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

                                        

                                   FORM 10-K

                 FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
          SECTIONS 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)
[X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
      ACT OF 1934

      For the fiscal year ended December 31, 1998


                                      OR

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

      For the transition period from           to

                       COMMISSION FILE NUMBER 000-22647

                        PERITUS SOFTWARE SERVICES, INC.
            (Exact Name of Registrant as Specified in Its Charter)

                                        
              MASSACHUSETTS                                  04-3126919        
     (State or Other Jurisdiction of                      (I.R.S. Employer  
     Incorporation or Organization)                       Identification No.)
                                                                            
                                        
  2 FEDERAL STREET, BILLERICA, MASSACHUSETTS                  01821-3540
  (Address of Principal Executive Offices)                    (Zip Code)
                                        
                                                          
<PAGE>
 
      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (978) 670-0800

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:


                              TITLE OF EACH CLASS
                              -------------------
                                 NOT APPLICABLE
                                        
                   NAME OF EACH EXCHANGE ON WHICH REGISTERED
                   -----------------------------------------
                                NOT APPLICABLE
                                        

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

                         COMMON STOCK, $0.01 PAR VALUE
                               (TITLE OF CLASS)

  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 the 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. [x]

  As of March 19, 1999 the aggregate market value of voting common stock held by
non-affiliates of the registrant was approximately $4,508,334. As of that date,
there were 16,349,986 shares outstanding of the registrant's common stock, $0.01
par value. The registrant has no shares of non-voting common stock authorized or
outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE

  Parts of the definitive Proxy Statement for the 1999 Annual Meeting of
Stockholders of the Company to be filed with the Securities and Exchange
commission not later than 120 days after December 31, 1998, are incorporated by
reference into Part III of this Annual Report on Form 10-K.

                                       2
<PAGE>
 
                        PERITUS SOFTWARE SERVICES INC.

                                   FORM 10-K

                                 ANNUAL REPORT

                               TABLE OF CONTENTS

                                        
<TABLE>
<CAPTION>
                                                                                                                Page
                                                                                                                -----
                                    PART I
<S>                                                                                                             <C> 
Item 1.       Business.....................................................................................       4
Item 2.       Properties...................................................................................      16 
Item 3.       Legal Proceedings............................................................................      17
Item 4.       Submission of Matters to a Vote of Security Holders..........................................      18

                                    PART II

Item 5.       Market for Registrant's Common Equity and Related Stockholder Matters........................      19  
Item 6.       Selected Financial Data......................................................................      20 
Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operations........      22  
Item 7A.      Quantitative and Qualitative Disclosures about Market Risk...................................      45
Item 8.       Financial Statements and Supplementary Data..................................................      46 
Item 9.       Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.........      75  

                                   PART III

Item 10.      Directors and Executive Officers of the Registrant...........................................      76
Item 11.      Executive Compensation.......................................................................      77
Item 12.      Security Ownership of Certain Beneficial Owners and Management...............................      78
Item 13.      Certain Relationships and Related Transactions...............................................      79 

                                    PART IV

Item 14.      Exhibits, Financial Statement Schedules and Reports on Form 8-K..............................      80 
</TABLE> 

SIGNATURES.

  Peritus is a registered trademark, Automate:2000 is a registered service mark,
AutoEnhancer is a trademark and Renovation Quality Evaluation and Software Asset
Maintenance are service marks of Peritus Software Services, Inc. Vantage YR 2000
is a trademark of Millennium Dynamics, Inc.


  From time to time, information provided by the Registrant or statements made
by its employees may contain "forward-looking" statements, as that term is
defined in the Private Securities Litigation Reform Act of 1995. For this
purpose, any statements contained herein that are not statements of historical
fact may be deemed to be forward-looking statements. Without limiting the
foregoing, the words "believes," "anticipates," "plans," "expects" and similar
expressions are intended to identify forward-looking statements.

  This Annual Report may contain forward looking statements which involve risks
and uncertainties. The Registrant's actual results may differ materially from
the results discussed in such statements. Certain factors that could cause such
a difference include, without limitation, the factors listed below in "Factors
That May Affect Future Results".

                                       3
<PAGE>
 
PART I.

ITEM 1.   BUSINESS

COMPANY CURRENT CONDITION AND REVISED STRATEGY

  In the second half of 1998, the overall market for the year 2000 tools and
services of Peritus Software Services, Inc. ("Peritus" or the "Company")
contracted dramatically, resulting in substantial financial losses. In response,
the Company substantially reduced its workforce in September of 1998 and again
in December of 1998. As a result of the Company's degraded financial condition,
the Company began encountering major obstacles in obtaining new outsourcing
business. Since most outsourcing engagements are multi-year and involve critical
applications, prospective new clients, although interested in the capabilities
and technology of the Company, have been reluctant or unwilling to commit to
contracts. Despite the significant reduction in the overall cost structure as a
result of the September and December actions, the Company was unable to achieve
a cash flow break-even position in the first quarter of 1999 and is considering 
various alternatives including the possibility of filing for the protection 
against creditors under applicable bankruptcy laws. The Company again
reduced its workforce in April of 1999, eliminating the majority of sales,
marketing and year 2000 resources.

  The Company's current strategy is to minimize expenses, while preserving its
principal saleable assets: its outsourcing business and its technology. Along
with Covington Associates, its investment banker, the Company is actively
pursuing strategic relationships with an emphasis on the sale of all or parts of
its assets. The Company is continuing to selectively pursue sales of its
EuroPac, SAM Relay, RQE and SAM Workbench tools. The Company is also focusing on
renewing its existing outsourcing contracts and licensing its methodologies and
providing limited consulting services. The Company continues to support its
existing software customers and plans to offer very limited year 2000 services
based on availability of resources.

  Based on the Company's existing fixed cost commitments, its limited cash
resources, and the reluctance of new customers to commit to long term
outsourcing engagements, the Company does not anticipate that it will be able to
achieve a cash flow breakeven position in the future. However, it will continue
to attempt to do so at the same time it seeks potential buyers. See "Part II,
Item 7, Management's Discussion and Analysis of Financial Condition and Results
of Operations" below.

COMPANY OVERVIEW

  Peritus provides solutions consisting of software products and services that
enable organizations to improve the productivity, quality and effectiveness of
their information technology ("IT"), systems maintenance or software evolution
functions. The Company employs software tools, methodologies and processes,
designed to automate the typically labor-intensive processes involved in
conducting mass change and other software maintenance tasks. In 1996, the
Company released its first commercially available product, its AutoEnhancer/2000
software, which was aimed at the industry's most pervasive mass change
challenge, the year 2000 problem, to value added integrators and directly to end
users. In 1996, the Company expanded its research and development efforts
through the acquisition of Vista Technologies Incorporated ("Vista"), a
developer of computer-aided engineering software. In 1997, the Company expanded
its product offerings and research and development efforts by releasing an
enhanced version of the AutoEnhancer/2000 software, which enables a client to
perform logic correction only changes with regard to year 2000 renovations.

  On December 1, 1997, Twoquay, Inc. ("Twoquay"), a wholly owned subsidiary of
the Company, acquired substantially all of the assets and assumed certain
liabilities of the business of Millennium Dynamics, Inc. ("MDI") from American
Premier Underwriters, Inc. ("APU") in exchange for 2,175,000 shares of
Registrant's common stock, $.01 par value per share, and $30 million in cash.
The number of shares issued to APU was determined in accordance with the terms
of the Asset Purchase Agreement by and among the Company and Twoquay and APU and
MDI dated October 22, 1997 (the "Purchase Agreement") based on the Average Share
Price (as defined therein) for the five trading days beginning on the second day
immediately preceding the date thereof and ending on the second trading day
immediately following the date thereof. Neither the Company nor Twoquay had any
material relationship with either APU or MDI prior to execution of the Purchase
Agreement. The cash portion of the purchase price was paid for from the proceeds
of the Company's initial public offering which closed on July 8, 1997. The
shares of common stock issued to APU at the closing are entitled to certain
registration rights as set forth

                                       4
<PAGE>
 
in a Registration Rights Agreement dated as of December 1, 1997 by and among the
Company and APU. Twoquay changed its name to MDI after the closing of the
acquisition. MDI's primary product, Vantage YR2000, is a software toolset
utilized for computer program analysis. The software was designed and developed
to automate the year 2000 conversion process.

  Although the Company continues to license tools to address the year 2000
problem, the Company, in response to changes in the markets for the Company's
products and services, emphasized the direct delivery of year 2000 renovation
services and renovation quality evaluation ("RQE") services in the beginning of
1998 and also began to refocus the Company's business on software maintenance
outsourcing services. In 1998, the Company also began licensing its RQE Tool, a
product used to facilitate an in-house evaluation of a completed year 2000
renovation. As the market continued to shift from the Company's year 2000
products and services during the third quarter of 1998, the Company revised its
overall strategy to emphasize growth of its software maintenance outsourcing
business over the long term and to meet its clients needs for year 2000
renovation services and RQE services. In July 1998, the Company announced its
software maintenance outsourcing offerings, "Software Asset Maintenance for
Software Providers" ("SAMsp")and "Software Asset Maintenance for Information
Systems" ("SAMis"), which are outsourcing solutions designed specifically for
the manufacturers of system software and software products and for information
technology departments that maintain application software, respectively.

  The Company provides on a fixed-fee basis software maintenance outsourcing
services that employ the Company's proprietary software tools, methodologies and
processes to generate productivity gains in the software maintenance and
evolution process.

  The Company derives its revenue from software maintenance outsourcing
services, software and methodology licensing and other services (including
direct delivery of year 2000 renovation and RQE services) sold directly to end
users or indirectly via value added integrators, and its clients include
primarily Fortune 1000 companies and similarly sized business and government
organizations worldwide. Historically, the Company's products and services have
been marketed through its direct sales force, both domestically and in Europe,
and through value added integrators operating worldwide. As a result of its
downsizings in 1998 and 1999, the Company currently has only one direct sales
force representative.

  In March 1998, the Company announced its intentions for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, and recorded a charge of $1,439,000 consisting in part
of severance payments associated with the termination of approximately 12% of
the Company's employees in April 1998 (48 employees). At June 30, 1998, all 48
employees had been terminated with no further terminations remaining under the
restructuring. In addition, a significant portion of the restructuring charge
related to the closure of two research and development and outsourcing centers,
consisting primarily of the accrual of future lease payments and other related
costs, net of estimated sublease income, and support costs for a discontinued
product, in excess of related services revenue. Payments related to terminated
employees were completed in June 1998 for 45 employees and are expected to be
completed by September 1999 for the remaining 3 employees. Payments related to
the closure and reduction of facilities are expected to be complete by April
2003. The restructuring resulted in a reduction of approximately $950,000 in
salary and related costs and $90,000 in facility related costs on a quarterly   
basis beginning in second quarter of 1998.

  During a review of the Company's 1998 third quarter financial results
performed by Peritus' management, the Audit Committee of the Company's Board of
Directors and the Company's independent auditor, PricewaterhouseCoopers LLP
("PwC"), the Company determined that the Company's results of operations for the
quarterly periods ended September 30, 1997, December 31, 1997, March 31, 1998
and June 30, 1998 and for the year ended December 31, 1997 required restatement.
The 1998 restatements first relate to the recording by Peritus of approximately
$1.09 million of software license revenue for a single customer in the second
quarter of 1998. Peritus believed that the amount of software license revenue as
originally recorded reflected a part of an approximately $1.9 million business
arrangement agreed to between the parties under a signed purchase order. The
Company has since determined that the customer did not require a separate
license and, therefore, no license revenue should have been recorded. The
balance of the 1998 restatements relate primarily to the Company's incorrect
interpretation of the complex provisions regarding recognition of revenue for
combined software/services arrangements under Statement of Position ("SOP") 97-
2, "Software Revenue Recognition," issued by the

                                       5
<PAGE>
 
American Institute of Certified Public Accountants ("AICPA"), and effective for
the Company as of January 1, 1998. In applying the Statement to its new year
2000 renovation offerings which the Company commenced in the first quarter, the
Company mistimed the recognition of revenue between quarters under certain
contracts providing for the delivery of combined software and services. The 1997
restatements involve two instances where the Company had recorded revenue for
software licenses in advance of shipment of the software. The first instance
involved the recording of software license revenue of $1.2 million in the third
quarter of 1997. The Company has determined that the software involved was not
shipped until early in the fourth quarter of 1997 and that payment of the
licensing fee was received in the fourth quarter. Therefore, the Company
restated its third quarter 1997 results to exclude the $1.2 million license fee
and its fourth quarter 1997 results to include the $1.2 million license fee. The
second instance involved $571,000 of license revenue and $21,000 of associated
maintenance revenue originally recorded in the fourth quarter of 1997. The
Company has determined that the software involved was not shipped until 1998.
The Company encountered collection difficulties with the customer during 1998.
Despite entering into a settlement agreement with the customer in the second
quarter of 1998, the Company concluded in the third quarter of 1998 that it
would be unable to realize the amounts recorded. Accordingly, the Company
restated its fourth quarter 1997 results to remove the $592,000 of revenue
involved and has not recorded this revenue in any subsequent period. As a result
of the restatements of results for 1997, the Company was informed by PwC that
users of the Company's 1997 financial statements should no longer rely upon
PwC's opinion for the year ended December 31, 1997. The opinion was reinstated
in January 1999 when the Company completed and filed its amendment number 2 to
its Form 10-K for 1997.

  In September 1998, the Company announced and recorded a charge
of $3,372,000 consisting in part of severance payments associated with the
termination of approximately 33% of the Company's employees (89 employees). At
September 30, 1998, all 89 employees had been terminated with no further
terminations remaining under the restructuring. In addition, a significant
portion of the restructuring charged related to the closure of two research and
development centers and a reduction of occupied space at the Company's
headquarters in Billerica, MA, consisting primarily of the accrual of future
lease payments and other related costs, net of estimated sublease income.
Payments related to terminated employees were completed by December 1998 for 82
employees and were expected to be completed by September 1999 for the remaining
7 employees. Payments related to the closure of facilities and reduction of
occupied space are expected to be completed by June 2003. The restructuring
resulted in a reduction of approximately $1,900,000 in salary and related costs
and $250,000 in lease related costs on a quarterly basis beginning in the fourth
quarter of 1998.

   In December 1998, the Company announced its intention to restructure and
recorded a charge of $1,316,000 consisting in part of severance payments
associated with the termination of approximately 22% of the Company's employees
(45 employees). At December 31, 1998, all 45 employees had been terminated with
no further terminations remaining under the restructuring. In addition, a
significant portion of the restructuring charge related to a further reduction
of occupied space at the Company's headquarters in Billerica, MA and consisted
primarily of the accrual of lease costs, net of estimated sublease income.
Payments related to the terminated employees were completed by December 31,
1998. Payments related to the reduction of occupied space are expected to be
complete by February 2006. The Company has estimated that the restructuring will
result in a reduction of approximately $950,000 in salary and related costs and
$70,000 in lease related costs on a quarterly basis beginning in the first
quarter of 1999.

  On February 3, 1999, the Company's common stock was delisted from trading on
the Nasdaq Stock Market. Currently, the common stock trades on the Over the
Counter ("OTC") Bulletin Board.

  In March 1999, the Company announced that it had retained Covington Associates
to render financial advisory and investment banking services in connection with
exploring strategic alternatives including the potential sale of the Company. On
March 29, 1999, the Company announced an anticipated $2.0 to $2.5 million loss
for the first quarter of 1999 and that the net loss will significantly erode the
Company's cash balances and jeopardize its ability to continue as a going
concern. The Company further announced that it did not believe that it would be
able to achieve a cash flow breakeven position in the future and that its Board
of Directors was considering various alternatives.

                                       6
<PAGE>
 
  On April 2, 1999, the Company announced a reduction in its workforce of
approximately 40 people in the areas of sales, marketing and year 2000 delivery.
The Company currently maintains its outsourcing service delivery resources and
limited sales and year 2000 resources required to meet current support
obligations.

INDUSTRY BACKGROUND

  With the globalization of markets and increased competitive pressures to
reduce operating costs, shorten time to market, improve product quality and
increase customer responsiveness, large organizations throughout the world have
become increasingly dependent on IT to organize and manage their businesses and
serve their customers. Many of these organizations utilize large mainframe
computer systems, client/server systems or a combination thereof for the
information processing requirements of their enterprises. These IT systems
contain the core knowledge and processes that support mission-critical
operations, and maintaining the investment in these IT systems is a requirement
for organizations worldwide. In some circumstances, it has formed the basis for
organizations to enter into new business or develop new businesses strategies.

  A key challenge facing organizations has been to modify, update and adapt
their IT systems and evolve their software to respond to a changing and more
competitive business environment. This challenge has increased with the
broadening complexity of IT and the continued evolution of mainframe systems, as
well as the advent of distributed, client/server computing and the proliferation
of third-party enterprise software applications. At the same time, the pace of
change in business environments has accelerated, requiring organizations to
continually evolve their IT systems and environments to adapt to changing
business conditions and processes. This software evolution process is typically
time-consuming, labor-intensive and expensive, and consists not only of fixing
"bugs" and maintaining the current level of software performance and
functionality, but also making enhancements, implementing mass changes to the
code and migrating applications to new computing platforms.

PERITUS SOLUTIONS

  Peritus offers products and services that enable organizations to improve the
productivity, effectiveness and quality of the software evolution process. The
Company's solutions employ a combination of tools, processes, skilled
professionals and methodologies. The Company's underlying technology consists of
its Peritus Intermediate Language ("PIL") and proprietary tools that can be
implemented to address mass change or other software maintenance challenges.

 Mass Change Solutions

  Technology for Mass Change.   The Company's Mass Change Engine, which is based
on PIL and other proprietary technologies, converts source code from a variety
of programming languages into PIL in order to perform analysis, correction and
testing on the code during mass change maintenance initiatives. The Mass Change
Engine is designed to automate the labor-intensive code maintenance function,
thereby increasing productivity, and can be customized to provide function-
specific mass change capabilities. The Mass Change Engine operates across
multiple platforms, languages and operating systems.  The Company has received a
United States Patent, Patent Number: 5,838,979 covering certain technology
applicable to the Mass Change Engine.

  Year 2000 Renovation Tools. The Company's year 2000 products and services
provide a comprehensive renovation solution for organizations seeking to address
the year 2000 problem. The Company's AutoEnhancer/2000 software, which is based
on its Mass Change Engine, is also designed to provide flexibility in addressing
the critical identification, correction and verification components of a year
2000 renovation. The AutoEnhancer/2000 software is designed to be interoperable
with third-party assessment, extraction and testing tools. The Vantage YR2000
software toolset is designed to assist and automate the code conversion process
required to make software code residing on the IBM mainframe and AS/400
platforms year 2000 compliant. The toolset employs a combination of
methodologies and automated software tools that are designed to enhance the
productivity of the code conversion process. The underlying technology is based
on an automated parsing and conversion technology that identifies date sensitive
variables and provides correction either through date expansion or logic
conversion.

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  Year 2000 Renovation Quality Evaluation Tool.  The Company's RQE Tool is used
to facilitate an in-house evaluation of a Year 2000 renovation of C and COBOL
code by identifying and evaluating date sensitive variables in the renovated
code.

 Service Offering Components

  Comprehensive Software Evolution Services. The Company's service offerings are
designed to address software evolution needs through tools and processes that
provide productivity gains by automating and improving the software evolution
process. These services are generally offered on a fixed-fee basis, and the
client can realize the resulting productivity gains in the form of reductions in
internal IT costs, increases in throughput, improved turn-around time and/or
improved software quality. The Company's current service offerings include SAMsp
and SAMis designed respectively for the manufacturers of systems software and
products and companies' information technology organizations. In each of these
services, Peritus assumes responsibility for the evolution of a client's
software, and technology transfer services, and provides its methodologies and
tools to clients in-house, enabling them to implement enhanced, repeatable
processes for software evolution.

  Team-Based Process Methodologies. The Company employs team-based methodologies
in its service offerings, on a stand alone basis or in conjunction with its SAM
Relay Tool. Teams typically consist of both Company and client employees, with a
Company project manager supervising the process. In the delivery of its
services, the Company combines concepts from disciplines such as scientific
inquiry, operations research and psychology with engineering "best practices"
(such as formal inspections, cross functional teams and quality initiatives) to
create a workflow paradigm that optimizes a team's ability to leverage its
combined talent, knowledge and experience.

  Advanced Technology Platform. The Company has developed its core technologies
through the use of advanced mathematical algorithms and techniques. To achieve
productivity gains, the Company utilizes proprietary tools that better enable
maintenance teams to rapidly locate and fix bugs and provide software
enhancements. These tools include a software maintenance assistance tool
designed to automate the process of logical code analysis, a business rules
extraction tool and a groupware tool designed to facilitate workflow
coordination.

TECHNOLOGY

  The Company's core technologies consist of its Peritus Intermediate Language,
its Mass Change Engine, other computer-based tools and formal mathematical
techniques.

  The Peritus Intermediate Language. The Company has developed its Peritus
Intermediate Language to support accurate analysis of why a program functions
incorrectly. PIL is based on the mathematical theory that all computations can
be expressed in a small number of abstract instructions into which existing
computer languages can be translated. PIL consists of 13 abstract instructions,
and currently the COBOL, RPG, C and PL/1 programming languages have been
translated by the Company into PIL. When data enter a computer program, their
paths can be traced by the values assigned to them by the instructions in that
program. In contrast, PIL can be used to trace the paths of all data that fall
into mathematically describable classes. As a result, if the data are in a
certain state when a program completes or aborts, it is possible, using PIL, to
determine the initial conditions of these data before the program was executed.
In addition, the use of PIL allows tools to be built that can verify that a
program is logically correct by specifying pre and post conditions of classes of
data rather than relying on the traditional method of testing, which is based on
trial and error using selected data points.

  Mass Change Engine. The Company's Mass Change Engine is designed to address
mass changes to IT systems (such as expansion of data fields or changes in
product or part identifiers) by accepting as input the identified data structure
and desired rules of transformation. The Mass Change Engine then examines the
entire set of computer programs to trace all related data and instructions,
computes the necessary changes that are the result of that simple change
requirement and makes corresponding adjustments in all programs and data so that
only the

                                       8
<PAGE>
 
desired change occurs without impacting the underlying logic. These tasks are
accomplished through the use of an adaptive seed generator based on neural
network technology, the creation of a repository of relationships between the
data and instructions using PIL and the use of propagations that determine the
relationship between variables and seeds using a set of identification rules and
information embedded in the repository. The Company's Mass Change Engine can be
adapted to address specific mass change needs. The Company's AutoEnhancer/2000
software is an example of an extension of the Mass Change Engine. The Company
has received a United Stated Patent, Patent Number: 5,838,979 covering certain
technology applicable to the Mass Change Engine.

  Other Computer-Based Tools. The Company's software maintenance tools have been
specifically designed to address the needs of the software maintenance
practitioner and are used primarily by the Company's outsourcing teams.
Currently, the Company's computer-based tools include:

     Peritus Code Analyzer ("PCA")--PCA is a software maintenance assistance
  tool designed to automate the process of logical code analysis. The tool is
  used to discover and correct defects, implement enhancements, verify
  properties of software (such as database integrity or security properties),
  migrate from one language to another and update systems or programs and data
  for specific enhancements (such as those required by the year 2000 problem).

     Business Rules Extraction--The Company's business rules extraction tool
  analyzes complex data structures and computer instructions within an
  information system and determines and distills the business rules that are
  embedded throughout the system. The extraction of business rules decreases the
  effort involved in porting, migrating, reengineering, simplifying and evolving
  software.

     SAM Relay--is a workflow and productivity-enhancing groupware tool designed
  to support the Peritus model for workflow coordination and accumulation of
  maintenance-related knowledge and experience.

  Formal Mathematical Techniques. Peritus has developed a discipline that makes
the analysis of software a more reliable activity based on the technique of
logical code analysis. Logical code analysis facilitates the understanding of
unfamiliar code and the isolation of the code specifically related to the
maintenance task and executes the required changes without impacting the
underlying logic. The Company's formal mathematical techniques are an integral
component of its core technologies and serve as the basis for the automation
capabilities of those technologies.

  SAM Workbench.  The SAM Workbench is a customizable toolset that enables
application understanding.  Its extraction, analysis, and estimation
capabilities improve the predictability of managing unfamiliar and complex sets
of applications in large outsourcing engagements.


PRODUCTS AND SERVICES

  Currently, the Company's product offering include its AutoEnhancer/2000 and
Vantage YR2000 software, its EuroPac RQE, SAM Relay and SAM Workbench Tools and
its service offerings include software maintenance outsourcing (SAMis and
SAMsp), technology transfer and insourcing services.

 AutoEnhancer/2000 Software

  The Company's AutoEnhancer/2000 software is a comprehensive solution designed
to address the correction phase of a year 2000 renovation. This software tool
currently processes COBOL, PL/1 and RPG computer languages. It contains a user-
friendly graphical user interface ("GUI") and can be easily modified to
interoperate with third-party assessment and testing tools. In 1996, the Company
began licensing a COBOL version of this product to end users and value added
integrators.

  Through a series of integrated and automated functions, the Company's
AutoEnhancer/2000 software identifies date-sensitive variables and corrects the
source code using date-field expansion or windowing techniques. In addition, the
tool generates bridges, wrappers, and data conversion programs that enable the
modified code to interface with remaining non-renovated programs and data.

                                       9
<PAGE>
 
  In order to increase the accurate identification of lines of affected software
code, the AutoEnhancer/2000 software traces and propagates variables that a user
has identified as date-sensitive to identify interrelated variables. The
AutoEnhancer/2000 software also uses a pattern matching program that identifies
variables that were named by a user in such a manner as to suggest that they may
be date-sensitive variables. This pattern matching program uses "neural net"
concepts, logical principles, user input and user feedback to attempt to learn
and adjust the patterns searched so as to improve accuracy in determining which
variations to encompass as variables of interest. Quantifying the speed at which
the Company's AutoEnhancer/2000 software (or other conversion tools) performs
data conversion or the accuracy at which the software identifies lines of
affected software code is not easily accomplished as results vary based on a
large number of variables, including: (i) the user-determined qualitative degree
of accuracy of identification and correction of errors; (ii) the nature and type
of the identification and correction methods; (iii) the computer languages used
in the code being corrected; (iv) whether the computer code contains a mixture
of various languages or involves proprietary aspects specific to the client; and
(v) the specific coding practices used by programmers in creating programs and
generating computer code. Among software tools designed for data correction of
the year 2000 problem, there is no mutually agreed upon standard benchmark of
comparison with regard to speed and accuracy.

 Vantage YR2000 Software

  The Company's Vantage YR2000 tools provide the ability to identify and
automatically convert substantially all of the software components and data
files of a client's information systems. The Vantage YR2000 tools:

  .  analyze the software components of an organization's systems environment

  .  provide valuable information, including date fields in programs and cross-
     reference reports, for planning, controlling and implementing year 2000
     projects

  .  and support the automatic conversion of the software and related data.

 
   RQE Tool

  The Company's RQE Tool is used to facilitate an in-house evaluation of a Year
2000 renovation of C and COBOL code by identifying date sensitive variables in
the renovated code.

  SAM Relay

  SAM Relay is a web-based, groupware tool used for managing and tracking
workflow. It was developed specifically to support task management as applied to
Peritus Software Maintenance Teams and facilitates twenty-four hours, seven days
per week service through its web-based interface, enabling geographically
dispersed individuals and teams to share information in real time.

  SAM Workbench.

  The SAM Workbench is a customizable toolset that enables application
understanding. Its extraction, analysis, and estimation capabilities improve the
predictability of managing unfamiliar and complex sets of applications in large
outsourcing engagements.

  EuroPac Tool

  The EuroPac Tool is a tool used to facilitate the conversion of local European
currencies into euro currency.

  Outsourcing Services

  The Company offers customized software maintenance outsourcing services to
clients. In an outsourcing project, the Company assumes responsibility for the
evolution of a client's software, including bug fixing, enhancements,
applications migration, modernization and porting. The Company's outsourcing
services address the maintenance needs of application software, system software,
embedded software and software products and are designed to provide productivity
gains regardless of platform, operating system, language or software function.
In

                                       10
<PAGE>
 
the delivery of its outsourcing services, the Company uses a number of
proprietary technologies. Compared to traditional software maintenance methods,
the Company's technologies allow faster de-bugging by identifying and excluding
irrelevant variables and by tracing the cause of errors from the known output
resulting from such errors and the Company's processes enable workflow
management techniques to improve a maintenance team's throughput. In addition,
the Company may from time to time directly provide year 2000 renovation services
for its clients. In 1998, the Company launched a marketing program combining
year 2000 renovation and outsourcing offerings and its SAMis and SAMsp services.

  The Company offers two distinct types of software maintenance outsourcing
services, SAMis and SAMsp. SAMsp is a fixed price software maintenance
outsourcing solution designed specifically for the manufacturers of both systems
software and software products. SAMsp combines people, process, formal
mathematical techniques, computer-based tools, and continuous improvement to
improve productivity and responsiveness. SAMis is a fixed price software
maintenance solution designed specifically to assist a company's information
technology organization in managing their application portfolio.

  Outsourcing services are performed at both Company and client locations with a
team of Company employees, or a team comprising Company and client employees.
Formal training, support and continuous improvement are part of every
outsourcing service offering. The Company's self-directed outsourcing teams
understand and exploit organizational dynamics, workflow management and
proprietary technology to enhance the productivity, responsiveness and quality
of the software evolution process. Individual team members develop a deep and
broad understanding of many programming languages and applications, as well as
maintenance technologies and de-bugging methodologies.  The Company also uses
its SAM Relay Tool in its outsourcing arrangements when appropriate.

  In connection with the delivery of its outsourcing services, the Company
assesses the IT costs of a client together with other factors such as quality,
productivity, and software and hardware environment and in general agrees to
provide IT services on a fixed price, fixed time frame basis after a detailed
assessment.

  A typical outsourcing engagement represents a multi-million dollar, multi-
year, fixed-price contract that specifies service rather than staffing levels.

 Technology Transfer Services

  The Company offers technology transfer services to assist organizations that
seek to increase the productivity of their software evolution activities while
keeping their software maintenance activities in-house. This technology transfer
program transfers the organizational model and workflow methodology of the
Company's software maintenance outsourcing solutions to enable clients to
implement enhanced, repeatable processes for software evolution.

  The Company also provides insourcing services, which combined the Company's
technology transfer services with on-site management of the Peritus-trained
client teams. In an insourcing engagement, the Company participates with the
client management to provide that the teams accurately implement the Company's
approach and perform at expected productivity levels. Typical insourcing
engagements have two revenue components: a fee for services and a royalty tied
to the client's productivity gains.

 Renovation Quality Evaluation
 
   The Company offers the Renovation Quality Evaluation ("RQE") service as an
automated evaluation by Peritus that analyzes the quality of C and COBOL code
renovated for Year 2000 compliance by identifying date sensitive variables in
the renovated code. The RQE Service incorporates the use of the RQE Tool and may
include the use of other proprietary technologies such as the AutoEnhancer/2000
and the Mass Change Engine for analyzing renovated code.

                                       11
<PAGE>
 
SALES AND MARKETING

  Historically, the Company offered its products and services to clients through
both direct and indirect channels, including relationships with value added
integrators using the Company's technology as an integral part of their overall
solutions, as well as domestic and international distributors.

 Direct Sales

  In April 1999, the Company reduced its direct sales force to one sales
representative. Future sales will be dependent upon this single sales
representative, the sales efforts of senior management and the potential
establishment of sales agency relationships with former sales representatives.
Prior to April 1999, the Company sold and supported its products and services
directly in the United States.

 Indirect Sales

  The Company has agreements with value added integrators. During 1998 and to
date, the Company had limited sales from these value added integrators.
Currently, the Company's integrators are located in the United States, Canada,
Europe and Japan and are authorized by Peritus to sublicense the Company's
products and/or services to end users or system integrators in their
respective territories.

 Marketing

  In April 1999, the Company eliminated its marketing organization to minimize
its expenses. Prior to April 1999, the Company's marketing organization worked
closely with product management and the sales organization in the development of
Company marketing literature, market research to assist in strategic planning
and tactical decision making, trade show programs and exhibit planning,
advertising and public relations support. In 1998, the Company launched its
marketing campaigns covering its combined year 2000 renovation and outsourcing
service offering, combined Auto Enhancer/2000 and Vantage YR 2000 product
offering and SAMis and SAMsp offerings. In 1998, the Company also conducted an
advertising campaign for its year 2000 and other products and services.

CLIENTS

  The Company offers its products and services to end users in a variety of
industries including insurance, financial services, telecommunications,
transportation, utilities and manufacturing.

  To date, the Company's revenue has been dependent on a few major clients,
including American Telephone & Telegraph, Inc. ("AT&T"), Bull HN Information
Systems, Inc. ("Bull"), Stratus Computer, Inc. ("Stratus"), Computervision
Corporation ("Computervision"), Metropolitan Life Insurance Company ("Met
Life"), IBM Global Services ("IBM") and Merrill Lynch, Pierce, Fenner & Smith
Incorporated ("Merrill Lynch"). During 1998, AT&T and Bull represented
approximately 12.2% and 10.0% of the Company's total revenue, respectively.
During 1997, Bull, Merrill Lynch and Met Life represented approximately 8.4%,
6.7% and 6.7% of the Company's total revenues, respectively. During 1996, Bull,
Merrill Lynch and Stratus represented approximately 29.0%, 14.6% and 12.1% of
the Company's total revenue, respectively. In addition, the Company's ten
largest clients represented approximately 52.4%, 63.8%, and 77.9% and of the
Company's total revenue in the years ended December 31, 1998, 1997 and 1996,
respectively.

  The Company has entered into agreements to provide software consulting
services and software maintenance services with each of Computervision and Bull.
These agreements expire, subject to extension, on December 31, 2000 and December
31, 1999, respectively. In 1999, the Bull contract was extended through December
31, 2006. The Company's agreement with Stratus terminated on June 6, 1998.

  The Company has also entered into a license agreement with Bull that expires
on December 31, 2001. This agreement grants to Bull certain use rights,
sublicensing rights and the right to make certain derivative works with

                                       12
<PAGE>
 
regard to proprietary software programs of the Company. In the event that the
Company fails to fulfill any of its obligations under the Bull license agreement
for a period of 90 days, Bull has the option, upon notice to the Company, to
elect in lieu of termination to assume performance of the Company's obligations
and to have access to source code of the Company's licensed software to perform
such assumed obligations.

  The Company and Merrill Lynch have entered into a master license agreement
granting to Merrill Lynch the right to use certain proprietary software of the
Company on a non-exclusive, perpetual use basis to address year 2000 issues. The
Company has also entered into a license agreement with Met Life that provides
for the purchase by Met Life of several non-exclusive, worldwide licenses of
certain of the Company's proprietary software.

CLIENT TECHNICAL SUPPORT

  In connection with the licensing of its products, the Company provides its
clients with technical support and advice, including problem resolution,
installation assistance, error corrections and product enhancements released
during maintenance. The Company provides each of its significant clients with a
client technical support representative whose primary responsibility is to
resolve questions and concerns and act as a liaison between the client and the
Company. In addition, the Company provides toll-free telephone support, as well
as access to electronic bulletin boards and other forms of electronic
communication to provide clients with the latest information regarding the
Company's products and services. Client technical support fees related to the
Company's year 2000 products are typically 15% of license fees and are typically
capped at $400,000 annually per direct licensee.

RESEARCH AND PRODUCT DEVELOPMENT

  Historically, the Company has invested significantly in enhancing existing
technology and developing new products and services. As a result of the
Company's restructurings in 1998 and 1999 to date, the majority of the Company's
research and development resources have been eliminated. The Company plans to
continue limited maintenance of and enhancements to its products and no
development of new products. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations" for a description of research and
development expenses incurred from 1996 through 1998.

  The Company has its remaining development facility  at the Company's
Billerica, Massachusetts headquarters.  The Company also maintains a development
and support center in Bangalore, India.

  The Company has generally relied on internal efforts and resources to develop
its software and methodologies. However, in some limited cases, the Company has
contracted with various firms, certain of which are located in India and Canada,
to develop materials, processes, software or portions of software for and on
behalf of the Company.

COMPETITION

  The market for the Company's software products and services, including its
solutions for the year 2000 problem, is intensely competitive and characterized
by rapid changes in technology and user needs and the frequent introduction of
new products. The Company's competitors include year 2000 software vendors, year
2000 service providers and outsourcing service providers.

  Vendors of year 2000 software products generally focus on a particular phase
of a year 2000 renovation, such as assessment, correction or testing. The
Company's AutoEnhancer/2000 and Vantage YR 2000 software primarily address the
correction phase of a year 2000 renovation. The Company's RQE Tool primarily
addresses the testing phase of a year 2000 renovation. The Company believes
that the principal competitive factors affecting competition in the year 2000
software market include product functionality, degree of automation, speed of
throughput, product performance and reliability, ability to respond to changing
client needs, ease of use, training, quality of support and price. The Company's
principal and potential competitors in the market for year 2000 software include
Computer Associates International, Inc., Compuware Corporation, Cognicase, Inc.,
Micro Focus Group Public Limited Company, Platinum Technology, Inc., SEEC, Inc.
and VIASOFT.

                                       13
<PAGE>
 
  During 1998, the Company provided year 2000 services through its relationships
with value added integrators. Peritus believed that these value added
integrators competed and continue to compete on the basis of service, the
expertise and experience of the service personnel, the ability of such personnel
to provide solutions to application problems and price. Principal competitors in
this market include AMDAHL, Cap Gemini America, CCd On-Line, Computer Horizons
Corp. and Information Management Resources, Inc. Many smaller local and regional
organizations also compete in the year 2000 services market.

  The Company also faces competition in the provision of its software
maintenance outsourcing services. The Company believes that the principal
competitive factors in the market for outsourcing services include price, the
ability to provide productivity guarantees, strong client relationships,
comprehensive delivery methodologies, responsiveness to client needs, depth of
technical skills and reputation. The Company's principal competitors in this
market include not only in-house IT departments and systems integrators such as
the major accounting firms but also outsourcing service providers such as
Computer Sciences Corp., Electronic Data Systems Corporation, IBM Global
Services, Keane, Inc. and PKS Information Services, Inc.

  A number of the Company's competitors are more established, benefit from
greater name recognition and have substantially greater financial, technical and
marketing resources than the Company and certain of the Company's value added
integrators. Moreover, other than the need for technical expertise, there are no
significant proprietary or other barriers to entry in the year 2000 industry.
There can be no assurance that the Company's products and services or the
solutions offered by the Company's value added integrators will compete
effectively with those of their respective competitors. The Company's value
added integrators may also offer or develop products and services that compete
with the Company's products and services. There can be no assurance that those
clients will not give higher priority to the sales of these or other competitive
products and services.

INTELLECTUAL PROPERTY

  The Company relies on a combination of copyright, trade secret, patent,
service mark, and trademark laws and license agreements to protect its
proprietary rights in technology. In addition, the Company currently requires
its employees and consultants to enter into nondisclosure and assignment of
invention agreements to limit use of, access to and distribution of its
proprietary information.

  The Company's business includes the maintenance, evolution, repair and
development of software applications, system software and other deliverables,
including written specifications and documentation in connection with specific
client engagements. Ownership of software and associated deliverables created
for clients is generally retained by or assigned to the client, and the Company
does not retain an interest in such software or deliverables. The source code
for the Company's proprietary software is generally protected as trade secrets
and as unpublished copyrighted works. However, the Company has entered into
source code escrow agreements with certain of its licensees requiring release of
source code in certain circumstances. Such source code escrow agreements usually
limit the use and disclosure of such source code in the event that it is
released.

  In addition, the Company has entered into license agreements with a limited
number of clients that allow these clients access to and use of the Company's
AutoEnhancer/2000 and Vantage YR 2000 software and SAM Relay and RQE Tools
source code for certain purposes. Access to the source code may increase the
likelihood of misappropriation or misuse by third parties.

  The Company's business also includes licensing of the Company's proprietary
software, methodologies and related services to end users, as well as to value
added integrators authorized to provide services to third parties. In general,
such licensing of the Company's proprietary software, methodologies and related
services to a licensee is a limited term, limited use, non-exclusive license
that contains restrictions on copying, disclosure, usage, decompiling and
transferability. In particular cases, however, a license agreement may have
certain provisions that are exclusive in some manner. Within these licensing
agreements the Company seeks to avoid disclosure of its trade secrets,
including, but not limited to, generally requiring those persons with access to
the

                                      14
<PAGE>
 
Company's proprietary information to execute confidentiality agreements
restricting use of and access to the Company's confidential information.

  The Company generally relies on internal efforts in order to develop its
software and methodologies. However, in some limited cases the Company has
contracted with various firms, certain of which are located in India and Canada,
to develop software or portions of software for and on behalf of the Company.
Software development by a contractor for the Company is done pursuant to
agreements that generally assign all rights to the Company and contain
nondisclosure provisions. Such software developed by a contractor may be merged
with software that the Company has developed using its internal employees. In
January 1996, the Company acquired Vista and was assigned all of Vista's
intellectual property rights, consisting mainly of unregistered copyrights. In
December 1997, the Company acquired additional year 2000 technology in
connection with the MDI acquisition.

  The Company has filed six patent applications with the United States Patent
and Trademark Office (the "PTO") pertaining to technologies, processes and
methodologies used by the Company's software. A patent has been granted on one
of these applications, United States Patent Number: 5,838,979, that covers
certain technology applicable to the Mass Change Engine. There can be no
assurance that a patent will be issued pursuant to any other of these
applications or that, if granted, such patent would survive a legal challenge to
its validity or provide meaningful or significant protection to the Company. In
addition, the Company may decide to abandon a patent application if, among other
things, it determines that continued prosecution of an application would be too
costly, the technologies, processes or methodologies are not critical to the
Company's business in the forseeable future or it is unlikely that a patent will
issue with regard to a particular application. Some competitors of the Company
have announced the filing with the United States Patent and Trademark Office of
patent applications relating to fixing and assessing the year 2000 problem. The
Company expects that the risk of infringement claims against the Company might
increase because its competitors might successfully obtain patents for software
products and processes or because as the number of competitors providing
software and software related services addressing year 2000 problem increases,
new and overlapping processes and methodologies used in such services will
become more pervasive, increasing the likelihood of infringement.

  There can be no assurance that the Company's means of protecting its
proprietary rights in the United States or abroad will be adequate. The laws of
some foreign countries may not protect the Company's proprietary rights as fully
or in the same manner as do the laws of the United States. Also, despite the
steps taken by the Company to protect its proprietary rights, it may be possible
for unauthorized third parties to copy aspects of the Company's products,
reverse engineer, develop similar technology independently, or obtain and use
information that the Company regards as proprietary. Furthermore, there can be
no assurance that others will not develop technologies similar or superior to
the Company's technology or design around the proprietary rights owned by the
Company. However, the Company believes that, because of the rapid pace of
technological change in the software industry, patent, trade secret and
copyright protection is less significant to the Company's competitive position
than factors such as the knowledge, ability and experience of its personnel, new
product development, frequent product enhancements, name recognition and ongoing
product maintenance support with regard to developing, establishing and
maintaining a technology leadership position.


EMPLOYEES

  As of April 12, 1999, the Company employed 98 full-time employees, including
15 in research and development (12 in the Company's development center in
India), 2 in sales and marketing, 69 in professional services and support and 12
in finance, administration, legal and  corporate management. It is important for
the Company to retain and attract highly skilled and qualified personnel.
Competition for such personnel is intense in the computer software industry,
particularly for software developers, service consultants, and sales and
marketing personnel. There can be no assurance that the Company will be able to
attract and retain qualified personnel in the future.

  The Company's employees are not represented by any labor unions. The Company
considers its relations with its employees to be good.

                                       15
<PAGE>
 
ITEM 2.   PROPERTIES

  The Company is headquartered in Billerica, Massachusetts, where it leases
approximately 100,000 square feet under a lease expiring in January 2006. In
addition, the Company leases office space of approximately 5,000 square feet in
Trumbull, Connecticut, and 8,200 square feet in Westborough, Massachusetts which
it currently uses to provide some outsourcing and software evolution services.
These leases expire in January 2000 and December 2001, respectively. The Company
leases approximately 16,000 square feet in Cincinnati, Ohio which it has vacated
and stopped making rental payments thereon under the related lease.

  The Company also continues to lease facilities in Lisle, Illinois of
approximately 5,000 square feet, the lease for which expires in February 2003.
The Company leases additional facilities and offices in Phoenix, Arizona and
Bangalore, India. The Company has a Spanish branch office that leases facilities
in Madrid, Spain. The Company believes its current facilities are in good
condition, are sufficient for its current operations and that the facilities
will continue to provide adequate space for its operations in the foreseeable
future. As a result of the restructurings in 1998, the Company is taking steps
to sublease, reduce or vacate excess space for its operations in Billerica,
Lisle and Cincinnati.

                                       16
<PAGE>
 
ITEM 3.   LEGAL PROCEEDINGS

  The Company and certain of its officers and directors were named as defendants
in purported class action lawsuits filed in the United States District Court for
the District of Massachusetts by Robert Downey on April 1, 1998, by Scott Cohen
on April 7, 1998, by Timothy Bonnett on April 9, 1998, by Peter Lindsay on April
17, 1998, by Harry Teague on April 21, 1998, by Jesse Wijntjes on April 29,
1998, by H. Vance Johnson and H. Vance Johnson as Trustee for the I.O.R.D.
Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on May 21, 1998 and
by Helen Lee on May 28, 1998 (collectively, the "complaints"). The complaints
principally alleged that the defendants violated federal securities laws by
making false and misleading statements and by failing to disclose material
information concerning the Company's December 1997 acquisition of substantially
all of the assets and assumption of certain liabilities of the Millennium
Dynamics, Inc. business from American Premier Underwriters, Inc., thereby
allegedly causing the value of the Company's common stock to be artificially
inflated during the purported class periods. In addition, the Howard complaint
alleged violation of federal securities laws as a result of the Company's
purported failure to disclose material information in connection with the
Company's initial public offering on July 2, 1997, and also named Montgomery
Securities, Inc., Wessels, Arnold & Henderson, and H.C. Wainwright & Co., Inc.
as defendants. The complaints further alleged that certain officers and/or
directors of the Company sold stock in the open market during the class periods
and sought unspecified damages.

  On or about June 1, 1998, all of the named plaintiffs and additional purported
class members filed a motion for the appointment of several of those individuals
as lead plaintiffs, for approval of lead and liaison plaintiffs' counsel and for
consolidation of the actions. The Court granted the motion on June 18, 1998.

  On January 8, 1999, the plaintiffs filed a Consolidated Amended Complaint
applicable to all previously filed actions. The Consolidated Amended Complaint
alleges a class period of October 22, 1997 through October 26, 1998 and
principally claims that the Company and three of its former officers violated
federal securities law by purportedly making false and misleading statements (or
omitting material information) concerning the MDI acquisition and the Company's
revenue during the proposed class period, thereby allegedly causing the value of
the Company's common stock to be artificially inflated. Previously stated claims
against the Company and its underwriters alleging violations of the federal
securities laws as a result of purportedly inadequate or incorrect disclosure in
connection with the Company's initial public offering are not included in the
Consolidated Amended Complaint. The Company and the individual defendants filed
motions to dismiss the Consolidated Amended Complaint on March 5, 1999. The
plaintiff's opposition to such motions are due on April 16, 1999 and oral
argument is currently scheduled to occur on April 21, 1999.

  Although the Company believes that it has meritorious defenses to the claims
made in the Consolidated Amended Complaint and intends to contest the action
vigorously, an adverse resolution of the lawsuit could have a material adverse
effect on the Company's financial condition and results of operations in the
period in which the litigation is resolved. The Company is not able to
reasonably estimate potential losses, if any, related to the Consolidated
Amended Complaint.

                                       17
<PAGE>
 
ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

  None.

                                       18
<PAGE>
 
                                   PART II.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

     The following table sets forth, for the periods indicated, the range of
high and low sales prices for the Company's common stock, as reported by the
Nasdaq National Market.. The Company's securities were traded on the Nasdaq
National Market through February 3, 1999. Thereafter, they have been traded on
the OTC Bulletin Board. The Company's common stock has been traded under the
symbol "PTUS" since the Company's initial public offering on July 2, 1997. These
prices reflect interdealer prices, without retail mark-ups, mark-downs or
commissions, and do not necessarily represent actual transactions.

<TABLE> 
<CAPTION> 
                                                    1997                                               1998
                                            --------------------                                --------------------
                                               HIGH       LOW                                     HIGH       LOW
                                            --------------------                                --------------------
      <S>                                   <C>       <C>           <C>                         <C>       <C> 
                                                                    First Quarter.............  $ 23.75    $5.4375
                                                                    Second Quarter............  $  7.00    $  3.75
      Third Quarter (since July 2, 1997)..    $32.375   $19.00      Third Quarter.............  $  7.50    $1.1562
      Fourth Quarter......................    $30.25    $14.75      Fourth Quarter............  $  1.50    $0.3438
</TABLE> 

     Historically, the Company has not declared or paid cash dividends on its
common stock and does not plan to pay cash dividends to its stockholders in the
foreseeable future. The Company presently intends to retain any earnings to
finance its business. As of March 19, 1999, there were 400 stockholders of
record of the Company's common stock.

     The Company is furnishing the following information with respect to the use
of proceeds from its initial public offering of common stock, $.01 par value per
share on July 2, 1997:

          (1) The effective date of the registration statement for the offering
     and the commission file number were July 1, 1997 and 333-27087,
     respectively.

          (4)(vii) From October 1, 1997 to December 31, 1998, $500,000 of the
     offering proceeds were used to repay certain indebtedness under a secured
     subordinated note, $30 million were paid to APU in connection with the MDI
     acquisition and $9,240,000 were used to fund the Company's operations or
     for working purposes capital. The balance of the offering proceeds $924,000
     was invested in commercial paper and money market accounts.

     Except for the $30 million paid to APU which, as a result of the MDI
acquisistion, owns 10% or more of the Company's common stock, payment of the
offering proceeds were to persons other than directors, officers, general
partners of the Company or their associates, persons owning 10% or more of the
equity securities of the Company or affiliates of the Company.

                                       19
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA

     The selected financial data set forth below as of December 31, 1998 and
1997, and for the three years ended December 31, 1998, are derived from the
Company's Consolidated Financial Statements, which appear elsewhere in this
Annual Report. The selected financial data set forth below as of December 31,
1995 and 1994 and for the years ended December 31, 1995 and 1994 are derived
from the Company's audited financial statements, which are not included in this
Annual Report. The data set forth below should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Company's Consolidated Financial Statements, including the
Notes thereto, included elsewhere in this Annual Report.

<TABLE> 
<CAPTION> 
                                                                                  YEAR ENDED DECEMBER 31,
                                                                      -------------------------------------------------
                                                                        1998      1997     1996      1995       1994
                                                                      --------- -------- --------  -------   ---------- 
                                                                            (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                                   <C>       <C>      <C>      <C>        <C>  
STATEMENT OF OPERATIONS DATA:
Revenue:
    Outsourcing services............................................   $  9,925 $ 11,447 $ 10,190  $ 16,400   $ 7,130 
    License.........................................................      9,444   21,255    6,526        --        --
    Other services..................................................     12,163    7,007    2,519     2,105       742 
                                                                      --------- -------- -------- ---------- ---------- 
        Total revenue(1)............................................   $ 31,532 $ 39,709   19,235    18,505     7,872 
                                                                      --------- -------- -------- ---------- ---------- 
Cost of revenue:                                                     
    Cost of outsourcing services....................................      7,577    9,536    8,488     9,602     4,700 
    Cost of license.................................................      1,631      690      162        --        --
    Cost of other services..........................................      9,110    5,357    2,931     2,421       319 
                                                                      --------- -------- -------- ---------- ---------- 
        Total cost of revenue.......................................     18,318   15,583   11,581    12,023     5,019 
                                                                      --------- -------- -------- ---------- ---------- 
Gross profit........................................................     13,214   24,126    7,654     6,482     2,853 
                                                                      --------- -------- -------- ---------- ---------- 
OPERATING EXPENSES:                                                  
Sales and marketing.................................................     13,244    8,864    3,116     2,129       366 
Research and development............................................      8,528    8,324    6,033     1,703       560 
General and administrative..........................................      7,466    4,312    3,249     2,357     1,283 
Write-off of acquired in-process research and development...........         --   70,800       --        --        --
Impairment of long-lived assets.....................................      5,218       --       --        --        --
Restructuring charge................................................      5,906       --       --        --        --
                                                                      --------- -------- -------- ---------- ---------- 
        Total operating expenses....................................     40,362   92,300   12,398     6,189     2,209 
                                                                      --------- -------- -------- ---------- ---------- 
Income (loss) from operations.......................................    (27,148) (68,174)  (4,744)      293       644 
Interest income (expense), net......................................        485      948     (296)     (203)      (63)
                                                                      --------- -------- -------- ---------- ---------- 
Income (loss) before gain on sale of majority-owned subsidiary,      
   income taxes, minority interest and equity in loss of less                                                          
   than majority-owned company......................................   (26,663)  (67,226)  (5,040)       90       581    
Gain on sale of majority-owned subsidiary...........................       (11)       --       --        --        --
Provision (benefit) for estimated income taxes......................        25       260     (143)       (8)      179 
                                                                      --------- -------- -------- ---------- ---------- 
Income (loss) before minority interest and equity in loss of less    
   than majority-owned company......................................   (26,677)  (67,486)  (4,897)       98       402 
Minority interest in majority-owned subsidiary......................        (4)        4       24        43        --
Equity in loss of less than majority-owned company..................        --        --       --        --        97 
                                                                      --------- -------- -------- ---------- ---------- 
Net income (loss)...................................................  $(26,673) $(67,490)$ (4,921)   $   55    $  305 
                                                                      ========= ======== ======== ========== ========== 
Net income (loss) per share:(2)                                      
    Basic...........................................................  $  (1.65) $  (7.03)$  (1.02)  $  0.01   $  0.06 
                                                                      ========= ======== ======== ========== ========== 
    Diluted.........................................................  $  (1.65) $  (7.03)$  (1.02)  $  0.01   $  0.05 
                                                                      ========= ======== ======== ========== ========== 
Weighted average shares outstanding:(2)                              
    Basic...........................................................     16,177    9,708    5,876     5,078     4,950 
                                                                      ========= ======== ======== ========== ========== 
    Diluted.........................................................     16,177    9,708    5,876     6,456     5,873 
                                                                      ========= ======== ======== ========== ========== 
Pro forma basic and diluted net loss per share (unaudited)..........            $  (5.83)$  (0.67)
                                                                                ======== ========
Pro forma basic and diluted weighted average shares outstanding                           
(unaudited).........................................................              11,574    7,394 
                                                                                ======== ========
</TABLE> 

                                       20
<PAGE>
 
<TABLE> 
<CAPTION> 
                                                                        DECEMBER 31,  
                                                   -------------------------------------------------------
                                                      1998       1997       1996       1995       1994
                                                   ---------   -------     -------   --------   ----------
                                                                       (IN THOUSANDS)
       <S>                                         <C>         <C>         <C>       <C>        <C> 
       BALANCE SHEET DATA:
       Cash and cash equivalents, including
          restricted cash........................     $ 3,378   $ 11,340   $ 7,388      $  264     $  339
       Short-term investments....................         500      3,000        --          --         --
       Working capital...........................       1,805     20,931     8,218       2,218      1,267
       Total assets..............................      13,723     39,870    17,725       7,179      2,924
       Long-term debt, net of current portion....          --        413     1,538       1,792        777
       Redeemable stock..........................          --         --    12,287          --         --
       Stockholders' equity (deficit)............       4,810     30,005    (3,302)      1,802        867
</TABLE> 

(1)  Revenue (in thousands) from related parties in the years ended December 31,
     1998, 1997, 1996, 1995 and 1994 was $1,331, $4,478, $6,443, $10,114, and
     $4,317, respectively. See the Company's Consolidated Financial Statements.

(2)  See Note 2 of Notes to the Company's Consolidated Financial Statements for
     an explanation of the determination of historical and pro forma net income
     (loss) per share.

     The following unaudited pro forma data has been prepared as if the MDI
acquisition was completed at the beginning of the periods presented, is
presented for illustrative purposes only and is not necessarily indicative of
results of operations which would actually have been achieved had the
acquisition occurred at the beginning of such periods or which may be achieved
in the future. In addition, the following unaudited pro forma data is adjusted
to reflect the amortization of acquired intangible assets and excludes the write
off of acquired in-process research and development of $70,800,000 due to its
non-recurring nature. Also, the net loss per share and unaudited pro forma net
loss per share data shown below assumes the 2,175,000 shares issued in
connection with the acquisition were outstanding for the entire periods
presented. In addition, consistent with the presentation in the Company's
statement of operations, the unaudited pro forma net loss per share data
presented in the last two rows below also assumes conversion of all redeemable
convertible preferred stock as of the beginning of the year or date of issuance,
if later, using the if-converted method (Note 2).

<TABLE> 
<CAPTION> 
                                                     FOR THE YEARS ENDED DECEMBER 31,
                                 -------------------------------------------------------------------------
                                                 1997                                1996
                                 -------------------------------------------------------------------------
                                      AS REPORTED         PRO FORMA         AS REPORTED      PRO FORMA
                                 ------------------     -------------      ------------    ---------------
                                                         (UNAUDITED)                         (UNAUDITED)
          <S>                         <C>               <C>                <C>             <C> 
          Revenues................      $39,709,000       $50,633,000      $19,235,000       $22,348,000 
          Net loss................      (67,490,000)       (2,879,000)      (4,921,000)       (5,689,000)
          Net loss per share:
               Basic..............      $     (7.03)      $     (0.31)     $     (1.02)      $     (0.84)
               Diluted............      $     (7.03)      $     (0.31)     $     (1.02)      $     (0.84)
          Pro forma net loss per..
          share (unaudited)(1)....
               Basic..............      $     (5.83)      $     (0.21)     $     (0.67)      $     (0.59)
               Diluted............      $     (5.83)      $     (0.21)     $     (0.67)      $     (0.59)
</TABLE> 

(1)      Assumes conversion of all redeemable convertible preferred stock as of
         the beginning of the year or date of issuance, if later, using the
         if-converted method.

                                       21
<PAGE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND 
         RESULTS  OF OPERATIONS

COMPANY CURRENT CONDITION AND REVISED STRATEGY

     In the second half of 1998, the overall market for the year 2000 tools and
services of the Company contracted dramatically, resulting in substantial
financial losses. In response, the Company substantially reduced its workforce
in September of 1998 and again in December of 1998. As a result of the Company's
degraded financial condition, the Company began encountering major obstacles in
obtaining new outsourcing business. Since most outsourcing engagements are 
multi-year and involve critical applications, prospective new clients, although
interested in the capabilities and technology of the Company, have been
reluctant or unwilling to commit to contracts. Despite the significant reduction
in the overall cost structure as a result of the September and December actions,
the Company was unable to achieve a cash flow break-even position in the first
quarter of 1999 and it is considering various alternatives including the
possibility of filing for the protection from creditors under applicable
bankruptcy laws. The Company again reduced its workforce in April of 1999,
eliminating the majority of sales, marketing and year 2000 resources.

     The Company's current strategy is to minimize expenses, while preserving
its principal saleable assets: its outsourcing business and its technology.
Along with Covington Associates, its investment banker, the Company is actively
pursuing strategic relationships with an emphasis on the sale of all or parts of
its assets. The Company is continuing to selectively pursue sales of its
EuroPac, SAM Relay, RQE and SAM Workbench tools. The Company is also focusing on
renewing its existing outsourcing contracts and licensing its methodologies and
providing limited consulting services. The Company continues to support its
existing software customers and plans to offer very limited year 2000 services
based on availability of resources.

     Based on the Company's existing fixed cost commitments, its limited cash
resources, and the reluctance of new customers to commit to long term
outsourcing engagements, the Company does not anticipate that it will be able to
achieve a cash flow breakeven position in the future. However, it will continue
to attempt to do so at the same time it seeks potential buyers. See "Liquidity
and Capital Resources" below.

COMPANY OVERVIEW

     Peritus was founded in 1991 to address the growing market for managing and
maintaining the installed base of software in organizations. The Company focused
its efforts on the delivery of software maintenance outsourcing services until
1995, when it began to devote significant resources to the development of
software tools addressing the problems associated with mass changes to
application systems and their associated databases, particularly the year 2000
problem. In 1996, the Company began licensing its AutoEnhancer/2000 software,
which was designed to address the year 2000 problem, to value added integrators
and directly to end users. In 1996, the Company expanded its research and
development efforts through the acquisition of Vista, a developer of
computer-aided engineering software. During the year ended December 31, 1997,
the Company expanded its product offering by releasing an enhanced version of
the AutoEnhancer/2000 software which enables a client to perform logic
correction only changes with regard to year 2000 renovations.

     On July 8, 1997, the Company closed its initial public offering of
4,025,000 shares of common stock, 2,800,000 of which were sold by the Company
and the balance by selling stockholders, at a public offering price of $16 per
share. The proceeds to the Company from the offering, net of offering expenses,
were $40,664,000. The Company used a portion of the net proceeds to repay a
secured subordinated note payable. The Company also used the proceeds to acquire
MDI and planned to use any remaining proceeds for research and development,
working capital and general corporate purposes. In connection with closing the
initial public offering, all outstanding shares of Series A and B preferred
stock and Class B common stock automatically converted into 3,822,903 shares of
common stock, all Class A common stock was redesignated as common stock, and the
redeemable common stock right automatically terminated.

     Effective December 1, 1997, Twoquay, Inc., a wholly owned subsidiary of the
Company, acquired substantially all of the assets and assumed certain
liabilities of the business of MDI from APU in exchange for $30 million in cash
and 2,175,000 unregistered shares of the Company's common stock. Pursuant to a
Registration Rights Agreement between the Company and APU, the Company agreed to
file a Registration Statement on Form S-

                                      22
<PAGE>
 
3 covering up to all of the common shares issued in the MDI acquisition by July
6, 1998 and to use its best efforts to cause such Registration Statement to
become effective prior to August 1, 1998. The Company also granted APU certain
incidental rights to register up to 500,000 of the shares of common stock prior
to July 6, 1998 in the event of a secondary offering of the Company's common
stock. Under the terms of the Registration Rights Agreement, APU also agreed
that up to 837,500 of the shares of common stock issued by the Company would be
subject to restrictions on sale through December 31, 1998. In determining the
purchase price for accounting purposes, the shares of common stock issued by the
Company in connection with this transaction were assigned a value of $47.3
million based on the average closing sale price of the Company's common stock
during the six trading days beginning on the second trading day immediately
preceding the completion and public announcement of the terms of the acquisition
on October 22, 1997, less a discount of approximately 13% primarily reflecting
the illiquid nature of the unregistered shares of common stock issued by the
Company in connection with this transaction as discussed above. Twoquay changed
its name to MDI after the closing of the acquisition. As the result of the MDI
acquisition, the results of operations and cash flows are included in the
results of the Company from the date of acquisition.


     In March 1998, the Company announced its intentions for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, and recorded a charge of $1,439,000 consisting in part
of severance payments associated with the termination of approximately 12% of
the Company's employees in April 1998 (48 employees). At June 30, 1998, all 48
employees had been terminated with no further terminations remaining under the
restructuring. In addition, a significant portion of the restructuring charge
related to the closure of two research and development and outsourcing centers,
consisting primarily of the accrual of lease costs, net of estimated sublease
income, and support costs for a discontinued product. Payments related to
terminated employees were completed in June 1998 for 45 employees and are
expected to be completed by September 1999 for the remaining 3 employees.
Payments related to the closure and reduction of facilities are expected to be
complete by April 2003. The restructuring resulted in a reduction of
approximately $950,000 in salary and related costs and $90,000 in facility
related costs on a quarterly basis beginning in second quarter of 1998.

     In September 1998, the Company announced its intention to restructure and
recorded a charge of $3,372,000 consisting in part of severance payments
associated with the termination of approximately 33% of the Company's employees
at that time (89 employees). At September 30, 1998, all 89 employees had been
terminated with no further terminations remaining under the restructuring. In
addition, a significant portion of the restructuring charge related to the
closure of two research and development centers and a reduction of occupied
space at the Company's headquarters in Billerica, MA and consisted primarily of 
the accrual of lease costs, net of estimated sublease income. Payments related
to terminated employees were completed by December 1998 for 82 employees and are
expected to be completed by September 1999 for the remaining 7 employees.
Payments related to the closure of facilities and reduction of occupied space
are expected to be completed by June 2003. The Company has estimated that the
restructuring will result in a reduction of approximately $1,900,000 in salary
and related costs and $250,000 in lease related costs on a quarterly basis
beginning in the fourth quarter of 1998.

     In December 1998, the Company announced its intention to restructure and
recorded a charge of $1,316,000 consisting in part of severance payments
associated with the termination of approximately 22% of the Company's employees
(45 employees). At December 31, 1998, all 45 employees had been terminated with
no further terminations remaining under the restructuring. In addition, a
significant portion of the restructuring charge related to a further reduction
of occupied space at the Company's headquarters in Billerica, MA and consisted
primarily of the accrual of lease costs, net of estimated sublease income.
Payments related to the terminated employees were completed by December 31,
1998. Payments related to the reduction of occupied space are expected to be
complete by February 2006. The Company has estimated that the restructuring will
result in a reduction of approximately $950,000 in salary and related costs and
$70,000 in lease related costs on a quarterly basis beginning in the first
quarter of 1999.

                                       23
<PAGE>
 
   Revenue Recognition Policies

     Revenue under contracts to provide outsourced software maintenance,
reengineering and development services is recognized using the percentage-of-
completion method and is based on the ratio that labor-hours incurred to date
bear to estimated total labor-hours at completion, provided that collection of
the related receivable is probable. Adjustments to contract cost estimates are
made in the periods in which the facts which require such revisions become
known. When the revised estimates indicate a loss, such loss is provided for
currently in its entirety. Costs and estimated earnings in excess of billings on
uncompleted contracts represent revenue recognized in excess of amounts billed.
Billings in excess of costs and estimated earnings on uncompleted contracts
represent billings in excess of revenue recognized.

     The Company licenses its software products and methodologies to end users
and to value added integrators for their use in serving their clients. License
fees charged to end users are fixed, with the amount of the fee based on the
estimated total lines of code to be processed or number of CPUs licensed.
License fees charged to value added integrators are generally royalties based on
lines of code processed or to be processed or number of CPUs licensed. Revenue
from software licenses is recognized when licensed software and methodologies
have been delivered, the fee is fixed and determinable and collection of the
related receivable is probable. The Company generally does not provide its
customers with the right to return software licenses and, once due, license fees
are non-refundable.

     Other services provided by the Company include direct delivery contracts as
well as technology transfer arrangements, product training, value added
integrator sales training, consulting services and software product maintenance.
Under direct delivery contracts, the Company provides full and pilot year 2000
renovations and renovation quality evaluation services for clients using the
Company's AutoEnhancer/2000, RQE Tool, and/or Vantage YR2000 software. Revenue
from full year 2000 renovation and RQE contracts is recognized using the
percentage-of-completion method and is based on the ratio that labor-hours
incurred to date bear to estimated total labor-hours at completion, provided
that collection of the related receivable is probable. Revenue from pilot direct
delivery contracts is recognized over the duration of such contracts as work is
performed and defined milestones are attained. Adjustments to contract cost
estimates are made in the periods in which the facts which require such
revisions become known. When the revised estimates indicate a loss, such loss is
provided for currently in its entirety. In cases where vendor-specific objective
evidence of fair value of both the license and service component exists under a
direct delivery contract, revenue recognized is allocated between license
revenue and other services revenue for income statement classification purposes
based on their relative fair values. Revenue from technology transfer
arrangements, product and sales training and consulting services is billed on a
time-and-materials basis and is recognized as the services are provided. Revenue
from software product maintenance contracts on the Company's licensed software
products, including client support bundled with the initial license fee, is
deferred and recognized ratably over the contractual periods during which the
services are provided.

    Recent Events

     In March 1999, the Company announced that it had retained Covington
Associates to render financial advisory and investment banking services in
connection with exploring strategic alternatives including the potential sale of
the Company. On March 29, 1999, the Company announced an anticipated $2.0 to
$2.5 million loss for the first quarter of 1999 and that the net loss will
significantly erode the Company's cash balances and jeopardize its ability to
continue as a going concern. The Company further announced that it did not
believe that it would be able to obtain a cash flow breakeven position in the
future and that its Board of Directors was considering various alternatives. On
April 2, 1999, the Company announced a reduction in its workforce of
approximately 40 people in the areas of sales, marketing and year 2000 delivery.
The Company currently maintains its outsourcing service delivery resources and
limited sales and year 2000 resources required to meet current support
obligations.

                                       24
<PAGE>
 
   Client Concentration

     For the year ended December 31, 1998, one customer, AT&T, accounted for
12.2% of the Company's total revenue. For the year ended December 31, 1997, no
single customer accounted for more than 10% of the Company's total revenue.
However, during 1996, revenue from three clients, Bull, Merrill, Lynch and Met
Life, accounted for 29.0%, 14.6% and 12.1% of the Company's total revenue,
respectively. The largest client in 1996 was Bull, a related party of the
Company. See Note 17 of Notes to the Company's Consolidated Financial
Statements. The Company's ten largest clients in the year ended December 31,
1998, 1997 and 1996 accounted for approximately 52.4%, 63.8% and 77.9% of the
Company's total revenue, respectively. The Company anticipates that this
concentration of clients as a percentage of the Company's total revenue may
diminish in the future but that the Company may continue to depend to a
significant extent upon revenue from a small number of clients.

                                       25
<PAGE>
 
RESULTS OF OPERATIONS

     The following table sets forth for the periods indicated the percentage of
total revenue of certain line items included in the Company's consolidated
statement of operations:


<TABLE> 
<CAPTION> 
                                                                                   YEAR ENDED DECEMBER 31,
                                                                             ------------------------------------
                                                                                1998        1997        1996
                                                                             ----------  ---------   ------------
<S>                                                                          <C>         <C>         <C> 
Revenue:
     Outsourcing services..................................................     31.5%       28.8%       53.0% 
     License...............................................................     30.0        53.5        33.9    
     Other services........................................................     38.5        17.7        13.1    
                                                                             ------------------------------------
          Total revenue(1).................................................    100.0       100.0       100.0    
                                                                             ------------------------------------
Cost of revenue:
     Cost of outsourcing services..........................................     24.0        24.0        44.1    
     Cost of license.......................................................      5.2         1.7         0.8    
     Cost of other services................................................     28.9        13.5        15.3    
                                                                             ------------------------------------
          Total cost of revenue............................................     58.1        39.2        60.2    
                                                                             ------------------------------------
Gross profit...............................................................     41.9        60.8        39.8    
                                                                             ------------------------------------
Operating expenses:
     Sales and marketing...................................................     42.0        22.3        16.2    
     Research and development..............................................     27.1        21.0        31.4    
     General and administrative............................................     23.7        10.9        16.9    
     Write-off of acquired in-process research and development.............       --       178.3          --
     Impairment of long-lived assets.......................................     16.5          --          --
     Restructuring charges.................................................     18.7          --          --
                                                                             ------------------------------------
          Total operating expenses.........................................    128.0       232.5        64.5    
                                                                             ------------------------------------
Loss from operations.......................................................    (86.1)     (171.7)      (24.7)   
Interest income (expense), net.............................................      1.5         2.4        (1.5)   
                                                                             ------------------------------------
Loss before gain on sale of majority-owned subsidiary, income taxes and
   minority interest in majority-owned subsidiary..........................    (84.6)     (169.3)      (26.2)   
Gain on sale of majority-owned subsidiary..................................     (0.1)         --          --
Provision (benefit) for estimated income taxes.............................      0.1         0.7        (0.7)   
                                                                             ------------------------------------
Loss before minority interest..............................................    (84.6)     (170.0)      (25.5)   
Minority interest in majority-owned subsidiary.............................       --          --         0.1
                                                                             ------------------------------------
          Net loss.........................................................    (84.6)%    (170.0)%     (25.6)% 
                                                                             ====================================
</TABLE> 

(1)  Revenue from related parties in the years ended December 31, 1998, 1997 and
     1996 represented 4.2%, 11.3%, and 33.5% of total revenue, respectively.


YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997

   Revenue

     Total revenue decreased 20.6% to $31,532,000 in the year ended December 31,
1998 from $39,709,000 in the year ended December 31, 1997. This decrease in
revenue was primarily due to a decrease in the licensing of the Company's Auto
Enhancer/2000 software and revenue attributable to Vantage YR2000 products.

     In 1998, the market for year 2000 products and services and the Company's
penetration of the market were far lower than anticipated by both the Company
and market analysts. In early 1998, the Company experienced a reduction in
license revenue. Although the sales pipeline remained healthy, the amount of
business that was actually closed was below the fourth quarter of 1997 level. At
the same time, the Company experienced an increase in demand for renovation and
renovation quality evaluation services. In the second quarter of 1998, based
upon sales campaigns underway and customer feedback, the Company was
anticipating substantial increases in demand for such services going forward. In
response, the Company began increasing its capacity to deliver such services
through increased resources and the establishment of third party relationships.
The sales pipeline remained healthy,

                                      26
<PAGE>
 
throughout the third quarter but the amount of business actually closed was far
below expectations and there was no significant increase in the fourth quarter.
The experience of the Company was shared by many of its Year 2000 competitors.
From the Company's perspective, the overall market for tools sales and the
market prices for its year 2000 services declined significantly over the course
of 1998. During 1998, one customer, AT&T, accounted for 12.2% of total revenue.
In July, 1998, the Company divested 100% of its equity interest in its majority-
owned Spanish subsidiary, Persist, S.A. ("Persist") to Persist for cash proceed
totaling $470,000. Accordingly, the results of operations of Persist subsequent
to the date of disposition have been excluded from the Company's consolidated
results. Persist generated $1,232,000 of revenue in 1998 compared to $1,925,000
in 1997. International revenue decreased to $4,119,000 in 1998 from $4,154,000
in 1997. Persist generated 29.9% of the Company's international revenue in 1998
compared to 46.3% of international revenue in 1997. In 1999, the Company
established a branch in Spain to provide outsourcing services to its clients.

     The Company anticipates that 1999 revenue will be substantially below the 
level achieved in 1998.

     Outsourcing Services. Outsourcing services revenue decreased 13.3% to
$9,925,000 in the year ended December 31, 1998 from $11,447,000 in the year
ended December 31, 1997. As a percentage of total revenue, outsourcing services
revenue increased to 31.5% in the year ended December 31, 1998 from 28.8% in the
year ended December 31, 1997. The decrease in outsourcing services revenue in
absolute dollars was primarily the result of the divestiture of Persist and the
termination of an Engineering Consultant Services Agreement between the Company
and one of its clients that specifically provided that the client could
terminate the Agreement for convenience on 180 days notice. Due to changes in
the client's business needs and circumstances, the client decided to terminate
the Agreement. The increase in outsourcing services revenue as a percentage of
total revenue is a result of the substantial reduction in license revenue
between the years 1997 and 1998.

     License. License revenue was $9,444,000 in the year ended December 31,
1998, or 30.0% of total revenue, compared to $21,255,000, or 53.5% of total
revenue, in the year ended December 31, 1997. License revenue decreased 55.6% in
1998. Direct delivery of licensed software to end users and license fees from
valued added integrators declined because the market for tools turned out to be
far less than forecasted. Line of code based licenses purchased by the Company's
value added integrators were not completely consumed and therefore there were
few additional orders from such customers. It is the Company's view that many
end users choose to manually renovate code with internal resources rather than
purchase tools or renovation services.

     Other Services. Other services revenue increased 73.6% to $12,163,000 in
the year ended December 31, 1998 from $7,007,000 in the year ended December 31,
1997. As a percentage of total revenue, other services revenue was 38.5% in the
year ended December 31, 1998 and 17.7% in the year ended December 31, 1997. The
increase in other services revenue was primarily the result of the Company's
providing renovation and renovation quality evaluation services directly to
clients offset by a decrease in consulting services revenue. During the first
half of 1998, the Company experienced significant growth in both actual business
and the sales pipeline of potential business. It was, therefore, anticipating
even higher revenues from such services in the second half of the year. Due to
the degrading financial condition of the Company, increased competition,
decreasing prices, and a lessening of client commitments, the Company's revenue
from such services did not continue to grow as anticipated.

   Cost of Revenue

     Cost of Outsourcing Services Revenue. Cost of outsourcing services revenue
consists primarily of salaries, benefits and overhead costs associated with
delivering outsourcing services to clients. The cost of outsourcing services
revenue decreased 20.5% to $7,577,000 in the year ended December 31, 1998 from
$9,536,000 for the year ended December 31, 1997. Cost of outsourcing services
revenue as a percentage of outsourcing services revenue decreased to 76.3% in
the year ended December 31, 1998 from 83.3% in the year ended December 31, 1997.
The decrease in costs of outsourcing services revenue in absolute dollars was
primarily the result of reduction of the resources associated with the
termination of the above-referenced Engineering Consultant Services Agreement
between the Company and one of its clients.

     Cost of License Revenue. Cost of license revenue consists primarily of
salaries, benefits, amortization expense of intangibles related to the MDI
acquisition and related overhead costs associated with license-related materials
packaging and freight. Cost of license revenue was $1,631,000 in the year ended
December 31, 1998, or 17.3% of license revenue. Cost of license revenue was
$690,000, or 3.2% of license revenue, in the year ended December 31, 

                                      27
<PAGE>
 
1997. The increase in cost of license revenue in absolute dollars was primarily
attributable to the amortization of intangibles related to the MDI acquisition.

     Cost of Other Services Revenue. Cost of other services revenue consists
primarily of salaries, benefits and related overhead costs associated with
delivering other services to clients. Cost of other services revenue increased
70.1% to $9,110,000 in the year ended December 31, 1998 from $5,357,000 in the
year ended December 31, 1997. Cost of other services revenue as a percentage of
other services revenue decreased to 74.9% in the year ended December 31, 1998
from 76.5% in the year ended December 31, 1997. Costs increased in absolute
dollars in the year ended December 31, 1998 were primarily the result of
increased staffing for actual and anticipated increases in demand for the
Company's renovation and renovation quality evaluation services. The actual
resources deployed were greater than required, as the anticipated growth in
demand for such service never materialized.

   Operating Expenses

     Sales and Marketing. Sales and marketing expenses consist primarily of
salaries, commissions and related overhead costs for sales and marketing
personnel; sales referral fees to third parties; advertising programs; and other
promotional activities. Sales and marketing expenses increased 49.4% to
$13,244,000 in the year ended December 31, 1998 from $8,864,000 in the year
ended December 31, 1997. As a percentage of total revenue, sales and marketing
expenses increased to 42.0% in the year ended December 31, 1998 from 22.3% in
the year ended December 31, 1997. The increase in expenses in absolute dollars
and as a percentage of revenue was primarily attributable to increased staffing,
commissions, and promotional activities. In April of 1999, the Company
eliminated its marketing resources and reduced its direct sales force to one
sales representative. Future sales will be dependent upon this single
representative, the sales efforts of senior management and the potential
establishment of ongoing agent relationships with former sales representatives.

     Research and Development. Research and development expenses consist
primarily of salaries, benefits and related overhead costs for engineering and
technical personnel and outside engineering consulting services associated with
developing new products and enhancing existing products. Research and
development expenses increased 2.5% to $8,528,000 in the year ended December 31,
1998 from $8,324,000 in the year ended December 31, 1997. As a percentage of
total revenue, research and development expenses increased to 27.1% in the year
ended December 31, 1998 from 21.0% in the year ended December 31, 1997. The
increase in research and development dollars in absolute terms was primarily
attributable to increased staffing for the product development efforts of the
Company's year 2000 products and services and mass change technologies including
an increase in staffing through new hires, internal transfers and the
acquisition of MDI. During the Company's employment reductions in September 
1998, December 1998 and April 1999 the majority of its research and
development resources were eliminated. The Company still has its development and
support center in India, and limited resources to support the potential sale of
its technology. There are no new development efforts underway.


     General and Administrative. General and administrative expenses consist
primarily of salaries and related costs for the finance and accounting, human
resources, legal services, information systems and other administrative
departments of the Company, as well as legal and accounting expenses and the
amortization of intangible assets associated with the Vista acquisition. General
and administrative expenses also include allowance for doubtful accounts and
any specific write-offs of uncollectible receivables. General and administrative
expenses increased 73.1% to $7,466,000 in the year ended December 31, 1998 from
$4,312,000 in the year ended December 31, 1997. As a percentage of total
revenue, general and administrative expenses increased to 23.7% in the year
ended December 31, 1998 from 10.9% in the year ended December 31, 1997. The
increase in general and administrative expenses in absolute dollars was
primarily due to the write-down of a customer receivable balance, an increase in
the Company's allowance for doubtful accounts reserve, additions to the
Company's administrative staff to support certain anticipated growth, higher
professional fees and increases in other general corporate expenses as well as
increased costs associated with being a publicly traded company.

        Impairment of Long-Lived Assets. The Company periodically assesses
whether any events or changes in circumstances have occurred that would indicate
that the carrying amount of a long-lived asset might not be recoverable. When
such an event or change in circumstance occurs, the Company evaluates whether
the carrying 

                                      28
<PAGE>
 
amount of such asset is recoverable by comparing the net book value of the asset
to estimated future undiscounted cash flows, excluding interest charges,
attributable to such asset. If it is determined that the carrying amount is not
recoverable, the Company recognizes an impairment loss equal to the excess of
the carrying amount of the asset over the estimated fair value of such asset.

      Due to lower than anticipated revenue and losses in excess of expectations
during the quarter ended September 30, 1998, the Company adopted a plan to stop
development of all existing and in-process products originally acquired from MDI
in December 1997, including all Vantage YR2000 renovation and testing software
tools and the generic mass change product. Substantially all direct sales
efforts relating to existing Vantage YR2000 products were also stopped. In
connection with these actions, the Company also undertook a restructuring of its
operations (See Note 5 to the Notes to Consolidated Financial Statements below.)
which included the closure of the Company's research and development facilities
in Cincinnati, Ohio and Lisle, Illinois and the termination of substantially all
the employees at these facilities. As a result of these events, management
concluded that an assessment of the recoverability of intangible assets recorded
in connection with the acquisition of MDI in December 1997 was required at
September 30, 1998. The Company determined that its property and equipment at
these locations was not subject to impairment as substantially all such assets
were scheduled to be redeployed.

      In connection with the assessment, management prepared forecasts of the
expected future cash flows related to these intangible assets on an undiscounted
basis and without interest charges. Due to the fact that product development
efforts had been stopped, the Company concluded that the existing technology
acquired as part of the MDI acquisition would only be used in existing Vantage
YR2000 products. As a result of this analysis, management determined that the
estimated undiscounted net cash flows to be generated by acquired technology
recorded as part of the MDI acquisition were less than the asset's net book
value as of September 30, 1998. Accordingly, the acquired technology was 
written-down to $289,000, its estimated fair value, using a discounted cash flow
model. With regard to intangible assets relating to assembled workforce and
goodwill acquired from MDI, management concluded that the net book value of
these amounts could no longer be supported due to the termination of all former
MDI employees and the shift of the Company's strategy away from MDI-related
products. Accordingly, the Company recorded an impairment charge totaling
$4,294,000 during the quarter ended September 30, 1998.

      Management's estimates of forecasted cash flows required an evaluation of
various risks and uncertainties. Although management has made its best estimate
of these factors based on current conditions and expected trends and events, it
is reasonably possible that changes could occur in the near term which could
adversely affect management's estimates of forecasted cash flows. If such
changes occur, asset impairment write-downs could be required in the future and
such write-downs could be material to the Company's financial statements.

      In December 1998, as a result of the significant downsizing of the
Company's operations (See Note 5 to the Notes to Consolidated Financial
Statements below.) and continuing decline in operating results, the Company
reviewed the carrying amount of its property and equipment at December 31, 1998
and committed to a plan to dispose certain of its assets, primarily excess
computer equipment and furniture relating to the restructured operations, either
by sale or abandonment. The plan is expected to be completed by June 30, 1999.
The fair value of the assets to be disposed of was measured at management's best
estimate of salvage value, by using the current market values or the current
selling prices for similar assets. Costs to sell are not expected to be
significant. Based upon management's review, the carrying amounts of assets
having a net book value of $1,145,000 were written-down to a total amount of
$221,000, representing the lower of carrying amount or fair value (salvage
value), and the Company recorded an impairment charge totaling $924,000. The
assets to be disposed of are not depreciated or amortized while they are held
for disposal and the reduction in depreciation expense resulting from this 
write-down is approximately $48,000 on a quarterly basis beginning in the first
quarter of 1999.

         Restructuring Charges. In December 1998, the Company announced its
intention to restructure and recorded a charge of $1,316,000 consisting in part
of severance payments associated with the termination of approximately 22% of
the Company's employees (45 employees). At December 31, 1998, all 45

                                      29
<PAGE>
 
employees had been terminated with no further terminations remaining under the
restructuring. In addition, a significant portion of the restructuring charge
related to a further reduction of occupied space at the Company's headquarters
in Billerica, MA and consisted primarily of accrual of lease costs, net of
estimated sublease income. Payments related to the terminated employees were
completed by December 31, 1998. Payments related to the reduction of occupied
space are expected to be complete by February 2006. The Company has estimated
that the restructuring will result in a reduction of approximately $950,000 in
salary and related costs and $70,000 in lease related costs on a quarterly basis
beginning in the first quarter of 1999.

     In September 1998, the Company announced its intention to restructure and
recorded a charge of $3,372,000 consisting in part of severance
payments associated with the termination of approximately 33% of the Company's
employees at that time (89 employees). At September 30, 1998, all 89 employees
had been terminated with no further terminations remaining under the
restructuring. In addition, a significant portion of the restructuring charge
related to the closure of two research and development centers and a reduction
of occupied space at the Company's headquarters in Billerica, MA and consisted
primarily of accrual of lease costs, net of estimated sublease income. Payments
related to terminated employees were completed by December 1998 for 82 employees
and are expected to be completed by September 1999 for the remaining 7
employees. Payments related to the closure of facilities and reduction of
occupied space are expected to be completed by June 2003. The Company has
estimated that the restructuring will result in a reduction of approximately
$1,900,000 in salary and related costs and $250,000 in lease related costs on a
quarterly basis beginning in the fourth quarter of 1998.

     In March 1998, the Company announced its intentions for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, and recorded a charge of $1,439,000 consisting in part
of severance payments associated with the termination of approximately 12% of
the Company's employees in April 1998 (48 employees). At June 30, 1998, all 48
employees had been terminated with no further terminations remaining under the
restructuring. In addition, a significant portion of the restructuring charge
related to the closure of two research and development and outsourcing centers,
consisting primarily of accrual of lease costs, net of estimated sublease
income, and support costs for a discontinued product. Payments related to
terminated employees were completed in June 1998 for 45 employees and are
expected to be completed by September 1999 for the remaining 3 employees.
Payments related to the closure and reduction of facilities are expected to be
complete by April 2003. The restructuring resulted in a reduction of
approximately $950,000 in salary and related costs and $90,000 in facility
related costs on a quarterly basis beginning in second quarter of 1998.

     Interest Income (Expense), Net. Interest income and expense is primarily
composed of interest income from cash balances and interest expense on debt. The
Company had interest income, net, of $485,000 in the year ended December 31,
1998 compared to interest income, net, of $948,000 in the year ended December
31, 1997. This change in interest income (expense), net was primarily
attributable to decreased interest income from decreased cash balances.

     Provision for Income Taxes. The Company's income tax provision was $25,000
and $260,000 in 1998 and 1997, respectively. The 1998 provision relates to
foreign income taxes. The Company recorded no U.S. Federal or State taxes in
1998 due to taxable losses incurred. The Company's effective tax rate for 1997
was significantly impacted by the write-off of the acquired in-process research
and development which is not immediately deductible by the Company and for which
a deferred tax asset valuation allowance was provided. Accordingly, the Company
did not realize a tax benefit in 1997 as a result of its net loss. The provision
was the result of an increase in taxable income and international taxes, which
was substantially offset by the Company's expected utilization in 1997 of
previously generated net operating loss carryforwards.

     The Company had net deferred tax assets of $35,520,000 and $24,072,000 at
December 31, 1998 and 1997, respectively. At December 31, 1998 and 1997, the
Company has provided a valuation allowance for the full amount of its net
deferred tax assets since, based on the weight of available evidence, management
has concluded that it is more likely than not (defined as a likelihood of
slightly more than 50%) that these future benefits will not be realized. If the
Company achieves profitability, these net deferred tax assets may be available
to offset future income tax liabilities and expense.

     Minority Interest in Majority-Owned Subsidiary. The minority interest in
majority-owned subsidiary represents the equity interest in the operating
results of Persist, the Company's majority-owned Spanish subsidiary, held by
stockholders of Persist other than the Company. The minority interest in
majority-owned subsidiary increased to a gain of $4,000 in the year ended
December 31, 1998 from a loss of $4,000 in the year ended

                                      30
<PAGE>
 
December 31, 1997. This change was the result of the decreased profitability of
Persist. The Company sold its majority interest in Persist to the minority
shareholders in July, 1998. The Company established a branch in Spain in 1999 to
provide outsourcing services.


YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996

   Revenue

     Total revenue increased 106.4% to $39,709,000 in the year ended December
31, 1997 from $19,235,000 in the year ended December 31, 1996. This increase in
revenue was primarily due to an increase in the licensing of the Company's Auto
Enhancer/2000 software and revenue attributable to Vantage YR2000 products as
well as from increases in other services revenue and, to a lesser extent,
outsourcing services revenue. International revenue increased 130.8% to
$4,154,000 in 1997 from $1,800,000 in 1996. Persist generated 46.3% of the
Company's international revenue in 1997 and substantially all of the Company's
international revenue in 1996.

     Outsourcing Services. Outsourcing services revenue increased 12.3% to
$11,447,000 in the year ended December 31, 1997 from $10,190,000 in the year
ended December 31, 1996. As a percentage of total revenue, outsourcing services
revenue decreased to 28.8% in the year ended December 31, 1997 from 53.0% in the
year ended December 31, 1996. The increase in outsourcing services revenue in
absolute dollars was primarily attributable to the addition of two new
outsourcing contracts in late 1996 and one in 1997 and was partially offset by
the recognition of lesser amounts of revenue under the percentage-of-completion
method on existing outsourcing contracts that were in their later phases during
1997. The decrease in outsourcing services revenue as a percentage of total
revenue reflects the increased contribution of license revenue to total revenue
during the year ended December 31, 1997 when compared to the prior year.
Outsourcing services remain a major component of the solutions offered by the
Company, and the Company anticipates that such services will continue to account
for a significant portion of total revenue for the foreseeable future.

     License. License revenue was $21,255,000 in the year ended December 31,
1997, or 53.5% of total revenue, compared to $6,526,000, or 33.9% of total
revenue, in the year ended December 31, 1996. The increase in license revenue
for 1997 was primarily attributable to the delivery of licensed software to
additional end users and to increased license fees from value added integrators.

     Other Services. Other services revenue increased 178.2% to $7,007,000 in
the year ended December 31, 1997 from $2,519,000 in the year ended December 31,
1996. As a percentage of total revenue, other services revenue was 17.7% in the
year ended December 31, 1997 and 13.1% in the year ended December 31, 1996. The
increase in other services revenue in absolute dollars was primarily
attributable to an increase in consulting, training and client support services
relating to the Company's year 2000 products and services.

Cost of Revenue

     Cost of Outsourcing Services Revenue. The cost of outsourcing services
revenue increased 12.3% to $9,536,000 in the year ended December 31, 1997 from
$8,488,000 for the year ended December 31, 1996. Cost of outsourcing services
revenue as a percentage of outsourcing services revenue remained flat at 83.3%
in the years ended December 31, 1997 and 1996. The increase in costs of
outsourcing services revenue in absolute dollars was due primarily to the
addition of resources necessary to provide services under new outsourcing
contracts.

     Cost of License Revenue. Cost of license revenue was $690,000 in the year
ended December 31, 1997, or 3.2% of license revenue. Cost of license revenue was
$162,000, or 2.5% of license revenue, in the year ended December 31, 1996. The
increase in cost of license revenue in absolute dollars was primarily
attributable to the addition of employees and related resources to support
additional end users and value added integrators.

                                       31
<PAGE>
 
     Cost of Other Services Revenue. Cost of other services revenue increased
82.8% to $5,357,000 in the year ended December 31, 1997 from $2,931,000 in the
year ended December 31, 1996. Cost of other services revenue as a percentage of
other services revenue decreased to 76.5% in the year ended December 31, 1997
from 116.4% in the year ended December 31, 1996. Costs exceeded revenues in the
year ended December 31, 1996 primarily as a result of expected overruns on one
significant pilot engagement, which subsequently became a significant product
license in 1997. Costs increased in absolute dollars in the year ended December
31, 1997 due to additional staffing in the Company's client support, training
and consulting organizations related to additional customers for the Company's
year 2000 products and services.

   Operating Expenses

     Sales and Marketing. Sales and marketing expenses increased 184.5% to
$8,864,000 in the year ended December 31, 1997 from $3,116,000 in the year ended
December 31, 1996. As a percentage of total revenue, sales and marketing
expenses increased to 22.3% in the year ended December 31, 1997 from 16.2% in
the year ended December 31, 1996. The increase in expenses in absolute dollars
and as a percentage of revenue was primarily attributable to increased staffing,
commissions, including an increase in sales referral fees to third parties, and
promotional activities in conjunction with the launch of the Company's
AutoEnhancer/2000 software in late 1996 and throughout 1997.

     Research and Development. Research and development expenses increased 38.0%
to $8,324,000 in the year ended December 31, 1997 from $6,033,000 in the year
ended December 31, 1996. As a percentage of total revenue, research and
development expenses decreased to 21.0% in the year ended December 31, 1997 from
31.4% in the year ended December 31, 1996. The increase in research and
development expenses in absolute dollars was primarily attributable to increased
staffing for the product development efforts for the Company's year 2000
products and services and mass change technologies, including an increase in
staffing effected through new hires and internal transfers.

     General and Administrative. General and administrative expenses increased
32.7% to $4,312,000 in the year ended December 31, 1997 from $3,249,000 in the
year ended December 31, 1996. As a percentage of total revenue, general and
administrative expenses decreased to 10.9% in the year ended December 31, 1997
from 16.9% in the year ended December 31, 1996. The increase in general and
administrative expenses in absolute dollars was primarily due to additions to
the Company's administrative staff to support growth, higher professional fees
and increases in other general corporate expenses as well as increased costs
associated with being a publicly traded company.

     Acquired Research and Development. As discussed in Note 4 to the
consolidated financial statements, the Company recorded a charge to operations
of $70,800,000 for the write-off of acquired in-process research and
development, the value of which was determined based upon an independent
appraisal. Acquired technology included in the in-process write-off reflects the
purchase price allocated to technology currently under development which is not
yet considered technologically feasible and which had no alternative future use
at the time of the acquisition.

     During 1998, the Company received and responded to a comment letter related
to the Company's Form 10-K for the year ended December 31, 1997 from the
Securities and Exchange Commission ("SEC") regarding, among other things, the
Company's accounting for this in-process research and development. A response to
the Company's letter has been received from the SEC, and the Company has further
responded. Although the
                                       32
<PAGE>
 
Company believes it has properly accounted for the item, a different conclusion
would require further restatement of the Company's results beginning with the
fourth quarter of 1997.

     Interest Income (Expense), Net. Interest income and expense is primarily
composed of interest income from cash balances and interest expense on debt. The
Company had interest income, net of $948,000 in the year ended December 31, 1997
compared to interest expense, net of $296,000 in the year ended December 31,
1996. This change in interest income (expense), net was primarily attributable
to increased interest income from increased cash balances resulting from the
Company's initial public offering.

     Provision for Income Taxes. The Company's income tax provision (benefit)
was $260,000 and ($143,000) in 1997 and 1996, respectively. The Company's
effective tax rate for 1997 was significantly impacted by the write-off of the
acquired in-process research and development which is not immediately deductible
by the Company and for which a deferred tax asset valuation allowance was
provided. Accordingly, the Company did not realize a tax benefit in 1997 as a
result of its net loss. The provision was the result of an increase in taxable
income and international taxes, which was substantially offset by the Company's
expected utilization in 1997 of previously generated net operating loss
carryforwards.

     The Company had net deferred tax assets of $24,072,000 and $2,178,000 at
December 31, 1997 and 1996, respectively. At December 31, 1997 and 1996, the 
Company has provided a valuation allowance for the full amount of its net 
deferred tax assets since, based on the weight of available evidence, management
has concluded that it is more likely than not (defined as a likelihood of 
slightly more than 50%) that these future benefits will not be realized. If the 
Company achieves profitability, these net deferred tax assets may be available 
to offset future income tax liabilities and expense.

     Minority Interest in Majority-Owned Subsidiary. The minority interest in
majority-owned subsidiary decreased to $4,000 in the year ended December 31,
1997 from $24,000 in the year ended December 31, 1996. This change was the
result of the decreased profitability of Persist. At December 31,1997 and 1996,
the Company held a 63.0% equity interest in Persist.


LIQUIDITY AND CAPITAL RESOURCES

     The Company has financed its operations and capital expenditures primarily
with the proceeds from sales of the Company's convertible preferred stock and
common stock, borrowings, advance payments for services from clients and
internally generated cash flows. The Company's cash balances were $3,378,000 and
$11,340,000 at December 31, 1998 and 1997, respectively. The Company's working
capital was $1,805,000 and $20,931,000, at December 31, 1998 and 1997,
respectively. On July 8, 1997, the Company closed an initial public offering of
4,025,000 shares (2,800,000 of which were offered by the Company and the balance
by selling stockholders) of common stock at a price of $16.00 per share. The net
proceeds to the Company from the offering after deducting offering expenses were
$40,664,000. The Company used such proceeds for repayment of certain existing
indebtedness and the MDI acquisition, and plans to use the remaining proceeds
for limited research and development, working capital and general corporate
purposes.

     The Company's operating activities used cash of $7,661,000 and provided
cash of $226,000 during the years ended December 31, 1998 and 1997,
respectively. The Company's operating use of cash during the year ended December
31, 1998 was primarily caused by its net loss of $18,372,000 (excluding the non-
cash items of depreciation and the charge for impairment of long-lived assets)
offset by its reduction of accounts receivable of $8,671,000. Receivables
decreased due to the reduction in revenues from 1997 to 1998.

     The Company used cash of $1,313,000 and $36,368,000 for investing
activities during the years ended December 31, 1998 and 1997, respectively.
Investing activities in 1998 consisted primarily of investment in property,
plant and equipment; and the net cash impact of the Company's divestiture of its
majority-owned subsidiary, Persist offset by the sale of short-term investments.

                                       33
<PAGE>
 
     The Company's financing activities provided cash of $428,000 and
$40,158,000 during the years ended December 31, 1998 and 1997, respectively. As
discussed above, the 1997 period includes the net proceeds of the Company's
initial public offering.

     In September 1996, the Company obtained a revolving line of credit facility
from a bank which bore interest at the bank's prime rate plus 0.5% (8.25% at
December 31, 1998). The line of credit expired and all borrowings were payable
in full on September 30, 1998. At December 31, 1998, there were no borrowings
outstanding under the line of credit. In addition to this line of credit, the
Company also entered into an equipment financing agreement in September 1996.
Under this agreement, the bank agreed to provide up to $1,500,000 for the
purchase of certain equipment (as defined by the agreement) through September
30, 1997. Ratable principal and interest payments were payable during the period
July 1, 1997 through June 1, 2000, and bore interest at the bank's prime rate
plus 1% (8.75% at December 31, 1998). At September 30, 1998, both of these
agreements required the Company to comply with certain financial covenants and
were secured by all of the assets of the Company. As of September 30, 1998, the
Company was in violation of such financial covenants and, accordingly,
classified all borrowings under this credit facility as short-term obligations.
The bank notified the Company in October, 1998 that the Company was in default
under its line of credit facility and equipment financing agreement and
requested that the Company provide cash collateral for the amount of equipment
financing outstanding and provide cash collateral for a $300,000 standy letter
of credit issued by the bank. There were no borrowings outstanding under the
revolving credit facility and $269,000 was outstanding under the equipment
financing agreement at December 31, 1998. The Company provided cash collateral
for all amounts outstanding under the equipment financing agreement in December
1998 and for the $300,000 letter of credit in October 1998. The letter of credit
was drawn upon and the equipment financing debt was paid in early 1999. The bank
has indicated that it will not renew or further extend the Company's revolving
credit facility. There can be no assurance that the Company will be able to
raise additional funds through bank borrowings and/or debt and/or equity
financings.

     To date, the Company has not invested in derivative securities or any other
financial instruments that involve a high level of complexity or risk. Excess
cash has been, and the Company contemplates that it will continue to be,
invested in interest-bearing, investment grade securities.

Going Concern Matters

     The Company's consolidated financial statements have been presented on the
basis that it is a going concern, which contemplates continuity of operations,
realization of assets and the satisfaction of liabilities in the ordinary course
of business. However, the Company experienced net losses in the year ended
December 31, 1998 and the three months ended March 31, 1999 which raise doubt
about its ability to continue as a going concern. On March 29, 1999, the Company
announced an anticipated $2.0 to $2.5 million loss for the first quarter of 1999
and that the net loss will significantly erode the Company's cash balances and
jeopardize its ability to continue as a going concern. The Company's continued
existence is dependent upon its ability to achieve a cash flow breakeven
position and/or to obtain additional sources of financing and there can be no
assurance that the Company will be able to achieve the foregoing. The Company
does not believe that it will be able to achieve a cash flow breakeven position
in the future and it is considering various alternatives including the
possibility of filing for the protection against creditors under applicable
bankruptcy laws.

     On February 3, 1999, the Company's common stock was delisted from trading
on the Nasdaq Stock Market. The common stock currently trades on the OTC
Bulletin Board. There can be no assurance that the Company will not be
de-listed.

     In March 1999, the Company announced that it had retained Covington
Associates to render financial advisory and investment banking services in
connection with exploring strategic alternatives including the potential sale of
the Company.

     On April 2, 1999, the Company announced a reduction in its workforce of
approximately 40 people in the areas of sales, marketing and year 2000 delivery.
The Company currently maintains its outsourcing service delivery resources and
limited sales and year 2000 resources required to meet current support
obligations. 

     Further reductions in expenses or the sale of assets may not be adequate to
bring the Company to a cash breakeven position. In addition, there can be no
assurance that such actions will not have an adverse affect on the

                                       34
<PAGE>
 
Company's ability to generate revenue or successfully implement any strategic
alternatives under consideration. Failure to establish a cash flow breakeven
position or raise additional funds through bank borrowings and/or equity and/or
debt financing have and will continue to adversely impact the Company's ability
to continue as a going concern. The Company does not believe that it will be
able to achieve a cash flow breakeven position in the future and its Board of
Directors is considering various alternatives.


FOREIGN CURRENCY

     Assets and liabilities of the Company's majority-owned foreign subsidiary
are translated into U.S. dollars at exchange rates in effect at the balance
sheet date. Income and expense items are translated at average exchange rates
for the period. Accumulated net translation adjustments are included in
stockholders' equity.

INFLATION

     To date, inflation has not had a material impact on Peritus' results of
operations.


RECENTLY ISSUED ACCOUNTING STANDARDS

     In October 1997, the Accounting Standards Executive Committee ("AcSEC") of
the American Institute of Certified Public Accountants ("AICPA") issued SOP 97-
2, "Software Revenue Recognition." SOP 97-2 provides guidance on the timing and
amount of revenue recognition when licensing, selling, leasing or otherwise
marketing computer software and became effective for transactions entered into
by the Company beginning on January 1, 1998. The Company adopted SOP 97-2 for
the year ended December 31, 1998. Subsequently, in March 1998, AcSEC issued SOP
98-4, "Deferral of the Effective Date of a Provision of SOP 97-2, Software
Revenue Recognition." SOP 98-4 deferred certain provisions of SOP 97-2
pertaining to its requirements for what constitutes vendor-specific objective
evidence ("VSOE") of the fair value of individual elements of a multiple-element
arrangement for a one-year period. At the same time, AcSEC immediately began a
project to further clarify the requirements surrounding VSOE. This project
resulted in SOP 98-9, "Modification of SOP 97-2, `Software Revenue Recognition,'
with Respect to Certain Transactions," which was issued in December 1998. In SOP
98-9, AcSEC decided to retain the limitations on what is considered VSOE of fair
value in a software arrangement, except in limited circumstances. Generally, the
limitations on VSOE of fair value that were deferred by SOP 98-4 will be
effective for transactions that are entered into in fiscal years beginning after
March 15, 1999. The Company believes that its current revenue recognition
policies and practices are consistent with the provisions of SOP 98-9.

                                       35
<PAGE>
 
Accordingly, the adoption of this guidance has not materially affected its
financial position or results of operations and is not expected to have a
material impact in future periods.

     In February 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use." SOP 98-1 establishes
the accounting for costs of software products developed or purchased for
internal use, including when such costs should be capitalized. The Company does
not expect SOP 98-1, which is effective for the Company beginning January 1,
1999, to have a significant impact on the Company's financial condition or
results of operations.

     In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." The new standard establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. SFAS No. 133 is effective for all
fiscal quarters of fiscal years beginning after June 15, 1999. The Company does
not invest in derivative instruments or engage in hedging activities. As a
result, SFAS No. 133 is not expected to have a material affect on its financial
position or results of operations.

                                       36
<PAGE>
 
FACTORS THAT MAY AFFECT FUTURE RESULTS

   Failure to Achieve Cash Flow Breakeven/Strategic Initiatives

     The Company's ability to achieve a cash flow breakeven position is critical
for achieving financial stability. The Company does not believe that it will be
able to achieve a cash flow breakeven and is considering various alternatives 
including the possibility of filing for the protection against creditors under
applicable bankruptcy laws. Further reductions in expenses or the sale of assets
may not be sufficient to bring the Company to a cash breakeven position. In
addition, there can be no assurance that any actions taken to sell assets or
reduce expenses will not have a material adverse impact on the Company's ability
to generate revenue or successfully implement any strategic alternatives under
consideration. Failure to establish a cash flow break even position or raise
additional funds through bank borrowings and/or equity and/or debt financings,
has and will continue to adversely impact the Company's ability to continue as a
going concern.

   Financing

     There can be no assurance that the Company will be able to successfully
negotiate a borrowing arrangement with a bank or obtain additional funds through
equity and/or debt financings. Failure to establish a cash flow break even
position or raise additional funds through bank borrowings and/or equity and/or
debt financings will continue to adversely impact the Company's ability to
continue as a going concern.

   Over the Counter Listing

     The Company's common stock trades on the Over the Counter Bulletin Board
which has certain continued listing criteria. Failure to meet those listing
requirements may result in the Company being de-listed. There can be no
assurance that the Company will not be de-listed. Trading of the common stock is
conducted in the over-the-counter market which could make it more difficult for
an investor to dispose of, or obtain accurate quotations as to the market value
of, the common stock. In addition, there are additional sales practice
requirements on broker-dealers who sell such securities to persons other than
established customers and accredited investors. For transactions covered by this
rule, the broker-dealer must make a special suitability determination for the
purchaser and must have received the purchaser's written consent to the
transaction prior to sale. Consequently, delisting, if it occurred, may affect
the ability of broker-dealers to sell the Company's common stock and the ability
of the stockholders to sell their common stock. In addition, if the trading
price of the common stock is below $5.00 per share, trading in the common stock
would also be subject to the requirements of certain rules promulgated under the
Securities Exchange Act of 1934, which require additional disclosure by
broker-dealers in connection with any trades involving a stock defined as a
penny stock (generally any non-NASDAQ equity security that has a market price of
less than $5.00 per share, subject to certain exceptions). Such rules require
the delivery, prior to any penny stock transaction, of a disclosure schedule
explaining the penny stock market and the risks associate therewith, and impose
various sales practice requirements on broker-dealers who sell penny stocks to
persons other than established customers and accredited investors (generally
institutions). For these types of transactions, the broker-dealer must make a
special suitability determination for the purchaser and have received the
purchaser's written consent to the transaction prior to sale. The additional
burdens imposed upon broker-dealers by such requirements may discourage
broker-dealers from effecting transactions in the common stock, which could
severely limit the market liquidity of the common stock and the ability of
purchasers in this offering to sell the common stock in the secondary market.

   Revenue Risk

     The Company's current strategy is to minimize expenses, while preserving
its principal saleable assets: its outsourcing business and its technology.
Along with Covington Associates, its investment banker, the Company is actively
pursuing strategic relationships with an emphasis on the sale of all or parts of
its assets. The Company is continuing to selectively pursue sales of its
EuroPac, SAM Relay, RQE Tool and SAM Workbench tools. The Company is also
focusing on renewing its existing outsourcing contracts and licensing its
methodology and providing limited consulting services. There can be no assurance
that this current strategy will generate revenues sufficient for the Company to
achieve a cash flow breakeven position.

   Litigation Risk

     The future course of the class action claims against the Company described
in footnote 19 to the consolidated financial statements could have a material
adverse impact on the Company's financial condition and results of operations in
the period in which the litigation is resolved.

   Limited Operating History
  
     The Company was founded in August 1991 and began operations in 1992. Most
of the Company's revenue prior to 1997 has been attributable to software
maintenance outsourcing and other services, and the Company had 

                                       37
<PAGE>
 
no license revenue prior to 1996. The Company's software maintenance
AutoEnhancer/2000 and VANTAGE YR 2000 software, has a limited history of client
acceptance and use. Accordingly, the Company has only a limited operating
history upon which an evaluation of the Company and its prospects can be based.
The Company's prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by organizations in their early stage of
development, particularly companies in new and rapidly evolving markets and in
light of its current difficult financial condition. To address these risks, the
Company must, among other things, respond to competitive developments, continue
to attract, retain and motivate qualified management and other employees,
continue to upgrade its technologies and commercialize products and services
that incorporate such technologies and achieve market acceptance for its
products and services. There can be no assurance that the Company will be
successful in addressing such risks, especially in light of its current
difficult financial condition.

   Potential Fluctuations in Quarterly Performance

     The Company's revenue and operating results have varied substantially from
quarter to quarter. The Company's quarterly operating results may continue to
fluctuate due to a number of factors, including the timing, size and nature of
the Company's individual outsourcing, technology transfer, insourcing and
licensing transactions; unforeseen difficulties in performing such transactions;
the performance of the Company's value added integrators and distributors; the
timing of the introduction and the market acceptance of new services, products
or product enhancements by the Company or its competitors; the relative
proportions of revenue derived from license fees and professional services;
changes in the Company's operating expenses; personnel changes; foreign currency
exchange rates and fluctuations in economic and financial market conditions.

     The timing, size and nature of individual outsourcing, technology transfer,
insourcing and licensing transactions are important factors in the Company's
quarterly operating results. Many such transactions involve large dollar
amounts, and the sales cycle for these transactions is often lengthy and
unpredictable. In addition, the sales cycle associated with these transactions
is subject to a number of uncertainties, including clients' budgetary
constraints, the timing of clients' budget cycles and clients' internal approval
processes. There can be no assurance that the Company will be successful in
closing such large transactions on a timely basis or at all. Most of the
Company's outsourcing engagements are performed on a fixed-price basis and,
therefore, the Company bears the risk of cost overruns and inflation. A
significant percentage of the Company's revenue derived from these engagements
is recognized on the percentage-of-completion method, which requires revenue to
be recorded over the term of a client contract. A loss is recorded at the time
when current estimates of project costs exceed unrecognized revenue. The
Company's operating results may be adversely affected by inaccurate estimates of
contract completion costs.

     The Company's expense levels are based, in part, on its expectations as to
future revenue and are fixed, to a large extent, in the short term. As a result,
the Company has been and may continue to be unable to adjust spending in a
timely manner to compensate for any further unexpected revenue shortfall.
Accordingly, any significant shortfall in revenue in addition to those already
experienced in relation to the Company's expectations would have an immediate
and material adverse effect on the Company's business, financial condition and
results of operations.

     Due to all of the foregoing factors, the Company believes that
period-to-period comparisons of its operating results are not necessarily
meaningful and that such comparisons cannot be relied upon as indicators of
future performance. There can be no assurance that future revenue and operating
results will not continue to vary substantially. It is also possible that in a
quarter the Company's operating results will be below the expectations of public
market analysts and investors. In either case, the price of the Company's Common
Stock has been and could continue to be materially adversely affected.

     Need to Develop Additional Products and Services

     During 1998, the Company generated significant revenue from, and devoted
significant resources to, products and services that address the year 2000
problem. That demand has diminished significantly and will eventually disappear.
Furthermore, in April 1999, the Company announced a reduction in workforce and
that it maintains only its outsourcing delivery resources and limited sales and
year 2000 resources to meet current support obligations. Also the Company plans
to continue limited maintenance of and enhancements to its products and no
development of new products. There can be no assurance that the Company will be
able to grow or maintain its outsourcing 

                                       38
<PAGE>
 
business especially in light of its current difficult financial condition. The
failure to diversify and develop additional products and services would have a
material adverse effect on the Company's business, financial condition and
results of operations.

   Concentration of Clients and Credit Risk

     To date, the Company's revenue has been dependent on a few major clients
such as AT&T, Bull and Computervision. Most of the Company's contracts with its
clients are terminable at will by either party upon written notice in accordance
with the terms of the contract, at which time payment for services rendered to
date is due. In addition, certain contracts provide for limited price protection
and related notice provisions that could require the Company to adjust the
pricing provisions of these contracts. To date, the Company has not made any
such adjustments. Although the Company's largest clients have varied from period
to period, the Company anticipates that its results of operations in any given
period will continue to depend to a significant extent upon revenue from a small
number of clients. There can be no assurance that the Company's major clients
will continue to purchase products and services from the Company at current
levels, if at all, or that the Company will be able to replace revenue from such
clients with revenue from other clients. The loss of, or a significant reduction
in revenue from, any of the Company's major clients would have a material
adverse effect on the Company's business, financial condition and results of
operations. In addition, with such a large percentage of the Company's revenue
attributable to a small number of clients, the loss of one or more major clients
would have a material adverse effect on the Company's liquidity.

   Competition

     The market for the Company's products and services is intensely competitive
and is characterized by rapid changes in technology and user needs and the
frequent introduction of new products. The mass change and year 2000 industries
have attracted many competitors, some of which may offer additional products and
services. There are no significant barriers to entry in the year 2000 industry.
In addition, the Company faces competition in the software maintenance
outsourcing services market. A number of the Company's competitors are more
established, benefit from greater name recognition and have substantially
greater financial, technical and marketing resources than those of the Company
and certain of the Company's value added integrators and distributors. As a
result, there can be no assurance that the Company's products and services,
including the solutions offered by the Company's value added integrators and
distributors, will compete effectively with those of their respective
competitors especially in light of the Company's current difficult financial
condition. The Company's value added integrators and distributors may also offer
or develop products and services that compete with the Company's products and
services. There can be no assurance that such value added integrators and
distributors will not give higher priority to the sales of these or other
competitive products and services. See "Business--Competition."

   Competitive Market for Technical Personnel

     The Company depends to a significant extent on its ability to attract,
train, motivate and retain highly skilled software professionals, particularly
project managers, software engineers and other senior technical personnel. The
Company believes that there is a shortage of, and significant competition for,
software development professionals with the skills and experience necessary to
perform the services offered by the Company. The Company's ability to maintain
and renew existing engagements and obtain new business depends, in large part,
on its ability to hire and retain technical personnel with the IT skills that
keep pace with continuing changes in software evolution, industry standards and
technologies and client preferences. The inability to hire additional qualified
personnel could impair the Company's ability to satisfy its client base,
requiring an increase in the level of responsibility for both existing and new
personnel. There can be no assurance that the Company will be successful in
retaining current or future employees, especially in light of its current
difficult financial condition.

   Fixed-Price, Fixed-Time Contracts

     Part of the Company's business is to offer its outsourcing and technology
transfer services on fixed-price, fixed- time frame contracts, rather than
contracts in which payment to the Company is determined solely on a
time-and-materials basis. These contracts are terminable by either party
generally upon prior written notice. Although the Company uses its proprietary
tools and methodologies and its past project experience to reduce the risks
associated 

                                      39
<PAGE>
 
with estimating, planning and performing the fixed-price projects, the Company's
standard outsourcing and technology transfer agreements provide for a fixed-fee
based on projected reductions in a client's maintenance costs and increases in a
client's maintenance productivity. The Company's failure to estimate accurately
the resources, costs and time required for a project or its failure to complete
its contractual obligations within the time frame committed could have a
material adverse effect on the Company's business, financial condition and
results of operations.

   Potential for Contract Liability

     The Company's products and services relating to software maintenance,
especially solutions addressing the year 2000 problem, involve key aspects of
its clients' computer systems. A failure in a client's system could result in a
claim for substantial damages against the Company, regardless of the Company's
responsibility for such failure. The Company attempts to limit contractually its
liability for damages arising from negligent acts, errors, mistakes or omissions
in rendering its products and services. Despite this precaution, there can be no
assurance that the limitations of liability set forth in its contracts would be
enforceable or would otherwise protect the Company from liability for damages.
Additionally, the Company maintains general liability insurance coverage,
including coverage for errors and omissions. However, there can be no assurance
that such coverage will continue to be available on acceptable terms, or will be
available in sufficient amounts to cover one or more large claims, or that the
insurer will not disclaim coverage as to any future claim. The successful
assertion of one or more large claims against the Company that exceed available
insurance coverage or changes in the Company's insurance policies, including
premium increases or the imposition of large deductible or co-insurance
requirements, could have a material adverse effect on the Company's business,
financial condition and results of operations. Furthermore, litigation,
regardless of its outcome, could result in substantial cost to the Company and
divert managements's attention from the Company's operations. Any contract
liability claim or litigation against the Company could, therefore, have a
material adverse effect on the Company's business, financial conditions and
results of operations.

   Software Errors or Bugs

     The Company's software products and tools are highly complex and
sophisticated and could from time to time contain design defects or software
errors that could be difficult to detect and correct. Errors, bugs or viruses
may result in loss of or delay in market acceptance, a failure in a client's
system or loss or corruption of client data. Although the Company has not
experienced material adverse effects resulting from any software defects or
errors, there can be no assurance that, despite testing by the Company and its
clients, errors will not be found in new products, which errors could have a
material adverse effect upon the Company's business, financial condition and
results of operations.

   Limited Protection of Proprietary Rights

     The Company relies on a combination of patent, copyright, trademark and
trade secret laws and license agreements to establish and protect its rights in
its software products and proprietary technology. In addition, the Company
currently requires its employees and consultants to enter into nondisclosure and
assignment of invention agreements to limit use of, access to and distribution
of its proprietary information. There can be no assurance that the Company's
means of protecting its proprietary rights in the United States or abroad will
be adequate. The laws of some foreign countries may not protect the Company's
proprietary rights as fully or in the same manner as do the laws of the United
States. Also, despite the steps taken by the Company to protect its proprietary
rights, it may be possible for unauthorized third parties to copy aspects of the
Company's products, reverse engineer, develop similar technology independently
or obtain and use information that the Company regards as proprietary.
Furthermore, there can be no assurance that others will not develop technologies
similar or superior to the Company's technology or design around the proprietary
rights owned by the Company.

     The Company has entered into license agreements with clients that allow
these clients access to and use of the Company's AutoEnhance/2000 an Vantage YR
2000 software and SAM Relay and RQE Tools source code for certain purposes.
Access to the Company's source code may increase the likelihood of
misappropriation or misuse by third parties.

                                       40
<PAGE>
 
     Currently, the Company has filed six patent applications with the United
States Patent and Trademark Office pertaining to technologies, processes and
methodologies with respect to the Company's software. A patent has been granted
on one of these applications, United States Patent Number: 5,838,979, that
covers certain technology applicable to the Mass Change Engine. There can be no
assurance that a patent will be issued pursuant to any other of these
applications or that, if granted, such patent would survive a legal challenge to
its validity or provide meaningful or significant protection to the Company. In
addition, the Company may decide to abandon a patent application if, among other
things, it determines that continued prosecution of an application would be too
costly, the technologies, processes or methodologies are not critical to the
Company's business in the forseeable future or it is unlikely that a patent will
issue with respect to a particular application. Some competitors of the Company
have announced the filing with the PTO of patent applications relating to fixing
and assessing the year 2000 problem. The Company expects that the risk of
infringement claims against the Company might increase because its competitors
might successfully obtain patents for software products and processes or because
new and overlapping processes and methodologies used in such services will
become more pervasive, increasing the likelihood of infringement. There can be
no assurance that third parties will not assert infringement claims against the
Company in the future, that the assertion of such claims will not result in
litigation or that the Company would prevail in such litigation or be able to
obtain a license for the use of any infringed intellectual property from a third
party on commercially reasonable terms, if at all. Furthermore, litigation,
regardless of its outcome, could result in substantial cost to the Company and
divert management's attention from the Company's operations. Any infringement
claim or litigation against the Company could, therefore, have a material
adverse effect on the Company's business, financial condition and results of
operations.

     The Company maintains trademarks and service marks to identify its various
service offerings, products and software. Although the Company has registered a
trademark and one service mark with the PTO and has several trademark and
service mark applications pending in the United States and foreign
jurisdictions, not all of the applications have been granted and, even if
granted, there can be no assurance that a particular trademark or service mark
will survive a legal challenge to its validity or provide meaningful or
significant protection to the Company. In some cases, entities other than the
Company are using certain trademarks and service marks, either in jurisdictions
in which the Company has not filed an application or in which the Company is
using a mark in a different manner than a third party. There may be some risk of
infringement claims against the Company in the event that a service or product
of the Company is too similar to that of another entity that is using a similar
mark.

   Dependence on Third-Party Technology

     The Company's proprietary software is currently designed, and may in the
future be designed to work on or in conjunction with certain third-party
hardware and/or software products. If any of these current or future third-party
vendors were to discontinue making their products available to the Company or to
licensees of the Company's software or to increase materially the cost to the
Company or its licensees to acquire, license or purchase the third-party
vendors' products, or if a material problem were to arise in connection with the
ability of the Company to design its software to properly use or operate with
third-party hardware and/or software products, the Company would be required to
redesign its software to function with or on alternative third-party products or
attempt to develop internally a replacement for the third-party products. In
such an event, interruptions in the availability or functioning of the Company's
software and delays in the introduction of new products and services may occur
until equivalent technology is obtained. There can be no assurance that an
alternative source of suitable technology would be available or that the Company
would be able to develop an alternative product in sufficient time or at a
reasonable cost. The failure of the Company to obtain or develop alternative
technologies or products on a timely basis and at a reasonable cost could have a
material adverse effect on the Company's business, financial condition and
results of operations.



   Rapid Technological Change

     The market for the Company's products and services is characterized by
rapidly changing technology, evolving industry standards and new product
introductions and enhancements that may render existing products obsolete. As a
result, the Company's market position could erode further due to unforeseen
changes in the features and functionality of competing products. The process of
developing products and services such as those offered by the Company is
extremely complex and is expected to become increasingly complex and expensive
in the future with the introduction of new platforms and technologies. There can
be no assurance that the Company will develop any 

                                      41
<PAGE>
 
new products in a timely fashion or that the Company's current or future
products will satisfy the needs of its target market especially in light of its
current difficult financial condition.

   Dependence on India Offshore Software Development Center

     The Company has established an offshore software development center in
Bangalore, India that is intended to provide the Company with a cost advantage
as well as the ability to provide 24-hour coverage for its outsourcing services
clients. To provide its service delivery model, the Company must maintain
communications between its offices, the offices of its clients in the U.S. and
the Bangalore offshore software development facility. Any loss of the Company's
ability to transmit voice and data through satellite communications to India
could have a material adverse effect on the Company's business, financial
condition and results of operations. In the past, India has experienced
significant inflation, low growth in gross domestic product and shortages of
foreign exchange. India also has experienced civil unrest and terrorism and, in
the past, has been involved in conflict with neighboring countries. No assurance
can be given that the Company will not be adversely affected by changes in
inflation, interest rates, taxation, social stability or other political,
economic or diplomatic developments in or affecting India in the future. In
addition, the Indian government has exercised and continues to exercise
significant influence over many aspects of the Indian economy, and Indian
government actions concerning the economy could have material adverse effect on
private sector entities, including the Company. During recent years, India's
government has provided significant tax incentives and relaxed certain
regulatory restrictions in order to encourage foreign investment in specified
sectors of the economy, including the software development industry. Certain of
those benefits that directly affect the Company include, among others, tax
holidays, liberalized import and export duties and preferential rules on foreign
investment and repatriation. Notwithstanding these benefits, however, India's
central and state governments remain significantly involved in the Indian
economy. The elimination of any of the benefits realized by the Company from its
Indian operations could have a material adverse effect on the Company's business
financial condition and results of operations.


YEAR 2000 ISSUE

     The Year 2000 issue relates to computer programs and systems that
recognize dates using two-digit year data rather than four-digit year data. As a
result, such programs and systems may fail or provide incorrect information when
using dates after December 31, 1999. If the Year 2000 issue were to disrupt to
the Company's internal information technology systems, or the information
technology systems of entities with whom the Company has significant commercial
relationships, the Company's business and financial condition could be
materially adversely affected.

     The Year 2000 issue is relevant to three areas of the Company's business:
(1) the Company's products, (2) the Company's internal computer systems and (3)
the computer systems of significant suppliers or customers of the company. Each
such area is addressed below.

          1.   The Company's Products. In some cases, the Company warrants to
               its clients that its software will be year 2000 compliant
               generally subject to certain limitations or conditions. The
               Company also provides solutions consisting of products and
               services to address the year 2000 problem involving key

                                       42
<PAGE>
 
               aspects of a client's computer systems. A failure in a client's
               system or failure of the Company's software to be year 2000
               compliant would result in substantial damages and therefore have
               a material adverse effect on the Company's business, financial
               condition and results of operations. Although the Company does
               not intend to adopt a formal Year 2000 compliance program for its
               existing products, it will use commercially reasonable efforts to
               be Year 2000 compliant.

          2.   Internal Systems. The Company's internal computer programs and
               operating systems relate to certain segments of the Company's
               business, including customer database management, marketing,
               order processing, order fulfillment, inventory management,
               customer service, accounting and financial reporting. These
               programs and systems consist primarily of:

 .    Business Systems. These systems automate and manage business functions such
     as customer database management, marketing, order-taking and order-
     processing, inventory management, customer service, accounting and
     financial reporting,
 .    Personal Computers and Networks. These systems are used for word
     processing, document management and other similar administrative functions,
     and
 .    Telecommunications Systems. These systems provide telephone, voicemail, e-
     mail, Internet and intranet connectivity, and enable the Company to manage
     overall internal and external communications.

     The Company's business systems are licensed from an outside vendor and the
Company expects that these business systems installed in 1997 will be Year 2000
compliant through upgrades and maintenance. Other internal systems consist of
widely available office applications and application suites for word-processing,
voicemail and other office-related functions. The Company maintains current
versions of all such applications and all are, or are expected to be, Year 2000
compliant. Accordingly, the Company does not intend to adopt a formal Year 2000
compliance program for these systems.

          3.   Third-Party Systems. The computer programs and operating systems
               used by entities with whom the Company has commercial
               relationships pose potential problems relating to the Year 2000
               issue, which may affect the Company's operations in a variety of
               ways. These risks are more difficult to assess than those posed
               by internal programs and systems, and the Company has not yet
               begun the process of formulating a plan for assessing them. The
               Company believes that the programs and operating systems used by
               entities with whom it has commercial relationships generally fall
               into two categories: (A) First, the Company relies upon programs
               and systems used by providers of basic services necessary to
               enable the Company to reach, communicate and transact business
               with its suppliers and customers. Examples of such providers
               include the United States Postal Service, overnight delivery
               services, telephone companies, other utility companies and banks.
               Services provided by such entities affects almost all facets of
               the Company's operations. However, these third-party dependencies
               are not specific to the Company's business, and disruptions in
               their availability would likely have a negative impact on most
               enterprises within the software and services industry and on many
               enterprises outside the software and services industry. The
               Company believes that all of the most reasonably likely worst-
               case scenarios involving disruptions to its operations stemming
               from the Year 2000 issue relate to programs and systems in this
               first category. (B) Second, the Company relies upon third parties
               for certain software code or programs that are embedded in, or
               work with, its products. The Company believes that the
               functionality of its products would not be materially diminished
               by a failure of such third-party software to be Year 2000
               compliant.

     There can be no assurance that the Company may not experience unanticipated
expenses or be otherwise adversely impacted by a failure of third-party systems
or software to be Year 2000 compliant. The most reasonably likely worst-case
scenarios may include: (i) corruption of data contained in the Company's
internal information systems, (ii) hardware failure, and (iii) failure of
infrastructure services provided by utilities and/or government. The Company
intends to include an evaluation of such scenarios in its plan for assessing the
programs and systems of the entities with whom it has commercial relationships.

     The Company expects to complete the formulation of its plan for assessing
its internal programs and systems and the programs and systems of the entities
with whom it has commercial relationships by the end of the second quarter of
fiscal 1999 and the identification of related risks and uncertainties by the end
of the third quarter of fiscal 

                                       43
<PAGE>
 
1999. Once such identification has been completed, the Company intends to
resolve any material risks and uncertainties that are identified by
communicating further with the relevant vendors and providers, by working
internally to identify alternative sourcing and by formulating contingency plans
to deal with such material risks and uncertainties. To date, however, the
Company has not formulated such a contingency plan. The Company expects the
resolution of such material risks and uncertainties to be an ongoing process
until all key year 2000 problems are satisfactorily resolved. The Company does
not currently anticipate that the total cost of any Year 2000 remediation
efforts that may be needed will be material.


EURO-CURRENCY ISSUE

     The participating member countries of the European Union have agreed to
adopt the Euro as the common legal currency on January 1, 1999. On that same
date, they established the fixed conversion rates between their existing
sovereign currencies and the Euro. The Company has begun to assess the potential
impact on the Company that may result from the Euro conversion. At this early
state of its assessment, the Company cannot yet predict the impact of the Euro
conversion. However, the Company does not expect the Euro conversion to have a
material impact on financial results because the Company does not have a
significant number of transactions within the European market.

                                       44
<PAGE>
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     As of December 31, 1998, the Company was exposed to market risks which
primarily include changes in U.S. interest rates. The Company maintains a
significant portion of its cash and cash equivalents in financial instruments
with purchased maturities of three months or less. These financial instruments
are subject to interest rate risk and will decline in value if interest rates
increase. Due to the short duration of these financial instruments, an immediate
increase in interest rates would not have a material effect on the Company's
financial condition or results of operations.

                                       45
<PAGE>
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


                        PERITUS SOFTWARE SERVICES, INC.

                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Financial Statements:

     Report of Independent Accountants....................................   47

     Consolidated Balance Sheet as of December 31, 1998 and 1997..........   48

     Consolidated Statement of Operations for the three years ended 
        December 31, 1998.................................................   49

     Consolidated Statement of Changes in Stockholders' Equity for 
        the three years ended December 31, 1998...........................   50

     Consolidated Statement of Cash Flows for the three years ended 
        December 31, 1998.................................................   52

     Notes to Consolidated Financial Statements...........................   55

Financial Statement Schedule:

     For the three years ended December 31, 1998

          II.   Valuation and Qualifying Accounts.........................   83

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

                                       46
<PAGE>
 
                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of
Peritus Software Services, Inc.

     In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the financial
position of Peritus Software Services, Inc. and its subsidiaries at December 31,
1998 and 1997, and the 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. 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 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.

      The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in Note
1 to the consolidated financial statements, the Company has suffered net losses
in each of the three years ended December 31, 1998, and the Company's continued
existence is dependent upon its ability to achieve a cash flow breakeven
position and/or to obtain additional sources of financing. The Company does not
believe that it will be able to achieve a cash flow breakeven position in the 
future. These factors raise substantial doubt about the Company's ability to
continue as a going concern. Management's plans in regard to these matters are
also described in Note 1. The consolidated financial statements do not include
any adjustments that might result from the outcome of this uncertainty.


PRICEWATERHOUSECOOPERS LLP

Boston, Massachusetts
February 18, 1999, except
as to Note 1 and the 
last sentence of Note
15, which are as of 
April 2, 1999

                                      47
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.

                          CONSOLIDATED BALANCE SHEET
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)

<TABLE> 
<CAPTION> 
                                                                                                     DECEMBER 31,
                                                                                                -----------------------
                                                                                                   1998         1997
                                                                                                ----------   ----------
                                             ASSETS
                                             ------
<S>                                                                                             <C>          <C> 
Current assets:
    Cash and cash equivalents..................................................................   $   2,809    $  11,340 
    Restricted cash............................................................................         569           --
    Short-term investments.....................................................................         500        3,000 
    Accounts receivable, net of allowance for doubtful accounts of $726 and $95,
    respectively, and including amounts receivable from related parties of $42 and $289, 
     respectively..............................................................................       3,720       12,627 
    Costs and estimated earnings in excess of billings on uncompleted contracts, including
     amounts on uncompleted contracts with related parties of $ -- and $250 respectively.......         951        2,547  
    Prepaid expenses and other current assets..................................................         816          710 
                                                                                                  ---------    ---------
        Total current assets...................................................................       9,365       30,224 
Property and equipment, net....................................................................       3,848        3,859 
Intangible and other assets, net...............................................................         510        5,787 
                                                                                                  ---------    ---------
                                                                                                  $  13,723    $  39,870 
                                                                                                  =========    =========
                              LIABILITIES AND STOCKHOLDERS' EQUITY
                              ------------------------------------

Current liabilities:
    Current portion of capital lease obligations...............................................   $      90    $      51 
    Current portion of long-term debt..........................................................         269          292 
    Accounts payable...........................................................................         462        1,650 
    Billings in excess of costs and estimated earnings on uncompleted contracts................         435          976 
    Deferred revenue...........................................................................       1,890        2,818 
    Other accrued expenses and current liabilities.............................................       4,414        3,506 
                                                                                                  ---------    ---------
        Total current liabilities..............................................................       7,560        9,293 
Capital lease obligations......................................................................         286          144 
Long-term debt.................................................................................          --          269 
Other long-term liabilities....................................................................       1,067           --
                                                                                                  ---------    ---------
        Total liabilities......................................................................       8,913        9,706 
                                                                                                  ---------    ---------
Minority interest in majority-owned subsidiary.................................................          --          159 
Commitments and contingencies (Notes 5, 18 and 19).............................................          --           --
Stockholders' equity:
     Common stock, $.01 par value; 50,000,000 shares authorized; 16,344,985 and 15,361,800
      shares issued and outstanding at December 31, 1998 and 1997, respectively................         164          154  
Additional paid-in capital.....................................................................     105,135      103,808 
Accumulated deficit............................................................................    (100,488)     (73,815)
Note receivable from stockholder...............................................................          --          (58)
Accumulated other comprehensive income.........................................................          (1)         (84)
                                                                                                  ---------    ---------
        Total stockholders' equity.............................................................       4,810       30,005 
                                                                                                  ---------    ---------
                                                                                                  $  13,723    $  39,870 
                                                                                                  =========    =========
</TABLE> 

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

                                       48
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.

                     CONSOLIDATED STATEMENT OF OPERATIONS
                 (IN THOUSANDS, EXCEPT PER SHARE-RELATED DATA)

<TABLE> 
<CAPTION> 
                                                                                        YEAR ENDED DECEMBER 31,
                                                                                   -----------------------------------
                                                                                      1998        1997         1996
                                                                                   ----------  ----------   -----------
<S>                                                                                <C>         <C>          <C> 
Revenue:
    Outsourcing services, including $872, $4,478, and $4,943 from related parties,   
     respectively.................................................................  $    9,925  $   11,447  $  10,190 
    License, including $255, $0, and $1,500 from related parties, respectively....       9,444      21,255      6,526
    Other services, including $204, $0, and $0 from related parties, respectively.      12,163       7,007      2,519
                                                                                    ----------  ----------  ---------
        Total revenue.............................................................      31,532      39,709     19,235
                                                                                    ----------  ----------- ---------
Cost of revenue:
    Cost of outsourcing services, including $750, $2,467, and $1,984 from related
     parties, respectively........................................................       7,577       9,536      8,488 
    Cost of license...............................................................       1,631         690        162
    Cost of other services, including $56, $0, and $0 from related parties,              
     respectively.................................................................       9,110       5,357      2,931 
                                                                                    ----------  ----------  ---------
        Total cost of revenue.....................................................      18,318      15,583     11,581
                                                                                    ----------  ----------  ---------
Gross profit......................................................................      13,214      24,126      7,654
                                                                                    ----------  ----------  ---------
Operating expenses:
    Sales and marketing...........................................................      13,244       8,864      3,116
    Research and development......................................................       8,528       8,324      6,033
    General and administrative....................................................       7,466       4,312      3,249
    Write off of acquired in-process research and development.....................          --      70,800         -- 
    Impairment of long-lived assets...............................................       5,218          --         --
    Restructuring charges.........................................................       5,906          --         --
                                                                                    ----------  ----------  ---------
        Total operating expenses..................................................      40,362      92,300     12,398
                                                                                    ----------  ----------  ---------
        Loss from operations......................................................    ( 27,148)    (68,174)    (4,744)
Interest income...................................................................         548       1,163         48 
Interest expense..................................................................         (63)       (215)      (344) 
                                                                                    ----------  ----------  ---------
    Loss before gain on sale of majority-owned subsidary, income taxes and
     minority interest in majority-owned subsidiary...............................     (26,663)    (67,226)    (5,040)
Gain on sale of majority-owned subsidary..........................................         (11)         --         --
Provision (benefit) for estimated income taxes....................................          25         260       (143)
                                                                                    ----------  ----------  ---------
    Loss before minority interest in majority-owned subsidiary....................     (26,677)    (67,486)    (4,897)
Minority interest in majority-owned subsidiary....................................          (4)          4         24 
                                                                                    ----------  ----------  --------- 
    Net loss......................................................................     (26,673)    (67,490)    (4,921)
Accrual of dividends on Series A and B preferred stock............................          --         675        689
Accretion to redemption value of redeemable stock.................................          --          57        413
                                                                                    ----------  ----------  ---------
Net loss available to common stockholders.........................................  $  (26,673) $  (68,222) $  (6,023)
                                                                                    ==========  ==========  =========
Net loss per share:
    Basic ........................................................................  $    (1.65) $    (7.03) $   (1.02)
                                                                                    ==========  ==========  =========
    Diluted.......................................................................  $    (1.65) $    (7.03) $   (1.02)
                                                                                    ==========  ==========  =========
Weighted average shares outstanding:
    Basic ........................................................................      16,177       9,708      5,876
                                                                                   ===========  ==========  =========
    Diluted.......................................................................      16,177       9,708      5,876
                                                                                   ===========  ==========  =========
Pro forma basic and diluted net loss per share (unaudited)........................              $    (5.83) $   (0.67)
                                                                                                ==========  =========
Pro forma basic and diluted weighted average shares outstanding (unaudited).......                  11,574      7,394
                                                                                                ==========  =========
</TABLE> 

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

                                       49
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.

           CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)

<TABLE> 
<CAPTION>                                                                                                                          
                                                                                  CLASS A                CLASS B         
                                             COMMON STOCK      ADDITIONAL       COMMON STOCK           COMMON STOCK      
                                        ---------------------              ---------------------  ---------------------  
                                          NUMBER                 PAID-IN     NUMBER                 NUMBER               
                                         OF SHARES    AMOUNT     CAPITAL    OF SHARES    AMOUNT    OF SHARES    AMOUNT   
                                        -----------  --------  ----------  -----------  --------  -----------  -------- 
<S>                                     <C>          <C>       <C>         <C>          <C>       <C>          <C> 
Balance, December 31, 1995...........            --  $     --   $      --    5,525,075  $  1,216       99,912  $    160   
Purchase of 189,588 shares of                                                                                             
Class A                                                                                                                   
  common stock for treasury..........                                                                                     
Issuance of common stock.............                                          431,515     1,027                          
Exercise of employee stock options,                                                                                       
  including related receivable from                                                                                       
  stockholder........................                                           36,250        58                          
Effect of accelerating vesting of                                                                                         
certain                                                                                      118                          
  common stock options...............                                                                                     
Sale of common stock pursuant to                                                                                          
  exercise of stock options..........                                          158,587       118        1,909         5   
Retirement of treasury stock.........                                         (117,813)     (330)        (625)       (1)  
Accrual of cumulative dividends on                                                                                        
  redeemable convertible preferred                                                                                        
  stock and accretion to redemption                                                                                       
  value on redeemable stock..........                                                                                     
Cumulative translation adjustment....                                                                                     
Net loss.............................                                                                                     
                                        -----------  --------  ----------  -----------  --------  -----------  --------   
Balance, December 31, 1996...........            --        --          --    6,033,614     2,207      101,196       164   
Sale of common stock pursuant to                                                                                          
  exercise of stock options..........        52,002         1          51      165,781        23                          
Accrual of cumulative dividends on                                                                                        
  redeemable convertible preferred                                                                                        
  stock and accretion to redemption                                                                                       
  value on redeemable stock..........                                                                                     
Termination of stock purchase right..                                 326                                                 
Conversion of Class A and Class B                                                                                         
  common stock to common stock.......     6,300,591        63       2,331   (6,199,395)   (2,230)    (101,196)     (164)  
Conversion of Series A and Series B                                                                                       
  redeemable convertible preferred                                                                                        
  stock to common stock..............     3,721,707        37      12,657                                                 
Sale of common stock in connection                                                                                        
  with initial public offering,                                                                                           
net of                                                                                                                    
  issuance costs.....................     2,800,000        28      40,636                                                 
Cumulative translation adjustment....                                                                                     
Sale of common stock pursuant to                                                                                          
  exercise of warrants...............       312,500         3         497                                                 
Issuance of common stock in                                                                                               
  connection with acquisition of                                                                                          
  Millennium Dynamics, Inc. .........     2,175,000        22      47,310                                                 
Net loss.............................                                                                                     
                                        -----------  --------  ----------  -----------  --------  -----------  --------   
Balance, December 31, 1997...........    15,361,800  $    154   $ 103,808           --  $     --           --  $     --   

<CAPTION>                                                                                                                           

                                                                             ACCUMULATED       TOTAL               
                                                               RECEIVABLE       OTHER       STOCKHOLDER'S                        
                                        ACCUMULATED  TREASURY     FROM      COMPREHENSIVE      EQUITY      
                                          DEFICIT     STOCK    STOCKHOLDER     INCOME        (DEFICIT)     
                                        -----------  --------  -----------  -------------   -------------  
<S>                                     <C>          <C>       <C>          <C>             <C>            
Balance, December 31, 1995...........   $       430  $     (4) $         -  $           -   $       1,802  
Purchaser of 189,588 shares of Class                                                                       
  A common stock for treasury........                    (531)                                       (531)    
Issuance of common stock.............                     201                                       1,228  
Exercise of employee stock options,                                                                        
  including related receivable from                                                                        
  stockholder........................                                  (58)                            --  
Effect of accelerating vesting of                                                                          
certain                                                                                               118  
  common stock options...............                                                                      
Sale of common stock pursuant to                                                                           
  exercise of stock options..........                       3                                         126  
Retirement of treasury stock.........                     331                                          --   
Accrual of cumulative dividends on                                                                         
  redeemable convertible preferred                                                                         
  stock and accretion to redemption                                                                        
  value on redeemable stock..........        (1,102)                                               (1,102)  
Cumulative translation adjustment....                                                 (22)            (22)  
Net loss.............................        (4,921)                                               (4,921)  
                                        -----------  --------  -----------  -------------   -------------  
Balance, December 31, 1996...........        (5,593)       --          (58)           (22)         (3,302) 
Sale of common stock pursuant to                                                                           
  exercise of stock options..........                                                                  75                    
Accrual of cumulative dividends on                                                                         
  redeemable convertible preferred                                                                         
  stock and accretion to redemption                                                                        
  value on redeemable stock..........          (732)                                                 (732)  
Termination of stock purchase right..                                                                 326  
Conversion of Class A and Class B                                                                          
  common stock to common stock.......                                                                  --  
Conversion of Series A and Series B                                                                        
  redeemable convertible preferred                                                                         
  stock to common stock..............                                                              12,694  
Sale of common stock in connection                                                                         
  with initial public offering,                                                                            
net of                                                                                                     
  issuance costs.....................                                                              40,664  
Cumulative translation adjustment....                                                 (62)            (62)  
Sale of common stock pursuant to                                                                           
  exercise of warrants...............                                                                 500  
Issuance of common stock in                                                                                
  connection with acquisition of                                                                           
  Millennium Dynamics, Inc. .........                                                              47,332  
Net loss.............................       (67,490)                                              (67,490) 
                                        -----------  --------  -----------  -------------   -------------  
Balance, December 31, 1997...........   $   (73,815) $     --  $       (58) $         (84)  $      30,005   
</TABLE> 

                                      51
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.

           CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)

<TABLE> 
<CAPTION> 
                                                                         CLASS A                CLASS B                           
                                       COMMON STOCK     ADDITIONAL     COMMON STOCK           COMMON STOCK                        
                                   --------------------            --------------------  ----------------------  
                                     NUMBER               PAID-IN    NUMBER                 NUMBER                  ACCUMULATED  
                                   OF SHARES    AMOUNT    CAPITAL  OF SHARES    AMOUNT     OF SHARES    AMOUNT       DEFICIT    
                                   ---------- --------   --------- ---------- ---------  ------------  --------  --------------     
<S>                                <C>        <C>        <C>       <C>        <C>        <C>           <C>       <C> 
Sale of common stock pursuant to                                                                                                 
 exercise of stock options........    883,185 $      9   $   1,018         -- $      --            --  $     --  $           --  
Sale of common stock pursuant to                                                                                                 
 employee stock purchase plan.....    100,000        1         309                                                               
Repayment of receivable from                                                                                                     
 stockholder......................                                                                                                
Cumulative translation adjustment.                                                                                               
Net loss..........................                                                                                      (26,673)  
                                                                                                                                 
                                   ---------- --------   --------- ---------- ---------  ------------  --------  --------------     
Balance, December 31, 1998........ 16,344,985 $    164   $ 105,135         -- $      --            --  $     --  $     (100,488)
                                   ========== ========   ========= ========== =========  ============  ========  ==============     

<CAPTION> 
                                                              ACCUMULATED        TOTAL          
                                               RECEIVABLE        OTHER        STOCKHOLDER'S   
                                   TREASURY       FROM       COMPREHENSIVE       EQUITY       
                                     STOCK     STOCKHOLDER       INCOME        (DEFICIT)      
                                   --------   -------------  -------------   ---------------  
<S>                                <C>        <C>            <C>             <C>              
Sale of common stock pursuant to                                                              
 exercise of stock options........ $     --   $          --  $          --   $         1,027  
                                                                                              
Sale of common stock pursuant to                                                              
   employee stock purchase plan...                                                       310  
Repayment of receivable from                             58                               58  
stockholder.......................                                                            
Cumulative translation adjustment.                                      83                83  
Net loss..........................                                                   (26,673) 
                                   --------   -------------  -------------   ---------------  
Balance, December 31, 1998........ $     --   $          --  $          (1)  $         4,810  
                                   ========   =============  =============   ===============   
</TABLE> 

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

                                      52
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.

                     CONSOLIDATED STATEMENT OF CASH FLOWS
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)

<TABLE> 
<CAPTION> 
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                               YEAR ENDED DECEMBER 31,      
                                                                                         ----------------------------------  
                                                                                            1998        1997        1996    
                                                                                         ----------  ---------   ----------  
<S>                                                                                      <C>         <C>         <C>         
Cash flows from operating activities:
     Net loss ........................................................................    $ (26,673)  $(67,490)   $ (4,921)
     Adjustments to reconcile net loss to net cash provided by (used for) operating                                       
       activities:                                                                                                        
          Depreciation and amortization...............................................        3,083      1,327         854 
          Minority interest in majority-owned subsidiary..............................           (4)         4          24 
          Impairment of long-lived assets.............................................        5,218         --          --
          Gain on sale of majority-owned subsidiary...................................          (11)        --          --
          Write off of acquired in process research and development...................           --     70,800          --
          Non-cash employee compensation..............................................           --         --         118 
          Changes in assets and liabilities, net of effects from acquisitions:                                            
               Accounts receivable....................................................        8,671     (6,193)     (1,690)
               Costs and estimated earnings in excess of billings on                                                      
                  uncompleted contracts...............................................        1,596         (9)        501 
               Unbilled license revenue from related parties..........................           --      1,400      (1,400)
               Prepaid expenses and other current assets..............................         (137)      (438)        177 
               Other assets...........................................................         (125)        --          --
               Accounts payable.......................................................         (979)       495        (222)
               Billings in excess of costs and estimated earnings on                                                      
                  uncompleted contracts...............................................          331         74         192 
               Deferred revenue.......................................................         (928)      (629)      3,262 
               Other accrued expenses and current liabilities, excluding accrued                                          
                  restructuring.......................................................         (383)       885         949 
               Accrued restructuring..................................................        1,613         --          --
               Deferred income taxes..................................................           --         --        (186)
               Other long-term liabilities............................................        1,067         --          -- 
                                                                                        -----------  ---------  ----------  
                    Net cash provided by (used for) operating activities..............       (7,661)       226      (2,342) 
                                                                                        -----------  ---------  ----------  
Cash flows from investing activities:                                                                                       
     Sale (purchase) of short-term investments........................................        2,500     (3,000)         --  
     Cash of majority-owned subsidiary disposed, net of cash received.................       (1,074)        --          --  
     Cash paid for acquisition of business, and related costs, net of cash                                                  
        acquired......................................................................           --    (31,350)        174  
     Partial sale of investment in consolidated subsidiary............................           --         --           8  
     Purchases of property and equipment..............................................       (2,739)    (2,018)     (1,240) 
     Acquisition of patents...........................................................           --         --          (1) 
                                                                                        -----------  ---------  ----------  
                    Net cash used for investing activities............................       (1,313)   (36,368)     (1,059) 
                                                                                        -----------  ---------  ---------- 
</TABLE> 

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

                                      53
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.

               CONSOLIDATED STATEMENT OF CASH FLOWS--(CONTINUED)
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)


<TABLE> 
<CAPTION> 
                                                                                     YEAR ENDED DECEMBER 31,
                                                                                -----------------------------------
                                                                                   1998        1997        1996
                                                                                ----------  ----------  -----------
<S>                                                                             <C>         <C>         <C> 
Cash flows from financing activities:
        Restricted cash.......................................................    $   (569)   $     --    $      --
     Proceeds from (principal payments on) line of credit borrowings, net.....          --          --         (440)
     Proceeds from long-term debt.............................................          --         200          450
     Principal payments on long-term debt.....................................        (292)     (1,201)        (686)
     Principal payments on capital lease obligations..........................        (106)        (80)        (107)
     Proceeds from sale of redeemable convertible preferred stock and
        redeemable common stock...............................................          --          --       11,184
     Proceeds from issuance of common stock, net of issuance costs                   1,337      41,239          626
     Proceeds from sale of subsidiary common stock............................          --          --           59
     Proceeds from repayment of note receivable from stockholder..............          58          --           --
     Treasury stock acquired..................................................          --          --         (531)
                                                                               -----------   ---------   ----------
                    Net cash provided by financing activities.................         428      40,158       10,555
                                                                               -----------   ---------   ----------
Effects of exchange rates on cash and cash equivalents........................          15         (64)         (30)
                                                                               -----------   ---------   ----------
Net increase (decrease) in cash and cash equivalents..........................      (8,531)      3,952        7,124
Cash and cash equivalents, beginning of year..................................      11,340       7,388          264
                                                                               -----------   ---------   ----------
Cash and cash equivalents, end of year........................................    $  2,809    $ 11,340    $   7,388
                                                                               ===========   =========   ==========
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS:
     Cash paid for income taxes...............................................    $     78    $    115    $      --
     Cash paid for interest...................................................          63         215          327
</TABLE> 

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:

     In the years ended December 31, 1998, 1997 and 1996, the Company incurred
capital lease obligations of $458, $0 and $39, respectively.

     In the year ended December 31, 1997, the Company issued 2,175,000 shares of
common stock valued at $47,332 and paid cash of $30,000 to acquire substantially
all of the assets and assume certain liabilities of Millenium Dynamics, Inc.
(Note 3).

     In the year ended December 31, 1996, the Company issued 280,005 shares of
Class A common stock valued at $728 and paid cash of $87 to acquire all of the
outstanding shares of Vista Technologies Incorporated (Note 3).

     In the year ended December 31, 1996, the Company issued 36,250 shares of
common stock to a stockholder in exchange for a note receivable of $58 from the
stockholder.

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

                                      54
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.   NATURE OF THE BUSINESS AND GOING CONCERN MATTERS

     Peritus Software Services, Inc. (the "Company") was incorporated in
Massachusetts in August 1991. The Company provides software products and
services that enable organizations to improve the productivity, quality and
effectiveness of their information technology systems maintenance, or "software
evolution" functions. The Company derives its revenue from software maintenance
outsourcing services, software and methodology licensing and other services sold
directly to end users or indirectly via value added integrators, and its clients
include primarily Fortune 1000 companies and similarly sized business and
government organizations worldwide.

     The Company's consolidated financial statements have been presented on the
basis that it is a going concern, which contemplates continuity of operations,
realization of assets and the satisfaction of liabilities in the ordinary course
of business. However, the Company experienced net losses in each of the three
years ended December 31, 1998 and anticipates a net loss in the first quarter of
1999, which raises doubt about its ability to continue as a going concern. The
Company's continued existence is dependent upon its ability to achieve a cash
flow breakeven position and/or to obtain additional sources of financing. The
anticipated net loss in the first quarter of 1999 will significantly erode the
Company's cash balances and jeopardize its ability to continue as a going
concern. In April 1999, the Company reduced its workforce by approximately 40
people. The reductions are concentrated in the areas of sales, marketing and
Year 2000 delivery. There are no reductions in the area of outsourcing service
delivery. After the reductions, the Company will have limited sales resources
and limited year 2000 resources outside of what is required to meet current
support obligations. The Company does not believe that it will be able to
achieve a cash flow breakeven position in the future and the Company is 
considering various alternatives including the possibility of filing for the
protection against creditors under applicable bankruptcy laws. In addition, the
OTC Bulletin Board has several requirements for continued listing thereon.
Failure to meet listing requirements may result in the Company being de-listed.
There can be no assurance that the Company will not be de-listed.

     In March 1999, the Company announced that it had retained Covington 
Associates to render financial advisory and investment banking services in 
connection with exploring strategic alternatives including the potential sale of
the Company.

     On April 2, 1999, the Company announced a reduction in its workforce of 
approximately 40 people in the areas of sales, marketing and year 2000 delivery.
The Company currently maintains its outsourcing service delivery resources and 
limited sales and year 2000 resources required to meet current support 
obligations.

     Further reductions in expenses or the sale of assets may not be adequate to
bring the Company to a cash breakeven position. In addition, there can be no
assurance that such actions will not have an adverse affect on the Company's
ability to generate revenue or successfully implement any strategic alternatives
under consideration. Failure to establish a cash flow breakeven position or
raise additional funds through bank borrowings and/or equity and/or debt
financing have and will continue to adversely impact the Company's ability to
continue as a going concern.


2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

   Principles of Consolidation

          The consolidated financial statements include the accounts of the
Company and its wholly-owned and majority-owned subsidiaries. All significant
intercompany balances and transactions have been eliminated.

                                      55
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


   Revenue Recognition

     Revenue under contracts to provide outsourced software maintenance,
reengineering and development services is recognized using the
percentage-of-completion method and is based on the ratio that labor-hours
incurred to date bear to estimated total labor-hours at completion, provided
that collection of the related receivable is probable. Adjustments to contract
cost estimates are made in the periods in which the facts which require such
revisions become known. When the revised estimates indicate a loss, such loss is
provided for currently in its entirety. Costs and estimated earnings in excess
of billings on uncompleted contracts represent revenue recognized in excess of
amounts billed. Billings in excess of costs and estimated earnings on
uncompleted contracts represent billings in excess of revenue recognized.

     The Company licenses its software products and methodologies to end users
and to value added integrators for their use in serving their clients. License
fees charged to end users are fixed, with the amount of the fee based on the
estimated total lines of code to be processed or number of CPUs licensed.
License fees charged to value added integrators are generally royalties based on
lines of code processed or to be processed or number of CPUs licensed. Revenue
from software licenses is recognized when licensed software and methodologies
have been delivered, the fee is fixed and determinable and collection of the
related receivable is probable. The Company generally does not provide its
customers with the right to return software licenses and, once due, license fees
are non-refundable.

     Other services provided by the Company include direct delivery contracts as
well as technology transfer arrangements, product training, value added
integrator sales training, consulting services and software product maintenance.
Under direct delivery contracts, the Company provides full and pilot year 2000
renovations and renovation quality evaluation ("RQE") services for clients using
the Company's AutoEnhancer/2000, RQE Tool, and/or Vantage YR2000 software.
Revenue from full year 2000 renovation and RQE contracts is recognized using the
percentage-of-completion method and is based on the ratio that labor-hours
incurred to date bear to estimated total labor-hours at completion, provided
that collection of the related receivable is probable. Revenue from pilot direct
delivery contracts is recognized over the duration of such contracts as work is
performed and defined milestones are attained. Adjustments to contract cost
estimates are made in the periods in which the facts which require such
revisions become known. When the revised estimates indicate a loss, such loss is
provided for currently in its entirety. In cases where vendor-specific objective
evidence of fair value of both the license and service component exists under a
direct delivery contract, revenue recognized is allocated between license
revenue and other services revenue for income statement classification purposes
based on their relative fair values. Revenue from technology transfer
arrangements, product and sales training and consulting services is billed on a
time-and-materials basis and is recognized as the services are provided. Revenue
from software product maintenance contracts on the Company's licensed software
products, including client support bundled with the initial license fee, is
deferred and recognized ratably over the contractual periods during which the
services are provided.

   Concentration of Credit Risk

     Financial instruments which potentially expose the Company to
concentrations of credit risk include trade accounts receivable. The Company
primarily sells to Fortune 1000 companies and therefore, generally does not
require collateral. Reserves for potential credit losses are maintained.

   Fair Value of Financial Instruments

     The Company's financial instruments consist of cash and cash equivalents,
short-term investments, accounts receivable, costs and estimated earnings in
excess of billings on uncompleted contracts, accounts payable, accrued expenses,
billings in excess of costs and estimated earnings on uncompleted contracts,
deferred revenue, other long-term liabilities and long-term debt. The carrying
amounts of these instruments at December 31, 1998 approximate their fair values.

                                      56
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


   Cash Equivalents and Short-Term Investments

     The Company considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents. The Company
invests its excess cash primarily in money market accounts, commercial paper and
corporate bonds. Accordingly, these investments are subject to minimal credit
and market risk.

     The Company accounts for its investments in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain
Investments in Debt and Equity Securities." SFAS No. 115 requires the Company to
classify its investments among three categories: held-to-maturity, which are
reported at amortized cost; trading securities, which are reported at fair
value, with unrealized gains and losses included in earnings; and
available-for-sale securities, which are reported at fair value, with unrealized
gains and losses excluded from earnings and reported as a separate component of
stockholders' equity. At December 31, 1998, the Company held short-term
investments in corporate bonds of $500,000 which are classified as
available-for-sale. At December 31, 1998, the Company's cash equivalents
included commercial paper and money market accounts of $249,000 and $176,000,
respectively, which are classified as available for sale. The fair market value
of these investments approximated their amortized cost.

   Property and Equipment

     Property and equipment are stated at cost less accumulated depreciation and
amortization. Depreciation of property and equipment is provided using the
straight-line method over the estimated useful lives of the assets or, where
applicable, over the lease term.

   Software Development Costs

     The Company capitalizes qualifying software development costs after
technological feasibility of the software has been established. Costs incurred
prior to the completion of a working model, which is the Company's primary basis
for determining technological feasibility, are charged to research and
development expense. Amortization of capitalized software costs, which is
charged to cost of revenue, is calculated based upon the ratio of current year
revenue from the related software to total revenue or ratably over the useful
life of the software, whichever is greater. During the years ended December 31,
1998, 1997 and 1996, costs subject to capitalization were not significant and
therefore, were not capitalized. At December 31, 1998 and 1997, the Company's
other assets included $8,000 and $54,000, respectively, in unamortized
capitalized software costs acquired from Vista Technologies Incorporated
("Vista") during 1996 (Note 3). Amortization expense related to capitalized
software costs for the years ended December 31, 1998, 1997 and 1996 was $46,000,
$50,000 and $108,000, respectively, of which $46,000, $50,000 and $45,000,
respectively, related to the capitalized software acquired from Vista.

   Intangible Assets

     At December 31, 1998, intangible assets relate primarily to the MDI and
Vista acquisitions (Note 3) and are being amortized on a straight-line basis
over their expected useful lives of two and three years, respectively. In
connection with an impairment of intangible assets relating to the MDI
acquisition (Note 6), the expected useful lives of such assets were reduced from
five years to two years. Costs associated with obtaining patents are capitalized
as incurred and amortized using the straight-line method over their estimated
economic lives beginning when each patent is issued. Pending such issuance, the
Company did not record amortization expense relating to capitalized patent costs
during the year ended December 31, 1996. For the years ended December 31, 1998
and 1997, the Company recorded $23,000 and $12,000, respectively, of
amortization expense relating to capitalized patent costs.

                                      57
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


   Accounting for Impairment of Long-Lived Assets

     In accordance with SFAS No. 121, "Accounting for the Impairment of Long-
Lived Assets and Long-Lived Assets to be Disposed Of," the Company records
impairment losses on long-lived assets used in operations when indicators of
impairment are present and the undiscounted cash flows estimated to be generated
by those assets are less than the assets' carrying amount. The Company recorded
impairment charges totaling $5,218,000 during the year ended December 31, 1998
(Note 6).

   Comprehensive Income

     In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, "Reporting Comprehensive Income." The Company adopted SFAS No. 130 on
January 1, 1998. Under SFAS No. 130, the Company is required to display
comprehensive income and its components as part of the Company's full set of
financial statements. The measurement and presentation of net income did not
change. Comprehensive income is comprised of net income and other comprehensive
income. Other comprehensive income includes certain changes in equity that are
excluded from net income, such as foreign currency translation adjustments,
unrealized holding gains and losses on available-for-sale marketable securities
and certain derivative instruments. The individual components of comprehensive
income are reflected in the Consolidated Statement of Changes in Stockholders'
Equity for years ended December 31, 1998, 1997 and 1996. At December 31, 1998
and 1997, accumulated other comprehensive income was comprised solely of
cumulative foreign currency translation adjustments.

   Segment Information

     In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information." The Company adopted SFAS No. 131 on
January 1, 1998. SFAS No. 131 establishes standards for reporting information on
operating segments in interim and annual financial statements. SFAS No. 131
relates to disclosure only and had no impact on the Company's consolidated
financial position or results of operations.

   Foreign Currency

     Assets and liabilities of the Company's foreign subsidiaries are translated
into U.S. dollars at exchange rates in effect at the balance sheet date. Income
and expense items are translated at average exchange rates for the period.
Accumulated net translation adjustments are included in stockholders' equity.

   Advertising Expense

     The Company recognizes advertising expense as incurred. Advertising expense
was approximately $842,000, $826,000, and $31,000 for the years ended December
31, 1998, 1997 and 1996, respectively.

   Accounting for Stock-Based Compensation

         The Company accounts for stock-based awards to its employees using the
intrinsic value based method as prescribed by Accounting Principles Board
Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. Accordingly, no compensation expense is recorded for options
issued to employees in fixed amounts and with exercise prices equal to the fair
market value of the Company's common stock at the date of grant. The Company has
adopted the provisions of SFAS No. 123, "Accounting for Stock-Based
Compensation," for disclosure only (Note 15). All stock-based awards to
non-employees are accounted for at their fair value in accordance with SFAS No.
123.

                                      58
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


   Net Income (Loss) Per Share

     The Company accounts for net loss per share in accordance with SFAS No.
128, "Earnings per Share." SFAS No. 128 requires the presentation of "basic"
earnings per share and "diluted" earnings per share. Basic earnings per share is
computed by dividing the net income (loss) available to common stockholders by
the weighted average shares of outstanding common stock. For purposes of
calculating diluted earnings per share, the denominator includes both the
weighted average shares of common stock outstanding and dilutive potential
common stock.

     In February 1998, the Securities and Exchange Commission issued Staff
Accounting Bulletin ("SAB") No. 98, which supersedes SAB No. 83 upon a company's
adoption of SFAS No. 128, and includes new guidance with respect to historical
and pro forma earnings per share computations in an initial public offering.
Pursuant to SAB No. 98, nominal issuances of common stock during the period from
January 1, 1995 through July 1, 1997 (the effective date of the Company's
initial public offering) would be included in computing basic net income per
share as if outstanding for all periods presented. In computing diluted net
income per share for such periods, nominal issuances of common stock and
potential common stock would be included as if outstanding for all periods
presented. During the period from January 1, 1996 through July 2, 1997, the
Company did not issue any common stock or potential common stock which would be
considered nominal pursuant to SAB No. 98.

     Antidilutive potential common stock excluded from the 1998, 1997 and 1996
diluted earnings per share computation includes approximately 382,000, 4,121,000
and 3,238,000 of common stock shares, respectively, issuable upon the conversion
of convertible preferred stock and the exercise of stock options and warrants.

     As described in Note 14, all outstanding shares of the Company's
redeemable convertible preferred stock converted to shares of the Company's
common stock upon the closing of the Company's initial public offering. The
unaudited pro forma diluted net income (loss) per share information included in
the accompanying consolidated statement of operations for the years ended
December 31, 1997 and 1996 reflects the impact of such conversion on basic and
diluted net income (loss) per share as of the beginning of the year, or date of
issuance, if later, using the if-converted method.

     Below is a summary of the shares used in calculating diluted net loss per
share and unaudited pro forma diluted net loss per share for the years
indicated.

<TABLE> 
<CAPTION> 
                                                                                YEAR ENDED DECEMBER 31,
                                                                    -------------------------------------------------
                                                                            1998           1997             1996  
                                                                    ----------------  ---------------- --------------
<S>                                                                 <C>               <C>              <C> 
Diluted weighted average shares outstanding:
     Attributable to common stock outstanding......................       16,177,000        9,708,000        5,876,000
     Attributable to common stock options and warrants.............               --               --               --
     Attributable to redeemable convertible preferred stock........               --               --               --
                                                                    ----------------   --------------   --------------
                                                                          16,177,000        9,708,000        5,876,000
                                                                    ================   ==============   ==============
Unaudited pro forma diluted weighted average shares outstanding:
     Attributable to common stock outstanding......................                         9,708,000        5,876,000
     Attributable to common stock options and warrants.............                                --               --
     Attributable to redeemable convertible preferred stock........                         1,866,000        1,518,000
                                                                                        -------------   --------------
                                                                                           11,574,000        7,394,000
                                                                                        =============   ==============
</TABLE> 

   Use of Estimates

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make certain estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of

                                      59
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


revenue and expenses during the reporting period. Areas particularly subject to
estimation include the allowance for doubtful accounts, revenue based on
percentage-of-completion, the valuation allowance on deferred tax assets, cash
flow projections used in impairment analyses and the timing and amount of future
sublease income on restructured facilities. Actual amounts could differ from
those estimates.

   Reclassifications

     Certain reclassifications have been made to the consolidated financial
statements for 1997 and 1996 to conform to 1998 presentation. These
reclassifications have no effect on the Company's results of operations or
financial position.

   Recently Issued Accounting Standards

     In October 1997, the Accounting Standards Executive Committee ("AcSEC") of
the American Institute of Certified Public Accountants ("AICPA") issued SOP 97-
2, "Software Revenue Recognition." SOP 97-2 provides guidance on the timing and
amount of revenue recognition when licensing, selling, leasing or otherwise
marketing computer software and became effective for transactions entered into
by the Company beginning on January 1, 1998. The Company adopted SOP 97-2 for
the year ended December 31, 1998. Subsequently, in March 1998, AcSEC issued SOP
98-4, "Deferral of the Effective Date of a Provision of SOP 97-2, Software
Revenue Recognition." SOP 98-4 deferred certain provisions of SOP 97-2
pertaining to its requirements for what constitutes vendor-specific objective
evidence ("VSOE") of the fair value of individual elements of a multiple-element
arrangement for a one-year period. At the same time, AcSEC immediately began a
project to further clarify the requirements surrounding VSOE. This project
resulted in SOP 98-9, "Modification of SOP 97-2, `Software Revenue Recognition,'
with Respect to Certain Transactions," which was issued in December 1998. In SOP
98-9, AcSEC decided to retain the limitations on what is considered VSOE of fair
value in a software arrangement, except in limited circumstances. Generally, the
limitations on VSOE of fair value that were deferred by SOP 98-4 will be
effective for transactions that are entered into in fiscal years beginning after
March 15, 1999. The Company believes that its current revenue recognition
policies and practices are consistent with the provisions of SOP 98-9.
Accordingly, the adoption of SOP 98-9 is not expected to have a material impact
in future periods.

     In February 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use." SOP 98-1 establishes
the accounting for costs of software products developed or purchased for
internal use, including when such costs should be capitalized. The Company does
not expect SOP 98-1, which is effective for the Company beginning January 1,
1999, to have a significant impact on the Company's financial condition or
results of operations.

     In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." The new standard establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. SFAS No. 133 is effective for all
fiscal quarters of fiscal years beginning after June 15, 1999. The Company does
not invest in derivative instruments or engage in hedging activities. As a
result, SFAS No. 133 is not expected to have a material affect on its financial
position or results of operations.

                                      60
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


3.   ACQUISITIONS

   Millennium Dynamics, Inc.

     Effective December 1, 1997, Twoquay, Inc., a wholly owned subsidiary of the
Company, acquired substantially all of the assets and assumed certain
liabilities of the business of Millennium Dynamics, Inc. ("MDI") from American
Premier Underwriters, Inc. ("APU") in exchange for $30 million in cash and
2,175,000 unregistered shares of the Company's common stock. Pursuant to a
Registration Rights Agreement between the Company and APU, the Company agreed to
file a Registration Statement on Form S-3 covering up to all of the shares of
common stock issued to APU by July 6, 1998 and to use its best efforts to cause
such Registration Statement to become effective prior to August 1, 1998. The
Company also granted APU certain incidental rights to register up to 500,000
shares of common stock prior to July 6, 1998 in the event of a secondary
offering of the Company's common stock. Under the terms of the Registration
Rights Agreement, APU also agreed that up to 837,500 of the shares of common
stock issued by the Company would be subject to certain restrictions on sale
through December 31, 1998. In determining the purchase price for accounting
purposes, the shares of common stock issued by the Company in connection with
this transaction have been assigned a value of $47.3 million based on the
average closing sale price of the Company's common stock during the six trading
days beginning on the second trading day immediately preceding the completion
and public announcement of the terms of the acquisition on October 22, 1997,
less a discount of approximately 13% primarily reflecting the illiquid nature of
the unregistered shares of common stock issued by the Company in connection with
this transaction as discussed above. Twoquay changed its name to MDI after the
closing of the acquisition.

     The acquisition was accounted for under the purchase method of accounting.
Accordingly, the results of the operations of MDI and the fair market value of
the acquired assets and assumed liabilities have been included in the Company's
financial statements since the effective date of the acquisition. The purchase
price was allocated to the acquired assets and assumed liabilities as follows:

<TABLE> 
<CAPTION> 
              <S>                                                                           <C> 
              Accounts receivable.........................................................     $2,271,000 
              Unbilled license revenues...................................................        343,000 
              Other current assets........................................................        135,000 
              Property and equipment......................................................      1,011,000 
              In-process research and development.........................................     70,800,000 
              Acquired technology.........................................................      4,800,000 
              Assembled workforce.........................................................        600,000 
              Goodwill....................................................................        103,000 
              Accounts payable............................................................       (658,000)
              Restructuring reserves......................................................       (435,000)
              Other current liabilities...................................................       (285,000)
                                                                                            -------------
                                                                                              $78,685,000 
                                                                                            =============
</TABLE> 

     The amounts allocated to intangible assets, including acquired in-process
research and development, was determined by an independent appraiser. The amount
allocated to acquired in-process research and development represented technology
which had not reached technological feasibility and had no alternative future
use. Accordingly, the amount of $70,800,000 was charged to operations at the
effective date of the acquisition. The amounts allocated to intangible assets
are being amortized on a straight-line basis over their expected useful lives.

     In connection with the acquisition, the Company recorded a reserve of
approximately $435,000 of which approximately $221,000 related to provisions for
the closure of certain MDI facilities and $214,000 related to severance benefits
for terminated MDI employees. At December 31, 1998, approximately $12,000 of
these costs remained to be paid.

                                      61
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


     The following unaudited pro forma data has been prepared as if the
acquisition was completed at the beginning of the periods presented, is
presented for illustrative purposes only and is not necessarily indicative of
results of operations which would actually have been achieved had the
acquisition occurred at the beginning of such periods or which may be achieved
in the future. In addition, the following unaudited pro forma data is adjusted
to reflect the amortization of acquired intangible assets and excludes the write
off of acquired in-process research and development of $70,800,000 due to its
non-recurring nature. Also, the net loss per share and unaudited pro forma net
loss per share data shown below assumes the 2,175,000 shares issued in
connection with the acquisition were outstanding for the entire periods
presented. In addition, consistent with the presentation in the Company's
statement of operations, the unaudited pro forma net loss per share data
presented in the last two rows below also assumes conversation of all redeemable
convertible preferred stock as of the beginning of the year or date of issuance,
if later, using the if-converted method (Note 2).


<TABLE> 
<CAPTION> 
                                                     FOR THE YEARS ENDED DECEMBER 31,
                                 -------------------------------------------------------------------------
                                                 1997                                1996
                                 ----------------------------------   ------------------------------------
                                    AS REPORTED        PRO FORMA         AS REPORTED        PRO FORMA
                                 -----------------  ---------------   -----------------  -----------------
                                                      (UNAUDITED)                          (UNAUDITED)
         <S>                     <C>                <C>               <C>                <C> 
         Revenues...............      $ 39,709,000     $ 50,633,000        $ 19,235,000       $ 22,348,000 
         Net loss...............       (67,490,000)      (2,879,000)         (4,921,000)        (5,689,000)
         Net loss per share:
              Basic.............      $      (7.03)    $      (0.31)       $      (1.02)      $      (0.84)
              Diluted...........      $      (7.03)    $      (0.31)       $      (1.02)      $      (0.84)
         Pro forma net loss per. 
         share (unaudited)(1)...
              Basic............       $      (5.83)    $      (0.21)       $      (0.67)      $      (0.59)
              Diluted..........       $      (5.83)    $      (0.21)       $      (0.67)      $      (0.59)
</TABLE> 

(1)      Assumes conversion of all redeemable convertible preferred stock as of
         the beginning of the year or date of issuance, if later, using the
         if-converted method.

Vista Technologies Incorporated

     In January 1996, the Company issued 280,005 shares of its Class A common
stock valued at $728,000 and incurred $87,000 for transaction costs in exchange
for all of the outstanding shares of Vista Technologies Incorporated ("Vista").
Vista is a developer of computer-aided engineering software.

     The Vista merger was accounted for under the purchase method. Accordingly,
the purchase price was allocated based on the estimated fair value of the assets
purchased and liabilities assumed upon acquisition. The excess of cost over fair
value of the net assets acquired of $173,000 is being amortized over three
years. Pro forma results of operations have not been presented because the
effect of this acquisition was not significant.


4.   IN-PROCESS RESEARCH AND DEVELOPMENT

      In connection with the acquisition of MDI (Note 3), the Company recorded a
charge to operations during the fourth quarter of 1997 in the amount of
$70,800,000 representing purchased in-process technology that had not yet
reached technological feasibility and had no alternative future use. The value
was determined via an independent appraisal. At the time of the acquisition of
MDI, the Company's plan for the acquired projects included continued development
of MDI's core technologies aiming to significantly enhance their features and
functionality in order to gain an increasing share of the year 2000 software
market. In addition, the Company planned to continue to focus product plans
around developing comprehensive testing capabilities for MDI's Vantage YR2000
product and a generic mass change software product with capabilities other than
year 2000 corrections, including a Euro currency

                                      62
<PAGE>
 
conversion application. The cost to complete the in-process development was
originally estimated at approximately $18.7 million to be incurred through the
end of the year 2000. These estimated costs were largely for personnel involved
in the planning, design, coding, integration, testing and modification of
products to be derived from the in-process technologies. However, due to lower
than anticipated revenue and losses in excess of expectations during the quarter
ended September 30, 1998, the Company stopped development of all new versions of
existing Vantage YR2000 products, the Vantage YR2000 testing product and the
generic mass change software product. As a result of these actions, the Company
closed its research and development centers in Cincinnati, Ohio, and Lisle, IL,
terminated substantially all employees at those facilities and recorded a
related restructuring charge (Note 5). Through December 31, 1998,
the Company had incurred approximately $ 2,200,000 in costs to develop these
in-process technologies. The Company does not expect to incur additional
development costs for these in-process technologies.

     During 1998, the Company received and responded to a comment letter related
to the Company's Form 10-K for the year ended December 31, 1997 from the 
Securities and Exchange Commission ("SEC") regarding, among other things, the 
Company's accounting for such in-process research and development. A response to
the Company's letter has been received from the SEC, and the Company has further
responded. Although the Company believes it has properly accounted for the item,
a different conclusion would require further restatement of the Company's 
results beginning with the fourth quarter of 1997.

5. RESTRUCTURING CHARGES

     In December 1998, the Company announced its intention to restructure and
recorded a charge of $1,316,000 consisting in part of severance payments
associated with the termination of approximately 22% of the Company's employees
(45 employees). At December 31, 1998, all 45 employees had been terminated with
no further terminations remaining under the restructuring. In addition, a
significant portion of the restructuring charge related to a further reduction
of occupied space at the Company's headquarters in Billerica, MA and consisted
primarily of accrual of lease costs, net of estimated sublease income. Payments
related to the terminated employees were completed by December 31, 1998.
Payments related to the reduction of occupied space are expected to be complete
by February 2006. The Company has estimated that the restructuring will result
in a reduction of approximately $950,000 in salary and related costs and $70,000
in lease related costs on a quarterly basis beginning in the first quarter of
1999.

     In September 1998, the Company announced its intention to restructure and
recorded a charge of $3,372,000 consisting in part of severance payments
associated with the termination of approximately 33% of the Company's employees
at that time (89 employees). At September 30, 1998, all 89 employees had been
terminated with no further terminations remaining under the restructuring. In
addition, a significant portion of the restructuring charge related to the
closure of two research and development centers and a reduction of occupied
space at the Company's headquarters in Billerica, MA and consisted primarily of
accrual of lease costs, net of estimated sublease income. Payments related to
terminated employees were completed by December 1998 for 82 employees and are
expected to be completed by September 1999 for the remaining 7 employees.
Payments related to the closure of facilities and reduction of occupied space
are expected to be completed by June 2003. The Company has estimated that the
restructuring will result in a reduction of approximately $1,900,000 in salary
and related costs and $250,000 in lease related costs on a quarterly basis
beginning in the fourth quarter of 1998.

     In March 1998, the Company announced its intentions for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, and recorded a charge of $1,439,000 consisting in part
of severance payments associated with the termination of approximately 12% of
the Company's employees in April 1998 (48 employees). At June 30, 1998, all 48
employees had been terminated with no further terminations remaining under the
restructuring. In addition, a significant portion of the restructuring charge
related to the closure of two research and development and outsourcing centers,
consisting primarily of accrual of lease costs, net of estimated sublease
income, and support costs for a discontinued product. Payments related to
terminated employees were completed in June 1998 for 45 employees and are
expected to be completed by September 1999 for the remaining 3 employees.
Payments related to the closure and reduction of facilities are expected to be
complete by April 2003. The restructuring resulted in a reduction of
approximately $950,000 in salary and related costs and $90,000 in facility
related costs on a quarterly basis beginning in second quarter of 1998.

                                      63
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


     The amounts accrued to, charged against and other adjustments made to the
restructuring accrual during the year ended December 31, 1998 and the
composition of the remaining balance at December 31, 1998 was as follows:

<TABLE> 
<CAPTION> 
                                            BALANCE                                               BALANCE
                                          DECEMBER 31,      1998         1998        OTHER      DECEMBER 31,
(in thousands)                                1997        ACCRUAL      CHARGES    ADJUSTMENTS       1998
                                          ------------  -----------  ----------- -------------  -------------
<S>                                       <C>           <C>          <C>         <C>            <C> 
Provision for severance and benefit
payments to                                   $    ----   $    3,264  $   (2,558)   $     (170)   $     536
   terminated employees.................
Provisions related to closure of
facilities and                                     ----        2,698        (503)          (51)       2,144
   reduction of occupied space..........
Other...................................           ----          165        (165)         ----         ----
                                            -----------  -----------  ----------   -----------   ----------
   Total................................      $    ----   $    6,127   $  (3,226)   $     (221)   $   2,680
                                            ===========  ===========  ==========   ===========   ===========
</TABLE> 

     As of December 31, 1998, $1,613,000 of the remaining balance of the
restructuring accrual is expected to be paid by December 31, 1999 with the
remaining balance of $1,067,000 being paid thereafter.


6. IMPAIRMENT OF LONG-LIVED ASSETS

     The Company periodically assesses whether any events or changes in
circumstances have occurred that would indicate that the carrying amount of a
long-lived asset might not be recoverable. When such an event or change in
circumstance occurs, the Company evaluates whether the carrying amount of such
asset is recoverable by comparing the net book value of the asset to estimated
future undiscounted cash flows, excluding interest charges, attributable to such
asset. If it is determined that the carrying amount is not recoverable, the
Company recognizes an impairment loss equal to the excess of the carrying amount
of the asset over the estimated fair value of such asset.

     Due to lower than anticipated revenue and losses in excess of expectations
during the quarter ended September 30, 1998, the Company adopted a plan to stop
development of all existing and in-process products originally acquired from MDI
in December 1997, including all Vantage YR2000 renovation and testing software
tools and the generic mass change product. Substantially all direct sales
efforts relating to existing Vantage YR2000 products were also stopped. In
connection with these actions, the Company also undertook a restructuring of its
operations (Note 5) which included the closure of the Company's research and
development facilities in Cincinnati, Ohio and Lisle, Ill. and the termination
of substantially all the employees at these facilities. As a result of these
events, management concluded that an assessment of the recoverability of
intangible assets recorded in connection with the acquisition of MDI in December
1997 was required at September 30, 1998. The Company determined that its
property and equipment at these locations was not subject to impairment as
substaintially all such assets were scheduled to be redeployed.

     In connection with the assessment, management prepared forecasts of the
expected future cash flows related to these intangible assets on an undiscounted
basis and without interest charges. Due to the fact that product development
efforts had been stopped, the Company concluded that the existing technology
acquired as part of the MDI acquisition would only be used in existing Vantage
YR2000 products. As a result of this analysis, management determined that the
estimated undiscounted net cash flows to be generated by acquired technology
recorded as part of the MDI acquisition were less than the asset's net book
value as of September 30, 1998. Accordingly, the acquired technology was
written-down to $289,000, its estimated fair value, using a discounted cash flow
model. With regard to intangible assets relating to assembled workforce and
goodwill acquired from MDI, management concluded that the net book value of
these amounts could no longer be supported due to the termination of all former
MDI employees and the shift of the Company's strategy away from MDI-related
products. Accordingly, the Company recorded an impairment charge totaling
$4,294,000 during the quarter ended September 30, 1998.

                                      64
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

      Management's estimates of forecasted cash flows required an evaluation of
various risks and uncertainties. Although management has made its best estimate
of these factors based on current conditions and expected trends and events, it
is reasonably possible that changes could occur in the near term which could
adversely affect management's estimates of forecasted cash flows. If such
changes occur, asset impairment write-downs could be required in the future and
such write-downs could be material to the Company's financial statements.

     In December 1998, as a result of the significant downsizing of the
Company's operations (Note 5) and continuing decline in operating results, the
Company reviewed the carrying amount of its property and equipment at December
31, 1998 and committed to a plan to dispose certain of its assets, primarily
excess computer equipment and furniture relating to the restructured operations,
either by sale or abandonment. The plan is expected to be completed by June 30, 
1999. The fair value of the assets to be disposed of was measured at
management's best estimate of salvage value, by using the current market values
or the current selling prices for similar assets. Costs to sell are not expected
to be significant. Based upon management's review, the carrying amounts of
assets having a net book value of $1,145,000 were written-down to a total amount
of $221,000, representing the lower of carrying amount or fair value (salvage
value) and the Company recorded an impairment charge totaling $924,000. The
assets to be disposed of are not depreciated or amortized while they are held
for disposal and the reduction in depreciation expense resulting from this 
write-down is approximately $48,000 on a quarterly basis beginning in the first
quarter of 1999.

7. DISPOSITION OF MAJORITY-OWNED SUBSIDIARY

     In July 1998, the Company divested 100% of its equity interest in its
majority-owned Spanish subsidiary, Persist, S. A. ("Persist"), to Persist for
cash proceeds totaling $470,000. Accordingly, the results of operations of
Persist subsequent to the date of disposition have been excluded from the
Company's consolidated results for the year ended December 31, 1998 and the
Company's consolidated December 31, 1998 balance sheet excludes Persist's assets
and liabilities. The gain on this transaction was determined as the excess of
cash proceeds received by the Company over the net assets of Persist at the date
of disposition and reflects the realization of the cumulative impact of foreign
exchange rate fluctuations on the balance sheet of Persist while a subsidiary of
the Company.


8. PROPERTY AND EQUIPMENT

     Property and equipment consist of the following:

<TABLE> 
<CAPTION> 
                                                                              DECEMBER 31,
                                                                       ----------------------------
                                                     ESTIMATED USEFUL        
                                                      LIVES (YEARS)         1998          1997 
                                                     ----------------- -------------- --------------
         <S>                                         <C>                 <C>          <C> 
         Equipment...................................      3-7           $  4,765,000  $   4,235,000
         Furniture and fixtures......................      5-7              1,936,000      1,876,000
         Leasehold improvements......................       5                 897,000        260,000
                                                                       --------------  -------------
                                                                            7,598,000      6,371,000
         Less: Accumulated depreciation and
         amortization................................                       3,750,000      2,512,000
                                                                       --------------  -------------
                                                                         $  3,848,000  $   3,859,000
                                                                       ==============  =============
</TABLE> 

     Equipment under capital leases at December 31, 1998 and 1997 was $471,000
and $239,000 with related accumulated depreciation of $52,000 and $234,000,
respectively. Furniture and fixtures under capital leases at December 31,

                                      65
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

1997 was $271,000, with related accumulated depreciation of $110,000.
Amortization expense related to assets under capital leases was $48,000,
$116,000, and $130,000 for the years ended December 31, 1998, 1997 and 1996,
respectively. Depreciation expense on all fixed assets amounted to $2,063,000,
$1,140,000, and $677,000 for the years ended December 31, 1998, 1997 and 1996,
respectively.


9. INTANGIBLE AND OTHER ASSETS

     Intangible and other assets consist of the following:

<TABLE> 
<CAPTION> 
                                                                              DECEMBER 31,
                                                                       ----------------------------
                                                                           1998          1997
                                                                       --------------  ------------
         <S>                                                           <C>             <C> 
         Acquired technology.........................................     $   289,000  $  4,903,000 
         Assembled workforce.........................................             ---       600,000 
         Goodwill....................................................         235,000       235,000 
         Other.......................................................     $   435,000       399,000 
                                                                       --------------  ------------
                                                                              959,000     6,137,000 
         Less: Accumulated amortization..............................         449,000       350,000 
                                                                       --------------  ------------
                                                                          $   510,000  $  5,787,000 
                                                                       ==============  ============
</TABLE> 

     Amortization expense related to intangible assets was $1,020,000, $187,000,
and $163,000 for the years ended December 31, 1998, 1997 and 1996, respectively.

     During the quarter ended September 30, 1998, the Company recorded an 
impairment charge totaling $4,294,000 which related to intangible assets 
(Note 6).

10. OTHER ACCRUED EXPENSES AND CURRENT LIABILITIES

     Other accrued expenses and current liabilities consist of the following:

<TABLE> 
<CAPTION> 
                                                                              DECEMBER 31,
                                                                       ----------------------------
                                                                           1998             1997
                                                                       -------------   ------------
         <S>                                                           <C>             <C> 
         Restructuring costs..........................................   $ 1,613,000   $       ---
         Employee-related costs.......................................       548,000     1,618,000
         Professional costs...........................................       342,000        85,000
         Acquisition costs............................................        12,000       435,000
         Other........................................................     1,899,000     1,368,000
                                                                       -------------   -----------
                                                                         $ 4,414,000   $ 3,506,000
                                                                       =============   ===========
</TABLE> 

11. REVOLVING LINE OF CREDIT AND TERM LOAN PAYABLE


     Borrowings outstanding under the Company's credit facilities are as
follows:

<TABLE> 
<CAPTION> 
                                                                                         DECEMBER 31,
                                                                                    ------------------------
                                                                                       1998         1997
                                                                                    -----------  -----------
     <S>                                                                            <C>          <C> 
     Term loan payable to bank in monthly principal installments of $24,000
        with interest at prime plus 1% (8.75% at December 31, 1998) through
        January 2000. Paid in full February 1999..............................       $  269,000    $  561,000
                                                                                    -----------   -----------
                                                                                        269,000       561,000
     Less--Current portion....................................................          269,000       292,000
                                                                                    -----------   -----------
                                                                                     $      ---    $  269,000
                                                                                    ===========   ===========
</TABLE> 

                                      66
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     In September 1996, the Company entered into a new revolving line of credit
facility (the "Revolver") with a bank which bears interest at the bank's prime
rate plus 0.5% (8.25% at December 31, 1998). The maximum borrowings under the
Revolver is $3,500,000 and is limited to 75% of certain receivables plus 50% of
costs and estimated earnings in excess of billings as defined in the Revolver
agreement. Borrowings are collateralized by all of the assets of the Company.
Interest is payable monthly in arrears. The Revolver facility was not used and
expired on June 30, 1998.

     In September 1996, the Company also entered into an equipment financing
agreement (the "Equipment Line") with a bank to provide financing of up to
$1,500,000 for the purchase of certain equipment as defined in the Equipment
Line. Borrowings under the Equipment Line take a form of a term loan, the terms
which are as shown above. Borrowings outstanding under the Equipment Line were
$269,000 at December 31, 1998.

     Both of these agreements require the Company to comply with certain
financial covenants and are secured by all of the assets of the Company. The
bank notified the Company in November 1998 that the Company was in default under
its line of credit facility and equipment financing agreement and required that
the Company provide cash collateral for the amount of equipment financing
outstanding, as well as a $300,000 standby letter of credit issued by the bank
on the Company's behalf. Accordingly, all borrowings outstanding at December 31,
1998 were classified as non-current. In addition, no amounts were available
under this arrangement at December 31, 1998 and the bank has indicated that it
will not renew or furter extend the Company's revolving credit facility.

     At December 31, 1998, $269,000 and $300,000 of cash was pledged as
collateral for all amounts outstanding under the equipment financing agreement
and the standby letter of credit, respectively. Accordingly, these amounts have
been classified as restricted cash on the accompanying consolidated balance
sheet.

     Subsequent to December 31, 1998, amounts outstanding on the equipment
financing agreement were paid in full and the standby letter of credit was drawn
down by the lessor of a noncancellable operating lease.


12. RELATED PARTY TRANSACTIONS

     For the years ended December 31, 1997 and 1996, the Company recorded
revenue of $3,319,000 and $5,579,000, respectively, related to outsourcing and
license agreements with a significant shareholder, Bull HN Information Systems
Inc. ("Bull"). At December 31, 1997, $289,000 was included in accounts
receivable from related parties with respect to this stockholder and $233,000,
was included in costs and estimated earnings in excess of billings on
uncompleted contracts with related parties; also, at December 31, 1996,
$1,400,000 was included in unbilled license revenue. During 1998, Bull sold
substantially all of its remaining interest in the Company.

     For the year ended December 31, 1998, the Company recorded revenue of
$204,000 and $255,000, respectively, related to software services and licensing
agreements with GAI, an affiliated company of a significant shareholder, APU
(Note 3). At December 31, 1998, $42,000 was included in accounts receivable from
related parties with respect to this customer.

     For the years ended December 31, 1998, 1997 and 1996, Persist recorded
revenue of $872,000, $1,183,000 and $776,000, respectively, related to
outsourcing services to a corporation owning a majority of and 27% of the
outstanding stock of Persist at December 31, 1998 and 1997, respectively 
(Note 7).

     For the year ended December 31, 1996, the Company recorded revenue of
$137,000, related to software services to a customer. A director of the Company
was also an officer and director of the customer during 1996.

     For the years ended December 31, 1997 and 1996 , the Company recorded
revenue of $2,640,000 and $1,501,000 respectively, related to software services
and licensing to a customer. An employee and officer of the

                                      67
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


Company, hired in September 1996, was previously employed by the customer as an
employee and officer until August 1996.

     For the years ended December 31, 1997 and 1996, the Company recorded
license and other services revenue of $2,828,000 and $190,000, respectively,
from a customer. An employee and officer of the Company, hired in December 1996,
was previously employed by the customer as an employee and officer until
December 1996.

     In February 1996, the Company accepted a $58,000 note receivable from an
employee of the Company in connection with the exercise of employee stock
options. This note matures on February 6, 2001, and is secured by the assets of
the now former employee. Interest is payable quarterly in arrears and accrues on
all outstanding principal plus previously accrued but unpaid interest at the
prime rate. The outstanding principal and accrued interest was paid in full in
1998.


13. INCOME TAXES

     The components of loss before income taxes are as follows:

<TABLE> 
<CAPTION> 
                                                                       YEAR ENDED DECEMBER 31,
                                                           -------------------------------------------------
                                                                1998             1997             1996
                                                           ---------------  --------------    --------------
              <S>                                          <C>              <C>               <C> 
              Domestic...................................    $(26,393,000)    $(67,323,000)   $ (5,141,000)
              Foreign....................................        (255,000)          97,000         101,000 
                                                           --------------   --------------    ------------
                                                             $(26,648,000)    $(67,226,000)   $ (5,040,000)
                                                           ==============   ==============    ============
</TABLE> 

         The provision (benefit) for income taxes consists of the following:

<TABLE> 
<CAPTION> 
                                                                                 YEAR ENDED DECEMBER 31,
                                                                    ----------------------------------------------
                                                                         1998             1997            1996
                                                                    ------------     -------------     ------------
                  <S>                                               <C>              <C>               <C> 
                  Current:
                       Federal.....................................   $       --       $   150,000      $       --
                       State.......................................           --            53,000              --
                       Foreign.....................................       25,000            57,000          43,000 
                                                                    ------------      ------------      ----------
                                                                          25,000           260,000          43,000 
                                                                    ------------      ------------      ----------
                  Deferred:
                       Federal.....................................   (9,546,000)      (18,538,000)     (1,798,000)
                       State.......................................   (1,902,000)       (3,356,000)       (435,000)
                                                                    ------------      ------------      ----------
                                                                     (11,448,000)      (21,894,000)     (2,233,000)
                  Change in deferred tax asset valuation allowance.   11,448,000        21,894,000       2,047,000 
                                                                    ------------      ------------      ----------
                                                                              --                --        (186,000)
                                                                    ------------      ------------      ----------

                                                                      $   25,000       $   260,000      $ (143,000)
                                                                    ============      ============     ===========
</TABLE> 

     No current federal or state income taxes were payable in the years ended
December 31, 1998 or 1996 as a result of taxable losses incurred.

                                      68
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


         The components of deferred tax assets and liabilities follow:

<TABLE> 
<CAPTION> 
                                                                                 DECEMBER 31,
                                                                      -------------------------------------
                                                                             1998                1997
                                                                      ------------------   ----------------
             <S>                                                      <C>                  <C> 
             Deferred tax assets:
                  Intangible asset amortization.....................       $  23,347,000     $  22,903,000
                  Net operating loss carryforwards..................           8,517,000           752,000
                  Tax credit carryforwards..........................           1,301,000           867,000
                  Nondeductible accrued expenses and reserves.......           2,057,000           102,000
                  Other deferred tax assets.........................             676,000           220,000
                                                                      ------------------   ---------------
             Gross deferred tax assets..............................          35,898,000        24,844,000
                                                                      ------------------   ---------------
             Deferred tax liabilities:
                   Estimated costs and earnings in excess of         
                   billings on uncompleted contracts................            (342,000)         (722,000)
                  Other deferred tax liabilities....................             (36,000)          (50,000)
                                                                      ------------------   ---------------
                  Gross deferred tax liabilities....................            (378,000)         (772,000)
                                                                      ------------------   ---------------
             Net deferred tax (liabilities) assets..................          35,520,000        24,072,000
             Deferred tax asset valuation allowance.................         (35,520,000)      (24,072,000)
                                                                      ------------------   ---------------
                                                                           $          --     $          --
                                                                      ==================   ===============
</TABLE> 

     At December 31, 1998 and 1997, the Company has provided a valuation
allowance for the full amount of its net deferred tax assets since, based on the
weight of available evidence, management has concluded that it is more likely
than not (defined as a likelihood of slightly more than 50%) that these future
benefits will not be realized. If the Company achieves profitability, these net
deferred tax assets may be available to offset future income tax liabilities and
expense.

     A reconciliation between the amount of reported income tax provision
(benefit) and the amount determined by applying the U.S. federal statutory rate
to the loss before income taxes and minority interest in majority-owned
subsidiary follows:


<TABLE> 
<CAPTION> 
                                                                        YEAR ENDED DECEMBER 31,
                                                            -------------------------------------------------
                                                                  1998             1997            1996
                                                            ----------------- --------------- ---------------
     <S>                                                    <C>               <C>             <C> 
     Loss at statutory rate...............................     $ (9,327,000)  $ (23,529,000)   $ (1,699,000)
     Tax credit carryforwards.............................         (655,000)       (237,000)       (251,000)
     Permanent differences and other, net.................          191,000       5,355,000          70,000 
     State tax benefit, net of federal effect.............       (1,632,000)     (3,223,000)       (310,000)
     Change in deferred tax asset valuation allowance.....       11,448,000      21,894,000       2,047,000 
                                                            ---------------   -------------    ------------
                                                               $     25,000   $     260,000    $   (143,000)
                                                            ===============   =============    ============
</TABLE> 

     At December 31, 1998, the Company had available net operating loss
carryforwards of approximately $20.6 million and $21.4 million for federal and
state income tax reporting purposes, respectively. At December 31, 1998, the
Company had research and development credit carryforwards of $879,000 and
$650,000 available to offset future federal and state income tax, respectively.
These carryforwards and credits will expire at various times during the period
2001 through 2018 if not utilized.

     In accordance with certain provisions of the Internal Revenue Code, a
change in ownership of greater than 50% within a three-year period will place an
annual limitation on the Company's ability to utilize its existing net operating
loss and research and development tax credit carryforwards. A future change in
ownership could result in such a limitation.

                                      69
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


14. COMMON STOCK

     On July 8, 1997, the Company closed its initial public offering of
4,025,000 shares of common stock, 2,800,000 of which were sold by the Company
and the balance by selling stockholders, at a public offering price of $16 per
share. The proceeds to the Company from the offering, net of offering expenses,
were approximately $40,664,000. 

     In connection with closing the initial public offering, the Company amended
its Articles of Organization to authorize 50,000,000 shares of Common Stock,
$0.01 par value. Concurrently, all outstanding shares of Series A and B
preferred stock and Class B common stock automatically converted into an
aggregate of 3,822,903 shares of common stock, the Class A common stock was
redesignated as common stock, and the redeemable common stock right
automatically terminated.


15. STOCK PLANS

   1992 Long-Term Incentive Plan and 1997 Stock Incentive Plan

     In January 1992, the Board of Directors established the Long-Term Incentive
Plan (the "1992 Incentive Plan"). In May 1997, the Board of Directors
established the 1997 Stock Incentive Plan (the "1997 Incentive Plan") which
replaced the 1992 Incentive Plan. The 1992 Incentive Plan and the 1997 Incentive
Plan allow for the grant of awards in the form of incentive and nonqualified
stock options, restricted stock awards and other stock-based awards, including
the grant of shares based upon certain conditions, the grant of securities
convertible into common stock and the grant of stock appreciation rights
(collectively, the "Awards") to officers, employees, directors, consultants and
advisors of the Company. At December 31, 1998, 3,950,000 shares of common stock
were authorized under the 1997 Incentive Plan, and no further grants may be made
under the 1992 Incentive Plan. Incentive stock options are granted at an
exercise price equal to the fair market value of the Company's common stock at
the grant date (or no less than 110% of the fair market value in the case of
optionees holding more than 10% of the voting stock of the Company) and expire
10 years from the date of grant or upon termination of employment. Non-qualified
stock options are granted at an exercise price determined by the Board of
Directors and expire 10 years from the date of grant. Both the incentive and
non-qualified stock options are exercisable at various dates as determined by
the Board of Directors. Through December 31, 1998, no awards other than
incentive stock options and non qualified stock options were issued under the
1992 Incentive and 1997 Incentive Plans.


   1997 Director Stock Option Plan

     In May 1997, the Board of Directors established the 1997 Director Stock
Option Plan (the "Director Plan") which provides for the issuance of up to
200,000 shares of the Company's common stock upon exercise of options granted
under the Director Plan to non-employee directors of the Company who are not
employees of the Company (the "Directors"). Under the Director Plan, each
Director received an option to purchase 15,000 shares of Common Stock at $16.00
at the time of the effective date of the initial public offering. In addition,
subsequent to the Company's initial public offering each Director will receive
an option to purchase 15,000 shares of common stock on the date of the
Director's initial election to the Board of Directors and an option to purchase
3,000 shares of common stock on the date of each annual meeting. The exercise
price per share of such options will be the closing price of a share of common
stock on the date of the grant. All options granted under the Directors Plan
vest at a rate of one-third of the shares per year over a period of three years
from the date of grant so long as the optionee remains a director of the
Company.

                                      70
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     At December 31, 1998, there were 1,510,425 options available for future
grant under the 1997 Incentive Plan and the Director Plan.

     The following table summarizes stock option activity during the years ended
December 31, 1998, 1997 and 1996:

<TABLE> 
<CAPTION> 
                                                                YEAR ENDED DECEMBER 31,
                                         ----------------------------------------------------------------------
                                                  1998                     1997                   1996
                                         ------------------------  --------------------------------------------
                                                       WEIGHTED                WEIGHTED               WEIGHTED
                                                        AVERAGE                AVERAGE                 AVERAGE
                                                       EXERCISE                EXERCISE               EXERCISE
                                            SHARES       PRICE     SHARES       PRICE      SHARES       PRICE
                                         ------------------------  --------------------  ----------------------
<S>                                      <C>           <C>         <C>         <C>       <C>          <C> 
Outstanding at beginning of year........    4,139,967     $  5.94  2,925,667    $  1.88  1,606,025      $  0.64
Granted.................................    3,151,340        4.00  1,511,613      12.92  1,558,292         3.04
Exercised...............................     (883,185)       1.15   (217,783)      0.34   (198,533)        0.92
Forfeited...............................   (2,091,550)       9.07    (79,530)      2.70    (40,117)        1.20
                                          -----------              ----------            ---------
Outstanding at end of year..............    4,316,572        4.00  4,139,967       5.94  2,925,667         1.88
                                          ===========              ==========            =========
Options exercisable at end of year......    1,254,326     $  2.78  1,453,740    $  1.33  1,030,036      $  0.47
                                          ===========              ==========            =========
</TABLE> 

     The following summarizes information regarding stock options outstanding
and exercisable at December 31, 1998:

<TABLE> 
<CAPTION> 
                                    OPTIONS OUTSTANDING                   OPTIONS EXERCISABLE
                           --------------------------------------      --------------------------
                                          WEIGHTED
                                           AVERAGE      WEIGHTED                        WEIGHTED
                                          REMAINING      AVERAGE                        AVERAGE
                             NUMBER      CONTRACTUAL    EXERCISE          NUMBER        EXERCISE
RANGE OF EXERCISE PRICES   OUTSTANDING  LIFE (YEARS)      PRICE         OUTSTANDING      PRICE
-------------------------  ------------ ------------  -----------      -------------  -----------
<S>                        <C>          <C>           <C>              <C>            <C> 
$  0.01 - $  0.50..........     216,601      3.6         $ 0.17              216,601     $ 0.17
$  0.51 - $  1.00..........   1,293,907      8.3         $ 0.87              277,907     $ 0.87
$  1.01 - $  2.00..........      30,750      6.0         $ 1.60               24,500     $ 1.60
$  2.01 - $  4.00..........   1,405,739      7.7         $ 3.10              579,443     $ 3.01
$  4.01 - $  6.00..........     776,075      6.1         $ 5.08               50,000     $ 4.65
$  8.01 - $ 10.00..........     301,500      8.4         $ 9.55               75,375     $ 9.55
$ 10.01 - $ 15.00..........      70,000      9.0         $14.16                5,000     $13.00
$ 15.01 - $ 20.00..........     222,000      3.8         $17.50               25,500     $16.01
                             ============                                =============
                              4,316,572                                    1,254,326
                            =============                                =============
</TABLE> 

     In accordance with APB No. 25, the Company recognized $118,000 in
compensation expense related to stock-based compensation awards to employees for
the year ended December 31, 1996. No compensation expense was recorded under APB
No. 25 during the years ended December 31, 1998 and 1997. Had compensation cost
been determined based upon the fair value of options at their grant dates as
prescribed in SFAS No. 123, the Company's net loss and basic and diluted net
loss per share would have been as follows:

<TABLE> 
<CAPTION> 
                                                                       YEAR ENDED DECEMBER 31,
                                                          ------------------------------------------------- 
                                                                1998             1997              1996
                                                          ---------------   --------------     ------------ 
   <S>                                                    <C>               <C>                <C> 
   Net loss:
        As reported......................................   $ (26,673,000)   $ (67,490,000)    $ (4,921,000)
        Pro forma........................................     (36,204,000)     (69,668,000)      (5,050,000)
   Basic and diluted net loss per share:
        As reported......................................   $       (1.65)   $       (7.03)    $      (1.02)
        Pro forma........................................           (2.24)           (7.25)           (1.05)
</TABLE> 

                                      71
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


     Because the determination of the fair value of all options granted after
May 14, 1997, the date the Company filed its initial registration statement on
Form S-1 in connection with its initial public offering of common stock,
includes an expected volatility factor, additional option grants could be made
subsequent to December 31, 1998 and options vest over several years, the above
pro forma effects may not be indicative of pro forma effects in future years.

     The fair value of options at the date of grant was estimated using the
Black-Scholes option pricing model with the following weighted average
assumptions:

<TABLE> 
<CAPTION> 
                                                                                      YEAR ENDED DECEMBER 31,
                                                                                  ---------------------------------
                                                                                     1998       1997       1996
                                                                                  ---------------------------------
     <S>                                                                          <C>          <C>       <C>    
     Expected life (years).....................................................           5          5          5   
     Risk-free interest rate...................................................        5.02%      6.05%      6.25%
     Dividend yield............................................................           0%         0%         0%
     Fair value of option grants--exercise price equal to the fair value of the
        related stock..........................................................       $2.90      $7.79      $0.52   
</TABLE> 

     The Company assumed an expected volatility factor of 90% for all option
grants made during 1998. On May 14, 1997, the Company filed its initial
registration statement on Form S-1. Accordingly, the Company assumed an expected
volatility factor of 70% for all option grants made from this date through
December 31, 1997. Prior to May 14, 1997, all options granted to employees were
valued using a volatility factor of 0%.


   1997 Employee Stock Purchase Plan

     In May 1997, the Board of Directors adopted the 1997 Employee Stock
Purchase Plan (the "Purchase Plan"). As amended, the Purchase Plan provides for
the issuance of up to 300,000 shares of the Company's common stock to
participating employees. All employees of the Company whose customary employment
is more than 20 hours per week and who own no more than 5% of the total combined
voting power or value of the stock of the Company are eligible to participate in
the Purchase Plan. Under the terms of the Purchase Plan, the option price is an
amount equal to 85% of the average market price per share of the common stock on
either the first day or the last day of the offering period, whichever is lower.
As amended, the Purchase Plan provides for four consecutive six-month offering
periods beginning with the six-month period extending from October 1, 1997
through March 31, 1998. A total of 50,000 and 50,000 shares were sold on April
1, 1998 and October 1, 1998 respectively, under the Purchase Plan. No awards
were made under the Purchase Plan in 1997. The Board of Directors terminated the
Purchase Plan on April 1, 1999.


16.  DEFINED CONTRIBUTION PLAN

     The Company maintains a defined contribution plan under Section 401(k) of
the Internal Revenue Code covering substantially all employees. Under the plan,
employees may contribute the lower of up to 20% of their salaries or a dollar
amount prescribed by the Internal Revenue Code. The Board of Directors may elect
to make a discretionary contribution to the plan. Vesting with respect to the
Company's discretionary contribution occurs four years from the date the
employee is admitted to the plan. For the years ended December 31, 1998 and
1997, the Company contributed $251,000 and $213,000 respectively, to the Plan.
There were no contributions made by the Company to the Plan during the year
ended December 31, 1996.

                                      72
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


17.   SEGMENT, GEOGRAPHIC, AND PRODUCT INFORMATION

      The Company operates in one reportable segment under SFAS No. 131 due to
its centralized structure and single industry segment: software maintenance,
tools and services. The Company currently derives its revenue from software
maintenance outsourcing services, software and methodology licensing and other
services (including direct delivery of year 2000 renovation services and
renovation quality evaluation ("RQE") sold directly to end users or indirectly
via value added integrators. Information by geographic area at December 31,
1998, 1997 and 1996 and for the years then ended, is summarized below (in
thousands):

<TABLE> 
<CAPTION> 
                 OUTSOURCING SERVICES           LICENSE REVENUE         OTHER SERVICES REVENUE     LONG-LIVED
              -------------------------  --------------------------  --------------------------  
              UNAFFILIATED   AFFILIATED   UNAFFILIATED   AFFILIATED   UNAFFILIATED   AFFILIATED     ASSETS 
              -------------------------  --------------------------  --------------------------  ------------  
<S>           <C>            <C>         <C>              <C>        <C>              <C>        <C>   
1998
United States  $    8,802    $       --    $    9,189     $     255    $   11,850     $     204    $    4,027
Foreign               251           872            --            --           109            --           211 
              -----------------------------------------------------------------------------------------------
               $    9,053    $      872    $    9,189     $     255    $   11,959     $     204    $    4,238
              ===============================================================================================
1997
United States  $    6,644    $    3,295    $   21,149      $     --    $    6,773      $     --    $    9,468
Foreign               325         1,183           106            --           234            --           118  
              -----------------------------------------------------------------------------------------------
               $    6,969    $    4,478    $   21,255      $     --    $    7,007      $     --    $    9,586
              ===============================================================================================
1996
United States  $    4,409    $    4,167    $    5,026    $    1,500    $    2,333      $     --    $    2,327
Foreign               838           776            --            --           186            --            54 
              -----------------------------------------------------------------------------------------------
               $    5,247    $    4,943    $    5,026    $    1,500    $    2,519      $     --    $    2,381
              ===============================================================================================
</TABLE> 

      The geographic classification of revenue is determined based on the
country in which the legal entity providing the services is located. Revenue
from no single foreign country was greater than 10% of the consolidated revenues
of the Company in 1998, 1997 or 1996.

Significant Customers

Revenue from two customers, AT&T and Bull, accounted for 12% and 10% of the
Company's total revenue for the year ended December 31, 1998, respectively. For
the year ended December 31, 1997, no single customer accounted for more than 10%
of the Company's total revenue. Revenue from three customers, Bull, Merrill
Lynch, and Stratus, accounted for 29%, 15% and 12% of the Company's total
revenue for the year ended December 31, 1996, respectively. At December 31,
1998, the Company had no amounts receivable outstanding from the first customer.
At December 31, 1998, the Company had amounts receivable from the second
customer of $164,000 for billed accounts receivable, $114,000 for costs and
estimated earnings in excess of billings on uncompleted contracts and $77,000
for unbilled revenue.


18.   COMMITMENTS

   Leases

     The Company leases its operating facilities and certain equipment under
noncancelable operating and capital lease agreements. Rent expense for the years
ended December 31, 1998, 1997 and 1996 was $ 2,244,000, $1,101,000, and
$999,000, respectively. Future minimum lease payments under noncancelable leases
as of December 31, 1998 are as follows:

                                      73
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

<TABLE> 
<CAPTION> 
                                                                          OPERATING       CAPITAL
                                   YEAR ENDING DECEMBER 31,                 LEASES        LEASES
               ------------------------------------------------------    -----------     ---------
               <S>                                                       <C>             <C>    
               1999..................................................    $ 1,493,000     $  96,000
               2000..................................................      1,582,000        96,000
               2001..................................................      1,613,000        96,000
               2002..................................................      1,534,000        95,000
               2003..................................................      1,406,000         7,000
               Thereafter............................................      3,004,000            --
                                                                         -----------     ---------
                                                                         $10,632,000       390,000
                                                                         ===========     
               Less--Amount representing interest.....................                      14,000
                                                                                         ---------
               Present value of minimum lease payments...............                    $ 376,000
                                                                                         =========
</TABLE> 

19.  LEGAL PROCEEDINGS

     The Company and certain of its officers and directors were named as
defendants in purported class action lawsuits filed in the United States
District Court for the District of Massachusetts by Robert Downey on April 1,
1998, by Scott Cohen on April 7, 1998, by Timothy Bonnett on April 9, 1998, by
Peter Lindsay on April 17, 1998, by Harry Teague on April 21, 1998, by Jesse
Wijntjes on April 29, 1998, by H. Vance Johnson and H. Vance Johnson as Trustee
for the I.O.R.D. Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on
May 21, 1998 and by Helen Lee on May 28, 1998 (collectively, the "complaints").
The complaints principally alleged that the defendants violated federal
securities laws by making false and misleading statements and by failing to
disclose material information concerning the Company's December 1997 acquisition
of substantially all of the assets and assumption of certain liabilities of the
Millennium Dynamics, Inc. business from American Premier Underwriters, Inc.,
thereby allegedly causing the value of the Company's common stock to be
artificially inflated during the purported class periods. In addition, the
Howard complaint alleged violation of federal securities laws as a result of the
Company's purported failure to disclose material information in connection with
the Company's initial public offering on July 2, 1997, and also named Montgomery
Securities, Inc., Wessels, Arnold & Henderson, and H.C. Wainwright & Co., Inc.
as defendants. The complaints further alleged that certain officers and/or
directors of the Company sold stock in the open market during the class periods
and sought unspecified damages.

     On or about June 1, 1998, all of the named plaintiffs and additional
purported class members filed a motion for the appointment of several of those
individuals as lead plaintiffs, for approval of lead and liaison plaintiffs'
counsel and for consolidation of the actions. The Court granted the motion on
June 18, 1998.

     On January 8, 1999, the plaintiffs filed a Consolidated Amended Complaint
applicable to all previously filed actions. The Consolidated Amended Complaint
alleges a class period of October 22, 1997 through October 26, 1998 and
principally claims that the Company and three of its former officers violated
federal securities law by purportedly making false and misleading statements (or
omitting material information) concerning the MDI acquisition and the Company's
revenue during the proposed class period, thereby allegedly causing the value of
the Company's common stock to be artificially inflated. Previously stated claims
against the Company and its underwriters alleging violations of the federal
securities laws as a result of purportedly inadequate or incorrect disclosure in
connection with the Company's initial public offering are not included in the
Consolidated Amended Complaint. The Company and the individual defendants filed
motions to dismiss the Consolidated Amended Complaint on March 5, 1999. The
plaintiff's opposition to such motions are due on April 16, 1999 and oral
argument is currently scheduled to occur on April 21, 1999.

     Although the Company believes that it has meritorious defenses to the
claims made in the Consolidated Amended Complaint and intends to contest the
action vigorously, an adverse resolution of the lawsuit could have a material
adverse effect on the Company's financial condition and results of operations in
the period in which the litigation is resolved. The Company is not able to
reasonably estimate potential losses, if any, related to the Consolidated
Amended Complaint.

     In addition to the matter noted above, the Company is from time to time
subject to legal proceedings and claims which arise in the normal course of its
business. In the opinion of management, the amount of ultimate liability with
respect to these other actions, currently known, will not have a material
adverse effect on the Company's financial position or results of operations for
the year ended December 31, 1998.

                                      74
<PAGE>
 
ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL DISCLOSURE

     None.

                                      75
<PAGE>
 
PART III.

ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The information required by Items 401 and 405 of Regulation S-K set forth
under the caption "Directors and Executive Officers" appearing in the Company's
definitive Proxy Statement for the 1999 Annual Meeting of Stockholders is to be
filed with the Securities and Exchange Commission not later than 120 days after
December 31, 1998, is incorporated herein by reference.

                                      76
<PAGE>
 
ITEM 11.   EXECUTIVE COMPENSATION

     The information required by Item 402 of Regulation S-K set forth under the
Caption "Compensation of Directors and Executive Officers" appearing in the
Company's definitive Proxy Statement for the 1999 Annual Meeting of Stockholders
is to be filed with the Securities and Exchange Commission not later than 120
days after December 31, 1998, is incorporated herein by reference.

                                      77
<PAGE>
 
ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information set forth under the Caption "Voting Securities and
Principal Holders Thereof" and "Election of Directors" appearing in the
Company's definitive Proxy Statement for the 1999 Annual Meeting of Stockholders
is to be filed with the Securities and Exchange Commission not later than 120
days after December 31, 1998, is incorporated herein by reference.

                                      78
<PAGE>
 
ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information set forth under the Caption "Certain Relationships and
Related Transactions" appearing in the Company's definitive Proxy Statement for
the 1999 Annual Meeting of Stockholders is to be filed with the Securities and
Exchange Commission not later than 120 days after December 31, 1998, is
incorporated herein by reference.

                                      79
<PAGE>
 
PART IV.

ITEM 14.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

(A)(1) FINANCIAL STATEMENTS

The financial statements filed as part of this report are listed on the Index to
Consolidated Financial Statements on Page 46 and incorporated herein by
reference.

(2) FINANCIAL STATEMENT SCHEDULES

Schedule II: Valuation and Qualifying Accounts
All other Schedules are omitted because they are not applicable or the required
information is shown in the consolidated financial statements or notes thereto.

(3) EXHIBITS

Documents listed immediately following the signature page to this Annual Report
on Form 10-K, except for documents identified by footnotes, are being filed as
exhibits herewith. Documents identified by footnotes are not being filed
herewith and, pursuant to Rule 12bg-32 of the General Rules and Regulations
promulgated by the Commission under the Securities Exchange Act of 1934 (the
"Act") reference is made to such documents as previously filed as exhibits filed
with the Commission. The Company's file number under the Act is 000-22647.


(B)      REPORTS ON FORM 8-K

         A Current Report on Form 8-K dated September 29, 1998 was filed by the
Company on October 9, 1998 to announce under Item 5 (Other Events) a
restructuring plan in response to reduction in the Company's forcasted revenues.
The Company also disclosed that it was evaluating the net realizability of the
intangible assets originally recorded in connection with the acquisition of
Millennium Dynamics, Inc. in December 1997.

         A Current Report on Form 8-K dated October 26, 1998 was filed by the
Company on October 29, 1998 to announce under Item 5 (Other Events) a
restatement of its results for the quarters ended March 31, 1998 and June 30,
1998.

         A Current Report on Form 8-K dated November 4, 1998 was filed by the 
Company on November 6, 1998 to announce under Item 5 (Other Events) that Allen 
K. Deary resigned as President, Chief Executive Officer and a member of the 
Board of Directors, that Dominic K. Chan was appointed President and Chief 
Executive Officer and that William Verity resigned from the Board of Directors.

         A Current Report on Form 8-K dated November 25, 1998 was filed by the
Company on December 4, 1998 to announce under Item 5 (Other Events) financial
results for the quarter ended September 30, 1998 and a restatement of its
results for the quarter ended September 30, 1997 and the quarter ended December
31, 1997.

         A Current Report on Form 8-K dated December 2, 1998 was filed by the
Company on December 4, 1998 to announce under Item 5 (Other Events) a
restructuring plan for the quarter ended December 31, 1998.

                                      80
<PAGE>
 
                                  SIGNATURES

PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS
BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.


                                   PERITUS SOFTWARE SERVICES, INC.


                                   By: /S/   JOHN GIORDANO
                                       -------------------
                                       John Giordano
                                       President (Principal Executive Officer)

                                                           April 14, 1999

                                                                (Date)

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.


                                   By: /S/   JOHN GIORDANO
                                       -------------------  
                                       John Giordano, President, Chief Financial
                                       Officer (Principal Executive, Financial 
                                       and Accounting Officer)


                                                           April 14, 1999

                                                                (Date)


                                   By: /S/  AXEL LEBLOIS
                                       ---------------------------------------- 
                                       Axel Leblois, Director


                                                           April 13, 1999
                                                                (Date)



                                   By: /S/  ROLAND PAMPEL
                                       ------------------------------------ 
                                       Roland Pampel, Director


                                                           April 13, 1999
                                                                (Date)

                                      81
<PAGE>
 
                                   By: /S/   HENRY MCCANCE
                                       -------------------
                                       Henry McCance, Director


                                                     March 31, 1999 
                                                     --------------
                                                          (Date)



                                   By: /S/   ARTHUR CARR
                                       ------------------------------------  
                                       Arthur Carr, Director


                                                     April 13, 1999
                                                          (Date)


                                   By: /S/   MICHAEL HUMPHREYS
                                       -----------------------
                                       W. Michael Humphreys, Director


                                                     March 31, 1999 
                                                     --------------
                                                          (Date)

                                      82
<PAGE>
 
                                                                     SCHEDULE II

                        PERITUS SOFTWARE SERVICES, INC.

                       VALUATION AND QUALIFYING ACCOUNTS
                                (IN THOUSANDS)

<TABLE> 
<CAPTION> 
                                                                       BALANCE    CHARGED TO   CHARGED                    BALANCE
                                                                      BEGINNING   COSTS AND     TO OTHER                  END OF 
FOR THE YEAR ENDED            CLASSIFICATION                           OF YEAR     EXPENSES     ACCOUNTS     DEDUCTIONS    YEAR 
------------------            --------------                           -------     --------     --------     ----------   ------
<S>                     <C>                                           <C>         <C>           <C>          <C>          <C>    
December 31, 1996.....  Allowance for doubtful accounts                $    30     $     --     $     --        $    --   $   30 
December 31, 1997.....  Allowance for doubtful accounts                $    30     $     65     $     --        $    --   $   95
December 31, 1998.....  Allowance for doubtful accounts                $    95     $  1,481     $   (850)       $    --   $  726
                                                                                                                          
<CAPTION>                                                                                                                 
                                                                       BALANCE    CHARGED TO   CHARGED                   BALANCE
                                                                      BEGINNING   COSTS AND     TO OTHER                 END OF 
FOR THE YEAR ENDED            CLASSIFICATION                           OF YEAR     EXPENSES     ACCOUNTS   DEDUCTIONS     YEAR    
------------------            --------------                           -------     --------     --------   ----------    ------   
<S>                     <C>                                           <C>         <C>           <C>        <C>           <C>      
December 31, 1996.....  Net deferred tax assets valuation allowance    $    --     $     --     $ (2,178)     $    --    $ (2,178)
December 31, 1997.....  Net deferred tax assets valuation allowance    $ (2,178)   $     --     $(21,894)     $    --    $(24,072)
December 31, 1998.....  Net deferred tax assets valuation allowance    $(24,072)   $     --     $(11,448)     $    --    $(35,520) 
</TABLE> 

<PAGE>
 
<TABLE> 
<CAPTION> 
  EXHIBIT
    NO.                                DESCRIPTION
------------   -----------------------------------------------------------------------------------------------------
<S>            <C> 
  3.1/1/       Restated Articles of Organization of the Registrant.

  3.2/1/       Amended and Restated By-Laws of the Registrant.

  4/1/         Specimen Certificate for shares of Common Stock.

*10.1/1/       Long-Term Incentive Plan (1992).

*10.2/1/       1997 Stock Incentive Plan.

*10.3/1/       1997 Director Stock Option Plan.

*10.4/1/       1997 Employee Stock Purchase Plan.

 10.5          Lease dated December 14, 1997, between MGI Two Federal Street, Inc. and the Registrant.

 10.6/1/       Common Stock Purchase Agreement dated May 29, 1992 between the Registrant and Bull HN Information Systems, Inc.

 10.7/1/       Agreement of Amendment dated as of March 15, 1996 between the Registrant and Bull HN Information Systems, Inc.

 10.8/1/       Security Agreement dated as of May 30, 1995 between the Registrant and Massachusetts Capital Resource Company.

 10.9/1/       Registration Rights Agreement dated as of March 15, 1996, as amended, among the Registrant and the stockholders
               listed on the signature pages thereto.

*10.10/1/      Non-Competition Agreement dated as of March 15, 1996 between the Registrant and Dominic K. Chan.

*10.11/1/      Employment Agreement dated as of December 30, 1996 between the Registrant and Douglas A. Catalano.

*10.12/1/      Employment Agreement dated as of January 27, 1997 between the Registrant and Robert D. Savoia.

*10.13/1/      Letter Agreement dated as of August 15, 1996 between the Registrant and Leonard Miller.

 10.14/1/      Master Software Services Agreement dated as of February 3, 1992 between the Registrant and Bull HN Information
               Systems, Inc.

 10.15/1/      License Agreement dated as of July 29, 1996 between the Registrant and Bull HN Information Inc., as amended.

 10.16/1/      Master License Agreement dated as of October 21, 1996, as amended, between the Registrant and Merrill Lynch, Pierce,
               Fenner & Smith Incorporated.

 10.17/1/      Engineering Consultant Services Agreement, as amended, between Stratus Computer, Inc. and the Registrant, dated
               November 30, 1993.

 10.18/1/      Letter Agreement dated September 6, 1996 between the Registrant and Fleet National Bank.

------------   -----------------------------------------------------------------------------------------------------
 10.19/1/      Promissory Note between the Registrant and Fleet National Bank in the amount of $3,500,000, dated September 6, 1996.
</TABLE> 
<PAGE>
 
<TABLE> 
<S>          <C> 
  10.20/1/   Promissory Note between the Registrant and Fleet National Bank in the amount of $675,000, dated September 6, 1996.

  10.21/1/   Promissory Note between the Registrant and Fleet National Bank in the amount of $825,000, dated September 6, 1996.

  10.22/1/   Inventory, Accounts Receivable and Intangibles Security Agreement between the Registrant and Fleet National Bank, dated

             September 6, 1996.

  10.23/1/   Supplemental Security Agreement between the Registrant and Fleet National Bank, dated September 6, 1996.

  10.24/1/   Security Agreement (Trademarks) between the Registrant and Fleet National Bank, dated September 6, 1996.

  10.25/1/   Security Agreement (Patents) between the Registrant and Fleet National Bank, dated September 6, 1996.

  10.26/1/   Subordination Agreement between Massachusetts Capital Resource Company and Fleet National Bank dated September 6, 1996.


  10.27/1/   License and Alliance Agreement dated as of May 1, 1996, as amended, between the Registrant and CSC Consulting, Inc., as

             amended.

  10.28/1/   Agreement and Plan of Merger among the Registrant, Vista Technologies Incorporated and its stockholders, dated January
             29, 1996.

  10.29/1/   Joint Marketing Agreement effective as of June 12, 1997 between the Registrant and VIASOFT, Inc.

  10.30/1/   Letter Agreement dated March 30, 1997 between the Registrant and Fleet National Bank.

  10.31/1/   Letter Agreement dated June 20, 1997 between the Registrant and Fleet National Bank.

  10.32/3/   Letter Agreement dated November 26, 1997 between the Registrant and Fleet National Bank.

  10.33/2/   Asset Purchase Agreement dated October 22, 1997 by and among the Registrant and Twoquay, Inc. and Millennium Dynamics,
             Inc. ("MDI") and American Premier Underwriters ("APU").

  10.34/2/   Registration Rights Agreement dated December 1, 1997 by and among the Registrant and APU.

 *10.35/3/   Employment Agreement dated as of January 20, 1998 between the Registrant and Adarsh Arora.

 *10.36/3/   Employment Agreement dated as of January 19, 1998 between the Registration and Donald Beck.

 *10.37/3/   Promissory Note of Donald Beck payable to the Registrant dated January 30, 1998.

  10.38/3/   License Agreement dated October 25, 1997 between MDI and Chiquita Brands International, Inc.

  10.39/3/   License Agreement dated December 31, 1996 between MDI and Windsor Group.

  10.40/3/   License Agreement dated March 17, 1997 between MDI and Provident Bank.

  10.41/3/   License Agreement dated November 11, 1997 between MDI and Great American Insurance Company.

 *10.42/4/   Employment Agreement dated as of May 18, 1998 between the Company and Richard Wilkie.

 *10.43/4/   Employment Agreement dated as of May 18, 1998 between the Company and Peter Espinosa.
</TABLE> 
<PAGE>
 
<TABLE> 
<S>          <C> 
 *10.44/4/   Promissory Note of Peter Espinosa payable to the Company dated May 29, 1998.

  10.45/4/   Service Agreement dated as of November 18, 1997 by and between the Company and Great American Insurance Company.

  10.46/5/   Employment Agreement dated August 13, 1998 between the Company and John Giordano.

  10.47/5/   Share Purchase Agreement dated July 20, 1998 between the Company and Persist S.A.

 *10.48      Addendum to Employment Agreement dated August 13, 1998 between the Company and John Giordano.

 *10.49      Letter Agreement dated April 9, 1999 between the Company and John Giordano

 *10.50      Letter Agreement dated December 10, 1998 between the Company and Peter Espinosa.

 *10.51      Letter Agreement dated December 1, 1998 between the Company and Donald Beck.      

 *10.52      Separation Agreement and Release dated as of March 30, 1999 between the Company and Peter Espinosa.

  11         Statement regarding computation of earnings per common share.

  21         Subsidiaries of the Registrant.

  23         Consent of PricewaterhouseCoopers LLP

  27.1       Financial Data Schedule for the year ended December 31, 1998
</TABLE> 

(1) Incorporated by reference to Registrant's Registration Statement on Form S-
    1, Commission file number 333-27087.
(2) Incorporated by reference to Registrant's Current Report on Form 8-K dated
    December 16, 1997.
(3) Incorporated by reference to Registrant's Annual Report on Form 10-K dated
    March 31, 1998.
(4) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
    dated August 14, 1998.
(5) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
    dated December 14, 1998.

*Management Contract or compensatory plan or arrangement filed in response to
Item 14(a)(3) of the instructions to the Annual Report on Form 10-K.