also holds an exclusive,
       worldwide license to several patents which cover the unique cytoprobe
       used by The White IRIS, as well as the multi-colored expression of 2-MPM
       in white blood cells. The Company completed development of The White IRIS
       leukocyte differential analyzer for hematology in 1997, but it has
       elected not to launch The White IRIS at the present time due to limited
       resources and the potential impact of product launch costs on near-term
       profitability. See "Overview."
 
                                        6
<PAGE>   9
 
     The Company's current research and development efforts include, among other
things:
 
     - Developing the Next Generation Platform for Its IVD Systems. The Company
       is pursuing improvements designed to significantly increase speed and
       enhance image quality while simultaneously reducing the amount of
       technologist time required to operate the system. The Company is
       currently conducting feasibility studies on an entirely new platform for
       The Yellow IRIS family of workstations.
 
     - Upgrading the PowerGene Cytogenetic Capabilities. Research and
       development efforts for this system are focused upon developing improved
       karyotyping image classification algorithms, enhanced functionality for
       molecular cytogenetic studies and expanded measures in chromosome
       analysis using M-FISH methods. The Company is also developing DNA probe
       kits for chromosome analysis to enhance the PowerGene revenue stream.
 
     - Developing the Poly Products. During 1998, the Company and Poly satisfied
       their funding commitment on this project. The Company decided not to
       exercise its option to acquire Poly but entered into ongoing discussions
       to acquire Poly at a price below the option price. No further development
       work is planned at this time. Regardless of whether the Company acquires
       Poly, the Company has the right and expects to use improvements to its
       analyte autorecognition technology from the Poly project in the Company's
       next generation walkaway urinalysis systems. See discussion below in this
       section.
 
     - Identifying Future Applications. The Company also performs market
       research to identify customer needs and experiments to determine future
       applications of its technology. The Company believes its AIM technology
       has potential for improved cost, speed, convenience and utility and may
       have a number of other potential IVD imaging applications such as
       cytology, microbiology and histology.
 
     The Company invested $4.3 million, $3.7 million and $3.7 million on total
product technology expenditures during the years ended December 31, 1996, 1997
and 1998, respectively. See "Management Discussion and Analysis of Financial
Condition and Results of Operations -- Overview."
 
     The Company has in the past partially funded research and development
programs through (i) grants from NASA and the National Institutes of Health,
(ii) joint development programs with strategic partners and (iii)
Company-sponsored research and development entities. In recent years, the
Company has entered into four significant projects, two joint development
projects with strategic partners -- Boehringer Mannheim Corporation ("BMC") and
Boehringer Mannheim GmbH ("BMG") -- and two projects with Company-sponsored
research and development entities -- LDA Systems, Inc. ("LDA") and Poly U/A
Systems, Inc. ("Poly"). From 1994 to 1996, the Company collaborated with BMC and
BMG in the development of CHEMSTRIP/IRIStrip urine test strips and the Model
900UDx. BMC supplies the Company with CHEMSTRIP/IRIStrip urine test strips and
has agreed to supply the Company with certain raw materials should the Company
elect to manufacture its own urine test strips, subject to royalty payments. The
Company was granted the non-exclusive right to distribute certain other BMC
urinalysis products to hospitals and commercial laboratories in the United
States. The Company manufactures the Model 900UDx with BMG providing certain
components on an OEM basis at cost. The Company has exclusive marketing rights
to the Model 900UDx in the United States, Canada and Taiwan and non-exclusive
rights for the rest of the world outside of Germany and Italy. During 1997,
Hoffman-LaRoche acquired the Boehringer Mannheim Group of companies, and BMC and
BMG are now operated as Roche Diagnostics.
 
     In 1992, the Company entered into a project with LDA for development of The
White IRIS leukocyte differential analyzer and later acquired LDA for
approximately 498,000 shares of the Company's common stock. In 1995, the Company
entered into a similar project with Poly for development of several new products
to enhance automated urinalysis. Poly funded most of the cost of the project
with the net proceeds from a 1995 private placement of units, each unit
consisting of shares of Poly common stock and warrants to purchase common stock
of the Company. The Company contributed $500,000 toward the cost of the project
and has no further funding commitments. Poly has also satisfied its funding
commitment, and no further development work is planned at this time. The Company
had an option until November 29, 1998 to acquire all of the common stock of Poly
for an aggregate price of $5.1 million, payable in cash or shares of the
Company's common stock. The Company decided not to exercise its option but
entered into ongoing discussions to
 
                                        7
<PAGE>   10
 
acquire Poly at a price below the option price. The Company cannot predict
whether these discussions will lead to mutually acceptable terms for an
acquisition.
 
MARKETING AND SALES
 
     In the United States, the Company's IVD imaging systems are sold and
serviced through the Company's own sales and service forces. Sales activities
consist of direct sales by field sales representatives, telemarketing to
initiate and aid in pursuing sales opportunities, logistics support of the field
sales representatives and after-sales support to customers in the operation of
their systems. In addition to its sales activities, the Company promotes the
advantages of its products through advertising in trade journals, attendance at
trade shows and direct mail. All sales of IVD imaging systems include
installation, customer training and a one-year warranty. The Company's small
instruments, targeted primarily at smaller customers, are sold through
distributors. The Company has an overseas sales office and staff based in
Chester, England that supports agents and distributors and promotes its
PowerGene and StatSpin products in more than forty foreign countries.
 
     The Company also maintains a rental program under which it has a number of
systems currently in place. Under the terms of the rental agreements, payments
generally are based on the number of tests performed with a guaranteed monthly
minimum payment to the Company. The Company is responsible for supply and
service of the systems. Alternatively, some customers lease the Company's IVD
systems from medical equipment leasing companies which, in turn, purchase the
systems from the Company.
 
     In addition, the Company markets most of the supplies used in the operation
of its IVD systems and maintains these systems through its own national service
organization. Service (after a one-year warranty period) is generally sold under
an annual service contract or, less frequently, on a per-call basis.
 
COMPETITION
 
  Urinalysis
 
     The Company's primary products for the urinalysis market are The Yellow
IRIS family of urinalysis workstations and the UF-100 urine cell analyzer. The
principal competitive factors in this market are cost-per-test, ease of use, and
quality of result. The Company believes The Yellow IRIS and the UF-100 compete
favorably with regard to these factors in their respective target markets.
 
     A number of hospitals conduct urine sediment examinations using the Kova
system made by Hycor Biomedical, Inc., as well as several other similar
products, all of which are composed largely of disposable plastic parts. These
products provide a more standardized method of preparing urine sediment for
microscopical examination as opposed to traditional means. While these
disposable products help somewhat to overcome manipulative imprecision, most of
them do so at the added expense of an increased number of disposable parts and
offer little in time savings. One exception is the CenSlide System acquired by
the Company in March of 1996. This system uses a combination centrifuge tube and
microscope slide, thereby actually eliminating much of the manipulation required
in preparing the urine specimen for microscopic observation. The Company views
these types of products as better suited for laboratories performing a small
number of urinalysis tests.
 
     Bayer Diagnostics, Roche Diagnostics, and Dade Behring Corporation sell
lines of urine test strips which are useful in determining the concentration of
various chemical substances often found in urine. Some claims have been made
that the absence of certain results determined with these test strips can
preclude the need for microscopic examinations of some specimens. In 1998, IRIS
obtained FDA clearance of its claims of improved performance of The Yellow IRIS
over reagent strip measures in detecting microscopic abnormalities in urine.
Nonetheless, a substantial portion of the urinalysis market has subscribed to
the theory that these test strips can be relied upon to reduce the number of
microscopic examinations. The Company believes that this is largely due to
laboratories' reacting to cost-cutting pressures. The result is significantly
slower growth in the demand for microscopic examinations at certain hospitals
and reference laboratories.
 
                                        8
<PAGE>   11
 
     The Yellow IRIS currently supports only automated test strip readers
supplied by Roche Diagnostics, and some potential customers who have previously
purchased automated test strip readers from Bayer Diagnostics (the dominant
company in the urine test strip business) cannot connect those readers to The
Yellow IRIS. The Company's ability to modify The Yellow IRIS to support a
connection to test strip readers from Bayer Diagnostics and Dade Behring is
subject to significant restrictions under its existing agreements with Roche
Diagnostics.
 
     The Company is also experiencing increased competitive pressures in the
urinalysis market due to the ongoing consolidation of both hospitals and medical
device suppliers. Large hospital chains and groups of affiliated hospitals are
negotiating comprehensive supply contracts with the larger medical device
suppliers. The larger suppliers often equip an entire laboratory and offer
one-stop shopping for laboratory instruments, supplies and service. In addition,
they typically offer the hospitals annual rebates based on the total volume of
business with the suppliers. These rebates create financial incentives against
purchasing instruments or supplies from others and act as a barrier to the
penetration of hospital laboratories covered by the contract. For example, the
Company has encountered significant difficulty in marketing its urinalysis
products to hospitals which are members of Premier Enterprises, a nationwide
buying cooperative of hospitals and healthcare systems. Premier generally
establishes a single vendor for particular product lines and has designated
Bayer Diagnostics as its vendor for urinalysis test strips. The Company's family
of urinalysis workstations, The Yellow IRIS, uses test strips manufactured for
the Company by Roche Diagnostics and thereby has encountered resistance to
purchasing The Yellow IRIS from many Premier affiliated hospitals for this
reason.
 
  Genetics
 
     The Company's products for the genetics market are the PowerGene family of
chromosome analyzers. The principal competitive factors in this market are
comparative product features, such as ease-of-use, software functionality and
user friendliness, clarity of visual output and the quality and responsiveness
of customer service. The Company believes the PowerGene analyzers compete
favorably with regard to these factors.
 
     The Company's primary competitors in this worldwide market are Applied
Imaging and Vysis, Inc. who market IVD imaging systems for prenatal and other
genetic testing. Vysis utilizes a strategy of offering its systems as a vehicle
for selling its DNA probes, a strategy that has made it the fastest growing
competitor. Leica (a German microscope manufacturer), MetaSystems (also based in
Germany) and ASI (an Israeli camera manufacturer) also sell systems for genetic
analysis.
 
  Hematology
 
     The Company's proposed product for the hematology market is The White IRIS
leukocyte differential analyzer. See "Research and Development." Intelligent
Medical Imaging, Inc. ("IMI") is presently manufacturing an IVD imaging system,
called the Micro 21, for performing certain aspects of white blood cell
differential analysis and certain other analyses. Unlike The White IRIS, which
uses imaging flow cytometry, the Micro 21 is a slide-based system. The Company
believes The White IRIS has certain performance advantages over the Micro 21.
For example, The White IRIS (1) uses a closed-tube sampling procedure which is
safer and more convenient because it does not require slide preparation, (2) is
more sensitive and precise because it counts significantly more white blood
cells, (3) allows an easier-to-obtain and more complete answer because it
automatically classifies variant, immature and other abnormal cells, as compared
only to automated classification of normal cells by the Micro 21, and (4) is
more cost effective because it has higher throughput and requires less attended
time. See " -- Overview".
 
     While other automated blood smear reading instruments capable of varying
degrees of white blood cell differential analysis exist, they are relatively
expensive. There is at least one such instrument currently in production (made
by Omron, a Japanese company), but, to the Company's knowledge, it is not
marketed outside of Japan. The Company is not aware of any current plans by
Omron to market its white blood cell slide readers in the United States. Sysmex,
Abbott Laboratories and Beckman Coulter, all manufacturers of blood cell
counters, have begun displaying devices which automate the blood smear
preparation process and are
 
                                        9
<PAGE>   12
 
attachable to their respective analyzers but do not provide for automation of
white blood cell differential analysis.
 
     In 1998, IMI introduced an automated blood smear reader which can be
combined with the Micro 21 for enhanced automation. IMI subsequently entered
into distribution arrangements with Bayer Diagnostics and Beckman Coulter for
the IMI blood smear reader. IMI has recently made public statements that it has
now placed over 70 of its Micro 21 systems as "revenue units."
 
  Other Potential Competitors
 
     The Company is aware of at least four other companies that sell IVD imaging
systems, all for cytology and/or histology applications. Neuromedical Systems,
Inc. and NeoPath, Inc. offer IVD imaging systems for PAP smears. Neuromedical
Systems recently filed for Chapter 11 bankruptcy protection due to rising
losses. Auto-Cyte, Inc. and ChromaVision Medical Systems, two newer ventures,
recently obtained significant funding through initial public offerings. AutoCyte
plans to compete in the PAP smear arena and recently announced a collaboration
with NeoPath and the purchase of intellectual property from Neuromedical
Systems. ChromaVision sells a system for rare event finding for applications
similar in concept to the PowerGene prototype automated rare event finder
delivered last year by PSI to NASA's Johnson Space Center.
 
INTELLECTUAL PROPERTY
 
     The Company's commercial success depends in large part on its ability to
protect and maintain its proprietary rights. As such, the Company pursues broad
protection of its proprietary technology through the filing of various patent
applications. The Company has received numerous United States patents for its
AIM technology and related applications as well as a number of corresponding
foreign patents. These patents also cover developments in image analysis and
blood processing. A number of additional patent applications are pending in the
United States and abroad. These patents also cover image analysis, urine and
blood processing. Also, numerous patents relating to digital refractometers,
centrifuges, automated slide handling and disposable urinalysis products were
acquired in its recent acquisitions.
 
     The Company has an exclusive license from Cytocolor, Inc. for the patented
2-MPM cytoprobe used in the operation of The White IRIS. Cytocolor has pursued
patent protection of this unique reagent through the filing of patent
applications in the United States and abroad. Under the terms of the license,
the Company is required to pay Cytocolor royalties of $1,000 per system for the
first 1,000 sales of The White IRIS plus 8% of the net sales price of all
consumable products containing 2-MPM.
 
     The Company has granted Sysmex a royalty-bearing license to use pre-1989
technology for urine sediment analyzers and non-medical industrial instruments.
The Company has also granted Dade International a royalty-bearing license to use
certain centrifuge technology.
 
     The Company has trade secrets and unpatented technology and proprietary
knowledge related to the sale, promotion, operation, development and
manufacturing of its products. To protect these rights, the Company enters into
confidentiality agreements with its employees and consultants.
 
     The Company claims copyright in its software and the ways in which it
assembles and displays images, and it has filed copyright registrations with the
United States Copyright Office. The Company also owns various federally
registered trademarks, including "IRIS," "The Yellow IRIS," "The White IRIS,"
"PowerGene," and "StatSpin." The Company owns numerous other registered and
unregistered trademarks. The Company also has certain trademark rights in
foreign jurisdictions. The Company intends to aggressively protect its
copyrights and trademarks.
 
GOVERNMENT REGULATION
 
     Most of the Company's products are subject to stringent government
regulation in the United States and other countries which govern the testing,
manufacture, labeling, storage, record-keeping, distribution, sale, marketing,
advertising and promotion of such products. The regulatory process can be
lengthy, expensive and uncertain, and securing clearances or approvals may
require the submission of extensive official data and other supporting
information. Failure to comply with applicable requirements can result in fines,
recall or seizure of
 
                                       10
<PAGE>   13
 
products, total or partial suspension of production, withdrawal of existing
product approvals or clearances, refusal to approve or clear new applications or
notices and criminal prosecution.
 
     In the United States, the FDA regulates medical devices under the Food,
Drug, and Cosmetic Act (the "FDC Act"). Before a new medical device can be
commercially introduced in the United States, the manufacturer usually must
obtain FDA clearance by filing a pre-market notification under Section 510(k) of
the FDC Act (a "510(k) Notification") or obtain FDA approval by filing a
pre-market approval application (a "PMA Application"). The 510(k) Notification
process can be lengthy, expensive and uncertain, but the PMA Application process
is significantly more complex, expensive, time-consuming and uncertain. To date,
the Company has cleared all of its regulated products with the FDA through the
510(k) Notification process.
 
     The Company's business strategy includes the development of additional
products for which FDA clearance or approval may be required, and no assurance
can be given that the Company can secure any necessary FDA clearance to market
these products or that the FDA will not require the filing of a PMA Application
for these products. Furthermore, FDA clearance of a 510(k) Notification or
approval of a PMA Application is subject to continual review, and the subsequent
discovery of previously unknown facts may result in restrictions on a product's
marketing or withdrawal of the product from the market.
 
     The Company is also required to register as a medical device manufacturer
with the FDA and comply with FDA regulations concerning good manufacturing
practices for medical devices ("GMP Standards"). In 1997, the FDA expanded the
scope of the GMP Standards with new regulations requiring medical device
manufacturers to maintain control procedures for the design process, component
purchases and instrument servicing. The FDA periodically inspects the Company's
manufacturing facilities for compliance with GMP Standards. The Company believes
that it is in substantial compliance with the expanded GMP Standards.
 
     The FDA also regulates computer software of the type used in the Company's
IVD imaging systems and is currently reevaluating the regulation of such
software. The Company cannot predict the extent to which the FDA will regulate
such software in the future.
 
     Labeling, advertising and promotional activities for medical devices are
subject to scrutiny by the FDA and, in certain instances, by the Federal Trade
Commission. The FDA also enforces statutory and policy prohibitions against
promoting or marketing medical devices for unapproved uses.
 
     Many states have also enacted statutory provisions regulating medical
devices. The State of California's requirements in this area, in particular, are
extensive, and require registration with the state and compliance with
regulations similar to the GMP Standards established by the FDA. While the
impact of such laws and regulations has not been significant to date, there can
be no assurance that future developments in this area will not have a material
adverse effect on the Company.
 
     In addition to domestic regulation of medical devices, many of the
Company's products are subject to regulations in the foreign jurisdictions in
which it operates or sells products. The requirements for the sale of medical
devices in foreign markets vary widely from country to country, ranging from
simple product registrations to detailed submissions similar to those required
by the FDA. Although the Company distributes the PowerGene analyzer in more than
40 foreign countries, it has not yet applied for regulatory clearances or
approvals to market The Yellow IRIS or The White IRIS in most of these foreign
countries. The Company's business strategy includes expanding the geographic
distribution of these and other products, and there can be no assurance that the
Company can secure the necessary clearances and approvals in the relevant
foreign jurisdictions. Furthermore, the regulations in certain foreign
jurisdictions continue to develop and there can be no assurance that new laws or
regulations will not have a material adverse effect on the Company's existing
business or future plans. Among other things, CE Mark certifications are, or may
soon be, required for the sale of many products in certain international markets
such as the European Community. The Company is actively pursuing CE Mark
certification for many of its products, but there can be no assurance that the
Company will be successful in securing such certification.
 
     In addition, the Company's products are subject to regulation by the United
States Department of Commerce export controls, primarily as they relate to the
associated computers and peripherals. The Company has not experienced any
material difficulties in obtaining necessary export licenses to date.
 
                                       11
<PAGE>   14
 
     Any change in existing federal, state or foreign laws or regulations, or in
the interpretation or enforcement thereof, or the discussion or promulgation of
any additional laws or regulations could have a material adverse effect on the
Company.
 
SEGMENT AND GEOGRAPHIC INFORMATION
 
     See Note 19 to the Consolidated Financial Statements, "Segment and
Geographic Information," for financial information regarding the Company's
operating segments and geographic areas.
 
EMPLOYEES
 
     At December 31, 1998, the Company had 154 full-time employees, which is
comparable to the number of employees at the end of 1997. The Company also uses
outside consultants and part-time and temporary employees in production,
administration, marketing and engineering. No employees are covered by
collective bargaining agreements, and the Company believes that its employee
relations are satisfactory.
 
FORWARD-LOOKING STATEMENTS
 
     This Annual Report contains various forward-looking statements which
reflect the Company's current views with respect to future events and financial
results and are subject to the safe harbor created by the Private Securities
Litigation Reform Act of 1995. These forward-looking statements include, but are
not limited to, the Company's views with respect to future financial results,
financing sources, capital requirements, market growth, new product
introductions and the like, and are generally identified by phrases such as
"anticipates," "believes," "estimates," "expects," "intends," "plans" and words
of similar import. The Company reminds stockholders that forward-looking
statements are merely predictions and therefore inherently subject to
uncertainties and other factors which could cause the actual results to differ
materially from the forward-looking statement. Some of these uncertainties and
other factors are discussed later in this Annual Report. See "Management
Discussion and Analysis of Financial Condition and Results of Operations." In
this section of the Annual Report, the Company has attempted to identify
additional uncertainties and other factors which may affect its forward-looking
statements.
 
     Stockholders should understand that the uncertainties and other factors
identified in the Annual Report do not constitute a comprehensive list of all
the uncertainties and other factors which may affect forward-looking statements.
The Company has merely attempted to identity those uncertainties and other
factors which, in its view at the present time, have the highest likelihood of
significantly affecting its forward-looking statements. In addition, the Company
does not undertake any obligation to update or revise any forward-looking
statements or the list of uncertainties and other factors which could affect
such statements.
 
  Potential Impact of Arbitration Proceeding
 
     The Company is presently in arbitration with the former owner of PSI. See
"Legal Proceedings." Although the Company does not presently anticipate any
material adverse effect as a result of this arbitration proceeding, there can be
no assurance that it will not have such an effect on the financial position or
results of operations of the Company or result in additional dilution to holders
of the Common Stock.
 
  Dependence on Instrument Sales
 
     The Company derives most of its revenues from the sale of two families of
high-priced instruments -- The Yellow IRIS urinalysis workstations and the
PowerGene genetic analyzers. These instruments have list prices ranging from
$10,000 to $195,000 depending on model and configuration, and relatively modest
declines in unit sales or gross margins for either product line could have a
material adverse effect on the Company's revenues and profits.
 
                                       12
<PAGE>   15
 
  Reliance on Single Source Suppliers
 
     Certain key components of the Company's instruments are manufactured
according to the Company's specifications or are available only from single
suppliers. For example, Roche Diagnostics is the sole source for the Company's
proprietary CHEMSTRIP/IRIStrip urine test strips and related urine test strip
readers used in The Yellow IRIS Models 300 and 500. From time to time, single
source suppliers have discontinued production of key components or encountered
production problems which potentially could have a material adverse effect on
instrument sales. Although, in the past, the Company has successfully
transitioned to new components to replace discontinued components, there can be
no assurance that the Company can always successfully transition to satisfactory
replacement components or that the Company will always have access to adequate
supplies of discontinued components on satisfactory terms during the transition
period. In the first quarter of 1997, Nikon discontinued production of the
microscope used in The Yellow IRIS. Prior to the end of production, the Company
significantly increased its inventory of these microscopes to facilitate a
two-year period for transitioning to a new microscope. The Company has selected
and placed orders for a new "off-the-shelf" microscope as the replacement. The
Company's inability to transition successfully to replacement components or to
secure adequate supplies of discontinued components on satisfactory terms during
the transition could have a material adverse effect on instrument sales. See
"-- Dependence on Instrument Sales."
 
  Dependence on Key Personnel
 
     The Company's success depends in significant part upon the continued
service of certain key personnel, and its continuing ability to attract,
assimilate and retain such personnel. Competition for such personnel is intense
and there can be no assurance that the Company can retain its key personnel or
that it can attract, assimilate or retain other highly qualified personnel in
the future. While the Company generally enters into agreements with its
employees regarding patents, confidentiality and related maters, the Company
does not have employment agreements with most of its key employees. The Company
does not maintain life insurance policies on such employees. The loss of key
personnel, especially without advance notice, or the inability to hire or retain
qualified personnel could have a material adverse effect on the Company.
 
     Dr. Deindoefer, the Company's Chairman, President and Chief Executive
Officer for the past eighteen years, announced during 1998 his desire to retire
before the year 2000. The Company is currently making succession plans, but
there can be no assurance that the transition will not have a material adverse
effect on the Company's business operations.
 
  Difficulties Associated with Introduction of Future Products
 
     The commercial success of the Company's future products and systems depends
upon their acceptance by the medical community. Capital-intensive laboratory
instruments such as The White IRIS and the Company's other future products can
significantly reduce labor costs, improve precision and offer other distinctive
benefits. However, often there is resistance to products which require
significant capital expenditures or which eliminate jobs through automation.
There can be no assurance that the Company's new products and systems will
achieve significant market acceptance in the future or that sales of such future
products and systems will grow at the rates expected by management. Furthermore,
new product introductions or product enhancements by the Company's competitors
or the use of other technologies could cause a decline in sales or gross margins
on sales or loss of market acceptance of the Company's systems.
 
     The Company has elected not to launch The White IRIS at the present time
due to limited resources and the potential impact of product launch costs on
near-term profitability. Commercial release of The White IRIS would also require
external funding and influential testimonials. See "Management Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources."
 
  Industry Consolidation Creating Barriers to Market Penetration
 
     The continuing consolidation of hospitals and medical device suppliers is
creating barriers to market penetration. Large hospital chains and groups of
affiliated hospitals prefer to negotiate comprehensive supply
 
                                       13
<PAGE>   16
 
contracts with the larger medical device suppliers. The larger suppliers can
often equip an entire laboratory and offer one-stop shopping for laboratory
instruments, supplies and service . In addition, they typically offer the
hospitals annual rebates based on the total volume of business with the
suppliers. These rebates create financial incentives against purchasing
instruments or supplies from the Company. The Company's plans for further market
penetration of the urinalysis market with The Yellow IRIS family of workstations
will depend in part on its ability to overcome these and any new barriers
resulting from consolidation in the healthcare industry.
 
  Technological Change
 
     The market for the Company's systems is characterized by rapid
technological advances, changes in customer requirements, and frequent new
product introductions and enhancements. The Company's future success depends
upon its ability to enhance its current product lines, to introduce new products
that keep pace with technological developments and to respond to evolving
customer requirements. Any failure by the Company to anticipate or respond
adequately to technological developments by its competitors or to changes in
customer requirements, or significant delays in product introduction, could
result in a loss of competitiveness and revenues. There can be no assurance that
the Company will be successful in developing and marketing new products or
product enhancements on a timely or cost-effective basis, and such failure could
have a material adverse effect on the Company.
 
  Government Regulation
 
     Most of the Company's products are subject to stringent government
regulation in the United States and other countries. The regulatory process can
be lengthy, expensive and uncertain, and securing clearances or approvals may
require the submission of extensive official data and other supporting
information. Failure to comply with applicable requirements can result in fines,
recall or seizure of products, total or partial suspension of production,
withdrawal of existing product approvals or clearances, refusal to approve or
clear new applications or notices, or criminal prosecution, any of which could
have a material adverse effect on the Company. Furthermore, changes in existing
federal, state or foreign laws or regulations, or in the interpretation or
enforcement thereof, or the discussion or promulgation of any additional laws or
regulations could have a material adverse effect on the Company.
 
  Acquisitions and Expansion
 
     As part of the Company's strategy to enhance and maintain its competitive
position, the Company may from time to time consider potential acquisitions of
complementary products, technologies and other businesses. The Company has
completed a number of acquisitions in the past three years. The evaluation,
negotiation and integration of acquisitions may consume significant time and
resources of the Company. There can be no assurance that acquisitions will not
have a material adverse effect upon the Company due to, among other things,
operational disruptions, integration issues, unexpected expenses and accounting
charges associated with such acquisitions.
 
  Healthcare Reform Policies
 
     In recent years, an increasing number of legislative proposals have been
introduced or proposed in Congress and in home state legislatures that would
effect major changes in the healthcare system, nationally, at the state level or
both. Future legislation, regulation or payment policies of Medicare, Medicaid,
private health insurance plans, health maintenance organizations and other
third-party payors could adversely affect the demand for the Company's current
or future products and its ability to sell its products on a profitable basis.
Moreover, healthcare legislation is an area of extensive and dynamic change, and
the Company cannot predict future legislative changes in the healthcare field or
their impact on its business.
 
                                       14
<PAGE>   17
 
GLOSSARY OF SELECTED TERMS
 
     The following glossary defines certain technical terms used to describe the
Company's business.
 
     AUTOMATED INTELLIGENT MICROSCOPY (AIM). The synthesis of visual microscopy,
digital image processing and automated image interpretation/pattern recognition
to analyze microscopic specimens. The Yellow IRIS, The White IRIS and PowerGene
are all examples of instruments which are based on AIM technology.
 
     AUTOMATIC KARYOTYPING. A procedure to capture and digitize an image of a
spread of chromosomes from a dividing nucleus (metaphase) which may be further
enhanced by image processing. The individual chromosomes in the enhanced image
are then automatically separated, matched and aligned into their respective
pairs (karyotype).
 
     COMPARATIVE GENOMIC HYBRIDIZATION (CGH). A molecular biology method to
globally view DNA for gain or loss (amplifications or deletions) of genetic
material using a FISH procedure.
 
     CYTOPROBE. A chemical reagent which reacts with enzymatic granules within a
cell to produce unique color characteristics which are useful in identifying the
cell.
 
     DNA. Deoxyribonucleic acid, the chemical composition of chromosomes in the
nuclei of living cells, consisting of two long chains of alternating phosphate
and deoxyribose units twisted into a double helix and joined by hydrogen bonds
between the complementary bases adenine and thymine or cytosine and guanine
bound in unique sequences that determine genetic characteristics.
 
     DNA PROBE ANALYSIS. A molecular biology method using synthesized nucleic
acid comprised of unique short sequences of DNA (deoxyribonucleotides) to locate
their exact template along the DNA chain in the nucleus of a cell.
 
     FLUORESCENT IN-SITU HYBRIDIZATION (FISH). A procedure that allows
microscopic observation of the location of a unique sequence of DNA by using a
DNA probe with a molecule attached to it which emits a distinctive color when
illuminated.
 
     IN VITRO DIAGNOSTIC (IVD) TESTING. Testing conducted outside of the body in
a laboratory apparatus using a specimen obtained from the patient (blood, urine,
tissue, etc.) to identify or monitor a disease.
 
     LEUKOCYTE DIFFERENTIAL ANALYZER. An automated, high-speed laboratory
instrument for classifying the white blood cells (or leukocytes) in a blood
specimen into different categories and determining the relative proportion of
each category.
 
     MULTIPLEX FLUORESCENT IN-SITU HYBRIDIZATION (M-FISH). A procedure which
utilizes a multiple combination of unique sequence DNA probes and fluorescent
markers to label all 22 chromosome pairs and 2 sex chromosomes in 24 unique
colors, permitting easy and rapid identification of chromosomal breakage and
rearrangements (translocations) such as often observed in cancer cells.
 
     REFERENCE LABORATORY. A commercial clinical laboratory which performs
general IVD testing of specimens referred from physician offices and more
specialized IVD testing for physician offices and hospitals.
 
     REFRACTOMETER. A device which measures the index of refraction of a
solution, typically to determine its concentration or specific gravity.
 
     SLIDELESS MICROSCOPY. The process of presenting a microscopic specimen to
the optical portion of a microscope without using a conventional microscope
slide. Slideless microscopy is implemented in The Yellow IRIS and The White IRIS
using a patented flowcell through which the specimen literally flows past a
microscope objective.
 
                                       15
<PAGE>   18
 
ITEM 2. PROPERTIES
 
     The Company leases all of its facilities. The leases expire at various
times over the next three years. The Company's headquarters are located at 9162
Eton Avenue, Chatsworth, California 91311. The table below sets forth certain
information regarding the Company's leaseholds as of December 31, 1998:
 
<TABLE>
<CAPTION>
                          APPROXIMATE FLOOR    MONTHLY
        LOCATION           SPACE (SQ. FT.)      RENT                          USE
        --------          -----------------    -------                        ---
<S>                       <C>                  <C>        <C>
Chatsworth, CA..........       26,000          $14,300    Sales and Marketing, Research and
                                                          Development, Manufacturing and Corporate
                                                          Administration
League City, TX.........        7,800          $11,200    Sales and Marketing, Research and
                                                          Development and Manufacturing
Norwood, MA.............       11,000          $ 7,800    Sales and Marketing, Research and
                                                          Development and Manufacturing
Chester, England........        5,000          L 4,200    Sales and Marketing and Manufacturing
</TABLE>
 
     The Company believes that its facilities are adequate to meet its current
needs. Although it has limited expansion space at its Chatsworth facility, the
Company believes that it can accommodate planned growth at this facility for the
near term by leasing additional office space for certain non-manufacturing
related activities, making modifications to the Chatsworth facility and adding a
second shift to its manufacturing operations. The lease for the League City
facility expires in August 1999. The Company believes that it can negotiate a
new lease for this facility or lease another adequate facility nearby on
suitable terms.
 
ITEM 3. LEGAL PROCEEDINGS
 
     In July 1996, the Company acquired PSI from Digital Imaging Technologies,
Inc. ("DITI"). As part of the purchase price, the Company issued to DITI a
five-year warrant to purchase 875,000 shares of Common stock at $8.00 per share.
In August 1997, the Company filed a demand for arbitration against DITI with the
American Arbitration Association. The Company's demand for arbitration alleges
material breaches of the representations, warranties and covenants in the
purchase agreement governing the PSI acquisition. DITI subsequently filed a
counterclaim in the arbitration proceeding alleging that the Company
misrepresented or omitted to disclose material facts in connection with the PSI
acquisition. DITI had previously requested a reduction in the exercise price of
the warrant but elected to seek unspecified monetary damages in the
counterclaim. The parties are currently engaged in discovery. Although the
Company does not presently anticipate any material adverse effect as a result of
this arbitration proceeding, there can be no assurance that it will not have
such an effect on the financial position or results of operations of the Company
or result in additional dilution to holders of the Common Stock.
 
     The Company is involved in routine litigation arising in the ordinary
course of its business, and, while the results of the proceedings cannot be
predicted with certainty, the Company believes that the final outcome of such
matters will not have a material adverse effect on the financial position or
results of operation of the Company.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     None.
 
                                       16
<PAGE>   19
 
                                    PART II
 
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
 
     The Company's Common Stock is traded on the American Stock Exchange
("Amex") under the symbol "IRI." The closing price of the Common Stock on March
12, 1999 was $ 7/8 per share. The table below sets forth high and low closing
prices reported by Amex for the period January 1, 1997 through December 31,
1998:
 
<TABLE>
<CAPTION>
                                                                PRICE PER SHARE
                                                              -------------------
                                                              HIGH            LOW
                                                              ----            ---
<S>                                                           <C>             <C>
FISCAL 1997
  First Quarter.............................................  $ 5 1/4         $ 3 5/8
  Second Quarter............................................    4 1/4           3 3/8
  Third Quarter.............................................    5               3 11/16
  Fourth Quarter............................................    5 1/8           3 1/4
FISCAL 1998
  First Quarter.............................................  $ 4 11/16       $ 3 1/4
  Second Quarter............................................    4 1/8           2
  Third Quarter.............................................    2 3/8           1 1/16
  Fourth Quarter............................................    1 1/2             3/4
</TABLE>
 
     As of March 12, 1999, IRIS had approximately 4,100 holders of record of its
Common Stock.
 
     The Company intends to employ all available funds in the development of its
business and the repayment of indebtedness and, as a result, does not expect to
pay any cash dividends for the foreseeable future. Furthermore, the Company may
not pay any cash dividends on the Common Stock, or repurchase any shares of the
Common Stock, without the written consent of the Company's lender, Foothill
Capital Corporation, and the holders of a majority of the outstanding shares of
Series A Preferred Stock.
 
                                       17
<PAGE>   20
 
ITEM 6. SELECTED FINANCIAL DATA
 
     This information as of December 31, 1997 and 1998 and for the years ended
December 31, 1996, 1997 and 1998, is derived in part from, and should be read in
conjunction with, the Company's Financial Statements, including the Notes
thereto, as included elsewhere in this Annual Report.
 
<TABLE>
<CAPTION>
                                                         YEAR ENDED DECEMBER 31,
                                           ---------------------------------------------------
                                            1994      1995(1)    1996(1)    1997(1)    1998(1)
                                           -------    -------    -------    -------    -------
                                                  (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                        <C>        <C>        <C>        <C>        <C>
FINANCIAL STATEMENT DATA
Net revenues.............................  $12,580    $14,488    $20,597    $27,495    $27,517
Operating income (loss)..................    1,495     (1,802)   (10,434)       246        556
Interest and other income (expense),
  net....................................       95        282       (452)    (1,042)    (1,061)
Net income (loss)........................    1,622      2,126     (7,428)      (503)      (385)
Net income (loss) per share -- basic.....      .30        .35      (1.21)      (.16)      (.06)
Net income (loss) per share -- diluted...      .28        .34      (1.21)      (.16)      (.06)
Working capital..........................    7,779     11,234      1,914      1,650      3,570
Total assets.............................   13,282     22,203     37,860     32,735     32,107
Long term debt, including current
  portion................................      367        311     13,000     11,442     10,442
Total liabilities........................    3,122      3,261     24,096     17,942     17,108
Shareholders' equity.....................   10,160     18,942     13,765     14,792     14,999
Cash dividends per share.................       --         --         --         --         --
OTHER FINANCIAL DATA
Operating income (loss) as adjusted(2)...    1,495      1,098     (1,292)     1,584        749
EBITDA(3)................................    2,407      2,150       (849)     4,050      3,407
</TABLE>
 
---------------
(1) The years ended December 31, 1995 and 1996 include write-offs of acquired in
    process research and development totaling $2.9 million and $7.3 million,
    respectively. The year ended December 31, 1996 also includes unusual charges
    totaling $1.9 million relating primarily to pooling-of-interest expenses,
    the write-off of deferred public offering costs, expenses relating to
    litigation and arbitration matters, severance and other incremental costs
    associated with a restructuring of the Company's personnel. The year ended
    December 31, 1997 includes unusual charges totaling $1.3 million relating to
    expenses for litigation and arbitration matters, the write-down of deferred
    private offering costs and the write-off of goodwill no longer considered
    recoverable. The year ended December 31, 1998 includes unusual charges
    totaling $193,000 primarily for legal expenses associated with the pending
    arbitration matter.
 
(2) Operating income (loss) as adjusted represents operating income (loss)
    before the write-off of acquired in-process research and development
    totaling $2.9 million and $7.3 million in the years ended December 31, 1995
    and 1996, respectively, and before unusual charges of $1.9 million, $1.3
    million and $193,000 in the years ended December 31, 1996, 1997 and 1998,
    respectively.
 
(3) EBITDA represents earnings before taxes, interest expense, write-off of
    acquired in-process research and development, depreciation and amortization,
    including amortization of common stock and stock option compensation. The
    Company believes that EBITDA serves as a financial analysis tool for
    measuring financial information such as operating performance leverage
    ratios. EBITDA should not be considered by the reader as an alternative to
    net income as an indicator of the Company's performance or as an alternative
    to cash flows as a measure of liquidity.
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
OVERVIEW
 
     The Company generates revenues primarily from sales of IVD imaging systems
based on its patented and proprietary AIM technology. Following the initial
sale, these systems become part of the "installed base" and generate follow-on
sales of supplies and service necessary for their operation. The Company also
generates revenues from sales of ancillary lines of small laboratory instruments
and supplies.
 
                                       18
<PAGE>   21
 
     Until 1996, the Company generated most of its revenues from sales of just
two models of The Yellow IRIS urinalysis workstation and related supplies and
services. These two models differ mainly by their speed and price. In 1996, the
Company introduced a third model of The Yellow IRIS, the Model 900UDx urine
pathology system, which is a higher capacity automated urinalysis workstation
designed especially for the high-volume testing requirements of large hospitals
and reference laboratories. The Company also began selling the PowerGene family
of genetic analyzers in August 1996 after completing the acquisition (the "PSI
acquisition") of the digital imaging business of Perceptive Scientific
Instruments, Inc. ("PSI"). The Company is currently seeking to enhance PSI's
revenue stream by adding DNA probe kits for chromosome analysis to the PowerGene
product line and may pursue this goal through internal research and development
efforts or a strategic transaction with another company. Finally, in December
1997, the Company began distributing the IRIS/Sysmex UF-100 urine cell analyzer
in the United States under an existing agreement with Sysmex Corporation, its
manufacturer. Sysmex has initiated contractual procedures in September 1998 for
terminating the exclusive nature of the Company's distribution rights to the
UF-100 based on allegations of inadequate performance. The Company disputed
these allegations and entered into discussions with Sysmex about the pricing and
marketing of the UF-100. Those discussions did not resolve the matter. Sysmex is
now asserting that it has the right to appoint additional distributors for the
UF-100 in North America. The Company disputes that Sysmex has this right but
expects that Sysmex will attempt to appoint at least one additional distributor
for North America in the near future. The Company is presently evaluating its
alternatives and may take legal action if Sysmex does in fact appoint an
additional distributor. The Company cannot presently predict the impact of any
attempt by Sysmex to appoint an additional distributor or any resulting legal
action taken by the Company. See "Business -- Overview."
 
     The Company invests significant amounts in research and development for new
products and enhancements to existing products. The following table summarizes
total product technology expenditures for the periods indicated:
 
<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31,
                                                              --------------------------
                                                               1996      1997      1998
                                                              ------    ------    ------
                                                                    (IN THOUSANDS)
<S>                                                           <C>       <C>       <C>
Research and development expense, net.......................  $1,978    $2,125    $2,421
Capitalized software development costs......................     577       535       353
Reimbursed costs for research and development grants and
  contracts.................................................   1,780     1,015       921
                                                              ------    ------    ------
          Total product technology expenditures.............  $4,335    $3,675    $3,695
                                                              ======    ======    ======
</TABLE>
 
     The Company has in the past partially funded its research and development
programs through (i) grants from NASA and the National Institutes of Health,
(ii) joint development programs with strategic partners and (iii)
Company-sponsored research and development entities. See "Business -- Research
and Development."
 
     In the quarter ended June 30, 1998, the Company adopted SFAS 131, replacing
SFAS 14. The Company operated in one industry segment under SFAS 14. The Company
is organized on the basis of products and related services and operates in three
segments under SFAS 131: (1) urinalysis, (2) genetic analysis and (3) small
laboratory devices. See Note 19 to the Consolidated Financial Statements,
"Segment and Geographic Information."
 
RESULTS OF OPERATIONS
 
  Comparison of Year Ended December 31, 1998 to Year Ended December 31, 1997
 
     Net revenues for the year ended December 31, 1998 totaled $27.5 million
which is comparable to the prior year. Sales of IVD systems decreased to $10.4
million from $11.8 million, a decrease of $1.4 million or 12% from the prior
year. Revenues from sales of urinalysis systems decreased to $5.0 million from
$5.6 million, a decrease of $627,000 or 11%. The decrease is due to a decline in
domestic sales, partially offset by increased sales to an international
distributor. Revenues from sales of the PowerGene line of genetic analyzers
decreased to $5.4 million from $6.2 million, a decrease of $837,000 or 13%. The
decrease relates
 
                                       19
<PAGE>   22
 
primarily to the non-recurrence of a record $1.25 million multi-system sale of
genetic analyzers during the second, third and fourth quarters of last year,
lower average selling prices in response to increased competition, partially
offset by increased unit volumes. Sales of IVD system supplies and services
increased to $12.3 million from $10.6 million, an increase of $1.7 million or
16% over the comparable period last year, primarily due to the larger installed
base of The Yellow IRIS IVD imaging systems. Sales of small instruments and
supplies decreased to $4.3 million from $4.4 million, a decrease of $102,000.
 
     Royalty and licensing revenue decreased to $465,000 for the year ended
December 31, 1998 as compared to $603,000 in the prior year. The decrease is
primarily due to differences in non-recurring licensing fees received in the two
years. Royalty and licensing revenue is expected to decrease in 1999.
 
     Revenues from the urinalysis segment totaled $17.0 million for the year
ended December 31, 1998 as compared to $16.2 million in the prior year, an
increase of $816,000. The net increase is due to increased revenues from
supplies and service for The Yellow IRIS which more than offset a decline in
sales of The Yellow IRIS instruments and a decline in licensing revenues.
Revenues from the genetic analysis segment declined to $5.9 million in 1998 as
compared to $6.8 million in the prior year for the reasons described above.
Revenues from the small laboratory devices segment were essentially comparable
as increased licensing revenues were substantially offset by reduced purchases
by a major distributor.
 
     Cost of goods for IVD systems increased as a percentage of their sales to
56% for the year ended December 31, 1998 from 51% for the prior year. The
increase is primarily due to lower average selling prices of The Yellow IRIS
urinalysis workstations caused by an increased proportion of international sales
and lower average sales prices relating to the PowerGene genetic analyzer. Cost
of goods for IVD system supplies and services as a percentage of sales of such
products decreased to 48% for the current period as compared to 50% for the
prior year. The decrease is primarily due to decreased costs and increased
selling prices. Cost of goods for small instruments and supplies as a percentage
of sales of small instruments and supplies totaled 55% for 1998 compared to 53%
for the prior year. The increase is primarily due to a change in the sales mix.
The net result of these changes was a decrease in aggregate gross margin to 49%
for 1998, as compared to 50% in the prior year.
 
     Cost of goods sold as a percentage of revenues from the urinalysis segment
totaled 68% in 1998, as compared to 51% in 1997. Lower average selling prices
for The Yellow IRIS workstation to an international distributor were partially
offset by improved pricing and decreased costs on supplies and service. Cost of
goods sold as a percentage of revenues from the genetic analysis segment totaled
52% in 1998, as compared to 47% in the prior year. This increase is primarily
the result of lower average selling prices due to the non-recurrence of the
multi-system order discussed above and price pressures from increased
competition. Cost of goods for the small instrument devices segment as a
percentage of revenues totaled 52% in 1998 and 1997.
 
     Marketing and selling expenses consist primarily of salaries, commissions
and related travel expenses of the Company's direct sales force, as well as
salaries for the marketing and distributor relations departments. Marketing and
selling expenses totaled $5.4 million for the year ended December 31, 1998, as
compared to $5.2 million for the prior year, an increase of $149,000 or 3%. The
increase is primarily due to increased promotion of the PowerGene genetic
analyzers. Marketing and selling expenses as a percentage of net revenues
amounted to 20% in 1998 and 19% in 1997.
 
     General and administrative expenses consist primarily of payroll costs
associated with the Company's management and support personnel, facilities
related costs and legal and accounting fees. General and administrative expenses
increased to $3.7 million for the year ended December 31, 1998 from $3.5
million, an increase of $162,000 or 5% over the prior year primarily due to
expansion of the Office of the Chief Executive, severance expenses and charges
associated with the repricing of options held by consultants. These increases
were partially offset by lower legal and accounting expenses. General and
administrative expenses as a percentage of net revenues totaled 13% in 1998 and
1997.
 
     Net research and development expenses consist of costs incurred for the
development of new products and improvements to existing products less
third-party reimbursements under joint development programs, grants and research
and development contracts. Net research and development expenses increased to
 
                                       20
<PAGE>   23
 
$2.4 million for the year ended December 31, 1998 from $2.1 million in the prior
year, an increase of $296,000 or 14%, due to increased expenditures and
decreased external funding under joint development programs. Net research and
development expenses as a percentage of net revenues amounted to 9% in 1998 and
8% in 1997. Reimbursements under joint development programs decreased to
$921,000 from $1.0 million. Total product technology expenditures, including
capitalized software development costs and reimbursed costs under research and
development grants and contracts, totaled to $3.7 million which is comparable to
the prior year.
 
     Amortization of intangible assets reflects the amortization of deferred
expenses for warrants issued in connection with joint development projects and
intangible assets arising from acquisitions and patents. Amortization of
intangible assets for the year ended December 31, 1998 decreased to $1.2 million
from $1.3 million, a decrease of $148,000 or 11% from the prior period. The
decline is primarily the result of the write-off in the fourth quarter of 1997
of goodwill from the digital refractometer product line acquired in 1995.
 
     The results of operations for the year ended December 31, 1998 include
unusual charges of $193,000 relating primarily to legal expenses for a pending
arbitration matter. See "Legal Proceedings." The unusual charges in the prior
year totaled $1.3 million and related primarily to the write-off of deferred
private offering expenses, goodwill no longer considered recoverable associated
with the digital refractometer product line and legal expenses.
 
     The net result of the above described changes was an increase in operating
income to $556,000 in 1998 as compared to $246,000 in the prior year.
 
     For the year ended December 31, 1998, urinalysis segment profits increased
to $2.9 million as compared to $2.7 million in the prior year, an increase of
$147,000 or 5%. This increase is largely attributable to increased sales of
related supplies and service described above, partially offset by a small
increase in operating expenses and lower system margins. Losses for the genetic
analysis segment totaled $2.7 million in 1998 as compared to losses of $1.9
million in the prior year, an increase of $837,000. The increased loss is due
primarily to the decrease in sales related to the non-recurrence of the
multi-system sale discussed above and gross margins for this segment, as well as
a modest increase in operating expenses. Segment profits from the small
laboratory devices segment totaled $1.1 million in 1998 as compared to $372,000
in 1997. The improvement is due to the increase in this segment's licensing
revenues and the write-off in 1997 of goodwill associated with the digital
refractometer product line. Unallocated corporate expenses totaled $1.7 million
in 1998 as compared to $2.0 million in the prior year, a decrease, of $275,000.
This is due to decreased unusual charges for deferred offering costs and legal
expenses as described above.
 
     The income tax benefit for the year ended December 31, 1998 totaled
$120,000 as compared to an income tax benefit of $293,000 for 1997. The income
tax benefit for the year ended December 31, 1998 differs from the federal
statutory rate due to state, local and foreign income taxes and permanent
differences between income reported for financial statement and income tax
purposes.
 
     The above factors contributed to a net loss of $385,000 or $0.06 per
diluted share for the year ended December 31, 1998 as compared to a net loss of
$503,000 or $0.16 per diluted share for the year ended December 31, 1997. The
decrease in the net loss per diluted share is due primarily to an imputed
dividend on the Series A Preferred Stock in 1997. In early 1997 the staff of the
Securities and Exchange Commission ("SEC staff") announced a new position on
accounting for convertible preferred stock which is potentially convertible at a
discount to the market price of the common stock, even if the potential for a
discount is only a possibility. The SEC staff has taken the position, that
solely for purposes of calculating earnings per share the potential discount is
an imputed dividend to the preferred stockholders, which reduces the amount of
earnings available to common stockholders. Accordingly, the issuance of the
Series A Preferred Stock resulted in a one-time reduction in earnings available
to common shareholders of $450,000 or $0.08 per share in first quarter of 1997.
The staff's position is limited to the calculation of earnings per share and did
not have any effect on the Company's net income or cash flow. See "-- Liquidity
and Capital Resources."
 
                                       21
<PAGE>   24
 
  Comparison of Year Ended December 31, 1997 to Year Ended December 31, 1996
 
     The consolidated financial statements for 1996 reflect the consummation of
the PSI Acquisition on July 31, 1996 which was accounted for using the purchase
method of accounting. Accordingly, the consolidated statements of operations
include the financial results of PSI for the entire 1997 fiscal year, but only
for the period from August 1 to December 31 for fiscal 1996.
 
     Net revenues for the year ended December 31, 1997 increased to $27.5
million from $20.6 million, an increase of $6.9 million or 33% over the prior
year. Sales of IVD systems increased to $11.8 million from $6.4 million, an
increase of $5.4 million or 86% over the prior year. The Company added the
PowerGene family of genetic analyzers to its product line in August 1996 as a
result of the PSI Acquisition. Of the 1997 increase in sales of IVD systems,
$4.0 million of the increase reflects the first full year of sales of the
PowerGene analyzer, which included a record $1.25 million multi-system sale, and
$1.4 million reflects increased sales of The Yellow IRIS. Sales of IVD imaging
system supplies and services increased to $10.6 million from $9.1 million, an
increase of $1.5 million or 16% over the prior year, due to the larger installed
base of IVD imaging systems and the conversion of The Yellow IRIS installed base
to the new CHEMSTRIP/IRIStrip urine test strips marketed exclusively by the
Company. Sales of small instruments and supplies decreased to $4.4 million from
$5.1 million, a decrease of $619,000 or 12%, over the prior year. The decrease
reflects lower sales levels of the StatSpin products to one of its distributors.
 
     Royalty and licensing revenue for the year ended December 31, 1997
increased to $603,000 from $43,000, an increase of $560,000 over the prior year.
The increase is primarily the result of increased royalties received, the
receipt of previously disputed royalties relating to the fourth quarter of 1996
and initial fees earned for the license of certain technology.
 
     Revenues from the urinalysis segment totaled $16.2 million for the year
ended December 31, 1997 as compared to $13.1 million in the prior year, an
increase of $3.1 million. This growth is due to the reasons noted above, as well
as improved licensing revenue for this segment. Revenues from the genetic
analysis segment increased to $6.8 million in 1997 as compared to $2.5 million
in the prior year for the reasons described above. Revenues from the small
laboratory devices segment decreased to $4.5 million from $5.1 million due to
lower sales to one distributor.
 
     Cost of goods for IVD systems as a percentage of their sales decreased to
51% for the year ended December 31, 1997 as compared to 54% in the prior year.
The decrease is primarily due to fixed costs being absorbed by increased sales
of The Yellow IRIS, partially offset by increased costs of goods sold relating
to the PowerGene analyzer sales. Cost of goods for IVD system supplies and
services decreased as a percentage of sales of such products to 50% for the year
ended December 31, 1997 from 56% for the prior year. This decrease is
principally due to decreased costs and increased sales prices. Cost of goods for
small instruments and supplies as a percentage of sales of small instruments and
supplies totaled 53% for the year ended December 31, 1997, and is comparable to
the prior year. The net result of these changes and increased royalties and
licensing revenues was an increase in gross margin for the year ended December
31, 1997 to 50%, as compared to 45% for the year ended December 31, 1996.
 
     Cost of goods sold as a percentage of revenues from the urinalysis segment
totaled 51% in 1997, as compared to 55% in 1996, primarily due to the
combination of increased sales of The Yellow IRIS and its related supplies and
services with a decrease in the cost of goods for the related supplies and
services. Cost of goods sold as a percentage of revenues from the genetic
analysis segment totaled 47% in 1997, as compared to 49% in the prior year. This
decrease is due to improved profit margins on service which were partially
offset by a decline in profit margins on the PowerGene instruments. Cost of
goods for the small instrument devices segment as a percentage of revenues
totaled 52% in 1997 and 53% in 1996.
 
     Marketing and selling expenses increased to $5.2 million for the year ended
December 31, 1997 from $4.6 million, an increase of $597,000 or 13% over the
prior year, primarily due to the addition of the sales force from the PSI
Acquisition partially offset by decreased marketing and selling expenses related
to The Yellow IRIS. Marketing and selling expenses as a percentage of net
revenues decreased from 22% in the prior year to 19% in the current year.
 
                                       22
<PAGE>   25
 
     General and administrative expenses increased to $3.5 million for the year
ended December 31, 1997 from $3.3 million, an increase of $243,000 or 7% over
the comparable period in the prior year. This increase is the result of the
addition of administrative functions following the PSI Acquisition, partially
offset by decreased expenses resulting from the restructuring implemented in the
fourth quarter of 1996 and decreased acquisition activities in the current year.
General and administrative expenses as a percentage of net revenues decreased
from 16% for 1996 to 13% for the current year.
 
     Net research and development expenses increased to $2.1 million for the
year ended December 31, 1997 from $2.0 million, an increase of $147,000 or 7%
over the prior year, and decreased as a percentage of net revenues from 10% to
8%. Reimbursements under joint development programs decreased to $1.0 million in
1997 from $1.8 million in 1996. Total product technology expenditures decreased
to $3.7 million from $4.3 million, a decrease of $660,000 or 15% over the prior
year, due primarily to reduced spending on the development of The White IRIS and
decreased expenditures on the products under joint development with Poly UA
Systems, Inc., partially offset by the addition of research and development
staff from the PSI Acquisition.
 
     Amortization of intangible assets for the year ended December 31, 1997
increased to $1.3 million from $794,000, an increase of $515,000 or 65% over the
prior year, primarily as a result of the acquisition of intangible assets in the
PSI Acquisition and a small product line acquisition.
 
     The results of operations for the year ended December 31, 1997 include
certain unusual charges to earnings of $1.3 million, primarily for the write-off
in the fourth quarter of deferred private offering expenses ($481,000), goodwill
no longer considered recoverable associated with the digital refractometer line
of business ($705,000) and legal expenses ($152,000) relating to a completed
patent litigation matter and the pending arbitration matter against Digital
Imaging Technologies, Inc. See "Legal Proceedings." The unusual charges in the
prior year totaled $1.9 million and related primarily to the write-off of
deferred public offering costs ($686,000), litigation expense ($617,000),
restructuring charges ($298,000) and merger related expenses ($244,000).
 
     Acquisition of in-process research and development charges for the year
ended December 31, 1996 amounted to $7.3 million. No similar charge was incurred
in 1997.
 
     The net result of the above described changes was an increase in operating
income in fiscal 1997 to $246,000 as compared to an operating loss of $10.4
million in the prior year.
 
     Interest income decreased to $57,000 for the year ended December 31, 1997
from $222,000 for the prior year, primarily as the result of decreased amounts
of invested cash in 1997.
 
     Interest expense increased to $1.2 million for the year ended December 31,
1997 from $681,000 for the prior year due to the indebtedness incurred to
finance the PSI Acquisition and increased interest rates on bank debt.
 
     Other income increased primarily due to the receipt of government grant
funds for reimbursement of expenses incurred in prior periods.
 
     For the year ended December 31, 1997, urinalysis segment profits increased
to $2.7 million as compared to a loss of $717,000 in the prior year, an increase
of $3.4 million or 479%. This increase is attributable to increased revenues, a
decline in unusual charges and lower operating costs following a restructuring
in the fourth quarter of 1996. Losses for the genetic analysis segment totaled
$1.9 million in 1997 as compared to losses of $8.7 million in the prior year, an
improvement of $6.8 million or 78%. The improvement is due primarily to
write-off in 1996 of in-process research and development in connection with the
PSI Acquisition. Segment profits from the small laboratory devices segment
totaled $372,000 in 1998 as compared to $985,000 in 1997, a decline of $613,000
or 62%. The change is due to the write-off in 1997 of goodwill associated with
the digital refractometer product line. Unallocated corporate expenses totaled
$2.0 million in 1997 as compared to $2.4 million in the prior year, a decrease
of $469,000 or 19%. This is due primarily to decreased unusual charges.
 
                                       23
<PAGE>   26
 
     The income tax benefit for the year ended December 31, 1997 was $293,000,
as compared to an income tax benefit of $3.5 million for 1996. The income tax
benefit for the year ended December 31, 1997 differs from the federal statutory
rate due to state, local and foreign income taxes and permanent differences
between income reported for the financial statement and income tax purposes.
 
     The above factors contributed to a net loss of $503,000. However, due to
the imputed dividend resulting from the issuance of the Series A Preferred Stock
discussed above, the loss per common share based upon the net loss attributable
to common stockholders of $953,000 amounted to $0.16 per share for the year
ended December 31, 1997 as compared to a net loss of $7.4 million or $1.21 per
share for the year ended December 31, 1996. Excluding the effect of unusual
charges, adjustment to the deferred tax valuation allowance and charges for the
acquisition of in-process research and development from the PSI Acquisition, the
Company would have had net loss attributable to common stockholders of $108,000
or $0.02 per share for the year ended December 31, 1997, as compared to a net
loss of $1.5 million, or $0.24 per share, for the year ended December 31, 1996.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     Cash and cash equivalents decreased to $389,000 at December 31, 1998 from
$1.5 million at December 31, 1997. The decrease is due to a decline in cash
provided by operations and increased cash used by investing activities.
 
     Cash provided by operations for the year ended December 31, 1998 decreased
to $960,000 from $2.0 million for the prior year. This decline is primarily due
to an increase in cash operating expenses, a decrease in gross margins,
increases in accounts receivable caused by a shift in the timing of system
sales, an increase in inventories and an increase in long-term sales-type leases
not sold to a third party. These increases were partially offset by increases in
accounts payable.
 
     Cash used by investing activities totaled $1.2 million for the year ended
December 31, 1998, as compared to $872,000 in the prior year. The increase is
primarily due to the conversion of short-term investments into cash during 1997.
Expenditures for property and equipment, including the cost of equipment leased
under short term rental agreements, totaled $1.0 million in 1998 as compared to
$950,000 in 1997. Expenditures for capitalized software development totaled
$353,000 in 1998 as compared to $535,000 in 1997. The Company does not presently
have any material commitments for capital expenditures, and it anticipates that
expenditures for property and equipment will decline in 1999.
 
     On May 8, 1998, the Company refinanced its bank loans with the proceeds of
a new credit facility from Foothill Capital Corporation. The credit facility
consists of a $3.6 million term loan and a $4.0 million revolving line of
credit. Borrowings under the revolving line of credit are limited to a
percentage of eligible accounts receivable, and the credit facility has a
combined limit of $7.0 million for the term loan and revolving line of credit.
The term loan bears interest at the lender's prime rate (7.75% on December 31,
1998) plus 3.0% and is payable in 36 equal monthly installments. The revolving
line of credit bears interest at the lender's prime rate plus 1.0%. The credit
facility matures in 2001 and is collateralized by a first priority lien on all
the assets of the Company. The credit facility is subject to minimum interest
charges, prepayment penalties and customary fees and imposes restrictions on
acquisitions, capital expenditures and cash dividends. It also contains
financial covenants based primarily on tangible net worth and cash flow. The
Company was not in compliance with one of the financial covenants at year end,
and the credit facility was subsequently amended to waive the non-compliance and
modify the financial covenants for future periods.
 
     Net cash used by financing activities totaled $880,000 and consisted
primarily of principal payments made in connection with the refinanced bank
loan, partially offset by proceeds from the new credit facility and proceeds
from the issuance of common stock. As of December 31, 1998, the Company had $2.9
million outstanding under the term loan and $465,000 outstanding under the
revolving line of credit. The Company had $1.2 million available under the
revolving credit line as of that date.
 
     As of December 31, 1998, the Company had outstanding (1) a $7.0 million
senior subordinated note issued to DITI in connection with the PSI Acquisition
and (2) notes payable in the aggregate amount of $542,000 from the repurchase of
common stock and warrants from a former strategic partner in 1996. The senior
subordinated note issued to DITI bears interest at the rate of 8.5%, and the
principal is all due upon
 
                                       24
<PAGE>   27
 
maturity on July 31, 2001. The notes issued to the former strategic partner bear
interest at the rate of 8.0%, and principal is due in bi-monthly installments of
$100,000.
 
     Assuming constant interest rates, the Company has minimum payments for
principal and interest on outstanding debt obligations totaling $2.8 million in
1999, $2.0 million in 2000 and $7.9 million in 2001. The Company believes that
its current cash on hand, together with cash expected from operations and cash
available under the credit facility, will be sufficient to fund normal
operations and pay principal and interest on outstanding debt obligations
through 2000. The Company will require additional outside capital to pay all or
a portion of the $7.0 principal payment due in July 2001 under the subordinated
note delivered to DITI as partial payment for the PSI Acquisition. The Company
has postponed its fundraising efforts pending resolution of its claims against
DITI through arbitration. See "Legal Proceedings."
 
     The FDA cleared The White IRIS leukocyte differential analyzer in May 1996,
but its commercial release was subsequently delayed by other priorities such as
the introductions of the Model 900UDx urine pathology system and the UF-100
urine cell analyzer. The Company has elected not to launch The White IRIS at the
present time due to limited resources and the potential impact of product launch
costs on near-term profitability. The Company plans to explore strategic
alternatives for The White IRIS program and therefore cannot reasonably estimate
any impact on the recoverability of the capitalized costs associated with the
product line, principally capitalized software and inventory. If the Company is
unable to develop a viable strategic alternative for the program and as a result
abandons the product line, it would incur a charge against future earnings of up
to $1.2 million for the related amounts capitalized.
 
     In September 1995, the Company and Poly U/A Systems Inc., a
Company-sponsored research and development entity, entered into a joint
development project for the development of several new products to enhance
automated urinalysis using the Company's technology. Poly UA funded most of the
cost of the project with the net proceeds from a 1995 private placement of
units, each unit consisting of shares of Poly UA common stock and warrants to
purchase common stock of the Company. The Company contributed $500,000 toward
the cost of the project. During 1998, the Company and Poly UA satisfied their
funding commitment on this project, and no further development work is planned
at this time. The Company had an option until November 29, 1998 to acquire all
of the common stock of Poly UA for an aggregate price of $5.1 million, payable
in cash or shares of the Company's common stock.
 
     The Company decided not to exercise its option but entered into ongoing
discussions to acquire Poly UA at a price below the option price. The Company
cannot predict whether these discussions will lead to mutually acceptable terms
for an acquisition. If the Company acquires Poly in a negotiated transaction, it
may result in a charge against then current earnings and additional dilution to
common stockholders.
 
     The Company has outstanding 3,000 shares of Series A Convertible Preferred
Stock ("Preferred Stock"). Each share of Preferred Stock is convertible into a
number of shares of common stock equal to (i) its $1,000 liquidation value
divided by (ii) a variable conversion price. The conversion price equals the
lower of (a) $3.56 per share or (b) 85% of the average closing bid price of the
common stock for the five consecutive trading days preceding the conversion (but
in no event less than $1.50). Assuming conversion prices of $3.56 and $1.50 per
share, the Preferred Stock is convertible into approximately 843,000 and
2,000,000 shares of Common Stock, respectively. Based on the average closing
price of $0.73 for the five-day period ending March 19, 1999, the conversion
price would be the minimum of $1.50, and the Preferred Stock would convert into
2,000,000 shares of common stock. Any unconverted shares of Preferred Stock will
automatically be converted into Common Stock on December 31, 1999. The Preferred
Stock is non-voting, is not entitled to any preferred dividends and is not
subject to any mandatory or optional redemption provisions. The Company may not
pay cash dividends on the Common Stock or repurchase any shares of the Common
Stock without the written consent of the holder of the Preferred Stock.
 
YEAR 2000 PROBLEM
 
     The Year 2000 ("Y2K") problem arose because many existing computer programs
use only the last two digits to recognize a year. Therefore, when the year 2000
arrives, these programs may not properly recognize a year beginning with "2000"
instead of the familiar "1900". The Y2K problem may result in the improper
processing of dates and date-sensitive calculations by computers and other
microprocessor-controlled equipment as the year 2000 is approached and reached.
 
                                       25
<PAGE>   28
 
  State of Readiness
 
     The Company has divided its review of Y2K problems into three major areas:
(1) internal systems, (2) Company products, including components supplied by
outside vendors, and (3) potential Y2K problems associated with outside vendors.
 
     The Company has focused most of its Y2K efforts on internal systems because
it believes this area could be its primary source of Y2K problems. The Company's
internal computer systems are the foundation for its business operations and
include such critical functions as order entry, shipping, purchasing, inventory
control, manufacturing, accounts receivable, accounts payable and the general
ledger. The Company has completed a review of these critical systems and has
determined that they are not Y2K compliant. These systems are supported by third
parties who currently have software updates available at reasonable prices. The
Company has purchased and installed these updates. Although the vendors have
certified the updates as Y2K compliant, the Company plans to test the updates on
its systems by June 30, 1999. The Company is also in the process of reviewing
other equipment that contains date-sensitive information. The Company expects to
complete its review of all other internal systems by June 30, 1999 and does not
expect this review to uncover a risk of a material adverse effect on its
operations from Y2K problems in this area.
 
     The Company has reviewed its products and has determined that the IVD
imaging systems produced by the urinalysis and genetics segments have date
sensitive fields or components that have date sensitive fields. Based on
completed verification and validation testing and, if applicable, certificates
received from third party vendors, the Company has concluded that all the
genetic segment IVD imaging systems, the unattended urinalysis IVD imaging
system (the Model 900UDx urinalysis workstation) and the UF-100 urine cell
analyzer are Y2K compliant. The Company has also determined that there are no
date sensitive fields contained in the products of the small instruments
segment. The Company has determined that the unattended IVD imaging systems
produced by the urinalysis segment (Models Bravo, 250, 300, 450 and 500
urinalysis workstations) have date sensitive fields. The Company has completed
work on the software updates to make these products Y2K compliant, including
verification and validation of these software updates. The Company expects to be
distributing these software updates by April 30, 1999.
 
     The Company has completed a review of outside vendor's products that
interface with the Company's and has determined that the Company's products need
no further modification to interface with the products of these vendors. The
Company is also in the process of identifying any potential Y2K problems from
other outside vendors whose systems interface with the Company's internal
systems. The Company expects to complete this review by June 30, 1999.
 
     Based on a preliminary review of the Y2K problem associated with outside
vendors, the Company does not expect this issue to have a material adverse
effect on its operations. However, since third-party Y2K compliance is not
within the Company's control, the Company cannot assure stockholders that Y2K
problems affecting the systems of other companies on which the Company's systems
rely will not have a material adverse effect on the Company's operations.
 
  Costs to Address the Y2K Issue
 
     Costs to address the Y2K problem include hardware, software, and
implementation costs for internal work and outside consultants and are estimated
at $175,000. To date, the Company has incurred approximately $125,000 of these
costs, the majority of which have been expensed. The Company estimates that the
cost to complete its Y2K work at less than $50,000, most of which will relate to
completing the verification and validation of Y2K software updates for the IVD
imaging systems for its urinalysis segment.
 
  Risks Presented by the Year 2000 Issue
 
     To date, the Company has not identified any Y2K problem that it believes
could materially adversely affect the Company or for which a suitable solution
cannot be timely implemented. However, as the review of its interfaces with
other outside vendors progresses and the verification and validation of changes
made to the urinalysis segment's unattended IVD imaging systems is completed, it
is possible that Y2K problems may be
 
                                       26
<PAGE>   29
 
identified that could result in a material adverse effect on its operations.
Also, the Company's credit facility with Foothill Capital Corporation requires
that it be Y2K compliant by October 1, 1999. If the Company is unable to
complete this work by that time, the Company would have to seek a waiver or
extension of this requirement.
 
     The Company cannot control Y2K planning and compliance by its customers and
cannot predict the extent to which the Y2K problem will affect them in their
business dealings with the Company. If customers are not adequately prepared for
the Y2K problem, the subsequent crisis could temporarily divert their financial
and management resources away from normal capital planning and temporarily
depress sales of high-priced instruments such as The Yellow IRIS urinalysis
workstations and the PowerGene genetic analyzers. This could have a material
adverse effect on the Company's revenues and profits. The Y2K problem may also
have a material adverse effect on the Company's cash flow if customer payments
are delayed significantly due to Y2K problems in its customers' accounting
departments.
 
  Contingency Plans
 
     Although the Company has not formulated a contingency plan to date, the
Company intends to continue to assess its Y2K risks to determine whether it
needs to do so. The Company will develop a contingency plan if its
implementation of internal systems, ongoing review of other outside vendors or
verification and validation of the urinalysis segment unattended IVD imaging
systems identify a Y2K problem that poses a significant risk to its business
operations.
 
MARKET RISK
 
     The Company is exposed to various market risks, including changes in
interest rates and foreign currency exchange rates. Market risk is the potential
loss arising from adverse changes in market rates and prices, such as interest
rates and foreign currency exchange rates. The Company does not enter into
derivatives or other financial instruments for trading or speculative purposes.
 
  Interest Rates
 
     The Company relies significantly on long- and short-term fixed and variable
rate debt in its capital structure. The Company does not use interest rate swaps
to manage any of its floating-rate debt obligations. As of December 31, 1998,
the Company's debt obligations consisted of (1) $7.0 million outstanding under
an 8.5% fixed rate subordinated note, (2) $2.9 million outstanding under a
variable rate term loan, (3) $465,000 outstanding under a variable rate
revolving line of credit and (4) $542,000 outstanding under fixed rate notes
issued to a former strategic partner. The variable rate obligations are based
upon the lender's prime rate. See "-- Liquidity and Capital Resources." Assuming
an increase of one-half of a percentage point in the lender's prime rate on
January 1, 1999 and no principal payments for the remainder of the year, the
Company's total interest expense would increase by less than $20,000 for 1999 as
compared to 1998.
 
  Foreign Currencies
 
     The Company has a subsidiary in the United Kingdom which conducts
operations outside the Americas. The U.K. Subsidiary purchases and sells
products in various currencies. As a result, the Company is exposed to foreign
currency gains and losses, and the U.K. subsidiary is exposed to cost increases
relative to local currencies in the markets in which it sells. For 1998, a
hypothetical 10% strengthening of the U.S. dollar relative to the foreign
currencies in which the U.K. subsidiary operates would not have been material.
The Company is also subject to some currency risk on a portion of its licensing
revenues. This portion is calculated quarterly based on sales results in
Japanese Yen and subsequently converted into United States dollars at the then
current exchange rate.
 
INFLATION
 
     The Company does not foresee any material impact on its operations from
inflation.
 
                                       27
<PAGE>   30
 
HEALTHCARE REFORM POLICIES
 
     In recent years, an increasing number of legislative proposals have been
introduced or proposed in Congress and in some state legislatures that would
effect major changes in the healthcare system, nationally, at the state level or
both. Future legislation, regulation or payment policies of Medicare, Medicaid,
private health insurance plans, health maintenance organizations and other
third-party payors could adversely affect the demand for the Company's current
or future products and its ability to sell its products on a profitable basis.
Moreover, healthcare legislation is an area of extensive and dynamic change, and
the Company cannot predict future legislative changes in the healthcare field or
their impact on its business.
 
FORWARD-LOOKING STATEMENTS
 
     The foregoing discussion, as well as the other sections of this Annual
Report on Form 10-K, contain various forward-looking statements which reflect
the Company's current views with respect to future events and financial results
and are subject to the safe harbor created by that Private Securities Litigation
Reform Act of 1995. These forward-looking statements include, but are not
limited to, the Company's views with respect to future financial results,
financing sources, capital requirements, market growth, new product
introductions and the like, and are generally identified by phrases such as
"anticipates," "believes," "estimates," "expects," "intends," "plans" and words
of similar import. The Company reminds stockholders that forward-looking
statements are merely predictions and therefore inherently subject to
uncertainties and other factors which could cause the actual results to differ
materially from the forward-looking statement. These uncertainties and other
factors include, among other things, (i) the ability of the Company to secure
additional financing to repay the remaining principal balance of its long-term
debt and to fund its long-term business strategy, (ii) unexpected technical and
marketing difficulties inherent in the introduction of sophisticated,
capital-intensive new medical instruments, (iii) the potential need for changes
in the Company's long-term strategy in response to future developments, (iv)
future advances in diagnostic testing methods and procedures, as well as
potential changes in government regulations and healthcare policies, both of
which could adversely affect the economics of the diagnostic testing procedures
automated by the Company's products, (v) rapid technological change in the
microelectronics and software industries, (vi) increasing competition from
imaging and non-imaging based in-vitro diagnostic products and (vii)
difficulties in assimilating acquired companies and product lines.
 
     The Company has attempted to identify additional significant uncertainties
and other factors affecting forward-looking statements elsewhere in this annual
report. See "Business -- Forward-Looking Statements."
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
     See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Market Risk."
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     The financial statements are listed in the Index to Financial Statements in
Part IV, Item 14(a)1.
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
     None.
 
                                       28
<PAGE>   31
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     Incorporated by reference from "Directors and Executive Officers" in the
Proxy Statement to be filed with the Securities and Exchange Commission for the
1999 Annual Meeting of IRIS Stockholders.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     Incorporated by reference from "Executive Compensation" in the Proxy
Statement to be filed with the Securities and Exchange Commission for the 1999
Annual Meeting of IRIS Stockholders.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     Incorporated by reference from "Security Ownership of Certain Beneficial
Owners and Management" in the Proxy Statement to be filed with the Securities
and Exchange Commission for the 1999 Annual Meeting of IRIS Stockholders.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     Incorporated by reference from "Certain Relationships and Related
Transactions" in the Proxy Statement to be filed with the Securities and
Exchange Commission for the 1999 Annual Meeting of IRIS Stockholders.
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
(a) The following documents are filed as a part of this report:
 
<TABLE>
<CAPTION>
                                                                       PAGE
                                                                       ----
    <S>  <C>                                                           <C>
    1.   INDEX TO FINANCIAL STATEMENTS
           Report of Independent Public Accountants..................    35
           Consolidated Balance Sheets at December 31, 1998 and
              1997...................................................    36
           Consolidated Statements of Operations for the Years Ended
              December 31, 1998, 1997, and 1996......................    37
           Consolidated Statements of Shareholders' Equity for the
              Years Ended December 31, 1998, 1997, and 1996..........    38
           Consolidated Statements of Cash Flows for the Years Ended
              December 31, 1998, 1997 and 1996.......................    39
           Consolidated Statements of Comprehensive Income for the
              Years Ended December 31, 1998, 1997 and 1996...........    40
           Notes to Consolidated Financial Statements................    41
    2.   FINANCIAL STATEMENT SCHEDULES COVERED BY THE FOREGOING
           REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
           Schedule II -- Valuation and Qualifying Accounts..........    61
</TABLE>
 
     Other financial statement schedules have been omitted since they are not
required, are not applicable, or the required information is shown in the
Financial Statements or Related Notes.
 
                                       29
<PAGE>   32
 
     3. EXHIBITS
 
<TABLE>
<CAPTION>
EXHIBIT
 NUMBER                           DESCRIPTION
--------                          -----------
<S>       <C>
3.1(a)    Certificate of Incorporation, as amended(1)
3.1(b)    Certificate of Designations of Series A Convertible
          Preferred Stock(2)
3.2       Restated Bylaws(3)
4.1       Specimen of Common Stock Certificate(4)
4.2       Certificate of Designations of Series A Convertible
          Preferred Stock(2)
10.1      Lease of the Company's headquarters facility, as amended(5)
10.2(a)   1982 Stock Option Plans and form of Stock Option
          Agreement(6)
10.2(b)   1983 and 1986 Stock Option Plans, and forms of Stock Option
          Agreements for each Plan(7)
10.2(c)   Amended and Restated 1986 Stock Option Plan(8)
10.2(d)   1994 Stock Option Plan and forms of Stock Option
          Agreements(9)
10.2(e)   Certificate of Officer With Respect to Amendment of 1994
          Stock Option Plan(10)
10.2(f)   Key Employee Stock Purchase Plan(11)
10.2(g)   1997 Stock Option Plan and form of Stock Option
          Agreement(12)
10.3(h)   1998 Stock Option Plan and form of Stock Option
          Agreement(13)
10.3(a)   Various Agreements with Sysmex Corporation, formerly TOA
          Medical Electronics Company, Ltd.(14)
10.3(b)   Patent License Agreement dated April 1, 1997 between the
          Company and Sysmex Corporation, formerly TOA Medical
          Electronics Company, Ltd.(15)
10.3(c)   Termination, Release and Reassignment of Security Interest
          dated October 30, 1997 executed by Sysmex Corporation,
          formerly TOA Medical Electronics Company, Ltd. in favor of
          the Company(15)
10.4(a)   Agreement for a Strategic Alliance in Urinalysis dated
          January 7, 1994 between the Company and Boehringer Mannheim
          Corporation(16)
10.4(b)   Research and Development and Distribution Agreement dated
          February 6, 1995 by and among the Company, LDA Systems, Inc.
          and Corange International Limited(16)
10.4(c)   Amendment to Distribution Agreements(17)
10.5      Warrant Certificate dated March 20, 1995 issued to
          Biovation, Inc.(16)
10.6(a)   Technology License Agreement dated as of September 29, 1995
          between the Company and Poly U/A Systems, Inc.(18)
10.6(b)   Research and Development Agreement dated as of September 29,
          1995 between the Company and Poly U/A Systems, Inc.(18)
10.6(c)   $100 Class "A" Note dated September 29, 1995 issued by Poly
          U/A Systems, Inc. in favor of the Company(18)
10.6(d)   Certificate of Incorporation of Poly U/A Systems, Inc. (See
          Article FOUR regarding the IRIS Option)(18)
10.6(e)   Form of Series D Warrant(15)
10.6(f)   Form of Series E Warrant(15)
10.6(g)   Form of Series F Warrant(15)
10.7(a)   Agreement and Plan of Merger dated January 31, 1996 between
          the Company and StatSpin, Inc.(19)
10.7(b)   Registration Rights Agreement dated January 31, 1996 between
          the Company and StatSpin Stockholders(19)
</TABLE>
 
                                       30
<PAGE>   33
 
<TABLE>
<CAPTION>
EXHIBIT
 NUMBER                           DESCRIPTION
--------                          -----------
<S>       <C>
10.7(c)   Employment Agreement dated January 30, 1996 with Thomas F.
          Kelley(19)
10.7(d)   Letter Agreement dated October 4, 1997 amending Employment
          Agreement of Thomas F. Kelley(15)
10.8(a)   Asset Purchase Agreement dated as of July 15, 1996 by and
          among the Company, Digital Imaging Technologies, Inc.,
          Perceptive Scientific Instruments, Inc. and Perceptive
          Scientific Technologies, Inc.(20)
10.8(b)   Registration Rights and Standstill Agreement dated July 31,
          1996 between the Company and Digital Imaging Technologies,
          Inc.(10)
10.8(c)   Warrant Certificate dated July 31, 1996 issued to Digital
          Imaging Technologies, Inc.(10)
10.8(d)   Stockholder Guaranty Agreement dated July 31, 1996 between
          Edward Randall, III and PSII Acquisition Corp., a
          wholly-owned subsidiary of the Company (now known as
          Perceptive Scientific Instruments, Inc.)(10)
10.8(e)   Non-Competition Agreement dated as of July 15, 1996 between
          Edward Randall, III and PSII Acquisition Corp., a
          wholly-owned subsidiary of the Company (now known as
          Perceptive Scientific Instruments, Inc.)(10)
10.8(f)   Technology License Agreement dated July 31, 1996 between
          Perceptive Scientific Imaging Systems, Inc. and PSII
          Acquisition Corp., a wholly-owned subsidiary of the Company
          (now known as Perceptive Scientific Instruments, Inc.)(10)
10.9      $7,000,000 Subordinated Note dated July 29, 1996 issued by
          the Company in favor of Digital Imaging Technologies,
          Inc.(10)
10.10(a)  Loan and Security Agreement dated as of May 5, 1998 among
          the Company, Perceptive Scientific Instruments, Inc., and
          StatSpin, Inc., on the one hand, and Foothill Capital
          Corporation, on the other hand.(21)
10.10(b)  Intellectual Property Security Agreement dated as of May 5,
          1998 between the Company and Foothill Capital
          Corporation(21)
10.10(c)  Copyright Security Agreement dated as of May 5, 1998 between
          the Company and Foothill Capital Corporation(21)
10.10(d)  Intellectual Property Security Agreement dated as of May 5,
          1998 between Perceptive Scientific Instruments, Inc. and
          Foothill Capital Corporation(21)
10.10(e)  Copyright Security Agreement dated as of May 5, 1998 between
          Perceptive Scientific Instruments, Inc. and Foothill Capital
          Corporation(21)
10.10(f)  Security Agreement -- Stock Pledge dated as of May 5, 1998
          between Perceptive Scientific Instruments, Inc. and Foothill
          Capital Corporation(21)
10.10(g)  Intellectual Property Security Agreement dated as of May 5,
          1998 between StatSpin, Inc. and Foothill Capital
          Corporation(21)
10.10(h)  Amendment Number One to Loan and Security Agreement dated as
          of March 23, 1999 among the Company, Perceptive Scientific
          Instruments, LLC, and StatSpin, Inc., on the one hand, and
          Foothill Capital Corporation, on the other hand
10.10(i)  Amendment Number One to Security Agreement -- Stock Pledge
          dated as of March 23, 1999 among the Company and Perceptive
          Scientific Instruments, LLC, on the one hand, and Foothill
          Capital Corporation, on the other hand
10.10(j)  Amendment to Copyright Security Agreement dated as of March
          23, 1999 among the Company and Perceptive Scientific
          Instruments, LLC, on the one hand, and Foothill Capital
          Corporation, on the other hand
</TABLE>
 
                                       31
<PAGE>   34
 
<TABLE>
<CAPTION>
EXHIBIT
 NUMBER                           DESCRIPTION
--------                          -----------
<S>       <C>
10.10(k)  Amendment to Intellectual Property Security Agreement dated
          as of March 23, 1999 among the Company and Perceptive
          Scientific Instruments, LLC, on the one hand, and Foothill
          Capital Corporation, on the other hand
10.10(l)  Amendment Number Two to Loan and Security Agreement dated as
          of March 19, 1999 among the Company, Perceptive Scientific
          Instruments, LLC, and StatSpin, Inc., on the one hand, and
          Foothill Capital Corporation, on the other hand
10.10(m)  Warrant to Purchase Common Stock dated June 1, 1997 issued
          to City National Bank(15)
10.10(n)  Warrant to Purchase Common Stock dated July 1, 1997 issued
          to City National Bank(15)
10.10(o)  Warrant to Purchase Common Stock dated March 15, 1997 issued
          to City National Bank(22)
10.11(a)  Securities Purchase Agreement dated December 31, 1996 by and
          between the Company and Thermo Amex Convertible Growth Fund
          I, L.P.(2)
10.11(b)  Common Stock Purchase Warrant dated December 31, 1996 issued
          to Thermo Amex Convertible Growth Fund I, L.P.(2)
10.11(c)  Registration Rights Agreement dated December 31, 1996 by and
          between the Company and Thermo Amex Convertible Growth Fund
          I, L.P.(2)
24        Consent of PricewaterhouseCoopers LLP
27        Financial Data Schedule 1998
</TABLE>
 
     Exhibits followed by a number in parenthesis are incorporated by reference
to the similarly numbered Company document cited below:
---------------
      (1) Current Report on Form 8-K dated August 13, 1987 and Quarterly Report
          on Form 10-Q for the quarter ended September 30, 1993.
 
      (2) Current Report on Form 8-K dated January 15, 1997.
 
      (3) Quarterly Report on Form 10-Q for the quarter ended September 30,
          1994.
 
      (4) Registration Statement on Form S-3, as filed with the Securities and
          Exchange Commission on March 27, 1996 (File No. 333-002001).
 
      (5) Annual Report on Form 10-K for the year ended December 31, 1989,
          Quarterly Report on Form 10-Q for the quarter ended September 30, 1993
          and Annual Report on Form 10-K for the year ended December 31, 1994.
 
      (6) Registration Statement on Form S-2, as filed with the Securities and
          Exchange Commission on September 4, 1985 (File No. 2-99240).
 
      (7) Registration Statement on Form S-8, as filed with the Securities and
          Exchange Commission on May 10, 1982 (File No. 2-77496).
 
      (8) Annual Report on Form 10-K for the year ended December 31, 1992.
 
      (9) Registration Statement on Form S-8, as filed with the Securities and
          Exchange Commission on August 8, 1994 (File No. 33-82560).
 
     (10) Quarterly Report on Form 10-Q for the quarter ended June 30, 1996.
 
     (11) Registration Statement on Form S-8, as filed with the Securities and
          Exchange Commission on January 3, 1997 (File No. 333-19265).
 
     (12) Registration Statement on Form S-8, as filed with the Securities and
          Exchange Commission on July 16, 1997 (File No. 333-31393).
 
     (13) Registration Statement on Form S-8, as filed with the Securities and
          Exchange Commission on October 9, 1998 (File No. 333-65547).
 
     (14) Current Report on Form 8-K dated July 15, 1988 and Quarterly Report on
          Form 10-Q for the quarter ended June 30, 1995.
 
                                       32
<PAGE>   35
 
     (15) Annual Report on Form 10-K for the year ended December 31, 1997.
 
     (16) Annual Report on Form 10-K for the year ended December 31, 1994.
 
     (17) Quarterly Report on Form 10-Q for the quarter ended September 30,
          1996.
 
     (18) Quarterly Report on Form 10-Q for the quarter ended September 31,
          1995.
 
     (19) Annual Report on Form 10-K for the year ended December 31, 1995.
 
     (20) Current Report on Form 8-K filed July 17, 1996.
 
     (21) Quarterly Report on Form 10-Q for the quarter ended March 31, 1998.
 
     (22) Annual Report on Form 10-K for the year ended December 31, 1996.
 
(b)  Reports on Form 8-K.
 
       None
 
(c)  See (a)(3) above.
 
(d)  See (a)(1) and (2) above.
 
                                       33
<PAGE>   36
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 of the Securities Exchange Act
of 1934, the Registrant has duly caused this report on Form 10-K to be signed on
its behalf by the undersigned, thereunto duly authorized, in Chatsworth,
California, on March 31, 1999.
 
                                               INTERNATIONAL REMOTE IMAGING
                                                      SYSTEMS, INC.
 
                                          By: /s/  FRED H. DEINDOERFER
 
                                            ------------------------------------
                                                    Fred H. Deindoerfer
                                             Chairman of the Board of Directors
                                             President and Member of the Office
                                                   of the Chief Executive
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
                      SIGNATURE                                     TITLE                    DATE
                      ---------                                     -----                    ----
<S>                                                      <C>                            <C>
 
               /s/ FRED H. DEINDOERFER                    Chairman of the Board of      March 31, 1999
-----------------------------------------------------     Directors, President and
                 Fred H. Deindoerfer                     Member of the Office of the
                                                               Chief Executive
 
                /s/ JOHN A. O'MALLEY                     Director and Member of the     March 31, 1999
-----------------------------------------------------        Office of the Chief
                  John A. O'Malley                                Executive
 
                   /s/ ROLAND JANG                       Member of the Office of the    March 31, 1999
-----------------------------------------------------          Chief Executive
                     Roland Jang
 
               /s/ MARTIN S. MCDERMUT                    Vice President Finance and     March 31, 1999
-----------------------------------------------------    Administration, Secretary,
                 Martin S. McDermut                      and Chief Financial Officer
 
                /s/ DONALD E. HORACEK                       Assistant Secretary,        March 31, 1999
-----------------------------------------------------     Controller, and Principal
                  Donald E. Horacek                          Accounting Officer
 
                /s/ STEVEN M. BESBECK                             Director              March 31, 1999
-----------------------------------------------------
                  Steven M. Besbeck
 
                /s/ THOMAS F. KELLEY                              Director              March 31, 1999
-----------------------------------------------------
                  Thomas F. Kelley
 
                /s/ RICHARD G. NADEAU                             Director              March 31, 1999
-----------------------------------------------------
                  Richard G. Nadeau
</TABLE>
 
                                       34
<PAGE>   37
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
To the Board of Directors and Stockholders
of International Remote Imaging Systems, Inc.
 
     In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)1 present fairly, in all material respects, the
financial position of International Remote Imaging Systems, Inc., and its
subsidiaries at December 31, 1998 and 1997, and the results of their operations
and their cash flows for the three years ended December 31, 1998, in conformity
with generally accepted accounting principles. In addition, in our opinion, the
financial statement schedule listed in the index appearing under Item 14(a)2
presents fairly, in all material respects, the information set forth therein
when read in conjunction with the related consolidated financial statements.
These financial statements and financial statement schedule are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements and financial statement schedule based on
our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which 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,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.
 
/s/ PricewaterhouseCoopers LLP
 
Los Angeles, California
March 11, 1999
 
                                       35
<PAGE>   38
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                                    AT DECEMBER 31,
                                                              ----------------------------
                                                                  1997            1998
                                                              ------------    ------------
<S>                                                           <C>             <C>
Current assets:
Cash and cash equivalents...................................  $  1,470,861    $    389,495
Short-term investments......................................        25,000              --
Accounts receivable, net of allowance for doubtful accounts
  of
  $267,579 in 1997 and $271,544 in 1998.....................     5,319,539       5,615,799
Inventories.................................................     3,739,483       4,503,446
Prepaid expenses and other current assets...................       259,822         251,483
Deferred tax asset..........................................       993,950         942,589
                                                              ------------    ------------
          Total current assets..............................    11,808,655      11,702,812
Property and equipment, at cost, net of accumulated
  depreciation..............................................     1,847,746       2,004,661
Purchased intangibles.......................................     8,597,601       7,512,100
Software development costs, net of accumulated amortization
  of
  $1,223,601 in 1997 and $1,558,597 in 1998.................     1,080,106       1,097,907
Deferred tax asset..........................................     7,621,800       7,914,129
Other assets................................................     1,778,669       1,875,475
                                                              ------------    ------------
          Total assets......................................  $ 32,734,577    $ 32,107,084
                                                              ============    ============
                           LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term borrowings.......................................  $    850,000    $    464,769
Current portion of long-term debt...........................     3,400,000       1,742,027
Accounts payable............................................     2,613,297       2,871,613
Accrued expenses............................................     2,383,946       2,259,802
Deferred income -- service contracts and other..............       911,459         794,688
                                                              ------------    ------------
          Total current liabilities.........................    10,158,702       8,132,899
Subordinated note payable...................................     7,000,000       7,000,000
Deferred income -- service contracts........................       241,507         274,798
Notes payable, long-term portion............................       542,027       1,700,000
                                                              ------------    ------------
          Total liabilities.................................    17,942,236      17,107,697
Commitments and contingencies
Shareholders' equity:
Preferred stock, $.01 par value; Authorized: 3,000,000
  shares;
  Convertible Series A, shares issued and outstanding: 1997
  and 1998 -- 3,000 ($3,000,000 liquidation preference).....            30              30
Common stock, $.01 par value; Authorized: 15,600,000 shares;
  Shares issued and outstanding: 1997 -- 6,259,728,
  1998 -- 6,432,875.........................................        62,597          64,328
Additional paid-in capital..................................    37,788,536      38,134,290
Treasury stock, at cost (26,240 shares in 1997 and none in
  1998).....................................................      (103,500)             --
Unearned compensation.......................................      (333,495)       (204,294)
Foreign currency translation adjustment.....................        35,877          47,510
Accumulated deficit.........................................   (22,657,704)    (23,042,477)
                                                              ------------    ------------
          Total shareholders' equity........................    14,792,341      14,999,387
                                                              ------------    ------------
          Total liabilities and shareholders' equity........  $ 32,734,577    $ 32,107,084
                                                              ============    ============
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       36
<PAGE>   39
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                          FOR THE YEAR ENDED DECEMBER 31,
                                                     ------------------------------------------
                                                         1996           1997           1998
                                                     ------------    -----------    -----------
<S>                                                  <C>             <C>            <C>
Sales of IVD systems...............................  $  6,370,346    $11,823,443    $10,359,929
Sales of IVD system supplies and service...........     9,117,493     10,621,211     12,347,274
Sales of small instruments and supplies............     5,066,292      4,447,418      4,345,304
Royalty and license revenues.......................        42,923        603,076        464,972
                                                     ------------    -----------    -----------
Net revenues.......................................    20,597,054     27,495,148     27,517,479
                                                     ------------    -----------    -----------
Cost of goods -- IVD systems.......................     3,423,140      6,077,391      5,827,729
Cost of goods -- IVD system supplies and service...     5,114,538      5,328,092      5,944,091
Cost of goods -- small instruments and supplies....     2,693,900      2,345,909      2,378,206
                                                     ------------    -----------    -----------
Cost of goods sold.................................    11,231,578     13,751,392     14,150,026
                                                     ------------    -----------    -----------
Gross margin.......................................     9,365,476     13,743,756     13,367,453
                                                     ------------    -----------    -----------
Marketing and selling..............................     4,627,089      5,224,513      5,373,053
General and administrative.........................     3,258,700      3,501,239      3,663,447
Research and development, net......................     1,978,326      2,125,095      2,420,658
Amortization of intangibles........................       793,916      1,308,596      1,161,035
Unusual charges (Note 18)..........................     1,891,592      1,338,338        193,186
Acquisition of in-process research and
  development......................................     7,250,000             --             --
                                                     ------------    -----------    -----------
          Total operating expenses.................    19,799,623     13,497,781     12,811,379
Operating income (loss)............................   (10,434,147)       245,975        556,074
Other income (expense):
  Interest income..................................       221,935         56,557         41,496
  Interest expense.................................      (681,114)    (1,208,138)    (1,162,634)
  Other income.....................................         7,211        109,318         60,551
                                                     ------------    -----------    -----------
Loss before benefit for income taxes...............   (10,886,115)      (796,288)      (504,513)
Benefit for income taxes...........................    (3,457,927)      (293,000)      (119,740)
                                                     ------------    -----------    -----------
Net loss...........................................    (7,428,188)      (503,288)      (384,773)
Less imputed preferred stock dividend..............            --       (450,000)            --
                                                     ------------    -----------    -----------
Net loss attributable to common stockholders.......  $ (7,428,188)   $  (953,288)   $  (384,773)
                                                     ============    ===========    ===========
Net loss per share -- basic........................  $      (1.21)   $      (.16)   $      (.06)
                                                     ============    ===========    ===========
Net loss per share -- diluted......................  $      (1.21)   $      (.16)   $      (.06)
                                                     ============    ===========    ===========
Weighted average number of common shares
  outstanding -- basic.............................     6,141,657      6,019,041      6,310,312
                                                     ============    ===========    ===========
Weighted average number of common shares
  outstanding -- diluted...........................     6,141,657      6,019,041      6,310,312
                                                     ============    ===========    ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       37
<PAGE>   40
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
                                           CONVERTIBLE
                                            SERIES A
                                         PREFERRED STOCK      COMMON STOCK       ADDITIONAL
                                         ---------------   -------------------     PAID-IN      TREASURY       UNEARNED
                                         SHARES   AMOUNT    SHARES     AMOUNT      CAPITAL        STOCK      COMPENSATION
                                         ------   ------   ---------   -------   -----------   -----------   ------------
<S>                                      <C>      <C>      <C>         <C>       <C>           <C>           <C>
Balance as of December 31, 1995........     --      --     6,292,408   $62,924   $34,154,116   $  (453,386)   $ (95,884)
Issuance of convertible preferred stock
 for cash..............................  3,000     $30            --        --     2,928,291            --           --
Common stock issued on exercise of
 stock options.........................     --      --       137,924     1,379       333,315            --           --
Common stock issued or issued from
 treasury under Employee Stock Purchase
 Plan:
 for Cash..............................     --      --        13,297       133        81,369        37,703           --
 for Services..........................     --      --        22,136       221       150,159        37,703     (153,190)
Stock option compensation..............     --      --            --        --       437,770            --     (270,925)
Issuance of warrants in connection with
 acquisition of Perceptive Scientific
 Instruments, Inc......................     --      --            --        --       927,000            --           --
Repurchase of shares of common stock
 and warrants..........................     --      --            --        --      (273,216)   (2,132,141)          --
Retire treasury stock..................     --      --      (553,875)   (5,539)   (2,504,582)    2,510,121           --
Amortization of unearned
 compensation..........................     --      --            --        --            --            --      134,120
Income tax benefit related to exercise
 of nonqualified stock options.........     --      --            --        --        77,313            --           --
Foreign currency translation
 adjustment............................     --      --            --        --            --            --           --
Stock tendered as payment for options
 exercised.............................     --      --            --        --            --      (103,500)          --
Net loss...............................     --      --            --        --            --            --           --
                                         -----     ---     ---------   -------   -----------   -----------    ---------
Balance, December 31, 1996.............  3,000      30     5,911,890    59,118    36,311,535      (103,500)    (385,879)
Common stock issued on exercise of
 stock options.........................     --      --        13,901       139        33,466            --           --
Common stock issued under Employee
 Stock Purchase Plan:
 for Cash..............................     --      --        34,964       350       140,458            --           --
 for Services..........................     --      --        34,964       350       140,458            --     (140,808)
Issuance of stock options for
 services..............................     --      --            --        --        73,680            --      (73,680)
Common stock and warrants to purchase
 common stock issued for cash on
 exercise of warrants..................     --      --       188,633     1,886       676,492            --           --
Issuance of common stock and warrants
 in satisfaction of accounts payable...     --      --        75,376       754       282,947            --           --
Issuance of warrants to purchase common
 stock in connection with bank debt
 renewal...............................     --      --            --        --       129,500            --           --
Amortization of unearned
 compensation..........................     --      --            --        --            --            --      266,872
Foreign currency translation
 adjustment............................     --      --            --        --            --            --           --
Net loss...............................     --      --            --        --            --            --           --
                                         -----     ---     ---------   -------   -----------   -----------    ---------
Balance, December 31, 1997.............  3,000      30     6,259,728    62,597    37,788,536      (103,500)    (333,495)
Common stock issued on exercise of
 stock options.........................     --      --        37,732       377       113,952       (25,932)          --
Common stock issued under Employee
 Stock Purchase Plan:
 for Cash..............................     --      --        48,400       484        76,345            --           --
 for Services..........................     --      --       108,775     1,088       174,187            --     (126,049)
Issuance of stock options for
 services..............................     --      --            --        --        12,000            --      (12,000)
Common stock and warrants to purchase
 common stock issued for cash on
 exercise of warrants and issuance of
 warrants, net of expenses.............     --      --        12,778       128        39,905            --           --
Retire treasury stock..................     --      --       (34,538)     (346)     (129,086)      129,432           --
Charge for repricing options held by
 non-employees.........................     --      --            --        --        58,451            --           --
Amortization of unearned
 compensation..........................     --      --            --        --            --            --      267,250
Foreign currency translation
 adjustment............................     --      --            --        --            --            --           --
Net loss...............................     --      --            --        --            --            --           --
                                         -----     ---     ---------   -------   -----------   -----------    ---------
Balance, December 31, 1998.............  3,000     $30     6,432,875   $64,328   $38,134,290            --    $(204,294)
                                         =====     ===     =========   =======   ===========   ===========    =========
 
<CAPTION>
 
                                           FOREIGN
                                          CURRENCY
                                         TRANSLATION   ACCUMULATED
                                         ADJUSTMENT      DEFICIT         TOTAL
                                         -----------   ------------   -----------
<S>                                      <C>           <C>            <C>
Balance as of December 31, 1995........         --     $(14,726,228)  $18,941,542
Issuance of convertible preferred stock
 for cash..............................         --               --     2,928,321
Common stock issued on exercise of
 stock options.........................         --               --       334,694
Common stock issued or issued from
 treasury under Employee Stock Purchase
 Plan:
 for Cash..............................         --               --       119,205
 for Services..........................         --               --        34,893
Stock option compensation..............         --               --       166,845
Issuance of warrants in connection with
 acquisition of Perceptive Scientific
 Instruments, Inc......................         --               --       927,000
Repurchase of shares of common stock
 and warrants..........................         --               --    (2,405,357)
Retire treasury stock..................         --               --            --
Amortization of unearned
 compensation..........................         --               --       134,120
Income tax benefit related to exercise
 of nonqualified stock options.........         --               --        77,313
Foreign currency translation
 adjustment............................    $37,791               --        37,791
Stock tendered as payment for options
 exercised.............................         --               --      (103,500)
Net loss...............................         --       (7,428,188)   (7,428,188)
                                           -------     ------------   -----------
Balance, December 31, 1996.............     37,791      (22,154,416)   13,764,679
Common stock issued on exercise of
 stock options.........................         --               --        33,605
Common stock issued under Employee
 Stock Purchase Plan:
 for Cash..............................         --               --       140,808
 for Services..........................         --               --            --
Issuance of stock options for
 services..............................         --               --            --
Common stock and warrants to purchase
 common stock issued for cash on
 exercise of warrants..................         --               --       678,378
Issuance of common stock and warrants
 in satisfaction of accounts payable...         --               --       283,701
Issuance of warrants to purchase common
 stock in connection with bank debt
 renewal...............................         --               --       129,500
Amortization of unearned
 compensation..........................         --               --       266,872
Foreign currency translation
 adjustment............................     (1,914)              --        (1,914)
Net loss...............................         --         (503,288)     (503,288)
                                           -------     ------------   -----------
Balance, December 31, 1997.............     35,877      (22,657,704)   14,792,341
Common stock issued on exercise of
 stock options.........................         --               --        88,397
Common stock issued under Employee
 Stock Purchase Plan:
 for Cash..............................         --               --        76,829
 for Services..........................         --               --        49,226
Issuance of stock options for
 services..............................         --               --            --
Common stock and warrants to purchase
 common stock issued for cash on
 exercise of warrants and issuance of
 warrants, net of expenses.............         --               --        40,033
Retire treasury stock..................         --               --            --
Charge for repricing options held by
 non-employees.........................         --               --        58,451
Amortization of unearned
 compensation..........................         --               --       267,250
Foreign currency translation
 adjustment............................     11,633               --        11,633
Net loss...............................         --         (384,773)     (384,773)
                                           -------     ------------   -----------
Balance, December 31, 1998.............    $47,510     $(23,042,477)  $14,999,387
                                           =======     ============   ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       38
<PAGE>   41
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                                  FOR THE YEAR ENDED DECEMBER 31,
                                                              ----------------------------------------
                                                                  1996          1997          1998
                                                              ------------   -----------   -----------
<S>                                                           <C>            <C>           <C>
Cash flows from operating activities:
  Net loss..................................................  $ (7,428,188)  $  (503,288)  $  (384,773)
Adjustments to reconcile net loss to net cash provided by
  operations:
  Deferred tax benefit......................................    (3,456,920)     (403,000)     (212,418)
  Acquisition of in-process research and development........     7,250,000            --            --
  Depreciation and amortization.............................     1,769,896     3,413,125     2,475,169
  Common stock and stock option compensation................       335,858       266,872       325,701
  (Gain) loss on disposal of property and equipment.........       (51,401)       62,844            --
  Allowance for doubtful accounts...........................       198,037        (7,187)        3,965
Changes in assets and liabilities:
  Accounts receivable -- trade and other....................       (77,240)     (153,983)     (466,176)
  Service contracts, net....................................      (475,034)      201,505        29,300
  Inventories...............................................    (1,433,834)    1,096,724      (764,923)
  Prepaid expenses and other current assets.................       176,061       (66,386)      (15,010)
  Other assets..............................................      (132,992)      (59,339)     (235,926)
  Accounts payable..........................................     2,851,805    (1,686,728)      260,790
  Accrued expenses..........................................       375,793        84,071       (27,557)
  Deferred income -- other..................................       279,591      (279,591)      (28,550)
                                                              ------------   -----------   -----------
Net cash provided by operating activities...................       181,432     1,965,639       959,592
                                                              ------------   -----------   -----------
Cash flows from investing activities:
  Acquisition of property and equipment.....................    (1,171,621)     (949,841)   (1,026,475)
  Sales of property and equipment...........................        85,000            --            --
  Acquisition of business and product line, net of cash
    acquired or adjustments to cost of business.............   (10,311,041)           --       167,790
  Software development costs................................      (577,421)     (534,855)     (352,797)
  Maturities of securities..................................     4,169,138       642,589        25,000
  Acquisition of other assets...............................            --       (30,000)           --
                                                              ------------   -----------   -----------
Net cash used by investing activities.......................    (7,805,945)     (872,107)   (1,186,482)
                                                              ------------   -----------   -----------
Cash flows from financing activities:
  Issuance of common and preferred stock and warrants for
    cash....................................................     3,278,720       907,791       205,259
  Installment payment on repurchase of common stock.........      (553,148)     (545,057)           --
  Borrowings on credit facility.............................     1,334,755     3,895,000     8,558,550
  Repayments on credit facility.............................            --    (4,879,755)   (7,843,781)
  Repayments of notes payable and capital lease.............    (2,110,633)   (2,600,000)   (1,611,509)
  Proceeds from notes payable...............................     7,800,000            --            --
  Deferred stock or debt issuance costs.....................       (35,049)           --      (188,937)
                                                              ------------   -----------   -----------
Net cash provided (used) by financing activities............     9,714,645    (3,222,021)     (880,418)
                                                              ------------   -----------   -----------
  Effect of foreign currency rate fluctuation on cash and
    cash equivalents........................................         1,008        (3,185)       25,942
                                                              ------------   -----------   -----------
  Net increase (decrease) in cash and cash equivalents......     2,091,140    (2,131,674)   (1,081,366)
  Cash and cash equivalents at beginning of year............     1,511,395     3,602,535     1,470,861
                                                              ------------   -----------   -----------
  Cash and cash equivalents at end of year..................  $  3,602,535   $ 1,470,861   $   389,495
                                                              ============   ===========   ===========
Supplemental schedule of non-cash financing activities:
  Non cash issuance of common stock and common stock
    warrants................................................  $    153,190   $   562,689   $   234,755
  Stock option compensation.................................       437,770            --            --
  Issuance of common stock under a stock for stock
    exercise................................................       103,500            --            --
  Issuance of warrants in connection with development
    agreements and for other assets.........................            --        65,000            --
  Issuance of warrants and subordinated note for asset
    purchase................................................     7,927,000            --            --
  Accrual for common stock and warrant repurchase...........     1,587,084            --            --
  Tax benefit related to exercise of nonqualified stock
    options.................................................        77,313            --            --
  Unpaid common stock issuance costs........................            --        55,000            --
  Issuance of notes payable for accrued liabilities.........            --     1,042,027            --
  Equipment acquired through issuance of capital lease......            --            --        70,000
Supplemental disclosure of cash flow information:
  Cash paid for income taxes................................        64,100            --       213,407
  Cash paid for interest....................................       526,182     1,104,605     1,093,253
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       39
<PAGE>   42
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
                CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
<TABLE>
<CAPTION>
                                                    FOR THE YEAR ENDED DECEMBER 31,
                                                 -------------------------------------
                                                    1996          1997         1998
                                                 -----------    ---------    ---------
<S>                                              <C>            <C>          <C>
Net loss.......................................  $(7,428,188)   $(503,288)   $(384,773)
  Other comprehensive income (loss), foreign
     currency translation adjustment...........       37,791       (1,914)      11,633
                                                 -----------    ---------    ---------
  Comprehensive loss...........................  $(7,390,397)   $(505,202)   $(373,140)
                                                 ===========    =========    =========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       40
<PAGE>   43
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
 1. FORMATION AND BUSINESS OF THE COMPANY.
 
     International Remote Imaging Systems, Inc. was incorporated in California
in 1979 and reincorporated during 1987 in Delaware. International Remote Imaging
Systems, Inc. and its subsidiaries (collectively "IRIS" or the "Company")
operate in three segments. (See Note 19 -- "Segment and Geographic
Information"). The Company designs, develops, manufactures and markets in vitro
diagnostic ("IVD") equipment, including IVD imaging systems based on patented
and proprietary automated intelligent microscopy ("AIM") technology, as well as
special purpose centrifuges and other small instruments for automating
microscopic procedures performed in clinical laboratories. In December 1997, the
Company also began distributing the IRIS/Sysmex UF-100 urine cell analyzer in
the United States under an existing agreement with its manufacturer, Sysmex
Corporation. AIM combines the Company's capabilities in automated specimen
presentation, including its patented slideless microscope, and proprietary
high-speed digital processing hardware and software to classify and visually
present images of microscopic particles in easy-to-use displays. The Company's
IVD imaging systems are designed to provide customers with better and more rapid
results and labor cost-savings over manual methods of performing microscopy. The
Company also provides on-going service and supplies to support equipment sold.
The Company's products are sold directly and through distributors primarily to
hospital and reference clinical laboratories, as well as veterinary, physician
office and research laboratories.
 
     On February 1, 1996, a newly formed subsidiary of IRIS completed its merger
with StatSpin, Inc. ("StatSpin"), which became a wholly owned subsidiary of
IRIS. StatSpin manufactures special purpose centrifuges and other small
instruments. IRIS issued approximately 340,000 shares of common stock for all of
the outstanding common stock and appreciation rights of StatSpin and assumed
options and warrants to purchase an additional 126,000 shares of IRIS common
stock. This represented an exchange ratio of 4.095 shares of IRIS common stock
for each common share and stock appreciation right of StatSpin. This transaction
was accounted for as a pooling-of-interests.
 
     On July 31, 1996, the Company, through a wholly owned subsidiary, PSI
Acquisition Corp., acquired the IVD imaging business of Perceptive Scientific
Instruments, Inc. ("Old PSI") for $9.5 million in cash (including $400,000 in
acquisition costs), issuance of a $7.0 million 8.5% subordinated note
("Subordinated Note") and a five year warrant to purchase 875,000 shares of the
Company's common stock at $8.00 per share (valued for accounting purposes at
$927,000). The cash portion of the purchase price was paid primarily with funds
obtained from a bank under a $7.8 million term loan and a $1.5 million revolving
line of credit. The Company subsequently changed the name of PSI Acquisition
Corp. to Perceptive Scientific Instruments, LLC ("PSI").
 
     PSI designs, develops, manufactures and markets IVD imaging systems for
biological, clinical and research applications. PSI's primary business is
providing cytogenetic analysis instrumentation and related services through
worldwide sales of its proprietary PowerGene product line. The PowerGene product
line is used in various procedures for chromosome analysis, including
karyotyping, DNA probe analysis via fluorescent in-situ hybridization methods
and comparative genomic hybridization analysis. The PowerGene system is marketed
in North America from PSI's Houston headquarters and internationally through its
U.K. subsidiary.
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES.
 
  Use of Estimates
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. The significant estimates in the
 
                                       41
<PAGE>   44
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
preparation of the consolidated financial statements relate to the assessment of
the carrying value of accounts receivables, inventories, purchased intangibles,
estimated provisions for warranty costs and deferred tax assets. Actual results
could differ from those estimates.
 
  Principles of Consolidation
 
     The financial statements include the accounts of International Remote
Imaging Systems, Inc. and its wholly-owned subsidiaries. All intercompany
accounts and transactions have been eliminated in the consolidated financial
statements.
 
  Foreign Currency
 
     The financial statements of the Company's foreign subsidiary are translated
into U.S. dollars using the exchange rate prevailing at each balance sheet date
for assets and liabilities and average exchange rates for each reporting period
for revenues and expenses. Translation adjustments are recorded directly to a
separate component of shareholders' equity. Gains and losses resulting from
foreign currency transactions are included in operations.
 
  Cash Equivalents and Short-Term Investments
 
     Short-term investments principally include certificates of deposit and debt
instruments of the United States Government with maturities greater than three
months and less than one year. For purposes of the statement of cash flows, IRIS
considers all highly liquid debt instruments purchased with a remaining maturity
of three months or less when purchased to be cash equivalents. IRIS places its
cash and investments with high credit quality financial institutions. At times,
these deposits may be in excess of the federally insured limit.
 
  Accounts Receivable
 
     IRIS sells predominantly to entities in the healthcare industry. IRIS
grants uncollateralized credit to its customers, primarily hospitals, clinical
and research laboratories, and distributors. IRIS performs ongoing credit
evaluations of its customers before granting uncollateralized credit. The
Company does not have any single customer which accounts for 10% or more of its
consolidated revenues.
 
  Inventories
 
     Inventories are carried at the lower of cost or market on a first in, first
out basis. Provision for potentially obsolete or slow-moving inventory is made
based on management's analysis of inventory levels and future sales forecasts.
 
  Property and Equipment and Depreciation
 
     Property and equipment are recorded at cost, less accumulated depreciation
and amortization. Depreciation is generally computed using the straight-line
method over three to five years, the estimated useful lives of the assets.
Leasehold improvements are amortized over the lesser of their useful life or the
remaining term of the lease.
 
     Costs of maintenance and repairs are charged to expense when incurred;
costs of renewals and betterments are capitalized. Upon sale or retirement, the
cost and related accumulated depreciation are eliminated from the respective
accounts, and the resulting gain or loss is included in current income.
 
                                       42
<PAGE>   45
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Purchased Intangibles
 
     Purchased intangibles are comprised of goodwill, acquired technology and
know-how and international distribution channel, and are being amortized on a
straight-line basis over ten years, six years and twenty-five years,
respectively. The realizability of purchased intangibles is evaluated
periodically as events or circumstances indicate a possible inability to recover
the carrying amount. Such evaluation is based on various analysis, including
cash flow and profitability projections. The analysis necessarily involves
significant management judgement to evaluate the capacity of an acquired
business to perform within projections. In the event the projected undiscounted
cash flows are less than net book value of the assets, the carrying value of the
assets will be written down to their fair value.
 
  Software Development Costs
 
     The Company capitalizes certain software development costs for new products
and product enhancements once all planning, designing, coding and testing
activities necessary to establish that the product can be produced to meet its
design specifications are completed, and concludes capitalization when the
product is ready for general release. Research and development costs relating to
software development are expensed as incurred. Amortization of capitalized
software development costs is provided on a product-by-product basis at the
greater of the amount computed using (a) the ratio of current revenues for a
product to the total of current and anticipated future revenues or (b) the
straight-line method over the remaining estimated economic life of the product.
Generally, an original estimated economic life of one and one half years to
three years is assigned to capitalized software development costs. Amortization
expense of software development costs was approximately $180,500, $375,721 and
$334,996 for 1996, 1997, and 1998 respectively.
 
  Deferred Warrant Costs
 
     Deferred warrant costs are included in other assets and result from the
issuance of warrants in conjunction with various development, distribution and
technology license agreements. These costs are generally being amortized over
the estimated term of the related agreements.
 
  Long-Lived Assets
 
     On January 1, 1996, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 121, "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed of." This statement requires
recognition of impairment losses for long-lived assets whenever events or
changes in circumstances result in the carrying amount of the assets exceeding
the sum of the expected future undiscounted cash flows associated with such
assets. The measurement of the impairment losses to be recognized is to be based
on the difference between the fair values and the carrying amounts of the
assets. During 1996, the Company determined that no impairment loss was required
for applicable assets; however, as a result of certain events discussed in Note
7, a $704,579 charge was recorded for write-down of long-lived assets in the
fourth quarter of 1997.
 
  Stock Based Compensation
 
     The Company has adopted the disclosure-only provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation." SFAS No. 123 defines a fair value
based method of accounting for an employee stock option. Fair value of the stock
option is determined considering factors such as the exercise price, the
expected life of the option, the current price of the underlying stock and its
volatility, expected dividends on the stock, and the risk-free interest rate for
the expected term of the option. Under the fair value based method, compensation
cost is measured at the grant date based on the fair value of the award and is
recognized over the service period. Pro forma disclosures for entities that
elect to continue to measure compensation cost under the intrinsic method
provided by Accounting Principles Board Opinion No. 25 must include the effects
 
                                       43
<PAGE>   46
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
of all awards granted in fiscal years that begin after December 15, 1994. An
expense is recognized for common stock, warrants or options issued or repriced,
for services rendered by non-employees based on the estimated fair value of the
security exchanged.
 
  Revenue Recognition
 
     IRIS derives revenue from the sale of IVD imaging systems, sales of
supplies and service for its IVD imaging systems and sales of small laboratory
instruments and related supplies. IRIS generally recognizes product revenues
once all of the following conditions have been met: a) an authorized purchase
order has been received in writing, b) customer credit worthiness has been
established, and c) shipment of the product to the customer designated location
has occurred. Estimated installation expense is recognized as part of the
accrual for warranty expense at the time of shipment.
 
     IRIS recognizes service revenues ratably over the term of the service
period, which typically ranges from twelve to sixty months. Payments for service
contracts are generally made in advance. Deferred revenue represents the
revenues to be recognized over the remaining term of the service contracts.
 
  Warranties
 
     IRIS recognizes the full estimated cost of warranty expense, including
installation costs, at the time of product shipment.
 
  Research and Development Expenditures
 
     Except for certain software development costs required to be capitalized as
described above (see Software Development Costs), research and development
expenditures are charged to operations as incurred. Net research and development
expense includes total research and development costs incurred, including costs
incurred under research and development grants and contracts, less costs
reimbursed under research and development contracts (see Note 17).
 
  Income Taxes
 
     IRIS accounts for income taxes in accordance with SFAS No. 109 "Accounting
for Income Taxes," which requires recognition of deferred tax liabilities and
assets for the expected future tax consequences of events that have been
included in the financial statements or tax returns. Under this method, deferred
tax liabilities and assets are determined based on the differences between the
financial statement and the tax bases of assets and liabilities using enacted
tax rates in effect for the year in which the differences are expected to
reverse. Valuation allowances are established when necessary to reduce deferred
tax assets to the amount expected to be realized. Income tax expense represents
the tax payable for the period and the change during the period in deferred tax
assets and liabilities.
 
  Marketing Costs
 
     All costs related to marketing and advertising the Company's products are
expensed at the time the advertising takes place.
 
  Fair Value of Financial Instruments
 
     The amount recorded for financial instruments in the Company's consolidated
financial statements approximates fair value as defined in SFAS No. 107,
"Disclosures about Fair Value of Financial Instruments," except for the
subordinated note described in Note 9 of which the fair value is not readily
determinable.
 
                                       44
<PAGE>   47
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Earnings Per Share
 
     In the fourth quarter of 1997, the Company adopted SFAS No. 128 "Earnings
Per Share." SFAS No. 128 requires dual presentation of newly defined basic and
diluted earnings per share on the face of the income statements of all entities
with complex capital structures. Basic earnings per share is computed by
dividing net income (loss) by the weighted average number of common shares
outstanding. Diluted earnings per share is computed by dividing net income
(loss) by the weighted average number of common shares and common stock
equivalents outstanding, calculated on the treasury stock method. Common stock
equivalents relate to stock options and warrants are excluded from the
computation when their effect is antidilutive.
 
  Segment Reporting
 
     In the second quarter of 1998, the Company adopted SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information". SFAS No.
131 supersedes SFAS No. 14, "Financial Reporting for Segments of a Business
Enterprise," replacing the "industry segment" approach with the "management"
approach. The management approach designates the internal organization that is
used by management for making operating decisions and assessing performance as
the source of the Company's reportable segments, SFAS No. 131 also requires
disclosures about products and services, geographic areas, and major customers.
The adoption of SFAS No. 131 did not affect results of operations or financial
position but did affect the disclosure of segment information. See Note
19 -- "Segment and Geographic Information".
 
  Reclassifications
 
     Certain reclassifications have been made to the 1996 and 1997 financial
statements to conform with the 1998 presentation.
 
  Certain Risks and Uncertainties
 
     Dependence on Instrument Sales: The Company derives most of its revenues
from the sale of two families of high-priced instruments -- The Yellow IRIS
urinalysis workstations, and the PowerGene genetic analyzers. These instruments
have list prices ranging from $10,000 to $195,000 depending on model and
configuration, and relatively modest declines in unit sales or gross margins for
either product line could have a material adverse effect on the Company's
revenues and profits.
 
     Reliance on Single Source Suppliers: Certain key components of the
Company's instruments are manufactured according to the Company's specifications
or are available only from single suppliers. For example, Roche Diagnostics is
the sole supplier for the Company's proprietary CHEMSTRIP/IRIStrip urine test
strips and related test reader used in The Yellow IRIS Models 300 and 500. From
time to time, single source suppliers have discontinued production of key
components or encountered production problems which potentially could have a
material adverse effect on instrument sales. Although, in the past, the Company
has successfully transitioned to new components to replace discontinued
components, there can be no assurance that the Company can always successfully
transition to satisfactory replacement components or that the Company will
always have access to adequate supplies of discontinued components on
satisfactory terms during the transition period. The Company's inability to
transition successfully to replacement components or to secure adequate supplies
of discontinued components on satisfactory terms could have a material adverse
effect on the Company.
 
 3. COMPREHENSIVE INCOME.
 
     In January 1998, the Company adopted the provisions of SFAS No. 130,
"Reporting Comprehensive Income." SFAS No. 130 establishes standards for
reporting and displaying comprehensive income and its components (revenues,
expenses, gains and losses) in financial statements. SFAS No. 130 requires that
all
 
                                       45
<PAGE>   48
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements.
 
     The Company's only component of comprehensive income (loss) relates to
foreign currency translation adjustments. No tax effect has been allocated to
the foreign currency translation adjustment for the periods presented.
 
     The following is a reconciliation of accumulated other comprehensive income
balance for the three years ended December 31, 1998:
 
<TABLE>
<CAPTION>
                                                FOR THE YEARS ENDED DECEMBER 31,
                                                --------------------------------
                                                  1996        1997        1998
                                                --------    --------    --------
<S>                                             <C>         <C>         <C>
Beginning balance.............................  $    --     $37,791     $35,877
Current period change.........................   37,791      (1,914)     11,633
                                                -------     -------     -------
Ending balance................................  $37,791     $35,877     $47,510
                                                =======     =======     =======
</TABLE>
 
 4. INVENTORIES.
 
     Inventories consist of the following:
 
<TABLE>
<CAPTION>
                                                          AT DECEMBER 31,
                                                      ------------------------
                                                         1997          1998
                                                      ----------    ----------
<S>                                                   <C>           <C>
Finished goods......................................  $  766,525    $1,647,028
Work-in-process.....................................     788,374       432,569
Raw materials, parts and sub-assemblies.............   2,184,584     2,423,849
                                                      ----------    ----------
                                                      $3,739,483    $4,503,446
                                                      ==========    ==========
</TABLE>
 
 5. PROPERTY AND EQUIPMENT.
 
     Property and equipment consist of the following:
 
<TABLE>
<CAPTION>
                                                         AT DECEMBER 31,
                                                    --------------------------
                                                       1997           1998
                                                    -----------    -----------
<S>                                                 <C>            <C>
Leasehold improvements............................  $   406,308    $   414,303
Furniture and fixtures............................      274,828        281,280
Machinery and equipment...........................    3,691,466      4,593,847
Tooling, dies and molds...........................      767,355        796,355
Rental units......................................      930,407      1,059,045
                                                    -----------    -----------
                                                      6,070,364      7,144,830
  Less accumulated depreciation...................   (4,222,618)    (5,140,169)
                                                    -----------    -----------
                                                    $ 1,847,746    $ 2,004,661
                                                    ===========    ===========
</TABLE>
 
     Property and equipment includes $2,710,335, and $3,791,505 respectively, at
December 31, 1997 and 1998, of fully depreciated assets which remain in service.
Depreciation expense was $830,914, $983,003, and $926,655, for 1996, 1997, and
1998, respectively.
 
 6. EQUIPMENT LEASING AND THIRD PARTY TRANSACTIONS.
 
     Certain sales-type leases originated by the Company have been sold on a
non-recourse basis to a financial institution ("Third Party"). The Third Party
assumes the administrative responsibility for the collection of the lease
receivable and the credit risk. Also, in connection with these leases the
Company agrees to provide on-
 
                                       46
<PAGE>   49
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
going supplies and maintenance service with respect to the equipment. For these
obligations the Company receives its normal supply and maintenance revenues. The
agreements with the Third Party provide the Company with residual rights in
revenues, if any, derived from the equipment after the Third Party has received
a designated return. Equipment sales revenues arising from these transactions
with the Third Party were $125,000, $525,000, and $513,000 for the years ended
December 31, 1996, 1997 and 1998, respectively.
 
     For sales-type leases not sold to third parties, the components of net
investment in sales-type leases recorded in other assets are as follows at
December 31, 1998.
 
<TABLE>
<S>                                                         <C>
Total minimum lease payments............................    $563,364
Less estimated executory costs including profit
  thereon...............................................    (180,268)
                                                            --------
Net minimum lease payments..............................     383,096
Less unearned income....................................    (120,189)
                                                            --------
Net investment in sales-type leases.....................     262,907
Less current portion....................................     (52,852)
                                                            --------
                                                            $210,055
                                                            ========
</TABLE>
 
     No sales-type leases were outstanding as of December 31, 1997.
 
     Any lease that does not meet the criteria for a sales-type or a financing
lease is accounted for as an operating lease. Under these leases the Company
also provides supplies and services. Generally operating leases are for periods
less than one year and contain provisions for early termination with a penalty
and renewal. The cost of leased systems is depreciated to a zero value on a
straight-line basis over five years. Accumulated depreciation on leased systems
was $232,302, and $413,992 at December 31, 1997 and 1998, respectively.
 
     Future minimum lease payments due from customers under sales-type leases
and noncancellable operating leases as of December 31, 1998 are as follows:
 
<TABLE>
<CAPTION>
                                       SALES-TYPE LEASES    OPERATING LEASES
                                       -----------------    ----------------
<S>                                    <C>                  <C>
1999.................................      $119,124             $544,857
2000.................................       119,124                7,642
2001.................................       119,124                7,642
2002.................................       119,124                6,368
2003.................................        86,868                   --
                                           --------             --------
                                           $563,364             $566,509
                                           ========             ========
</TABLE>
 
7. PURCHASED INTANGIBLES.
 
     Purchased intangibles, at cost, consist of the following:
 
<TABLE>
<CAPTION>
                                                 AT DECEMBER 31,
                                            --------------------------
                                               1997           1998
                                            -----------    -----------
<S>                                         <C>            <C>
Goodwill..................................  $   383,108    $   383,108
International distribution channel........    5,571,728      5,403,938
Acquired technology and know-how..........    3,960,904      3,960,904
                                            -----------    -----------
                                              9,915,740      9,747,950
Less accumulated amortization.............   (1,318,139)    (2,235,850)
                                            -----------    -----------
Total.....................................  $ 8,597,601    $ 7,512,100
                                            ===========    ===========
</TABLE>
 
                                       47
<PAGE>   50
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     In 1996 the Company acquired the genetic analysis segment. A portion of the
purchase price was allocated to the international distribution channel and
acquired technology and know-how. During the year ended December 31, 1998, the
Company received a contractual adjustment to the purchase price of $167,790.
Consistent with the original allocation methodology, these monies were offset
against the value assigned to the international distribution channel intangible.
 
     In the fourth quarter of 1997, the Company was notified that a certain
distributor would no longer carry the digital refractometer product line. Based
on this development, the Company determined that estimated cash flows
(undiscounted and without interest charges) from this product line would not be
sufficient to recover the associated goodwill, and that it had become impaired.
The Company measured impairment based on a discounted cash flow approach. As a
result, the Company recorded a $704,579 charge to earnings in the fourth quarter
of 1997 as an impairment loss.
 
 8. ACCRUED EXPENSES.
 
     Accrued expenses consist of the following:
 
<TABLE>
<CAPTION>
                                                  AT DECEMBER 31,
                                              ------------------------
                                                 1997          1998
                                              ----------    ----------
<S>                                           <C>           <C>
Accrued bonuses.............................  $  194,444    $  207,892
Accrued commissions.........................     260,296       232,766
Accrued payroll.............................      21,121         7,015
Accrued vacation............................     301,337       284,262
Accrued taxes and other.....................     101,528        14,458
Accrued professional fees...................     156,321       206,955
Accrued warranty expense....................     466,569       441,771
Accrued interest............................     133,242       138,817
Accrued -- other............................     749,088       725,866
                                              ----------    ----------
                                              $2,383,946    $2,259,802
                                              ==========    ==========
</TABLE>
 
 9. SHORT-TERM BORROWINGS AND NOTES PAYABLE.
 
     The Company financed the purchase price of the PSI Acquisition with the
Subordinated Note ($7.0 million) and a term loan and line of credit of $9.3
million. On May 8, 1998, the remaining balance outstanding under the term loan
and line of credit ($3.1 million) was replaced with a new credit agreement with
Foothill Capital Corporation, a Wells Fargo Company, ("New Credit Facility").
 
     At December 31, 1998, the outstanding amounts under the New Credit Facility
consists of $2.9 million outstanding under a $3.6 million term loan and $464,769
outstanding under a $4.0 million revolving line of credit. Borrowings under the
line of credit are limited to a percentage of eligible accounts receivable. The
Company had approximately $1.2 million available under the line of credit at
December 31, 1998. The term loan bears interest at the lender's prime rate
(7.75% on December 31, 1998) plus 3.0% and is payable in monthly installments of
$100,000. The revolving credit line bears interest at the lender's prime rate
plus 1.0%. The New Credit Facility is subject to minimum interest charges,
prepayment penalties and customary fees, is collateralized by a first priority
lien on all assets of the Company and matures in 2001. It also contains
financial covenants based primarily on tangible net worth and cash flows and
imposes restrictions on acquisition, capital expenditures and cash dividends.
The Company was not in compliance with one of the financial covenants at year
end, and the credit facility was subsequently amended to waive the
non-compliance and modify certain financial covenants for future periods.
 
                                       48
<PAGE>   51
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The outstanding principal balance on the Subordinated Note was $7.0 million
on December 31, 1998. The Subordinated Note bears interest at a fixed rate of
8.5% per annum, payable in quarterly installments. The entire principal is due
on or before July 31, 2001. The Company may prepay the Subordinated Note at any
time without premium or penalty. Upon the issuance by the Company of equity
securities generating net proceeds in excess of $14.5 million, the Company must
apply fifty percent of the excess to the prepayment of the Subordinated Note.
The payment of principal and interest on the Subordinated Note is subordinated
in right of payment, to the extent and in the manner provided therein, to the
prior payment in full of the New Credit Facility.
 
     In 1996, Corange International Limited, an affiliate of the Boehringer
Mannheim Group of companies, sold to the Company 469,413 shares of common stock
and the warrant to purchase 250,000 shares of common stock previously acquired
from the Company in connection with various joint development projects at their
original aggregate purchase price of $2.1 million, or $4.54 per share of common
stock. During 1997, the Company issued two 8.0% promissory notes in the
aggregate amount of $1.0 million due in semi-monthly installments of $100,000
commencing April 1, 1998. These notes constitute the final payments for the
repurchase of the common stock and a warrant. The remaining amount due under
these notes as of December 31, 1998 totaled $542,027.
 
     Annual maturities of long term borrowings are $1,742,027 (1999), $1,200,000
(2000) and $7,500,000 (2001).
 
10. INCOME TAXES.
 
     The benefit for income taxes consisted of the following:
 
<TABLE>
<CAPTION>
                                            FOR THE YEAR ENDED DECEMBER 31,
                                         -------------------------------------
                                            1996          1997         1998
                                         -----------    ---------    ---------
<S>                                      <C>            <C>          <C>
Currently payable:
  Federal..............................  $   (22,000)   $      --    $      --
  State................................       21,000       60,000       70,000
  Foreign..............................           --       50,000       23,000
                                         -----------    ---------    ---------
                                              (1,000)     110,000       93,000
                                         -----------    ---------    ---------
Deferred:
  Federal..............................   (3,198,000)    (325,000)    (196,000)
  State................................     (259,000)     (78,000)     (17,000)
                                         -----------    ---------    ---------
                                          (3,457,000)    (403,000)    (213,000)
                                         -----------    ---------    ---------
                                         $(3,458,000)   $(293,000)   $(120,000)
                                         ===========    =========    =========
</TABLE>
 
                                       49
<PAGE>   52
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The benefit for income taxes differs from the amount obtained by applying
the federal statutory income tax rate to loss before benefit for income taxes
for the years ended December 31, 1996, 1997 and 1998 as follows:
 
<TABLE>
<CAPTION>
                                            FOR THE YEAR ENDED DECEMBER 31,
                                         -------------------------------------
                                            1996          1997         1998
                                         -----------    ---------    ---------
<S>                                      <C>            <C>          <C>
Tax benefit computed at Federal
  statutory rate.......................  $(3,701,000)   $(271,000)   $(172,000)
Increase (decrease) in taxes due to:
  Change in valuation allowance........      437,000           --           --
  Foreign losses for which there is no
     benefit...........................           --           --       75,000
  State taxes, net of federal
     benefit...........................     (196,000)     (42,000)      (9,000)
  Nondeductible expenses...............       44,000       20,000       38,000
  Other................................      (42,000)          --      (52,000)
                                         -----------    ---------    ---------
                                         $(3,458,000)   $(293,000)   $(120,000)
                                         ===========    =========    =========
</TABLE>
 
     At December 31, 1998, the Company had federal net operating loss
carryforwards of approximately $18.3 million and state net operating loss
carryforwards of approximately $2.8 million which expire in fiscal years ending
in 1999 through 2012. As of December 31, 1998, IRIS had investment tax, research
and experimentation and foreign tax credit carryforwards of $279,000 expiring in
fiscal years through 2004.
 
     The primary components of temporary differences which give rise to the
Company's net deferred tax asset at December 31, 1996, 1997 and 1998 are as
follows:
 
<TABLE>
<CAPTION>
                                                   AT DECEMBER 31,
                                      -----------------------------------------
                                         1996           1997           1998
                                      -----------    -----------    -----------
<S>                                   <C>            <C>            <C>
Depreciation and amortization.......  $   200,000    $   961,000    $ 1,163,000
Allowance for doubtful accounts.....      102,000         99,000        100,000
Accrued liabilities.................      339,000        598,000        332,000
Deferred revenue-service
  contracts.........................       83,000        138,000        232,000
Deferred research and development...    2,857,000      2,549,000      2,276,000
Net operating loss carryforwards....    6,424,000      6,112,000      6,337,000
Other...............................      208,000        159,000        417,000
Valuation allowance.................   (2,000,000)    (2,000,000)    (2,000,000)
                                      -----------    -----------    -----------
                                      $ 8,213,000    $ 8,616,000    $ 8,857,000
                                      ===========    ===========    ===========
</TABLE>
 
     Although realization is not assured, management believes it is more likely
than not that the remaining net deferred tax assets will be realized. The amount
of the deferred tax assets considered realizable, however, could be reduced in
the future if estimates of future taxable income during the carryforward period
are reduced.
 
11. POLY DEVELOPMENT AGREEMENT.
 
     On September 29, 1995, Poly U/A Systems, Inc. ("Poly") engaged IRIS to
develop several new products based on IRIS' and other technology to further
enhance automation in the urinalysis field. Under the terms of the project, Poly
has the right to use the IRIS technology and any newly developed technology for
developing, manufacturing and marketing the new products as stand-alone devices,
and IRIS has the right to use any newly developed technology for any other
purpose and to incorporate the new products into The Yellow IRIS. Poly retained
IRIS to conduct the research, development, clinical evaluation and pre-market
 
                                       50
<PAGE>   53
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
testing of the proposed new products. IRIS funded the first $15,000 per month
(up to a maximum of $500,000) of the cost of the project, and Poly reimbursed
IRIS for the excess. IRIS provided financial and administrative services to Poly
at cost. IRIS had an option until November 29, 1998 to acquire all of the Common
Stock of Poly at an aggregate price of $5.1 million. IRIS may pay the option
exercise price in cash or with shares of IRIS Common Stock. The Company decided
not to exercise its option but entered into ongoing discussions to acquire Poly
at an amount below the option price. If the Company acquires Poly under these
circumstances, it may result in a charge against then current earnings.
 
12. REFERENCE LAB AGREEMENT.
 
     During the first quarter of 1995, IRIS and Boehringer Mannheim GmbH
("BMG"), a German affiliate of Boehringer Mannheim Corporation ("BMC"),
announced a joint project to develop a high capacity automated urinalysis system
primarily for reference laboratories based on the proprietary technologies of
both companies. The program was jointly funded by both companies. In addition to
designing specific components on the new system, BMG agreed to pay IRIS a fixed
amount of $640,000 for its research and development of the project. In
connection with this project and certain distribution considerations, IRIS
issued Corange International Limited (an affiliate of BMG) warrants to purchase
250,000 shares of IRIS common stock at an exercise price of $7.375 per share and
granted Corange International Limited certain registration rights with respect
to the shares of IRIS Common Stock issuable upon exercise of these warrants. The
Company later repurchased these securities. See Note 9 and 13.
 
13. CAPITAL STOCK.
 
  Issuance of Common and Preferred Stock
 
     On December 31, 1996, the Company completed a sale of equity securities for
approximately $3 million in a private placement. Specifically, the Company sold
(i) 3,000 shares of a new Series A Convertible Preferred Stock ("Preferred
Stock") with a liquidation value of $1,000 per share and (ii) a warrant (the
"Warrant") to purchase 84,270 shares of the Company's common stock at an
exercise price of $3.56 per share. The Warrant exercise price was based on the
average closing price of the common stock for the five trading days immediately
preceding the closing of the sale.
 
     Each share of Preferred Stock is convertible into a number of shares of
common stock equal to the liquidation value of a share of Preferred Stock
divided by a variable conversion price (discussed below). Any shares of
Preferred Stock not voluntarily converted during the three years following their
initial sale will be automatically converted into common stock on December 31,
1999. The Preferred Stock is non-voting, is not entitled to any preferred
dividends and is not subject to any mandatory or optional redemption provisions.
As long as any of the shares of Preferred Stock are outstanding, the Company may
not pay dividends on, or repurchase any shares of, common stock without the
written consent of the holders of a majority of the outstanding shares of
Preferred Stock.
 
     The conversion price of the Preferred Stock (the "Conversion Price") was
fixed at $3.56 per share of Common Stock until April 1, 1997. Based on this
Conversion Price, each share of Preferred Stock would be convertible into
approximately 281 shares of common stock, and the Company would issue
approximately 843,000 shares of common stock if the holder elected to convert
all of the outstanding shares of Preferred Stock. Commencing April 1, 1997, the
Conversion Price was equal to the lower of (i) 85% of the average closing bid
price of the common stock for the five consecutive trading days immediately
preceding the conversion date (but in no event less than $1.50) or (ii) $3.56.
The Company filed with the Securities and Exchange Commission a registration
statement for resale of the shares of common stock issuable upon conversion of
the Preferred Stock and exercise of the Warrant. Based on the closing price of
the Company's
 
                                       51
<PAGE>   54
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
common stock at December 31, 1998, the preferred stock was convertible into
2,000,000 common shares. The Company reserved 2,000,000 shares of common stock
for issuance upon conversion of the Preferred Stock.
 
     In 1996 the staff of the Securities and Exchange Commission announced a new
position on accounting for convertible preferred stock which is potentially
convertible at a discount to the market price of the common stock, even if the
potential for a discount is only a possibility. The staff has taken the position
that, solely for purposes of calculating earnings per share, the potential
discount is an embedded dividend to the preferred stockholders which reduces the
amount of income available to common stockholders. As a result of the staff's
new accounting position, the issuance of the Preferred Stock resulted in a
reduction in earnings per share. The staff's position is limited to the
calculation of earnings per share and did not have any effect on the Company's
net income or cash flow.
 
  Repurchase of Common Stock and Warrant
 
     As described above in Note 9, in 1996 Corange International Limited sold to
the Company the 469,413 shares of common stock and the warrant to purchase
250,000 shares of common stock previously acquired from the Company in
connection with various joint development projects at their original aggregate
purchase price of $2.1 million or $4.54 per share of common stock. The
unamortized cost of $273,216 related to the repurchased warrant has been offset
against additional paid in capital.
 
  Stock Issuances
 
     During 1990, the IRIS Board of Directors adopted an Employee Stock Purchase
Plan designed to allow employees of the Company to buy its shares at 50% of the
then current market price, provided that the employee agrees to hold the shares
purchased for a minimum of two years. The employee's 50% portion of stock
purchases under the plan may not exceed 15% of the employee's salary during any
year. The remaining 50% portion is recorded as deferred compensation and
amortized over the vesting period. The shares purchased pursuant to this plan
may not be transferred, except following the death of the employee or a change
in control, for a period of two years following the date of purchase. During the
period of the limitation on transfer, the Company has the option to repurchase
the shares at the employee's purchase price if the employee terminates
employment with the Company either voluntarily or as a result of termination for
cause. During 1996, 1997 and 1998, IRIS issued 35,433, 69,928 and 157,175 shares
of common stock, respectively, in exchange for $307,288, $281,616 and $252,104
in cash and services, respectively, under this plan.
 
  Stock Option Plans and Employee Benefit Plans
 
     As of December 31, 1998, the Company had three stock option plans under
which it may grant non-qualified stock options, incentive stock options and
stock appreciation rights. Options remain outstanding under another plan,
although no new options may be granted thereunder. No stock appreciation rights
or incentive stock options have been granted under these plans.
 
     The following schedule sets forth options authorized, exercised,
outstanding and available for grant under the Company's four stock option plans
as of December 31, 1998.
 
<TABLE>
<CAPTION>
                                                NUMBER OF OPTION SHARES
                                  ---------------------------------------------------
                                                                            AVAILABLE
              PLAN                AUTHORIZED    EXERCISED    OUTSTANDING    FOR GRANT
              ----                ----------    ---------    -----------    ---------
<S>                               <C>           <C>          <C>            <C>
1986............................    360,000      258,469         23,000           --
1994............................    700,000       23,832        626,601       49,567
1997............................    600,000           --        598,500        1,500
1998............................    600,000           --        252,900      347,100
                                  ---------      -------      ---------      -------
                                  2,260,000      282,301      1,501,001      398,167
                                  =========      =======      =========      =======
</TABLE>
 
                                       52
<PAGE>   55
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The exercise price of the above options was determined by the Compensation
Committee. Payment of the exercise price may be made in cash or with shares of
common stock. The options generally vest over three years and expire either five
or ten years from the date of grant. On November 6, 1998, the Board of Directors
acted to reprice all outstanding stock options to a maximum of $1.31 per share,
the current market price as of that date. Also, any common stock acquired upon
exercise of the repriced options cannot be resold without the Board of Directors
approval until January 1, 2000.
 
     IRIS has adopted the disclosure only provisions of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock Based Compensation." If
compensation expense for the stock options had been determined using "fair
value" at the grant date for awards in 1996, 1997 and 1998, consistent with the
provisions of Statement of Financial Accounting Standards No. 123, the Company's
net loss and loss per share would have been reduced to the pro forma amounts
indicated below:
 
<TABLE>
<CAPTION>
                                           FOR THE YEAR ENDED DECEMBER 31,
                                       ---------------------------------------
                                          1996           1997          1998
                                       -----------    -----------    ---------
<S>                                    <C>            <C>            <C>
Net loss attributable to common
  stockholders as reported...........  $(7,428,188)   $  (953,228)   $(384,773)
Net loss attributable to common
  stockholders pro forma.............   (7,890,943)    (1,604,718)    (584,374)
Loss per diluted share as reported...  $     (1.21)   $      (.16)   $     (06)
Loss per diluted share pro forma.....        (1.28)          (.27)        (.09)
</TABLE>
 
     The fair value of each option grant is estimated on the date of the grant
using the Black-Scholes option pricing model with the following weighted average
assumptions used for grants in 1996, 1997 and 1998.
 
<TABLE>
<CAPTION>
                                                   FOR THE YEAR ENDED DECEMBER 31,
                                                   --------------------------------
                                                    1996         1997         1998
                                                   ------       ------       ------
<S>                                                <C>          <C>          <C>
Risk free interest rate..........................   5.98%        6.10%        4.98%
Expected lives (years)...........................      5            5            5
Expected volatility..............................     55%          54%          59%
Expected dividend yield..........................     --           --           --
</TABLE>
 
     The pro forma calculations above are for informational purposes only.
Future calculations of the pro forma effects of stock options may vary
significantly due to changes in the assumptions described above as well as
future grants, and for forfeitures of stock options.
 
                                       53
<PAGE>   56
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The following table sets forth certain information relative to stock
options during the years ended December 31, 1996, 1997 and 1998.
 
<TABLE>
<CAPTION>
                                                                OPTION PRICE           FAIR VALUE AT
                                                         --------------------------     GRANT DATE
                                                                           WEIGHTED      WEIGHTED
                                             SHARES          RANGE         AVERAGE        AVERAGE
                                            ---------    --------------    --------    -------------
<S>                                         <C>          <C>               <C>         <C>
Outstanding at January 1, 1996............    621,801    $1.16 to $7.37     $4.22             --
  Granted.................................    650,300    $3.61 to $8.29     $5.55          $4.41
  Exercised...............................   (116,133)   $1.75 to $5.00     $2.19             --
  Canceled or expired.....................   (131,934)   $2.90 to $8.29     $5.98             --
                                            ---------    --------------     -----          -----
Outstanding at December 31, 1996..........  1,024,034    $1.90 to $6.22     $3.02             --
  Granted.................................    325,100    $3.19 to $4.50     $3.73          $3.84
  Exercised...............................    (13,901)   $1.90 to $3.03     $2.64             --
  Canceled or expired.....................    (68,933)   $2.59 to $6.22     $4.04             --
                                            ---------    --------------     -----          -----
Outstanding at December 31, 1997..........  1,266,300    $3.03 to $4.50     $3.21             --
  Granted.................................    368,800    $0.81 to $4.25     $2.36          $2.36
  Exercised...............................    (37,732)            $3.03     $3.03             --
  Canceled or expired.....................    (96,367)   $3.03 to $4.00     $3.11             --
                                            ---------    --------------     -----          -----
Outstanding at December 31, 1998..........  1,501,001    $0.81 to $4.50     $1.46
                                            =========    ==============     =====
Outstanding at December 31, 1998
  Weighted average life -- 82 months......  1,501,001                       $1.46
Outstanding at December 31, 1997
  Weighted average life -- 95 months......  1,266,300                       $3.21
Outstanding at December 31, 1996
  Weighted average life -- 3 months.......      1,000                       $1.90
  Weighted average life -- 72 months......  1,023,034                       $3.03
Exercisable at December 31, 1998
  Weighted average life -- 42 months......    762,579                       $1.46
Exercisable at December 31, 1997
  Weighted average life -- 32 months......    537,167                       $3.03
Exercisable at December 31, 1996
  Weighted average life -- 3 months.......      1,000                       $1.90
  Weighted average life -- 72 months......    271,773                       $3.03
</TABLE>
 
     In connection with the merger with StatSpin, each outstanding option and
warrant of StatSpin was converted into an option to purchase IRIS common stock
at a ratio of 4.095 shares of IRIS common stock for each share of StatSpin
common stock, resulting in options to purchase an aggregate of 126,000 shares of
IRIS common stock. The exercise price ranged from $3.66 to $7.32 per share of
IRIS common stock. During 1996, options to purchase 19,050 shares at $7.32 per
share expired, and options to purchase 21,791 shares at $3.66 per share were
exercised. During 1997, options to purchase 10,283 shares at $3.66 per share
were exercised. During 1998, options to purchase 4,778 shares at $3.66 per share
were exercised and the remaining options expired.
 
     In 1996, the Company adopted a 401(k) Plan. All employees are eligible to
participate in the plan. Contributions by the Company are discretionary.
Employees vest in amounts contributed by the Company immediately. The Company
contributed $34,190 and $46,844 to the plan for 1997 and 1998, respectively.
 
                                       54
<PAGE>   57
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Warrants
 
     At December 31, 1998, the following warrants to purchase common stock were
outstanding and exercisable:
 
<TABLE>
<CAPTION>
NUMBER OF WARRANTS    PRICE     EXPIRATION DATE
------------------   -------    ---------------
<S>                  <C>       <C>
     123,000         $ 7.80    September 28, 2000
     875,000           8.00         July 31, 2001
      84,270           3.56     December 31, 2001
      50,000           3.875     January 15, 2000
      25,000           4.375         June 1, 2000
      10,000           4.3125        May 15, 2002
      25,000           4.0625        July 1, 2000
     298,633           4.00        March 29, 2000
</TABLE>
 
14. COMMITMENTS AND CONTINGENCIES.
 
  Leases
 
     The Company leases real property under agreements which expire at various
times over the next three years. Certain leases contain renewal options and
generally require the Company to pay utilities, insurance, taxes and other
operating expenses.
 
     Future minimum rental payments required under capital and operating leases
that have an initial term in excess of one year as of December 31, 1998, are as
follows:
 
<TABLE>
<CAPTION>
            YEAR ENDED DECEMBER 31,               CAPITAL LEASES    OPERATING LEASES
            -----------------------               --------------    ----------------
<S>                                               <C>               <C>
1999............................................     $ 29,982           $301,523
2000............................................       29,982            106,446
2001............................................       29,982             51,994
2002............................................       29,982                 --
2003............................................       10,930                 --
                                                     --------           --------
                                                      130,858            459,963
Less amounts representing interest..............      (23,699)                --
                                                     --------           --------
                                                     $107,159           $459,963
                                                     ========           ========
</TABLE>
 
     Rent expense under all operating leases during 1996, 1997 and 1998 was
$347,925 and $489,500 and $514,555 respectively.
 
                                       55
<PAGE>   58
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Other
 
     IRIS has a licensing agreement with Cytocolor, Inc. relating to the use of
its patented leukocyte stain in The White IRIS. Under the terms of the
agreement, IRIS is subject to the following future minimum royalty payments:
 
<TABLE>
<CAPTION>
         YEAR ENDED DECEMBER 31,             AMOUNT
         -----------------------            --------
<S>                                         <C>
1999......................................  $ 20,000
2000......................................    20,000
2001......................................    20,000
2002......................................    20,000
Years thereafter..........................   220,000
                                            --------
                                            $300,000
                                            ========
</TABLE>
 
  Litigation
 
     In July 1996, the Company acquired PSI from Digital Imaging Technologies,
Inc. ("DITI"). As part of the purchase price, the Company issued to DITI a
five-year warrant to purchase 875,000 shares of Common Stock at $8.00 per share.
In August 1997, the Company filed a demand for arbitration against DITI with the
American Arbitration Association. The Company's demand for arbitration alleges
material breaches of the representations, warranties and covenants in the
purchase agreement governing the PSI acquisition. DITI subsequently filed a
counterclaim in the arbitration proceeding alleging that the Company
misrepresented or omitted to disclose material facts in connection with the PSI
acquisition. DITI had previously requested a reduction in the exercise price of
the warrant but elected to seek unspecified monetary damages in the
counterclaim. The parties are currently engaged in discovery. Although the
Company does not presently anticipate any material adverse effect as a result of
this arbitration proceeding, there can be no assurance that it will not have
such an effect on the financial position or results of operations of the Company
or result in additional dilution to holders of the Common Stock.
 
15. EARNINGS PER SHARE.
 
     The computation of per share amounts for 1996, 1997 and 1998 is based on
the average number of common shares outstanding for the period. Options and
warrants to purchase 2,636,034, 3,072,203 and 2,991,904 shares of common stock
outstanding during 1996, 1997 and 1998, respectively, were not considered in the
computation of diluted EPS because their inclusion would have been antidilutive.
 
     For earnings per share purposes, the preferred stock convertible into
842,697 common shares at December 31, 1996 and 1997 and 1,052,632 common shares
at December 31, 1998 was also not considered in the computation of diluted EPS
because its inclusion would have been antidilutive.
 
16. LICENSE.
 
     Sysmex Corporation, formerly known as TOA Medical Electronics Co., Ltd.,
has developed several urine sediment analyzers under license from IRIS using
pre-1989 IRIS technology. IRIS received royalties under this license of $43,000,
$513,000 and $230,000 in 1996, 1997 and 1998, respectively.
 
17. RESEARCH AND DEVELOPMENT GRANTS AND CONTRACTS.
 
     The Company has in the past partially funded its research and development
programs through (i) grants from NASA and the National Institutes of Health (ii)
joint development programs with strategic partners and (iii) Company-sponsored
research and development entities. In recent years, the Company has entered into
four significant externally-funded projects, two joint development projects with
strategic partners -- BMC and
 
                                       56
<PAGE>   59
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
BMG -- and two projects with Company-sponsored research and development
entities -- LDA Systems, Inc. and Poly.
 
     From 1994 to 1996, the Company collaborated with BMC and BMG in the
development of CHEMSTRIP/IRIStrip urine test strips and the Model 900UDx. BMC
supplies the Company with CHEMSTRIP/ IRIStrip urine test strips and has agreed
to supply the Company with certain raw materials should the Company elect to
manufacture its own urine test strips, subject to royalty payments. The Company
was granted the non-exclusive right to distribute certain other BMC urinalysis
products to hospitals and commercial laboratories in the United States. The
Company manufactures the Model 900UDx with BMG providing certain components on a
OEM basis at cost. The Company has exclusive marketing rights to the Model
900UDx in the United States, Canada and Taiwan and non-exclusive rights for the
rest of the world outside of Germany and Italy. During 1997, Hoffman-LaRoche
acquired the Boehringer Mannheim Group of companies, and BMC and BMG are now
operated as Roche Diagnostics.
 
     In 1992, the Company entered into a project with LDA for development of The
White IRIS leukocyte differential analyzer and later acquired LDA for
approximately 498,000 shares of the Company's common stock. The FDA cleared The
White IRIS in May 1996, but its commercial release has been delayed by other
priorities. In 1995, the Company entered into a similar project with Poly for
development of several new products to enhance automated urinalysis (the "Poly
Products").
 
     Reimbursements are recognized under research and development grants and
contracts in amounts equivalent to reimbursable research and development costs
incurred on the related project plus, where contractually provided for, an
amount to cover general and administrative costs of the project.
 
     Reimbursements and direct costs connected with research and development
grants and agreements were as follows:
 
<TABLE>
<CAPTION>
                                            FOR THE YEAR ENDED DECEMBER 31,
                                         --------------------------------------
                                            1996          1997          1998
                                         ----------    ----------    ----------
<S>                                      <C>           <C>           <C>
Reimbursements.........................  $1,779,820    $1,014,520    $  921,153
Costs..................................   1,498,165     1,414,113     1,013,347
                                         ----------    ----------    ----------
Net costs (reimbursements).............  $ (281,655)   $  399,593    $   92,194
                                         ==========    ==========    ==========
</TABLE>
 
     Net costs incurred under research and development grants and contracts have
been included in research and development expense in the statements of
operations.
 
18. UNUSUAL CHARGES.
 
     The results of operations for the year ended December 31, 1996 included
unusual charges totaling $1,891,592. Due to the Company's decision not to pursue
a previously announced public offering, the Company recognized $685,721 of
expenses associated with the offering. The charge also included $617,266 for
expenses related to completed litigation and arbitration matters. In the fourth
quarter of 1996, the Company incurred a charge of $298,113 for severance and
other incremental costs associated with a restructuring of the Company's
personnel. Legal and accounting expenses for the Company's merger with StatSpin
totaled $244,492. Reductions in the net realizable value of other assets totaled
$46,000. The results of operations for the year ended December 31, 1997 include
certain unusual charges to earnings of $1,338,338 primarily for the write-off of
deferred offering costs ($481,325), goodwill associated with the digital
refractometer line of business ($704,579) and legal expenses ($152,434) related
to the recently completed Intelligent Medical Imaging, Inc. patent litigation
and the pending arbitration matter against Digital Imaging Technologies, Inc.
Unusual charges for the year ended December 31, 1998 totaled $193,186 and
related primarily to the pending arbitration matters.
 
                                       57
<PAGE>   60
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
19. SEGMENT AND GEOGRAPHIC INFORMATION.
 
     In the quarter ended June 30, 1998, the Company adopted SFAS No. 131,
replacing SFAS No. 14. (See Note 2 -- "Segment Reporting".) Under SFAS No. 14
the Company operated in one industry segment. The Company is organized on the
basis of products and related services and under SFAS No. 131 operates in three
segments: (1) urinalysis, (2) genetic analysis and (3) small laboratory devices.
 
     The urinalysis segment designs, develops, manufactures and markets IVD
systems based on patented and proprietary AIM technology for automating
microscopic procedures for urinalysis. In December 1997, this segment also began
distributing the UF-100 urine cell analyzer in the United States under an
existing agreement with its manufacturer. The segment also provides ongoing
sales of supplies and service necessary for the operation of installed
urinalysis workstations. In the United States, these products are sold through a
direct sales force. Internationally, these products are sold through
distributors. This segment has also had a major program over a number of years
to develop The White IRIS leukocyte differential analyzer. The Company has
elected not to launch The White IRIS at this time due to limited resources and
the potential impact of product launch costs on profitability. The Company is
exploring strategic alternatives for The White IRIS program and therefore cannot
reasonably estimate any impact on the recoverability of the capitalized costs
associated with the product line, principally capitalized software and
inventory. If the Company is unable to develop a viable strategic alternative
for the program and as a result abandons the product line, it would incur a
charge against future earnings of up to $1.2 million for the related amounts
capitalized.
 
     The genetic analysis segment designs, develops, manufactures and markets
IVD imaging systems for karyotyping, DNA probe analysis and comparative genomic
hybridization. These products are sold in the United States through a direct
sales force and internationally through its United Kingdom subsidiary directly
as well as through distributors and agents.
 
     The small laboratory devices segment designs, develops, manufactures and
markets a variety of benchtop centrifuges, small instruments and supplies. These
products are used primarily for manual specimen preparation and dedicated
applications in coagulation, cytology, hematology and urinalysis. These products
are sold worldwide through distributors.
 
     The accounting policies of the segments are the same as those described in
the "Summary of Significant Accounting Policies" included in this annual report
for the year ended December 31, 1998. The Company evaluates the performance of
its segments and allocates resources to them based on earnings before income
taxes, excluding corporate charges ("Segment Profit").
 
     The tables below present information about reported segments for the three
years ended December 31, 1998:
 
<TABLE>
<CAPTION>
                                                              SMALL       UNALLOCATED
                                               GENETIC      LABORATORY     CORPORATE
                               URINALYSIS      ANALYSIS      DEVICES       EXPENSES        TOTAL
                               -----------   ------------   ----------    -----------   ------------
<S>                            <C>           <C>            <C>           <C>           <C>
FOR THE YEAR ENDED DECEMBER
31, 1996
Revenues.....................  $13,064,102   $  2,466,660   $5,066,292             --   $ 20,597,054
Interest income..............  $   209,609   $      1,081   $   11,245             --   $    221,935
Interest expense.............           --   $    677,818   $    3,296             --   $    681,114
Depreciation and
  amortization...............  $ 1,110,305   $    638,890   $  281,261    $    75,298   $  2,105,754
Other noncash items..........  $   146,636   $  7,250,000           --             --   $  7,396,636
Unusual items................  $   822,958   $  7,282,206   $   19,074    $ 1,017,354   $  9,141,592
Segment profit (loss)........  $  (717,081)  $ (8,707,958)  $  984,695    $(2,445,771)  $(10,886,115)
Segment assets...............  $15,606,015   $ 11,089,196   $2,952,284    $ 8,212,750   $ 37,860,245
Additions to long-lived
  assets.....................  $ 1,592,495   $ 10,512,360   $  788,526             --   $ 12,893,381
</TABLE>
 
                                       58
<PAGE>   61
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
<TABLE>
<CAPTION>
                                                              SMALL       UNALLOCATED
                                               GENETIC      LABORATORY     CORPORATE
                               URINALYSIS      ANALYSIS      DEVICES       EXPENSES        TOTAL
                               -----------   ------------   ----------    -----------   ------------
<S>                            <C>           <C>            <C>           <C>           <C>
FOR THE YEAR ENDED
DECEMBER 31, 1997
Revenues.....................  $16,184,542   $  6,771,032   $4,539,574             --   $ 27,495,148
Interest income..............  $    34,673   $      4,203   $   17,681             --   $     56,557
Interest expense.............           --   $  1,208,138           --             --   $  1,208,138
Depreciation and
  amortization...............  $ 1,207,014   $  1,472,518   $  936,005(1) $    64,460   $  3,679,997
Other noncash items..........  $    57,031             --   $   (1,374)            --   $     55,657
Unusual items................  $    95,129             --   $  704,579    $   538,630   $  1,338,338
Segment profit (loss)........  $ 2,720,558   $ (1,912,239)  $  371,988    $(1,976,595)  $   (796,288)
Segment assets...............  $10,872,075   $ 11,179,455   $2,067,297    $ 8,615,750   $ 32,734,577
Additions to long-lived
  assets.....................  $ 1,080,419   $    402,890   $   31,387             --   $  1,514,696
FOR THE YEAR ENDED
DECEMBER 31, 1998
Revenues.....................  $17,000,874   $  5,936,301   $4,580,304             --   $ 27,517,479
Interest income..............  $    20,123   $      7,561   $   13,812             --   $     41,496
Interest expense.............  $     5,147   $  1,157,487           --             --   $  1,162,634
Depreciation and
  amortization...............  $ 1,069,208   $  1,453,770   $  163,074    $   114,818   $  2,800,870
Other noncash items..........  $     3,965             --           --             --   $      3,965
Unusual items................                          --           --    $   193,186   $    193,186
Segment profit (loss)........  $ 2,867,240   $ (2,748,950)  $1,079,027    $(1,701,830)  $   (504,513)
Segment assets...............  $11,283,687   $ 10,219,931   $1,746,774    $ 8,856,692   $ 32,107,084
Additions to long-lived
  assets.....................  $   950,260   $    377,948   $   51,064             --   $  1,379,272
</TABLE>
 
---------------
(1) Includes writeoff totaling $704,579 relating to the goodwill associated with
    the digital refractometer line of business.
 
     The Company ships products from three locations in the United States and
from its subsidiary in the United Kingdom. The following table presents sales by
its United States and United Kingdom locations for the three years ended
December 31, 1998:
 
<TABLE>
<CAPTION>
                                         1996           1997           1998
                                      -----------    -----------    -----------
<S>                                   <C>            <C>            <C>
Sales
  United States.....................  $18,937,542    $24,862,561    $24,193,326
  United Kingdom....................    1,659,512      2,632,587      3,324,153
                                      -----------    -----------    -----------
                                      $20,597,054    $27,495,148    $27,517,479
                                      ===========    ===========    ===========
</TABLE>
 
     The following is long-lived assets information by geographic area for the
three years ended December 31, 1998:
 
<TABLE>
<CAPTION>
                                         1996           1997           1998
                                      -----------    -----------    -----------
<S>                                   <C>            <C>            <C>
Long-lived assets
  United States.....................  $ 9,544,977    $ 7,914,822    $ 7,777,769
  United Kingdom....................    5,622,790      5,389,300      4,712,374
                                      -----------    -----------    -----------
                                      $15,167,767    $13,304,122    $12,490,143
                                      ===========    ===========    ===========
</TABLE>
 
                                       59
<PAGE>   62
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
20. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED).
 
     The following table summarizes certain financial information by quarter for
1997 and 1998:
 
<TABLE>
<CAPTION>
                                                             1997 QUARTER ENDED
                                           -------------------------------------------------------
                                            MARCH 31      JUNE 30      SEPTEMBER 30    DECEMBER 31
                                           ----------    ----------    ------------    -----------
<S>                                        <C>           <C>           <C>             <C>
Net revenues.............................  $6,290,035    $6,604,284     $7,196,713     $7,404,116
Gross margin on net revenues.............   3,114,152     3,238,330      3,612,316      3,778,958
Other income (expense), net..............    (291,062)     (231,608)      (234,666)      (322,935)
Net income (loss)........................    (202,075)       17,330        214,381       (532,924)
Net income (loss) per share -- Basic.....  $     (.11)   $      .00     $      .04     $     (.09)
Net income (loss) per share -- Diluted...  $     (.11)   $      .00     $      .03     $     (.09)
</TABLE>
 
     The quarters ended March 31 and June 30 and September 30, 1997 include
unusual charges totaling $95,129, $2,900 and $31,633 relating to litigation and
arbitration matters. The quarter ended December 31, 1997 includes unusual
charges totaling $1,208,676 primarily relating to the write-off of deferred
private offering costs and the write-off of goodwill no longer considered
recoverable.
 
<TABLE>
<CAPTION>
                                                             1998 QUARTER ENDED
                                           -------------------------------------------------------
                                            MARCH 31      JUNE 30      SEPTEMBER 30    DECEMBER 31
                                           ----------    ----------    ------------    -----------
<S>                                        <C>           <C>           <C>             <C>
Net revenues.............................  $6,592,641    $6,707,030     $7,137,603     $7,080,205
Gross margin on net revenues.............   3,354,827     2,848,691      3,672,516      3,491,419
Other income (expense), net..............    (283,681)     (263,276)      (224,616)      (289,014)
Net income (loss)........................       3,806      (211,090)        94,048       (271,537)
Net income (loss) per share -- Basic.....  $      .00    $     (.03)    $      .01     $     (.04)
Net income (loss) per share -- Diluted...  $      .00    $     (.03)    $      .01     $     (.04)
</TABLE>
 
     The quarters ended March 31, June 30, September 30 and December 31, 1998
include unusual charges totaling $37,666, $48,922, $38,254 and $68,344 relating
to litigation and arbitration matters.
 
                                       60
<PAGE>   63
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
                SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
 
<TABLE>
<CAPTION>
                                                        ADDITIONS
                                             --------------------------------
                                BEGINNING    CHARGED TO COST     CHARGED TO                       ENDING
                                 BALANCE      AND EXPENSES     OTHER ACCOUNTS   DEDUCTIONS       BALANCE
                                ----------   ---------------   --------------   ----------      ----------
<S>                             <C>          <C>               <C>              <C>             <C>
YEAR ENDED DECEMBER 31, 1998
Allowance for Doubtful
  Accounts....................  $  267,579      $  3,965               --              --       $  271,544
Reserve for Inventory
  Obsolescence................  $  589,772      $213,826               --       $(151,507)(1)   $  652,091
Deferred Tax Asset Valuation
  Allowance...................  $2,000,000            --               --              --       $2,000,000
YEAR ENDED DECEMBER 31, 1997
Allowance for Doubtful
  Accounts....................  $  274,766      $ 15,105          $10,714       $ (33,006)(1)   $  267,579
Reserve for Inventory
  Obsolescence................  $  404,611      $417,787               --       $(232,626)(1)   $  589,772
Deferred Tax Asset Valuation
  Allowance...................  $2,000,000            --               --              --       $2,000,000
YEAR ENDED DECEMBER 31, 1996
Allowance for Doubtful
  Accounts....................  $   87,759      $198,037          $10,000       $ (21,030)(1)   $  274,766
Reserve for Inventory
  Obsolescence................  $  380,845       232,626               --       $(208,860)(1)   $  404,611
Deferred Tax Asset Valuation
  Allowance...................  $1,563,000      $437,000               --              --       $2,000,000
</TABLE>
 
---------------
(1) Relates to the write-off of accounts receivable or disposal of obsolete
    inventory.
 
                                       61
<PAGE>   64
 
                                   IRIS LOGO
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
                                9162 ETON AVENUE
                              CHATSWORTH, CA 91311
                                 (818) 709-1244
 
                                       62
<PAGE>   65
 
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
 
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
 
                            ------------------------
 
                                    EXHIBITS
 
                                       TO
 
                                   FORM 10-K
                            ------------------------
 
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
 
                           COMMISSION FILE NO. 1-9767
 
                   INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
 
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
 
                                       63
<PAGE>   66
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
EXHIBIT
 NUMBER                             DESCRIPTION
--------                            -----------
<S>         <C>
 3.1(a)     Certificate of Incorporation, as amended(1)
 3.1(b)     Certificate of Designations of Series A Convertible
            Preferred Stock(2)
 3.2        Restated Bylaws(3)
 4.1        Specimen of Common Stock Certificate(4)
 4.2        Certificate of Designations of Series A Convertible
            Preferred Stock(2)
10.1        Lease of the Company's headquarters facility, as amended(5)
10.2(a)     1982 Stock Option Plans and form of Stock Option
            Agreement(6)
10.2(b)     1983 and 1986 Stock Option Plans, and forms of Stock Option
            Agreements for each Plan(7)
10.2(c)     Amended and Restated 1986 Stock Option Plan(8)
10.2(d)     1994 Stock Option Plan and forms of Stock Option
            Agreements(9)
10.2(e)     Certificate of Officer With Respect to Amendment of 1994
            Stock Option Plan(10)
10.2(f)     Key Employee Stock Purchase Plan(11)
10.2(g)     1997 Stock Option Plan and form of Stock Option
            Agreement(12)
10.3(h)     1998 Stock Option Plan and form of Stock Option
            Agreement(13)
10.3(a)     Various Agreements with Sysmex Corporation, formerly TOA
            Medical Electronics Company, Ltd.(14)
10.3(b)     Patent License Agreement dated April 1, 1997 between the
            Company and Sysmex Corporation, formerly TOA Medical
            Electronics Company, Ltd.(15)
10.3(c)     Termination, Release and Reassignment of Security Interest
            dated October 30, 1997 executed by Sysmex Corporation,
            formerly TOA Medical Electronics Company, Ltd. in favor of
            the Company(15)
10.4(a)     Agreement for a Strategic Alliance in Urinalysis dated
            January 7, 1994 between the Company and Boehringer Mannheim
            Corporation(16)
10.4(b)     Research and Development and Distribution Agreement dated
            February 6, 1995 by and among the Company, LDA Systems, Inc.
            and Corange International Limited(16)
10.4(c)     Amendment to Distribution Agreements(17)
10.5        Warrant Certificate dated March 20, 1995 issued to
            Biovation, Inc.(16)
10.6(a)     Technology License Agreement dated as of September 29, 1995
            between the Company and Poly U/A Systems, Inc.(18)
10.6(b)     Research and Development Agreement dated as of September 29,
            1995 between the Company and Poly U/A Systems, Inc.(18)
10.6(c)     $100 Class "A" Note dated September 29, 1995 issued by Poly
            U/A Systems, Inc. in favor of the Company(18)
10.6(d)     Certificate of Incorporation of Poly U/A Systems, Inc. (See
            Article FOUR regarding the IRIS Option)(18)
10.6(e)     Form of Series D Warrant(15)
10.6(f)     Form of Series E Warrant(15)
10.6(g)     Form of Series F Warrant(15)
10.7(a)     Agreement and Plan of Merger dated January 31, 1996 between
            the Company and StatSpin, Inc.(19)
</TABLE>
 
                                       64
<PAGE>   67
 
<TABLE>
<CAPTION>
EXHIBIT
 NUMBER                             DESCRIPTION
--------                            -----------
<S>         <C>
10.7(b)     Registration Rights Agreement dated January 31, 1996 between
            the Company and StatSpin Stockholders(19)
10.7(c)     Employment Agreement dated January 30, 1996 with Thomas F.
            Kelley(19)
10.7(d)     Letter Agreement dated October 4, 1997 amending Employment
            Agreement of Thomas F. Kelley(15)
10.8(a)     Asset Purchase Agreement dated as of July 15, 1996 by and
            among the Company, Digital Imaging Technologies, Inc.,
            Perceptive Scientific Instruments, Inc. and Perceptive
            Scientific Technologies, Inc.(20)
10.8(b)     Registration Rights and Standstill Agreement dated July 31,
            1996 between the Company and Digital Imaging Technologies,
            Inc.(10)
10.8(c)     Warrant Certificate dated July 31, 1996 issued to Digital
            Imaging Technologies, Inc.(10)
10.8(d)     Stockholder Guaranty Agreement dated July 31, 1996 between
            Edward Randall, III and PSII Acquisition Corp., a
            wholly-owned subsidiary of the Company (now known as
            Perceptive Scientific Instruments, Inc.)(10)
10.8(e)     Non-Competition Agreement dated as of July 15, 1996 between
            Edward Randall, III and PSII Acquisition Corp., a
            wholly-owned subsidiary of the Company (now known as
            Perceptive Scientific Instruments, Inc.)(10)
10.8(f)     Technology License Agreement dated July 31, 1996 between
            Perceptive Scientific Imaging Systems, Inc. and PSII
            Acquisition Corp., a wholly-owned subsidiary of the Company
            (now known as Perceptive Scientific Instruments, Inc.)(10)
10.9        $7,000,000 Subordinated Note dated July 29, 1996 issued by
            the Company in favor of Digital Imaging Technologies,
            Inc.(10)
10.10(a)    Loan and Security Agreement dated as of May 5, 1998 among
            the Company, Perceptive Scientific Instruments, Inc., and
            StatSpin, Inc., on the one hand, and Foothill Capital
            Corporation, on the other hand.(21)
10.10(b)    Intellectual Property Security Agreement dated as of May 5,
            1998 between the Company and Foothill Capital
            Corporation(21)
10.10(c)    Copyright Security Agreement dated as of May 5, 1998 between
            the Company and Foothill Capital Corporation(21)
10.10(d)    Intellectual Property Security Agreement dated as of May 5,
            1998 between Perceptive Scientific Instruments, Inc. and
            Foothill Capital Corporation(21)
10.10(e)    Copyright Security Agreement dated as of May 5, 1998 between
            Perceptive Scientific Instruments, Inc. and Foothill Capital
            Corporation(21)
10.10(f)    Security Agreement -- Stock Pledge dated as of May 5, 1998
            between Perceptive Scientific Instruments, Inc. and Foothill
            Capital Corporation(21)
10.10(g)    Intellectual Property Security Agreement dated as of May 5,
            1998 between StatSpin, Inc. and Foothill Capital
            Corporation(21)
10.10(h)    Amendment Number One to Loan and Security Agreement dated as
            of March 23, 1999 among the Company, Perceptive Scientific
            Instruments, LLC, and StatSpin, Inc., on the one hand, and
            Foothill Capital Corporation, on the other hand
10.10(i)    Amendment Number One to Security Agreement -- Stock Pledge
            dated as of March 23, 1999 among the Company and Perceptive
            Scientific Instruments, LLC, on the one hand, and Foothill
            Capital Corporation, on the other hand
10.10(j)    Amendment to Copyright Security Agreement dated as of March
            23, 1999 among the Company and Perceptive Scientific
            Instruments, LLC, on the one hand, and Foothill Capital
            Corporation, on the other hand
</TABLE>
 
                                       65
<PAGE>   68
 
<TABLE>
<CAPTION>
EXHIBIT
 NUMBER                             DESCRIPTION
--------                            -----------
<S>         <C>
10.10(k)    Amendment to Intellectual Property Security Agreement dated
            as of March 23, 1999 among the Company and Perceptive
            Scientific Instruments, LLC, on the one hand, and Foothill
            Capital Corporation, on the other hand
10.10(l)    Amendment Number Two to Loan and Security Agreement dated as
            of March 19, 1999 among the Company, Perceptive Scientific
            Instruments, LLC, and StatSpin, Inc., on the one hand, and
            Foothill Capital Corporation, on the other hand
10.10(m)    Warrant to Purchase Common Stock dated June 1, 1997 issued
            to City National Bank(15)
10.10(n)    Warrant to Purchase Common Stock dated July 1, 1997 issued
            to City National Bank(15)
10.10(o)    Warrant to Purchase Common Stock dated March 15, 1997 issued
            to City National Bank(22)
10.11(a)    Securities Purchase Agreement dated December 31, 1996 by and
            between the Company and Thermo Amex Convertible Growth Fund
            I, L.P.(2)
10.11(b)    Common Stock Purchase Warrant dated December 31, 1996 issued
            to Thermo Amex Convertible Growth Fund I, L.P.(2)
10.11(c)    Registration Rights Agreement dated December 31, 1996 by and
            between the Company and Thermo Amex Convertible Growth Fund
            I, L.P.(2)
24          Consent of PricewaterhouseCoopers LLP
27          Financial Data Schedule 1998
</TABLE>
 
     Exhibits followed by a number in parenthesis are incorporated by reference
to the similarly numbered Company document cited below:
---------------
 (1) Current Report on Form 8-K dated August 13, 1987 and Quarterly Report on
     Form 10-Q for the quarter ended September 30, 1993.
 
 (2) Current Report on Form 8-K dated January 15, 1997.
 
 (3) Quarterly Report on Form 10-Q for the quarter ended September 30, 1994.
 
 (4) Registration Statement on Form S-3, as filed with the Securities and
     Exchange Commission on March 27, 1996 (File No. 333-002001).
 
 (5) Annual Report on Form 10-K for the year ended December 31, 1989, Quarterly
     Report on Form 10-Q for the quarter ended September 30, 1993 and Annual
     Report on Form 10-K for the year ended December 31, 1994.
 
 (6) Registration Statement on Form S-2, as filed with the Securities and
     Exchange Commission on September 4, 1985 (File No. 2-99240).
 
 (7) Registration Statement on Form S-8, as filed with the Securities and
     Exchange Commission on May 10, 1982 (File No. 2-77496).
 
 (8) Annual Report on Form 10-K for the year ended December 31, 1992.
 
 (9) Registration Statement on Form S-8, as filed with the Securities and
     Exchange Commission on August 8, 1994 (File No. 33-82560).
 
(10) Quarterly Report on Form 10-Q for the quarter ended June 30, 1996.
 
(11) Registration Statement on Form S-8, as filed with the Securities and
     Exchange Commission on January 3, 1997 (File No. 333-19265).
 
(12) Registration Statement on Form S-8, as filed with the Securities and
     Exchange Commission on July 16, 1997 (File No. 333-31393).
 
(13) Registration Statement on Form S-8, as filed with the Securities and
     Exchange Commission on October 9, 1998 (File No. 333-65547).
 
(14) Current Report on Form 8-K dated July 15, 1988 and Quarterly Report on Form
     10-Q for the quarter ended June 30, 1995.
 
                                       66
<PAGE>   69
 
(15) Annual Report on Form 10-K for the year ended December 31, 1997.
 
(16) Annual Report on Form 10-K for the year ended December 31, 1994.
 
(17) Quarterly Report on Form 10-Q for the quarter ended September 30, 1996.
 
(18) Quarterly Report on Form 10-Q for the quarter ended September 31, 1995.
 
(19) Annual Report on Form 10-K for the year ended December 31, 1995.
 
(20) Current Report on Form 8-K filed July 17, 1996.
 
(21) Quarterly Report on Form 10-Q for the quarter ended March 31, 1998.
 
(22) Annual Report on Form 10-K for the year ended December 31, 1996.
 
                                       67