EXHIBIT 13.0
                 EXCERPTS FROM ANNUAL REPORT TO SECURITY HOLDERS

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

SHAREHOLDERS AND BOARD OF DIRECTORS
INTER-TEL, INCORPORATED

We have  audited the  accompanying  consolidated  balance  sheets of  Inter-Tel,
Incorporated  and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of income, shareholders' equity, and cash flows for each
of the three  years in the period  ended  December  31,  1998.  These  financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is to express an opinion on these financial  statements based on
our audits.

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

In our opinion,  the financial  statements  referred to above present fairly, in
all  material  respects,  the  consolidated  financial  position  of  Inter-Tel,
Incorporated   and   subsidiaries  at  December  31,  1998  and  1997,  and  the
consolidated  results of their  operations  and their cash flows for each of the
three years in the period ended December 31, 1998, in conformity  with generally
accepted accounting principles.

                                             /s/ Ernst & Young LLP

Phoenix, Arizona
February 26, 1999

                                       32
<PAGE>
INTER-TEL, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 1998 and 1997

(In thousands, except share amounts)                       1998          1997
                                                           ----          ----
ASSETS
CURRENT ASSETS
Cash and equivalents                                    $  63,124     $  88,805
Accounts receivable, less allowances of
   $4,604 in 1998 and $3,722 in 1997                       41,116        32,234
Inventories, less allowances of $5,453 in
   1998 and $5,740 in 1997                                 19,663        21,539
Net investment in sales-leases                             13,979         9,196
Prepaid expenses and other assets                           2,781         5,625
                                                        ---------     ---------
TOTAL CURRENT ASSETS                                      140,663       157,399
PROPERTY, PLANT & EQUIPMENT                                28,969        19,559
OTHER ASSETS                                               27,398        18,030
                                                        ---------     ---------
                                                        $ 197,030     $ 194,988
                                                        ---------     ---------
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable                                        $  14,956     $  14,864
Other current liabilities                                  29,390        18,721
                                                        ---------     ---------
TOTAL CURRENT LIABILITIES                                  44,346        33,585

DEFERRED TAX LIABILITY                                      5,026        11,343
OTHER LIABILITIES                                           4,972         4,555

SHAREHOLDERS' EQUITY
Common stock, no par value - authorized
  100,000,000 shares, issued and outstanding -
  26,029,987 shares in 1998 and 26,687,766
  shares in 1997                                          104,539        99,229
Retained earnings                                          54,194        46,547
Accumulated other comprehensive income                       (196)         (271)
                                                        ---------     ---------
                                                          158,537       145,505

Less:  Treasury stock at cost                             (15,851)           --
                                                        ---------     ---------

TOTAL SHAREHOLDERS' EQUITY                                142,686       145,505
                                                        ---------     ---------
                                                        $ 197,030     $ 194,988
                                                        ---------     ---------
See accompanying notes.

                                       33
<PAGE>
INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME 
Years Ended December 31, 1998, 1997 and 1996

(In thousands, except per share data)          1998         1997         1996
                                               ----         ----         ----

NET SALES                                   $ 274,504    $ 223,569    $ 185,884
Cost of sales                                 140,946      122,363      104,966
                                            ---------    ---------    ---------
GROSS PROFIT                                  133,558      101,206       80,918

Research and development                       11,373        7,998        6,581
Selling, general and administrative            86,554       69,942       56,386
Special charge                                 22,755           --        4,542
                                            ---------    ---------    ---------

OPERATING INCOME                               12,876       23,266       13,409
                                            ---------    ---------    ---------
Other income                                    3,018        1,383        1,974
Interest expense                                  (60)         (47)         (77)
                                            ---------    ---------    ---------

INCOME BEFORE INCOME TAXES                     15,834       24,602       15,306

INCOME TAXES
Current                                        13,390        8,850        3,480
Deferred                                       (6,600)       1,070        2,784
                                            ---------    ---------    ---------
                                                6,790        9,920        6,264
                                            ---------    ---------    ---------

NET INCOME                                  $   9,044    $  14,682    $   9,042
                                            ---------    ---------    ---------
NET INCOME PER SHARE
Basic                                       $    0.34    $    0.59    $    0.35
Diluted                                     $    0.32    $    0.57    $    0.34
                                            ---------    ---------    ---------

Average common shares outstanding              26,602       24,836       25,780

Average common shares outstanding
   assuming dilution                           27,846       25,983       26,572
                                            ---------    ---------    ---------

See accompanying notes.

                                       34
<PAGE>
INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF
SHAREHOLDERS' EQUITY 
Years Ended December 31, 1998, 1997 and 1996
<TABLE>
<CAPTION>
                                                                    Accumulated
                                                                       Other      Receivable
(In thousands, except            Common     Treasury    Retained   Comprehensive     From
 share amounts)                  Stock       Stock      Earnings      Income         ESOP       Total
 --------------                  -----       -----      --------      ------         ----       -----
<S>                            <C>         <C>         <C>          <C>            <C>       <C>
BALANCE AT DECEMBER 31, 1995    $  58,966   $     --    $ 26,422     $ (112)        $ (159)   $ 85,117

Exercise of stock options             611                                                          611
Tax benefit from stock options        417                                                          417
Escrow share cancellation from
  prior stock acquisition            (119)                                                        (119)
Collection from ESOP                                                                   113         113

Net income                                                 9,042                                 9,042
Loss on currency translation                                           (247)                      (247)
                                                                                              --------
Comprehensive income                                                                             8,795

-------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1996       59,875         --      35,464       (359)           (46)     94,934

Stock repurchase                             (27,194)                                          (27,194)
Exercise of stock options             642      4,533      (3,332)                                1,843
Tax benefit from stock options      1,967                                                        1,967
Collection from ESOP                                                                    46          46
Stock issued under
   Employee Stock Purchase Plan       256                                                          256
Issuance of 3,000,000 shares of
   common stock                    36,489     22,661                                            59,150

Net income                                                14,682                                14,682
Gain on currency translation                                             88                         88
                                                                                              --------
Comprehensive income                                                                            14,770

Dividends                                                   (267)                                 (267)

-------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1997       99,229         --      46,547       (271)            --     145,505

Stock repurchase                             (16,815)                                          (16,815)
Exercise of stock options           1,487        642        (368)                                1,761
Tax benefit from stock options      1,979                                                        1,979
Issuance of 140,000 shares in
acquisition                         1,485                                                        1,485
Stock issued under
   Employee Stock Purchase Plan       359        322          30                                   711

Net income                                                 9,044                                 9,044
Gain on currency translation                                             75                         75
                                                                                              --------
Comprehensive income                                                                             9,119

Dividends                                                 (1,059)                               (1,059)

-------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1998    $ 104,539   $(15,851)   $ 54,194     $ (196)        $   --    $142,686
=======================================================================================================
</TABLE>
See accompanying notes.

                                       35
<PAGE>
INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 1998, 1997 and 1996
--------------------------------------------------------------------------------

(In thousands)                                     1998       1997       1996
                                                   ----       ----       ----
OPERATING ACTIVITIES:
Net income                                       $  9,044   $ 14,682   $  9,042
Adjustments to reconcile net income
 to net cash provided by operating activities:
   Depreciation and amortization                    6,718      4,578      4,097
   Provision for losses on receivables              5,851      4,104      3,746
   Provision for inventory valuation                1,828      4,021        609
   Net contribution to ESOP                            --         46        113
   Increase/(decrease) in other liabilities           586      1,269       (604)
   (Gain)/loss on sale of property and equipment       36        (25)     3,421
   Deferred income taxes                           (6,600)     1,070      2,784
   Effect of exchange rate changes                     74         88       (247)
   Purchased in-process research and development   22,755         --         --
   Changes in operating assets and liabilities     (8,541)    (1,633)   (15,704)
                                                 --------   --------   --------
NET CASH PROVIDED BY OPERATING ACTIVITIES          31,751     28,200      7,257
                                                 --------   --------   --------
INVESTING ACTIVITIES:
Additions to property and equipment               (15,175)   (12,449)    (6,951)
Proceeds from sale of property and equipment          117         63        159
Cash used in acquisitions                         (25,362)        --     (1,780)
                                                 --------   --------   --------
NET CASH USED IN INVESTING ACTIVITIES             (40,420)   (12,386)    (8,572)
                                                 --------   --------   --------
FINANCING ACTIVITIES:
Net proceeds from stock offering                       --     59,150         --
Cash dividends paid                                (1,059)        --         --
Proceeds from exercise of stock options             1,761      1,843        611
Proceeds from stock issued under the
   Employee Stock Purchase Plan                       711        256         --
Payments on acquired long-term debt                (1,610)        --         --
Treasury stock purchases                          (16,815)   (27,194)        --
                                                 --------   --------   --------
NET CASH (USED IN) / PROVIDED BY
 FINANCING ACTIVITIES                             (17,012)    34,055        611
                                                 --------   --------   --------
INCREASE (DECREASE)
  IN CASH AND EQUIVALENTS                         (25,681)    49,869       (704)

CASH AND EQUIVALENTS AT BEGINNING
    OF YEAR                                        88,805     38,936     39,640
                                                 --------   --------   --------
CASH AND EQUIVALENTS AT END OF YEAR              $ 63,124   $ 88,805   $ 38,936
                                                 ========   ========   ========

Noncash transaction: acquisition of
 ITS for stock                                   $  1,485   $     --   $     --

See accompanying notes.

                                       36
<PAGE>
INTER-TEL, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
-------------------------------------------------------------------------------

NOTE A -- SIGNIFICANT ACCOUNTING POLICIES

         DESCRIPTION OF BUSINESS.  Inter-Tel is a single point of contact,  full
service  provider  of  digital  business  telephone  systems,   call  processing
software, voice processing software, call accounting software, Internet Protocol
(IP) telephony software,  computer telephone  integration  applications and long
distance calling services.  Inter-Tel's products and services include the AXXESS
and Inter-Tel  Axxent digital business  communication  software  platforms,  the
AXXESSORY TALK voice processing  platform,  the Inter-Tel Vocal'Net IP telephony
gateway,  InterPrise gateway,  the Inter-Tel Vocal'Net Service Provider Software
and Centralized  Accounting  Software and Inter-Tel.net,  an IP telephony packet
switched long distance service. The Company also provides  maintenance,  leasing
and support services for its products.

         PRINCIPLES OF  CONSOLIDATION.  The  consolidated  financial  statements
include the accounts of Inter-Tel, Incorporated and all significant subsidiaries
(collectively, the "Company").  Intercompany accounts and transactions have been
eliminated in consolidation.

         CASH AND  EQUIVALENTS.  Cash and equivalents  include all highly liquid
investments  with a  remaining  maturity  of  three  months  or  less at date of
acquisition.  Excess cash and equivalents are primarily invested in mutual funds
comprised of foreign and domestic high quality dollar  denominated  money market
instruments rated A-1 by Standard & Poor's Ratings Group, or equivalent.

         INVENTORIES.  Inventories, consisting principally of telephone systems,
computer  equipment  and  related  components,  are  stated at the lower of cost
(first-in, first-out method) or market.

         PROPERTY, PLANT AND EQUIPMENT.  Property, plant and equipment is stated
at cost.  Depreciation  is  computed  using the  straight-line  method  over the
estimated  useful lives of the related  property  which range from 3 years to 12
years.  Leasehold  improvements  are depreciated over the shorter of the related
lease terms or the estimated useful lives of the improvements.

         EXCESS OF PURCHASE PRICE OVER NET ASSETS  ACQUIRED.  Purchase prices of
acquired  businesses  that are accounted for as purchases have been allocated to
the assets and  liabilities  acquired  based on the estimated fair values on the
respective  acquisition dates. Based on these values, the excess purchase prices
over the fair value of the net assets  acquired are being amortized over 3 to 40
years. Accumulated amortization through December 31, 1998 was $1,343,000.

         SALES-LEASES.  The discounted present values of minimum rental payments
under sales-type  leases are recorded as sales, net of provisions for continuing
administration  and other  expenses over the lease period.  The costs of systems
installed  under these  sales-leases,  net of residual  values at the end of the
lease periods,  are recorded as costs of sales.  Gains or losses  resulting from
the sale of rental  income from such leases are recorded as  adjustments  to the
original sales amounts.

         INCOME TAXES.  Deferred income taxes result from temporary  differences
in the  recognition of revenues and expenses for financial  reporting and income
tax purposes.

         ADVERTISING.  The cost of  advertising  is  expensed as  incurred.  The
Company  incurred  $616,000;  $577,000 and $437,000 in advertising  costs during
1998, 1997, and 1996, respectively.

         STOCK BASED COMPENSATION.  The Company grants stock options for a fixed
number of shares to  employees  with an exercise  price equal to the fair market
value of the shares at the date of grant.  The Company accounts for stock option
grants  in  accordance  with  Accounting   Principles   Board  Opinion  No.  25,
"Accounting  for  Stock  Issued  to  Employees,"  ("APB  25")  and  accordingly,
recognizes no compensation  expense for these stock option grants. Refer to note
J regarding additional disclosures.

                                       37
<PAGE>
         FOREIGN CURRENCY TRANSLATION. For the Company's foreign operations, the
local  currency  is the  functional  currency.  All assets and  liabilities  are
translated at period-end  exchange  rates and all income  statement  amounts are
translated at an average of month-end  rates.  Adjustments  resulting  from this
translation are recorded in accumulated other comprehensive income.

         CONTINGENCIES.  The  Company  is a party to certain  litigation  in the
normal course of business. Management does not anticipate that the resolution of
such matters will have a material  adverse effect on the Company's  consolidated
financial position.

         USE  OF  ESTIMATES.  The  preparation  of  the  consolidated  financial
statements in conformity with generally accepted accounting  principles requires
management to make estimates and assumptions that affect the amounts reported in
the consolidated  financial  statements and accompanying  notes.  Actual results
could differ from those estimates.

         RECLASSIFICATIONS. Certain reclassifications have been made to the 1997
and 1996 financial statements to conform to the 1998 presentation.

RECENTLY ISSUED ACCOUNTING STANDARDS.

         COMPREHENSIVE  INCOME.  Effective  January 1, 1998, the Company adopted
Statement of Financial  Accounting  Standards No. 130, ("SFAS 130"),  "Reporting
Comprehensive  Income." SFAS 130 established new standards for the reporting and
display  of  comprehensive  income  and  its  components.  Comprehensive  income
includes certain  non-owner  changes in equity that are currently  excluded from
net income (i.e.,  foreign currency  translation  adjustments).  The adoption of
SFAS 130 had no impact on the Company's net income or stockholders' equity.

         SEGMENT  INFORMATION.   The  Company  adopted  Statement  of  Financial
Accounting  Standards No. 131,  "Disclosures about Segments of an Enterprise and
Related  Information"  ("SFAS 131") in the fiscal year ended  December 31, 1998.
SFAS 131 establishes  standards for reporting  information  regarding  operating
segments in annual financial  statements and requires  selected  information for
those  segments  to  be  presented  in  interim   financial  reports  issued  to
stockholders.  SFAS 131 also establishes standards for related disclosures about
products and services and geographic  areas. To date, the Company has viewed its
operations as principally one segment;  telephone systems,  software and related
long distance calling services.  Refer to Note M for more information  regarding
segment disclosures.

         CAPITALIZATION OF COSTS OF COMPUTER  SOFTWARE.  On January 1, 1999, the
Company will adopt the accounting  provisions required by the American Institute
of Certified Public Accountants' Statement of Position ("SOP") 98-1, "Accounting
for the Costs of Computer  Software  Developed or Obtained  for  Internal  Use,"
issued in March 1998. SOP 98-1, among other things,  requires that certain costs
of  internal  use  software,  whether  purchased  or  developed  internally,  be
capitalized and amortized over the estimated useful life of the software.  Based
on information  currently available,  the adoption of the SOP is not expected to
have a material  impact on the  Company's  consolidated  results of  operations,
financial position or cash flows.

NOTE B --  ACQUISITIONS

         Effective   June  1998,  the  Company   acquired   certain  assets  and
liabilities  of TMSI for  cash.  The  transaction  has been  accounted  for as a
purchase  transaction.  The  purchase  price of  approximately  $25 million plus
related  acquisition  costs  has  been  allocated  to the  acquired  assets  and
liabilities  based on fair  values  at  acquisition.  In  connection  with  this
purchase,  the Company recorded a charge to net income of $13.7 million, for the
write-off  of  in-process  research  and  development  and  acquisition  related
expenses.  The  purchase  price over net  assets  acquired  (goodwill)  is being
amortized over 10 years.

                                       38
<PAGE>
         At the end of the second quarter of 1998, the Company  acquired 100% of
the stock of ITS in exchange for 140,000  shares of the Company's  common stock.
The transaction has been accounted for as a purchase  transaction.  The purchase
price has been allocated to the acquired  assets and  liabilities  based on fair
values at acquisition. The purchase price over net assets acquired (goodwill) is
being amortized over 10 years.

         In November 1998, the Company  acquired  certain assets and liabilities
of  Telesystems  for  cash  and a short  term  note.  The  transaction  has been
accounted for as a purchase  transaction.  The purchase  price of  approximately
$300,000 has been allocated to the acquired assets and liabilities based on fair
values at acquisition. The purchase price over net assets acquired (goodwill) is
being amortized over 10 years.

         In December 1998, the Company  acquired  certain assets and liabilities
of Southcom for cash and a short term note. The  transaction  has been accounted
for as a purchase transaction.  The purchase price of approximately $2.3 million
has been allocated to the acquired assets and  liabilities  based on fair values
at acquisition.  The purchase price over net assets acquired (goodwill) is being
amortized over 10 years.

         TMSI, ITS,  Southcom,  and  Telesystems did not constitute  significant
subsidiaries as defined by the Securities and Exchange Commission. Goodwill from
these acquisitions totaled $5.0 million.

NOTE C -- NET INVESTMENT IN SALES-LEASES

         Net investment in  sales-leases  represents  the value of  sales-leases
presently  held under the Company's  Totalease  program.  The Company  currently
sells the rental  income from some of the  sales-leases.  The Company  maintains
reserves  against  potential  recourse  following  the  resales  based upon loss
experience and past due accounts. Activity during the years was as follows:

                                            Year Ended December 31
     (In thousands)                      1998        1997        1996
                                         ----        ----        ----
     Sales of rental income            $ 68,375     $57,812     $42,985
     Sold income remaining
         unbilled at end of year       $131,292     $99,900     $65,970
     Allowance for uncollectible
         minimum lease payments
         and recourse liability at
         end of year                   $  5,716     $ 3,969     $ 2,706

         The Company  does not expect any  significant  losses from the recourse
provisions  related to the sale of rental income. The Company is compensated for
administration and servicing of rental income sold.

NOTE D -- PROPERTY, PLANT & EQUIPMENT
                                                     December 31
     (In thousands)                               1998        1997
                                                  ----        ----
     Computer systems and equipment             $32,255     $27,886
     Transportation equipment                     1,644       1,665
     Furniture and fixtures                       4,611       4,043
     Leasehold improvements                       2,323       1,693
     Operating leases (telephone equipment)       7,970         684
     Building                                     1,822          --
     Land                                         2,629       2,619
                                                -------     -------
                                                 53,254      38,590
     Less:  Accumulated depreciation
          and amortization                       24,285      19,031
                                                -------     -------
                                                $28,969     $19,559
                                                =======     =======

                                       39
<PAGE>
NOTE E -- OTHER ASSETS
                                                     December 31
     (In thousands)                               1998        1997
                                                  ----        ----
     Net investment in sales-leases             $17,141     $13,402
     Excess of purchase price over net
          assets acquired, net                    8,715       4,380
     Other assets                                 1,542         248
                                                -------     -------
                                                $27,398     $18,030
                                                =======     =======

NOTE F-- OTHER CURRENT LIABILITIES
                                                     December 31
     (In thousands)                               1998        1997
                                                  ----        ----
     Compensation and employee benefits         $10,829     $ 8,163
     Deferred revenues                            2,947       2,947
     Other accrued expenses                      15,614       7,611
                                                -------     -------
                                                $29,390     $18,721
                                                =======     =======
NOTE G -- CREDIT LINE

         The Company maintains a $7,000,000  unsecured bank credit line at prime
rate to cover international letters of credit and for other purposes. The credit
agreement  matures June 1, 2000 and contains certain  restrictions and financial
covenants.  At December 31, 1998,  $1,692,000  of the credit line was  committed
under letter of credit arrangements.

NOTE H -- LEASES

         Rental expense  amounted to $5,060,000;  $4,342,000 and $3,538,000;  in
1998, 1997 and 1996, respectively. Noncancellable operating leases are primarily
for buildings.  Certain of the leases contain provisions for renewal options and
scheduled rent increases. At December 31, 1998, future minimum commitments under
noncancellable leases, including a five year lease for its headquarters facility
and a 15 year lease for its  distribution  and support  facility,  are:  1999 --
$3,262,000;  2000 -- $2,255,000; 2001 -- $1,588,000; 2002 -- $1,083,000; 2003 --
$590,000; thereafter -- $2,523,000.

NOTE I -- INCOME TAXES

         The Company  accounts  for income  taxes under  Statement  of Financial
Accounting  Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under
SFAS 109, the  liability  method is used in accounting  for income taxes.  Under
this method,  deferred tax assets and liabilities are determined (and classified
as current or long-term) based on differences  between  financial  reporting and
tax bases of assets and liabilities and are measured using the enacted tax rates
and laws that will be in effect when the differences are expected to reverse.

                                       40
<PAGE>
         Significant  components of the Company's  deferred tax  liabilities and
assets as of December 31, are as follows:

     (In thousands)                          1998        1997
                                             ----        ----
     DEFERRED TAX LIABILITIES:
          Lease--sales and reserves        $21,029     $15,624
                                           -------     -------
     TOTAL DEFERRED TAX LIABILITIES         21,029      15,624
                                           -------     -------
     DEFERRED TAX ASSETS:
          Inventory basis differences        3,097       2,580
          Accounts receivable reserves       1,782       1,357
          Maintenance reserve                  200         259
          Accrued vacation pay                 750         604
          Book over tax depreciation         1,058           5
          Foreign loss carryforwards         1,160       1,047
          In-process R&D write-off           9,102          --
          Other -- net                       2,674       1,853
                                           -------     -------
     Deferred tax assets                    19,823       7,705
          Less valuation reserve             1,160       1,047
                                           -------     -------
     Net deferred tax assets                18,663       6,658
                                           -------     -------
     NET DEFERRED TAX LIABILITIES          $ 2,366     $ 8,966
                                           =======     =======

         During 1998 and 1997,  the  Company  incurred  losses of  $322,000  and
$722,000 with respect to foreign  operations.  At December 31, 1998, the Company
had foreign loss carryforwards of approximately $3,466,000,  which will begin to
expire in 1999.  The  valuation  allowance  increased  by  $113,000  in 1998 and
$253,000 in 1997 due to increases in foreign loss carryforward benefits.

         Federal and state income taxes consisted of the following:

         (In thousands)         1998           1997           1996
                                ----           ----           ----

         Federal               $4,910         $8,290         $5,414
         State                  1,880          1,630            850
                               ------         ------         ------
                               $6,790         $9,920         $6,264
                               ======         ======         ======

         The  principal  reasons for the  difference  between  total  income tax
expense and the amount  computed by applying the  statutory  federal  income tax
rate to income before taxes are as follows:

                                                 1998        1997        1996
                                                 ----        ----        ----
         Federal tax at statutory rates
              applied to pre-tax income           35%         35%         34%
         State tax net of federal benefit          5           4           4
         Valuation reserve increase
              for foreign losses                   1           1           2
         Other - net                               2          --           1
                                                 ---         ---         ---
                                                  43%         40%         41%
                                                 ===         ===         ===
NOTE J -- EQUITY TRANSACTIONS

         TREASURY STOCK. During the third quarter of 1998, the Company initiated
a stock  repurchase  program under which the Board of Directors  authorized  the
repurchase of up to 2,500,000  shares of the Company's Common Stock. The Company
purchased  1,203,600 shares and expended  approximately  $16.8 million for stock
repurchases  during  1998,  which was funded  primarily  through  existing  cash
balances.  The Company  reissued  shares through  December  through stock option
exercises and issuances.  The proceeds  received for the stock reissued was less
than its cost basis. Accordingly,  the difference was recorded as a reduction to
retained  earnings.  The Company also expended  approximately  $27.2 million for
repurchases of 1,470,000 shares of the Company's Common Stock during 1997, which
was funded primarily through existing cash balances.

         PUBLIC  STOCK  OFFERING.  In a public  offering in December  1997,  the
Company sold  3,000,000  shares of Common Stock.  Net proceeds from the offering
were approximately $59,150,000.  In conjunction with the offering, all remaining
treasury  shares  were  reissued  first and the  remaining  shares  issued  from
previously unissued Common Stock.

                                       41
<PAGE>
         DIVIDEND  POLICY.  On  September  24,  1997,  the  Company's  Board  of
Directors  declared a cash  dividend  (the "Cash  Dividend")  of $0.01 for every
share of Common Stock,  payable  quarterly to shareholders  of record  beginning
December 31, 1997, with dividend  payments to commence on or about 15 days after
the end of each fiscal quarter. The Company has made quarterly dividend payments
for each quarter  since the dividend was declared.  Prior to the Cash  Dividend,
the  Company  had  declared  no  cash   dividends  on  its  Common  Stock  since
incorporation.

         STOCK  OPTION  PLANS.  In July 1990,  the Company  adopted the Director
Stock Option Plan ("the  Director  Plan") and reserved a total of 500,000 shares
of Common  Stock for  issuance  thereunder.  Options must be granted at not less
than 100% of the fair market value of the Company's stock at the dates of grant.
Commencing  with the adoption of the Plan,  each  Eligible  Director  received a
one-time  automatic grant of an option to purchase 5,000 shares of the Company's
Common Stock. In addition,  each Eligible Director shall be granted an option to
purchase  5,000  shares  upon the date five (5) days  after such  person  became
Director,  and an additional option to purchase 5,000 shares five (5) days after
the date of annual reelection as Director.  All options granted have a five-year
term and fully vest at the end of six months from the grant date.

         In November  1993,  the Board of Directors  authorized  the  Inter-Tel,
Incorporated  Long-Term  Incentive Plan ("the 1994 Long Term Plan").  A total of
2,000,000  shares of Common Stock has been reserved for issuance  under the 1994
Long Term Plan to selected  officers and key employees.  Options must be granted
at not less than 100% of the fair  market  value of the  Company's  stock at the
dates of grant.  Options  generally vest over four or five years and expire five
to ten years from the date of grant.

         In February  1997,  the Board of Directors  authorized  the  Inter-Tel,
Incorporated 1997 Long-Term  Incentive Plan ("the 1997 Long Term Plan"). A total
of  2,400,000  shares of Common Stock has been  reserved for issuance  under the
1997 Long Term Plan to selected  officers  and key  employees.  Options  must be
granted at not less than 100% of the fair market value of the Company's stock at
the dates of grant.  Options  generally  vest over four or five years and expire
ten years from the date of grant.

         Under  the  1994  and  1997  Incentive   Plans,   in  some   instances,
predetermined  performance goals and share market value increases must be met to
allow the options to be exercised before the end of the option term.

         Option activity for the past three years under all plans is as follows:

                                                    Number of Shares
                                            1998          1997          1996
                                            ----          ----          ----
     Outstanding at beginning of year    2,962,524     2,192,300     1,695,000
     Granted                               576,928     1,523,000       788,000
     Exercised                            (370,770)     (511,426)     (205,000)
     Expired or canceled                  (220,650)     (241,350)      (85,700)
                                      ------------  ------------  ------------
     Outstanding at end of year          2,948,032     2,962,524     2,192,300
                                      ------------  ------------  ------------
     Exercise price range             $2.24-$26.00  $2.88-$25.88  $2.88-$10.22
     Exercisable at end of year            882,310       587,774       578,700
     Weighted-average fair value of
       options granted                $       9.75  $       8.42  $       2.36

         At December 31,  1998,  the Company has  reserved  4,111,708  shares of
Common Stock for issuance in connection with the stock option plans.

         For the stock option plans discussed above, the Company has adopted the
disclosure  only provisions of Statement of Financial  Accounting  Standards No.
123 "Accounting for Stock-Based  Compensation,"  ("SFAS 123").  Accordingly,  no
compensation cost has been recognized in the accompanying  financial  statements
for the stock option plans.

                                       42
<PAGE>
         The  following  table  summarizes   information   about  stock  options
outstanding at December 31, 1998:

<TABLE>
<CAPTION>
                                Options Outstanding                     Options Exercisable
                     Number                                           Number
      Range       Outstanding at   Weighted-Average    Weighted    Exercisable at    Weighted
   of Exercise     December 31,       Remaining        Average      December 31,     Average
      Price           1998        Contractual Life  Exercise Price     1998       Exercise Price
      -----           ----        ----------------  --------------     ----       --------------
<S>                 <C>               <C>               <C>           <C>             <C>
   $2.24 - $4.31      556,328         6 years            $2.98        385,900          $3.00
   $4.81 - $7.06      593,200         6 years            $5.75        168,400          $6.01
  $7.25 - $13.44    1,153,510         6 years            $8.16        285,710          $8.26
 $15.13 - $26.00      644,994         9 years           $22.12         42,300         $23.90
</TABLE>

         During 1998, the weighted  average  exercise price of options  granted,
exercised, and expired or canceled was $20.89, $4.99 and $8.22, respectively.

         Had  compensation  cost  for the  Company's  stock  option  plans  been
determined  based on the fair value at the grant  date for awards in 1998,  1997
and 1996 consistent with the provisions of SFAS 123, the estimated fair value of
the options would be amortized to expense over the option's  vesting  period and
the Company's  net income and net income per share would have been  decreased to
the pro forma amounts indicated below for the year ended December 31:

(in thousands, except per share amounts)        1998        1997       1996
                                               ------     -------     ------
Net income as reported                         $9,044     $14,682     $9,042

Pro forma net income                           $8,319     $14,345     $8,950

Pro forma earnings per diluted share           $ 0.30     $  0.55     $ 0.34

         Pro forma  results  disclosed  are based on the  provisions of SFAS 123
using  the  Black-Scholes  option  valuation  model  and  are not  likely  to be
representative  of the  effects on pro forma net income  for  future  years.  In
addition,  the  Black-Sholes  option  valuation  model was  developed for use in
estimating the fair value of traded  options which have no vesting  restrictions
and are fully  transferable.  In addition,  option  valuation models require the
input of highly  subjective  assumptions  including  the  expected  stock  price
volatility.  Because the Company's  employee stock options have  characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially  affect the fair value estimate,  in
management's  opinion,  the  estimating  models  do not  necessarily  provide  a
reliable single measure of the fair value of its employee stock options.

         The fair value for these  options  was  estimated  at the date of grant
using a  Black-Scholes  option  pricing  model  using the low end of  reasonable
assumptions for input variables  rather than attempting to identify a best-point
estimate.  The option  pricing  model  utilized the following  weighted  average
assumptions for 1998, 1997 and 1996,  respectively:  risk free interest rates of
5.0% in each  year;  dividend  yields  of 0.25% in 1998 and 1997 and 0% in 1996;
volatility  factors of the expected market price of the Company's stock averaged
 .30;  and a  weighted  average  expected  life of the  option  of 3.0  years for
employee stock options which vest over four to five year periods with a weighted
average vesting period of 2.5 years and 1.5 years for Company  director  options
which vest at the end of six months from the grant date.

         1997  EMPLOYEE  STOCK  PURCHASE  PLAN.  In  April  1997,  the  Board of
Directors  and  stockholders  adopted  the  Employee  Stock  Purchase  Plan (the
"Purchase Plan") and reserved 500,000 shares for issuance to eligible employees.
Under the Purchase Plan,  employees are granted the right to purchase  shares of
Common  Stock at a price per share that is 85% of the lesser of the fair  market
value of the

                                       43
<PAGE>
shares at: (i) the participant's entry date into each six-month offering period,
or (ii) the end of each six-month offering period. Employees may designate up to
10% of their compensation for the purchase of stock. Under the Plan, the Company
sold 45,654 shares for approximately $711,000 ($15.57 per share) to employees in
1998, and 36,018 shares for approximately $256,000 ($7.12 per share) in 1997. At
December 31, 1998, 418,328 shares remained authorized under the Plan.

NOTE K - EARNINGS PER SHARE

         The  following  table sets forth the  computation  of basic and diluted
earnings per share:

(in thousands, except per share amounts)      1998        1997        1996
                                              ----        ----        ----
Numerator:
  Net Income                                $ 9,044     $14,682     $ 9,042
                                            -------     -------     -------
Denominator:
  Denominator for basic earnings per
    share - weighted average shares          26,602      24,836      25,780

  Effect of dilutive securities:
    Employee and director stock options       1,244       1,147         792
                                            -------     -------     -------
  Denominator for diluted earnings per
    share - adjusted weighted average
    shares and assumed conversions           27,846      25,983      26,572
                                            -------     -------     -------

Basic earnings per share                    $  0.34     $  0.59     $  0.35
                                            =======     =======     =======

Diluted earnings per share                  $  0.32     $  0.57     $  0.34
                                            =======     =======     =======

         Options which are  antidilutive  because the exercise price was greater
than the average  market  price of the common  shares,  are not  included in the
computation  of diluted  earnings  per share.  The number of options to purchase
shares of Common Stock that were outstanding  during 1998 that were antidilutive
were  immaterial,  because the market price of the Company's stock was generally
higher  during  the  course of the year than the  prices at which  options  were
granted.

NOTE L -- RETIREMENT PLANS

         The  Company  has two  retirement  plans for the  benefit of all of its
employees.  Under its 401(k)  Retirement  Plan,  participants  may contribute an
amount not exceeding 15 percent of compensation received during participation in
the Plan. The Company makes voluntary annual  contributions to the Plan based on
a percentage of contributions  made by Plan  participants of up to 10 percent of
compensation.  Contributions to the Plan totaled $621,000; $491,000 and $394,000
in 1998, 1997 and 1996, respectively.

         In 1992, the Company initiated an Employee Stock Ownership Plan (ESOP),
advancing  $500,000 to the ESOP Trust for the purpose of purchasing Common Stock
of the Company. The Trust purchased 307,000 shares of the Company's Common Stock
in July 1992. The loan was paid in full during 1997. As the principal  amount of
the loan was repaid to the Company  through  Company annual  contributions,  the
equivalent number of shares released were allocated to employees' accounts to be
held until retirement.  Total shares so allocated were 32,380 and 69,424 in 1997
and 1996,  respectively.  Contributions to the ESOP totaled $62,500 in 1997, and
$125,000 in 1996 and are based upon the historic cost of the shares purchased by
the  ESOP.  After  the final  allocation  of  shares in 1997,  the ESOP plan was
"frozen,"  so that all  eligible  participants  as of July 1, 1997  became  100%
vested in their accounts,  regardless of length of service. No further purchases
are  anticipated  through the ESOP, and the Company does not  anticipate  making
future allocations of shares from this plan.

                                       44
<PAGE>
NOTE M - SEGMENT INFORMATION

         The Company  adopted  Statement of Financial  Accounting  Standards No.
131,  "Disclosures  about  Segments of an  Enterprise  and Related  Information"
("SFAS 131") in the fiscal year ended  December 31, 1998.  SFAS 131  establishes
standards  for  reporting  information  regarding  operating  segments in annual
financial  statements and requires selected information for those segments to be
presented in interim  financial  reports issued to  stockholders.  SFAS 131 also
establishes  standards for related  disclosures  about products and services and
geographic  areas.  Operating  segments  are  identified  as  components  of  an
enterprise about which separate discrete financial  information is available for
evaluation by the chief  operating  decision maker, or decision making group, in
making decisions how to allocate resources and assess performance. The Company's
chief decision maker, as defined under SFAS 131, is the Chief Executive Officer.
To date,  the Company has viewed its  operations  as  principally  one  segment;
telephone  systems,  software and related long distance calling services.  These
services  are provided  through the  Company's  direct sales  offices and dealer
network to business  customers  throughout the United States,  Europe,  Asia and
South  America.  As  a  result,  the  financial   information  disclosed  herein
materially  represents all of the financial information related to the Company's
principal operating segment.

         The  Company's  revenues  are  generated  predominantly  in the  United
States.  Total revenues  generated from U.S.  customers  totaled $263.9 million,
$217.8 million and $183.1 million of total revenues for the years ended December
31, 1998, 1997 and 1996, respectively. The Company's revenues from international
sources were primarily  generated from customers  located in the United Kingdom,
Europe,  Asia and South America. In 1998, 1997 and 1996, revenues from customers
located  internationally  accounted for 3.9%,  2.6% and 1.5% of total  revenues,
respectively.

NOTE N -- FINANCIAL INSTRUMENTS

         CONCENTRATION  OF CREDIT RISK.  Financial  instruments that potentially
subject  the  Company  to  significant  concentrations  of credit  risk  consist
principally of cash investments,  trade accounts receivable,  and net investment
in  sales-leases.  The Company  maintains cash and  equivalents  not invested in
money market funds with a major bank in its  marketplace.  The Company  performs
periodic   evaluations  of  the  relative   credit  standing  of  the  financial
institution.  Concentrations  of credit  risk  with  respect  to trade  accounts
receivable  and net  investment  in  sales-leases  are  limited due to the large
number of entities comprising the Company's customer base.

         FAIR VALUE OF FINANCIAL  INSTRUMENTS.  The carrying  amount of cash and
equivalents,  accounts receivable, net investment in sales-leases,  and accounts
payable  reported in the  consolidated  balance  sheets  approximate  their fair
value.

NOTE O -- SUPPLEMENTAL CASH FLOW
(In thousands)                                  1998        1997        1996
                                                ----        ----        ----
     CASH PAID FOR:
        Interest                              $     60    $     47    $     77
        Income taxes                          $  5,528    $  5,914    $  4,213
                                              --------    --------    --------
     CHANGES IN OPERATING ASSETS
        AND LIABILITIES:
        Increase in receivables               $(17,887)   $ (7,294)   $ (8,569)
        Decrease (increase) in inventories       1,151      (4,280)     (1,309)
        (Increase) decrease in prepaid
           expenses and other assets             2,526       4,407      (6,268)
        Increase in long-term other assets      (3,635)     (2,028)     (4,024)
        Increase in accounts payable
           and other current liabilities         9,304       7,562       4,466
                                              --------    --------    --------
                                              $ (8,541)   $ (1,633)   $(15,704)
                                              ========    ========    ========

                                       45
<PAGE>
NOTE P -- QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

         A summary of the quarterly  results of  operations  for the years ended
December 31, 1998 and 1997 follows:

(In thousands, except per share amounts)

   1998                                 1ST QTR   2ND QTR     3RD QTR   4TH QTR
                                        -------   -------     -------   -------
   Net sales                           $63,758   $ 68,088     $70,389   $72,269
   Gross profit                         31,141     32,635      34,846    34,936
   Net income                            5,362    (8,643) (1)   5,791     6,534
   Net income per share--Basic         $  0.20   $ (0.32) (1) $  0.22   $  0.25
   Net income per share--Diluted       $  0.19   $ (0.32) (1) $  0.21   $  0.24
   Average number of common
     shares outstanding -- Basic        26,741     26,877      26,754    26,035
   Average number of common
     shares outstanding -- Diluted      28,242     26,877      27,489    27,225

         (1) Reflects  change to purchase  from pooling  accounting  for the ITS
         acquisition,  and  recalculation  of the TMSI  in-process  research and
         development write-off.

   1997                                 1ST QTR   2ND QTR     3RD QTR   4TH QTR
                                        -------   -------     -------   -------
   Net sales                           $50,322   $54,823     $56,915   $61,508
   Gross profit                         22,170    24,401      26,298    28,336
   Net income                            2,670     3,424       3,978     4,610
   Net income per share--Basic         $  0.10   $  0.13     $  0.17   $  0.19
   Net income per share--Diluted       $  0.10   $  0.13     $  0.16   $  0.18
   Average number of common
     shares outstanding -- Basic        25,901    25,438      23,397    24,606
   Average number of common
     shares outstanding -- Diluted      26,450    26,623      24,682    26,179

                                       46
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

         THIS  MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND
RESULTS  OF  OPERATIONS  AND OTHER  PARTS OF THIS  REPORT  ON FORM 10-K  CONTAIN
FORWARD-LOOKING  STATEMENTS  THAT  INVOLVE  RISKS AND  UNCERTAINTIES.  THE WORDS
"EXPECTS," "ANTICIPATES,"  "BELIEVES," "INTENDS," "WILL" AND SIMILAR EXPRESSIONS
IDENTIFY FORWARD-LOOKING  STATEMENTS WHICH ARE BASED ON INFORMATION AVAILABLE TO
THE COMPANY ON THE DATE HEREOF,  AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE
ANY SUCH FORWARD-LOOKING  STATEMENTS.  THE COMPANY'S ACTUAL RESULTS COULD DIFFER
MATERIALLY  FROM THOSE  ANTICIPATED  IN THESE  FORWARD-LOOKING  STATEMENTS  AS A
RESULT OF CERTAIN FACTORS, INCLUDING THOSE SET FORTH IN "FACTORS THAT MAY AFFECT
FUTURE OPERATING RESULTS" AND ELSEWHERE IN THIS 10-K.

GENERAL

         Inter-Tel  is a single  point of  contact,  full  service  provider  of
digital business telephone systems,  call processing software,  voice processing
software,  call accounting software,  Internet Protocol (IP) telephony software,
computer telephone  integration  ("CTI")  applications and long distance calling
services.  Inter-Tel's  products and services  include the AXXESS and  Inter-Tel
Axxent digital business  communication  software  platforms,  the AXXESSORY TALK
voice processing  platform,  the Inter-Tel  Vocal'Net IP telephony gateway,  the
Inter-Tel  Vocal'Net  Service  Provider  Software  and  Centralized   Accounting
Software  and  Inter-Tel.net,  an IP telephony  packet  switched  long  distance
service. The Company also provides maintenance, leasing and support services for
its products. The Company's Common Stock is quoted on the Nasdaq National Market
System under the symbol INTL.

         The Company has developed networks of direct sales offices, dealers and
value  added  resellers  (VARs)  which sell the  Company's  products.  In recent
periods,  the Company has focused on expanding its direct sales capabilities and
its dealer and VAR  network.  The Company has  acquired a number of resellers of
telephony  products and integrated  these  operations  with its existing  direct
sales operations in the same geographic areas and in other strategic markets.

         Sales of systems  through  the  Company's  dealers  and VARs  typically
generate  lower gross  margins  than sales  through the  Company's  direct sales
organization,  although direct sales typically require higher levels of selling,
general and administrative  expenses.  In addition,  the Company's long distance
and  network  services  typically  generate  lower gross  margins  than sales of
software and system products.  Accordingly,  the Company's margins may vary from
period to period  depending  upon  distribution  channel and product mix. In the
event that sales through dealers or sales of long distance  services increase as
a percentage of net sales, the Company's overall gross margin could decline.

         The  Company's  operating  results  depend  upon a variety of  factors,
including the volume and timing of orders received  during a period,  the mix of
products sold and the mix of distribution channels, general economic conditions,
patterns  of  capital   spending  by  customers,   the  timing  of  new  product
announcements  and  releases  by  the  Company  and  its  competitors,   pricing
pressures,  the cost and effect of acquisitions and the availability and cost of
products  and  components  from  the  Company's   suppliers.   Historically,   a
substantial  portion of the  Company's  net sales in a given  quarter  have been
recorded in the third month of the  quarter,  with a  concentration  of such net
sales in the last two weeks of the quarter. In addition,  the Company is subject
to seasonal  variations in its operating results, as net sales for the first and
third quarters are frequently less than those experienced  during the fourth and
second quarters, respectively.

         The markets  served by the  Company  have been  characterized  by rapid
technological  changes and  increasing  customer  requirements.  The Company has
sought to  address  these  requirements  through  the  development  of  software
enhancements  and  improvements to existing  systems and the introduction of new
products and applications.  The Company's research and development  efforts over
the last several years have been focused  primarily on  developing  new products
such as the Inter-Tel  Vocal'Net  Server,  Inter-Tel Axxent system and AXXESSORY
TALK  CENTRAL;   enhancing   the  CTI   capabilities   of  the  AXXESS   digital
communications platform; and expanding the capacity of the

                                       47
<PAGE>
Company's AXXESS and AXXESSORY TALK systems.  Current efforts are related to the
support of industry  standard CTI  interfaces,  the  development  of  additional
applications and features,  the enhancement of the Inter-Tel  Vocal'Net  Gateway
Server  and  Service  Provider  Package,  and  the  development  of a  LAN-based
Communications  Server  incorporating  the Company's  Call  Processing and Voice
Processing software.  New applications under development also include Basic Rate
ISDN,  PBX  networking,  the  Inter-Tel.net  private IP  telephony  service  and
enhanced unified messaging. The software-based architecture of the AXXESS system
facilitates  maintenance and support,  upgrades, and incorporation of additional
features and functionality.

         The Company  offers to its  customers a package of lease  financing and
other services under the name Totalease.  Totalease  provides to customers lease
financing,  maintenance  and support  services,  fixed price  upgrades and other
benefits. The Company finances this program through the periodic resale of lease
rental streams to financial institutions.

         Net sales of the Company have  increased  substantially  in each of the
past three years.  Such increases were 22.8%,  20.3% and 23.5% in 1998, 1997 and
1996, respectively, over the preceding year.

RESULTS OF OPERATIONS

         The following table sets forth certain  statement of operations data of
the Company expressed as a percentage of net sales for the periods indicated:

                                                  Year Ended December 31
                                               1998        1997        1996
                                               ----        ----        ----
     Net sales                                100.0%      100.0%      100.0%
     Cost of sales                             51.3        54.7        56.5
                                              -----       -----       -----
     Gross margin                              48.7        45.3        43.5
     Research and development                   4.2         3.6         3.5
     Selling, general and administrative       31.5        31.3        30.3
     Special charge                             8.3          --         2.5
                                              -----       -----       -----
     Operating income                           4.7        10.4         7.2
     Interest and other income                  1.1         0.6         1.1
     Interest expense                           0.0         0.0         0.0
     Income taxes                               2.5         4.4         3.4
                                              -----       -----       -----
     Net income                                 3.3%        6.6%        4.9%
                                              -----       -----       -----

YEAR ENDED DECEMBER 31, 1998 VERSUS YEAR ENDED DECEMBER 31, 1997

         NET SALES.  Net sales  increased  22.8% to $274.5  million in 1998 from
$223.6 million in 1997.  Sales from the Company's  direct sales offices and from
wholesale   distribution  accounted  for  approximately  $38.2  million  of  the
increase.  The  remaining  increases  occurred in long distance and IP sales and
other operations.

         GROSS PROFIT.  Gross profit increased 32.0% to $133.6 million, or 48.7%
of net sales in 1998 from $101.2  million,  or 45.3% of net sales,  in 1997. The
increases  in gross  profit and gross  margin were  primarily a result of higher
sales,  as a  percentage  of total net sales,  of AXXESS  digital  communication
platforms,  call processing software and voice processing software. In addition,
gross margin increased despite a lower percentage  increase in sales through the
Company's direct sales offices compared to its dealer network,  as gross margins
are typically higher for sales through the Company's direct sales offices.

         RESEARCH AND DEVELOPMENT.  Research and development  expenses increased
to $11.4 million, or 4.2% of net sales in 1998 from $8.0 million, or 3.6% of net
sales,  in 1997.  The  increases in absolute  dollars and as a percentage of net
sales were principally  attributable to the continued  development of the AXXESS
software and systems, unified messaging and voice processing software, Inter-Tel
IP

                                       48
<PAGE>
telephony  products  and certain CTI  applications.  The  Company  expects  that
research and development  expenses will continue to increase in absolute dollars
as the Company  continues to develop and enhance  existing and new  technologies
and products. These expenses may vary, however, as a percentage of net sales.

         SELLING,    GENERAL   AND   ADMINISTRATIVE.    Selling,   general   and
administrative  expenses  increased to $86.6  million,  or 31.5% of net sales in
1998 from  $69.9  million,  or 31.3% of net  sales,  in 1997.  The  increase  in
absolute dollars  reflected  increased  selling,  incentive,  training and other
compensation  costs  attributable  to the increased  sales through the Company's
direct sales offices,  additional personnel to support the direct dealer network
and  expansion of IP telephony  and long distance  operations,  development  and
expansion   of  the   Inter-Tel.net   network  and  expenses   associated   with
international  operations.  Such increase is also  attributable to the hiring of
additional  sales and technical  training  staff,  and increases in reserves for
accounts   receivable.   The  Company   expects   that   selling,   general  and
administrative  expenses  will increase in absolute  dollars,  but may vary as a
percentage of net sales.

         INTEREST AND OTHER INCOME.  Other income increased  approximately  $1.6
million in 1998  principally  as a result of higher levels of cash available for
investment due to the issuance of the Company's  common stock from the secondary
public offering in the fourth quarter of 1997, offset by the payment of cash for
the purchase of TMSI assets, and the Company's stock repurchases made during the
last half of 1998.

         NET INCOME.  Including the special  charge  related to the write-off of
in-process  research and  development of TMSI during the second quarter of 1998,
net income decreased 38.4% to $9.0 million,  or $0.32 per diluted share, in 1998
compared to net income of $14.7  million,  or $.57 per diluted  share,  in 1997.
Excluding the 1998 special charge, net income would have been $22.7 million,  or
$0.82 per diluted share, an increase of 44.2% over 1997.

YEAR ENDED DECEMBER 31, 1997 VERSUS YEAR ENDED DECEMBER 31, 1996

         NET SALES.  Net sales  increased  20.3% to $223.6  million in 1997 from
$185.9 million in 1996.  Sales from the Company's  direct sales offices and from
wholesale   distribution  accounted  for  approximately  $26.3  million  of  the
increase.  The remaining  increases  occurred in long  distance  sales and other
operations.

         GROSS PROFIT.  Gross profit increased 25.1% to $101.2 million, or 45.3%
of net sales in 1997 from $80.9 million,  or 43.5% of net sales,  in 1996.  This
increase was  primarily a result of higher  sales,  as a percentage of total net
sales, of AXXESS digital communication  platforms,  call processing software and
voice  processing  software.  In  addition,  gross margin  increased  based on a
percentage increase in sales through the Company's direct sales offices compared
to its dealer network.

         RESEARCH AND DEVELOPMENT.  Research and development  expenses increased
to $8.0 million,  or 3.6% of net sales in 1997 from $6.6 million, or 3.5% of net
sales, in 1996.  These expenses in both 1997 and 1996 were directed  principally
toward the continued development of the AXXESS and Inter-Tel Axxent software and
systems,  unified messaging and voice processing  software,  Inter-Tel Vocal'Net
and certain CTI applications.

         SELLING,    GENERAL   AND   ADMINISTRATIVE.    Selling,   general   and
administrative  expenses  increased to $69.9  million,  or 31.3% of net sales in
1997  from  $56.4  million,  or 30.3% of net  sales,  in  1996.  This  reflected
increased selling, incentive, training and other compensation costs attributable
to the increased  sales through the Company's  direct sales offices,  additional
personnel to support the direct  dealer  network and  expansion of long distance
operations,  development of the  Inter-Tel.net  network and expenses  associated
with international operations.  Such increase is also attributable to the hiring
of  additional  sales and  technical  training  staff,  expansion  of its credit
management group, and increases in reserves for accounts receivable.

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         INTEREST  AND  OTHER  INCOME.  Other  income  decreased   approximately
$591,000 in 1997  principally  as a result of lower levels of cash available for
investment.

         NET INCOME.  Net income  increased 62.4% to $14.7 million,  or $.57 per
diluted  share,  in 1997  compared to net income of $9.0  million,  or $0.34 per
diluted  share,  in 1996.  Excluding  the special  charge in 1996 related to the
write-off  of its MIS  software,  net income would have been $11.8  million,  or
$0.44 per diluted share.

INFLATION/CURRENCY FLUCTUATION

         Inflation and currency  fluctuations have not previously had a material
impact on Inter-Tel's  operations.  International  procurement  agreements  have
traditionally been denominated in U.S. currency.  Moreover, a significant amount
of  contract  manufacturing  has been or is  expected  to be  moved to  domestic
sources.  The expansion of  international  operations in the United  Kingdom and
Europe  and  increased  sales,  if any,  in Japan and other  parts of Asia could
result in higher international sales as a percentage of total revenues; however,
international revenues are currently not significant.

LIQUIDITY AND CAPITAL RESOURCES

         At  December  31,  1998,  the  Company  had $63.1  million  in cash and
equivalents,  which  represents a decrease of  approximately  $25.7 million from
December 31, 1997.  The Company  maintains a $7.0 million,  unsecured  revolving
line of credit  with Bank One,  Arizona,  NA. The credit  facility  is  annually
renewable and is available through June 1, 2000. Under the credit facility,  the
Company  has the option to borrow at a prime  rate or  adjusted  LIBOR  interest
rate.  Historically,  the credit  facility  has been used  primarily  to support
international  letters of credit to  suppliers.  In December  1997,  the Company
received  net  proceeds  of  approximately  $59.2  million  from a public  stock
offering of 3,000,000  common  shares.  During the year ended December 31, 1998,
approximately  $25 million plus  acquisition  costs was used to purchase certain
assets of TMSI and an additional $16.7 million was expended to repurchase shares
of the  Company's  Common  Stock.  The  remaining  cash  balances may be used to
develop  and expand  Inter-Tel.net  and for  potential  acquisitions,  strategic
alliances, working capital and general corporate purposes.

         Net cash provided by operating activities totaled $31.8 million for the
year ended  December  31,  1998,  compared  to net cash  provided  by  operating
activities of $28.2  million for the same period in 1997.  This increase in cash
provided by operating  activities in 1998 was primarily the result of profitable
operations (excluding the write-off of in-process research and development costs
associated with the TMSI  acquisition),  and lower inventory  levels,  offset in
part  by  increased  accounts  receivable.   During  1998,  accounts  receivable
increased  approximately $8.9 million, while inventories decreased approximately
$1.9  million.  The Company  continues to expand its dealer  network,  which has
required and is expected to continue to require  working  capital for  increased
accounts  receivable and  inventories.  During 1998,  other current  liabilities
increased  primarily  as a result  of the  change  in taxes  and  other  accrued
expenses.

         Net  cash  used  in  investing  activities,  primarily  in the  form of
acquisitions and capital  expenditures,  totaled $40.4 million and $12.4 million
for the years ended  December 31, 1998 and 1997,  respectively.  This net use of
cash in 1998 was primarily the result of the purchase of certain  assets of TMSI
and the related write-off of in-process  research and development costs, as well
as  additions  to property  and  equipment.  Cash used in  acquisitions  totaled
approximately $25.4 million in 1998. Capital expenditures totaled  approximately
$15.2 million for the same period.  The Company  anticipates  additional capital
expenditures during 1999, principally relating to expenditures for equipment and
management  information  systems  used  in  operations,   facilities  expansion,
acquisition  activities and anticipated  increased  volumes of operating  leases
offered by the  Company to its  customers,  which must be  capitalized  as fixed
assets by the Company.

         Net cash used in financing activities totaled $17.0 million during 1998
compared  to net cash  proceeds  of $34.1  million  in  1997.  Net cash  used in
financing activities during both periods was

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primarily due to the  initiation of separate  stock  repurchase  programs  under
which the Board of Directors  authorized the repurchase of up to 2.5 million and
1.47 million shares of the Company's common stock during the year ended December
31,  1998 and 1997,  respectively.  The  Company  expended  approximately  $16.8
million  and  $27.2  million  for  stock  repurchases   during  1998  and  1997,
respectively, funded by existing cash balances during each period. Additionally,
in 1997 the Company  raised  approximately  $59.2  million in a secondary  stock
offering. During 1998, the Company reissued treasury shares through stock option
exercises and issuances,  with the proceeds received totaling less than the cost
basis of the treasury stock reissued.  Accordingly,  the difference was recorded
as a reduction to retained  earnings.  Treasury shares reissued during 1997 were
reissued  through stock option  exercises and issuances,  as well as through the
secondary stock offering.  In 1997, the proceeds  received totaled more than the
cost basis of the  treasury  stock  reissued.  Net cash used for cash  dividends
totaled  $1.1  million  during  1998,  which was offset by cash  provided by the
exercise of stock options and stock issuances pursuant to the Company's Employee
Stock Purchase Plan.

         The Company offers to its customers lease financing and other services,
including its Totalease program,  through its Inter-Tel Leasing subsidiary.  The
Company funds these programs in part through the sale to financial  institutions
of rental income streams under the leases.  Resold lease rentals totaling $131.3
million and $99.9 million remain  unbilled at December 31, 1998 and December 31,
1997,  respectively.  The Company is obligated to repurchase such income streams
in the event of defaults by lease customers and, accordingly, maintains reserves
based upon loss  experience and past due accounts.  Although the Company to date
has been able to resell the rental  streams from leases under its lease programs
profitably and on a substantially current basis, the timing and profitability of
lease  resales  could  impact the  Company's  business  and  operating  results,
particularly  in an  environment  of  fluctuating  interest  rates and  economic
uncertainty.  If the Company  were  required to  repurchase  rental  streams and
realize losses thereon in amounts exceeding its reserves,  its operating results
could be materially adversely affected.

The Company  believes  that its cash  balances,  working  capital and  available
credit  facilities,  together  with  anticipated  ongoing  cash  generated  from
operations,  will be sufficient to develop and expand its Inter-Tel.net network,
to finance  acquisitions of additional resellers of telephony products and other
strategic  acquisitions or corporate alliances,  and to provide adequate working
capital  for at least  the next  twelve  months.  However,  to the  extent  that
additional funds are required in the future to address working capital needs and
to provide  funding for capital  expenditures,  expansion of the business or the
Inter-Tel.net  network  or  additional   acquisitions,   the  Company  may  seek
additional  financing.  There can be no assurance that such additional financing
will be available when required or on acceptable terms.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS.

Refer to Note A in the notes to consolidated financial statements.

ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT.

In connection  with the TMSI asset  purchase,  the Company  expensed  in-process
research and  development  ("IPRD")  totaling  $22.8 million as a  non-recurring
charge  on the  acquisition  date.  This  was  necessary  because  the  acquired
technology  had not yet  reached  technological  feasibility  and had no  future
alternative  uses.  The  Company  is using the  acquired  IPRD to create  new IP
products,  which will become part of the  Inter-Tel  product suite over the next
several years.  The Company  expects that the acquired IPRD will be successfully
developed,  but there can be no assurance of the  commercial  viability of these
products.

The  value  of  the  purchased   in-process   technology  was  determined  using
management's  estimates of the  projected  discounted  net cash flows related to
such products, including costs to complete development and future revenues to be
earned  upon   commercialization.   Calculations   were  revised   after  giving
consideration  to the SEC Staff's  views as set forth in its  September 15, 1998
letter to the American Institute of Certified Public  Accountants.  Calculations
of value therefore gave consideration to

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value creation efforts of TMSI prior to the purchase  relative to the efforts of
the Company subsequent to the transaction.  These efforts were estimated, giving
consideration  to time-,  cost- and  complexity-based  data.  Time-based data is
measured in developer months. Cost-based data estimates dollar amounts spent and
to be spent to complete these projects. Complexity-based data considers the high
risk development  issues and major milestones  associated with the completion of
particular projects.

The  purchased  in-process  technology  acquired  in  the  TMSI  asset  purchase
comprised  five main  projects,  estimated at 49% to 97% complete.  The discount
rates utilized for the developed and in-process  technologies  were 25% and 35%,
respectively.  Revenues  and  operating  profits were assumed to increase in the
first three years of the  seven-year  projection  period at annual rates ranging
from 238% to 520% while  decreasing  over the remaining term.  Projections  were
based on assumed  penetration  of the  existing  customer  base,  synergies as a
result of the TMSI purchase,  new customer transactions and historical retention
rates.  Costs to  complete  the  projects  were  estimated  at $1  million  plus
maintenance.

         During 1998,  revenues and operating profit  attributable to in-process
technology  were below  original  expectations.  No assurance  can be given that
additional  deviations from these  projections will not occur in the future.  If
the projects to develop  commercial  products  based on the acquired  in-process
technology are not successfully  completed,  the sales and  profitability of the
Company  may be  adversely  affected in future  periods,  and the value of other
intangible assets may become impaired.

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