<PAGE>
 
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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
                               ----------------
                        AMENDMENT NO. 2 ON FORM 10-K/A
 
                       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, 1997
 
                                      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)
 
<TABLE>
<S>                                            <C>
                MASSACHUSETTS                                    04-3126919
       (STATE OR OTHER JURISDICTION OF                        (I.R.S. EMPLOYER
       INCORPORATION OR ORGANIZATION)                       IDENTIFICATION NO.)
</TABLE>
 
<TABLE>
<S>                                            <C>
 2 FEDERAL STREET, BILLERICA, MASSACHUSETTS                      01821-3540
  (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                       (ZIP CODE)
</TABLE>
 
      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (978) 670-0800
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
 
<TABLE>
<CAPTION>
                                 NAME OF EACH EXCHANGE
             TITLE OF EACH CLASS  ON WHICH REGISTERED
             -------------------  -------------------
<S>                              <C>
  Not applicable                    Not applicable
</TABLE>
 
          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 [_] No [X]
 
  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. [_]
 
  As of March 19, 1998, the aggregate market value of common stock held by
non-affiliates of the registrant was approximately $162,793,651. As of that
date, there were 16,085,325 shares outstanding of the registrant's common
stock, $0.01 par value.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Parts of the definitive Proxy Statement for the Annual Meeting of
Stockholders of the Company held June 10, 1998, which were filed with the
Securities and Exchange commission not later than 120 days after December 31,
1997, are incorporated by reference into Part III of this Annual Report on
Form 10-K.
 
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<PAGE>
 
                         PERITUS SOFTWARE SERVICES INC.
 
                                   FORM 10-K
 
                                 ANNUAL REPORT
 
                               TABLE OF CONTENTS
 
<TABLE>
<CAPTION>
                                                                                                  PAGE
                                                                                                  ----
<S>       <C>                                                                                     <C>
                                                  PART I
Item 1.   Business...............................................................................   3
Item 3.   Legal Proceedings......................................................................  17
                                                  PART II
Item 6.   Selected Consolidated Financial Data...................................................  18
Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations..  19
Item 8.   Financial Statements and Supplementary Data ...........................................  39
                                                  PART IV
Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K........................  68
SIGNATURES......................................................................................   71
</TABLE>
 
  Peritus is a registered trademark, Automate:2000 is a registered service mark
and AutoEnhancer is a trademark of Peritus Software Services, Inc. Vantage
YR2000 is a trademark of Millennium Dynamics, Inc.
 
                                       2
<PAGE>
 
  The Registrant hereby amends its Annual Report on Form 10-K for the fiscal
year ended December 31, 1997, as amended, by replacing Item 1. Business, Item
6. Selected Consolidated Financial Data, Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations, Item 8. Financial
Statements and Supplementary Data, Exhibit 11. Computation of Net Income
(Loss) per share and Unaudited Pro Forma Net Income (Loss) per share, Exhibit
23 Consent of PricewaterhouseCoopers LLP and Exhibit 27.1 Financial Data
Schedule in their entirety as follows.
 
ITEM 1. BUSINESS
 
OVERVIEW
 
  Peritus Software Services, Inc. (the "Company" or "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 is aimed at the industry's most pervasive
mass change challenge, the year 2000 problem. The Company also 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 evolution process.
 
  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 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.
 
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.
 
                                       3
<PAGE>
 
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.
 
  One of the most crucial software evolution challenges currently facing IT
departments is the cost-effective implementation of mass change to application
systems and their associated databases. A mass change software modification
initiative is the process of effecting a change to the way a basic variable is
interpreted and acted upon by a computer program and associated databases in
which the variable may appear or be used thousands, or even millions, of
times. The primary goal of a mass change initiative is to allow organizations
to evolve their applications to accommodate changes in business practices or
conditions by modifying frequently occurring variables without altering or
impacting the underlying logic or function of the program. In large mainframe
computing environments, a typical mass change initiative may involve sorting
through hundreds of millions of lines of code to locate and then correct the
targeted variables. Mass change problems have become more acute for businesses
with the increase in the complexity and volume of computer data, and also have
coupled with the use of disparate IT platforms, operating systems and
languages.
 
  Examples of mass change problems include the year 2000 problem, which is the
inability of certain computer systems to properly interpret dates for the year
2000 and beyond; the European Union's expected conversion to the euro
currency; the anticipated increase in the number of digits in Japan's
telephone numbers; the increase in the number of characters in Australia's
medical account classification codes; and the extension of the number of
digits or other characters in zip codes, product codes for manufactured goods
and account numbers for service providers. Additional mass change needs are
being driven by internationalization and localization requirements, weights
and measures standardization, identity-code changes, mergers and acquisitions
and privatization of government agencies.
 
  Presently, the most pervasive mass change problem is the year 2000 problem,
which will affect IT systems in organizations worldwide. To make mission-
critical applications "year 2000 compliant," organizations will be required to
devote considerable IT resources, including investment in software tools and
processes, personnel, time and other resources, to undertake large-scale mass
change initiatives.
 
  A typical year 2000 renovation project includes: an Assessment Phase, where
an enterprise performs an inventory of its code, analyzes the impact and
exposure of the year 2000 problem on its business and plans the renovation of
the affected code; a Correction Phase, which entails the implementation of
source code renovation, including the identification of all date-sensitive
variables, correction of the code, and generation of bridges and data
converters so the corrected code will still function with non-compliant code,
and verification of the corrected code; and a Testing Phase, which ensures the
integrity of a year 2000 renovation by performing unit and systems tests prior
to re-deploying the code into production. To date, most large organizations
that have begun to address the year 2000 problem have focused on the initial
assessment phase, and a smaller percentage have begun the more critical
correction and testing phases. The Company's AutoEnhancer/2000 software
focuses on the correction phase of a year 2000 renovation project with links
to third-party assessment tools on the front of the process and third-party
testing tools on the back.
 
  To respond to the foregoing challenges in software evolution, many large
organizations are seeking to improve the software evolution process. With the
lack of internal resources to incorporate new and developing technologies,
select and train personnel and develop efficient methodologies to improve IT
applications, many large organizations are seeking ways to outsource their IT
requirements, particularly on a fixed-price, fixed-time frame basis in order
to minimize the risks and costs associated with such large-scale technology
requirements. In addition, industry analysts acknowledge that there is a
growing shortage of IT professionals, which is being exacerbated by the year
2000 problem. These trends have resulted in increased demand for automated
software tools that supplement traditional, mostly manual, maintenance methods
that are often tedious, time-consuming and error-prone.
 
                                       4
<PAGE>
 
  Historically, software development tools have been targeted to address the
front end of the software development cycle--the analysis, design and coding
of an application--rather than on the maintenance or evolution of the
application. Existing tools and processes to address the software evolution
and mass change needs of organizations typically provide limited
functionality, lack a high degree of automation and are not designed to
address the full scope of the maintenance process. In addition, many existing
solutions do not emphasize productivity and do not address the broad range of
requirements needed to manage the software evolution process across
heterogeneous computing environments.
 
  With software evolution becoming an increasing burden in the operation of
mission-critical systems, organizations are actively seeking solutions that:
(i) provide comprehensive software evolution capabilities to accommodate
continually changing business needs; (ii) automate and streamline the software
evolution function; (iii) provide a comprehensive solution to mass change
initiatives, including the year 2000 problem; (iv) are compatible with
multiple platforms, operating systems and programming languages; and (v)
provide measurable productivity gains.
 
PERITUS SOLUTIONS
 
  Peritus offers comprehensive 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
 
  Proven 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.
 
  Comprehensive 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.
 
 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 outsourcing, in which Peritus assumes responsibility for the evolution
of a client's software, and technology
 
                                       5
<PAGE>
 
transfer services, in which Peritus 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. 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.
 
STRATEGY
 
  The Company's objective is to establish leadership in providing tools,
processes and services that significantly increase productivity and quality in
software evolution. The Company's strategy includes the following key
elements:
 
  Establish Leadership in Software Evolution Technology. The Company intends
to continue to develop its core technologies by enhancing its Peritus
Intermediate Language and related technologies in the areas of mass change,
business rules extraction, verification, testing and code analysis. At March
31, 1998, the Company was developing specific versions of its Mass Change
Engine to address mass change market opportunities in addition to the year
2000 problem.
 
  Leverage Year 2000 Opportunities. The Company acquired the MDI business and
has focused a significant portion of its recent research and development
expenditures on enhancing current products and technologies in order to
leverage year 2000 market opportunities. The Company intends to continue
marketing its year 2000 products and services through both direct and indirect
channels. The Company believes that the year 2000 problem has heightened
industry concerns regarding software maintenance. The Company anticipates that
these concerns will serve as a catalyst in helping organizations to view
software maintenance as a dynamic, evolutionary process capable of addressing
mass change problems and enabling organizations to improve the productivity,
effectiveness and quality of their software maintenance. In addition, the
Company intends to leverage the relationships developed through its year 2000
products and services into long-term outsourcing engagements and future mass
change sales opportunities.
 
  Develop Multiple Distribution Channels. The Company currently markets its
products through a combination of direct and indirect channels. The Company
believes that indirect channels are an important part of its distribution
strategy and plans to continue to develop these channels. At March 31, 1998,
the Company had agreements with over 30 value added integrators and
distributors that license its AutoEnhancer/2000 and its Vantage YR2000
software. At March 31, 1998, the Company's value added integrators operated on
a worldwide basis, and its distributors were located in the United States,
Canada, Europe and Japan.
 
  Leverage Existing Client Base. The Company has established strong long-term
client relationships, which often involve multiple contracts over several
years. The Company intends to leverage existing client relationships by cross-
selling other products and services to its clients. For example, the Company
believes that clients that purchase year 2000 products and services will
likely have other mass change and software evolution needs, which the Company
intends to target.
 
                                       6
<PAGE>
 
  Expanded Service Offerings. The Company expanded its service offerings by
introducing insourcing services to organizations interested in retaining the
maintenance function in-house and by continuing to offer outsourcing and
technology transfer services. Through its resources in the United States,
Spain and India, the Company has developed "virtual" outsourcing teams that
provide outsourcing coverage and support 24 hours a day.
 
  Pursue Strategic Opportunities. Although the Company's growth through March
31, 1998 had occurred principally through internally developed products and
services and the MDI acquisition, the Company is pursuing additional strategic
alliances with value added integrators to enhance the scope of the products
and services offered to end users. In addition, the Company believes that the
opportunity exists to expand its products and services through the acquisition
of complementary businesses and technologies. Although at March 31, 1998, the
Company has no commitments or agreements with respect to any such acquisition,
management intends to analyze potential acquisitions and to pursue those
opportunities that complement or supplement its business strategy.
 
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 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 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.
 
  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. The
Company anticipates that certain of its tools may be released as commercial
products in the future. At March 31, 1998, the Company's computer-based tools
included:
 
    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).
 
                                       7
<PAGE>
 
    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.
 
    Peritus Control System ("PCS")--PCS 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.
 
PRODUCTS AND SERVICES
 
  The Company provides solutions consisting of products and services that are
designed to deliver increased productivity through tools, processes, skilled
professionals and methodologies. The Company initially provides clients with
process and methodology before introducing its products and technologies, thus
laying the foundation for the successful use of the Company's products. At
March 31, 1998 the Company's product offering included its AutoEnhancer/2000
and Vantage YR2000 software, and its service offerings included software
maintenance outsourcing, 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.
 
  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.
 
                                       8
<PAGE>

  The following table highlights the various steps in which the
AutoEnhancer/2000 software addresses the correction phase of a year 2000
renovation:
 
                          AUTOENHANCER/2000 SOFTWARE
 
<TABLE>
<CAPTION>
    FUNCTION            FEATURES                          BENEFITS
    --------            --------                          --------
 <C>            <S>                        <C>
 Segmentation   . Load source code into    . EBCDIC to ASCII encoded accurately
                  program                    and recoverably
                . Perform pre-renovation   . Strict source code control
                  compile                    environment established
                . Establish source code    . Source code completeness verified
                  boundary
                . Identify print and       . Source code compliability validated
                  display outputs
                . Perform dataset name     . Data synonyms established
                  unification
 Identification . Convert source code      . Logic of code unraveled for
                  into PIL                   automated analysis
 .              . Perform record name      . Record synonyms established
                  unification
                . Select bridging          . Bridging strategies specified
                  strategies
                . Find the date-           . Date-sensitive variables and
                  sensitive items            constants identified
                  through propagation
                . Resolve ambiguous        . Procedure-division uses of date-
                  conditions                 sensitive items identified
                                           . Accuracy and completeness of
                                             identification verified
                                             identification
 Correction     . Create and apply         . Source code corrected
                  correction
                  transactions
                . Facilitate               . Redefines realigned
                  identification
                  completeness using
                  Adaptive Seed
                  Generator
                . Create and apply         . All identified uses of date-
                  harmonization              sensitive items corrected
                  transactions
                . Resolve correction
                  warnings
 Bridge         . Generate bridge          . Interoperability of renovated and
                  programs by building       unrenovated code established
                  wrappers, filters and
                  converters
 Adaptation     . Identify Job Control     . Date-sensitive JCL identified and
                  Language (JCL) date-       corrections suggested
                  sensitive issues
                . Identify record size
                  changes
                . Create JCL correction
                  plan
 Verification   . Reconcile planned and    . Intended and actual changes
                  implemented                reconciled
                  corrections
                . Perform post-            . Verification to ensure that changes
                  renovation compile and     do not impact compiler results
                  compare to pre-
                  renovation compile
                  results
 Packaging      . Package renovated        . Source code returned to facilitate
                  source code and            replacement and testing
                  generated source code
                  and for return to
                  client
</TABLE>
 
 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
 
                                       9
<PAGE>
 
  .  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.
 
  The Company believes that the use of an automated tool in a conversion
project reduces the project timeframe, the experience levels and number of
people required and the overall project costs, and increases the reliability
of the converted system.
 
  The Vantage YR2000 tools are available as a suite of products or as
individual components depending on the needs of each customer. The Company
provides the toolset and the necessary support and technical training for
clients that wish to control their own conversion project or for those clients
that may use outside consultants for their conversion project. At March 31,
1998, the Vantage YR2000 toolset included products for the IBM mainframe and
AS/400 platforms.
 
  Various components of the client's software and related data files are
analyzed and the Vantage YR2000 tool marks dates in programs and files and
generates an audit trail that identifies the size and complexity of the
project. Using this information, an assessment of resource requirements,
skills, project timelines and costs can be prepared.
 
  The Vantage YR2000 tools automatically identify and change dates in existing
programs and files throughout the client's environment as well as document
those changes. The tools also highlight areas that may require intervention
due to inconsistent naming conventions or other factors that may prevent
automatic date changes and instances where the client may prefer to pursue a
logic approach to code conversion.
 
  Peritus offers extensive training and support to its software licensees
including "quick-start" consulting and training program for Vantage YR2000.
The licensees' renovation engineers participate in both formal and on-the-job
training supported by the Company's expert renovation engineers. This training
and support facilitates successful implementation and deployment of
AutoEnhancer/2000 and/or Vantage YR2000 software in the licensees'
environment. The Company also provides licenses with client technical support
as well as on-site or remote consulting.
 
  The Company licenses its AutoEnhancer/2000 and Vantage YR2000 software
directly and indirectly (via distributors) to end users and to value added
integrators for their use in addressing the year 2000 needs of their clients.
License fees 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 central processing
units (CPUs) licensed, and license fees to value added integrators and
distributors are generally royalties based on lines of code processed or to be
processed or CPUs licensed.
 
 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 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
began to launch a marketing program combining year 2000 renovation and
outsourcing offerings.
 
                                      10
<PAGE>
 
  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.
 
  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 from bases after a detailed
assessment. Benefits are often realized in the first year. In addition, the
Company's outsourcing services are designed to:
 
  .  Re-deploy key resources to mission-critical applications
 
  .  Enhance control of the maintenance function
 
  .  Improve turnaround time and quality of response
 
  .  Reduce dependency on specific individuals and specific domain knowledge
 
  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.
 
  With respect to technology transfer services, the Company targets an
increase in client productivity of up to 25% within six months. Productivity
gains are measured against pre-determined metrics that are established during
a detailed upfront assessment of the client's applications and workflow. A
typical technology transfer engagement consists of training multiple teams of
client personnel in the Company's methodology. Engagements have a duration of
four to six months with approximately 14 days of on-site delivery and
coaching.
 
  During 1997, the Company introduced 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.
 
SALES AND MARKETING
 
  The Company offers its products and services to clients through both direct
and indirect channels, which include relationships with value added
integrators that use the Company's technology as an integral part of their
overall solutions, as well as domestic and international distributors.
 
 Direct Sales
 
  The Company sells and supports its products and services directly through
its regional sales force located in the Northeast, Southeast, Central and West
areas of the United States.
 
                                      11
<PAGE>
 
 Indirect Sales
 
  At March 31, 1998, the Company had agreements with over 30 value added
integrators and distributors. The Company's value added integrators include
large systems integrators, IT consulting organizations and other providers of
IT services and solutions that use the Company's AutoEnhancer/2000 and/or
Vantage YR2000 software to perform year 2000 renovation projects for their
clients. The Company regularly offers sales training to its value added
integrators. At March 31, 1998 the Company's distributors were located in the
United States, Canada, Europe and Japan and were authorized by Peritus to
sublicense the Company's products and/or services to end users or system
integrators or distributors their respective territories.
 
 Marketing
 
  The Company's marketing organization works 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 1997, the Company began "Powered by Peritus," a new marketing and
advertising campaign. It comprises several programs, including a direct mail
initiative aimed at potential year 2000 end-user licensees, new channel
candidates and outsourcing prospects. In 1998, the Company began to launch its
marketing campaigns covering its combined year 2000 renovation and outsourcing
service offering and combined Auto Enhancer/2000 and Vantage YR 2000 product
offering. 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 number of
industries. Below is a partial list of the Company's clients at March 31, 1998
from industries including insurance, financial services, telecommunications,
transportation, utilities and manufacturing.
 
Advanced Micro Devices, Inc.           Metropolitan Life Insurance Company
Bell Communications Research, Inc.     ("Met Life")
Bull HN Information Systems Inc.       MicroAge Computer Center, Inc.
 ("Bull")                              Microcom, Inc.
Computervision Corporation             Bell Atlantic
 ("Computervision")                    Prudential Life Insurance
BankBoston Corporation
Lucent Technologies
Merrill Lynch, Pierce, Fenner & Smith
 Incorporated ("Merrill Lynch")
 
  To date, the Company's revenue has been dependent on a few major clients,
including Bull, Stratus Computer, Inc. ("Stratus"), Computervision, Met Life,
IBM Global Services ("IBM") and Merrill Lynch. 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. During 1995, Bull, Stratus and Computervision
represented approximately 50.3%, 12.9% and 11.0% of the Company's total
revenue, respectively. During 1994, Bull and Computervision represented
approximately 51.7% and 29.3% of the Company's total revenue, respectively. In
addition, the Company's ten largest clients represented approximately 63.8%,
77.9% and 90.5% and of the Company's total revenue in the years ended December
31, 1997, 1996 and 1995, respectively.
 
  The Company has entered into agreements to provide software consulting
services and software maintenance services with each of Computervision,
Stratus and Bull. These agreements expire, subject to extension, on December
31, 2000, June 6, 1998 and December 31, 1999, respectively. The agreement with
Stratus has not been extended.
 
                                      12
<PAGE>
 
  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 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.
 
  While each client engagement differs, the following examples illustrate the
types of business needs the Company has addressed:
 
  Merrill Lynch--AutoEnhancer/2000 Licensee. Merrill Lynch, a global financial
services concern, evaluated the Company's AutoEnhancer/2000 software in 1996
as part of its process of developing a comprehensive solution to its year 2000
renovation efforts. Along with a number of other vendors, Peritus was invited
to conduct two pilot programs, which were designed to demonstrate the tool's
ability to automate the identification and correction tasks of a year 2000
conversion. In December 1996, Merrill Lynch entered into a direct end-user
license for the AutoEnhancer/2000 software to support its data expansion
renovation efforts. Merrill Lynch notified the Company that the tool was among
those selected based upon the accuracy of its identification function and the
level of automation provided. Merrill Lynch has established a renovation
center in New York that provides divisions with remote access to perform the
renovations, and Peritus has trained more than 35 of Merrill Lynch's
renovation engineers.
 
  Computer Sciences Corp.--AutoEnhancer/2000 Value Added Integrator. Computer
Sciences Corp. ("CSC"), an international provider of IT services, provides a
dedicated national practice that addresses the year 2000 problem. CSC's
Catalyst 2000(R) service includes a renovation center designed to process
large amounts of code through the correction phase. To achieve the desired
throughput, the CSC renovation center sought tools that would automate the
process. After evaluating several tools and technologies, CSC chose the
Company's AutoEnhancer/2000 software for its center and signed a strategic
agreement that provided for a usage-based license. Since the initiation of the
agreement, Peritus has trained CSC renovation engineers to work with the
Peritus technology in this renovation center.
 
  Bell Atlantic--Outsourcing Engagement. In mid-1995, NYNEX began exploring
ways to reduce costs and improve the process of maintaining its IT
applications. Peritus was invited to bid on an outsourcing engagement that
involved the maintenance of a budget and planning application. After a
competitive process, NYNEX awarded the contract to Peritus for a number of
reasons, including the fixed-price nature of the bid and the commitment to
improved productivity. In April 1996, NYNEX extended the contract to include
additional applications.
 
  Fina Oil and Chemical--Vantage YR2000 Licensee. In 1996, Fina Oil and
Chemical ("Fina"), a large petroleum and chemical company, conducted an impact
analysis of its year 2000 problem and began to review the options available to
address the problem in April of that year. MDI conducted a pilot program for
Fina later in the year after which Fina licensed the Vantage YR2000 tools.
Fina set up an internal factory in early 1997 to begin renovating its code and
had completed renovating over 1.5 million lines of code by the end of 1997.
 
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
 
                                      13
<PAGE>
 
released during maintenance. The Company believes that a high level of service
and support is critical to its success and represents an important competitive
advantage. Furthermore, the Company believes that a close and active service
and support relationship is important to client satisfaction and provides the
Company with important information regarding evolving client requirements. The
Company provides each of its significant clients with a dedicated 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
 
  The Company believes that its future success depends in large part on its
ability to maintain and enhance its current product line, develop new
products, maintain technological competitiveness and meet an expanding range
of client requirements. The Company plans to continue to enhance its products
and develop or acquire new products, including the development of new versions
of its mass change software and the commercialization of its internally used
outsourcing tools and methodologies. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations" for a description of
research and development expenses incurred from 1995 through 1997.
 
  The Company had research and development facilities in Lisle, Illinois,
Cincinnati, Ohio and Nashua, NH as well as at the Company's Billerica,
Massachusetts headquarters in 1998. In January 1997, the Company began
research and development activities 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. In January 1996, the Company
acquired Vista Technologies Incorporated ("Vista") to gain additional
technologies in user interface and software behavior modeling. In December
1997, the Company acquired additional year 2000 technology in connection with
the MDI acquisition.
 
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 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.
 
  The Company provides year 2000 services primarily through its relationships
with value added integrators. Peritus believes that these value added
integrators 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
 
                                      14
<PAGE>
 
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 Big Six 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 and distributors. 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 and distributors will compete effectively with those of their
respective competitors. 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 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 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 and distributors 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 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
 
                                      15
<PAGE>
 
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 pertaining to technologies, processes and methodologies
used by the Company's software. One of these patents has been granted and
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. 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 February 28, 1998, the Company employed 453 full-time employees,
including 124 in research and development, 52 in sales and marketing, 244 in
professional services and support and 33 in finance, administration and
corporate support. The success of the Company depends on its continued ability
to attract and retain 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.
 
 
                                      16
<PAGE>
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company and certain of its officers and directors have been 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 Downey complaint alleges a class period of October 22,
1997 to March 27, 1998. The Cohen, Bonnett, Wijntjes and Lee complaints allege
a class period of January 27, 1998 to March 27, 1998. The Lindsay, Teague and
Johnson complaints allege a class period of January 28, 1998 to March 27,
1998. The Howard complaint alleges a class period of July 3, 1997 to March 27,
1998. The complaints principally allege 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 alleges 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 names Montgomery Securities, Inc., Wessels, Arnold &
Henderson, and H.C. Wainwright & Co., Inc. as defendants. The complaints
further allege that certain officers and/or directors of the Company sold
stock in the open market during the class periods and seek 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. Although the Company believes that it and the other defendants
have meritorious defenses to the claims made in the complaints and intends to
contest the lawsuits vigorously, an adverse resolution of the lawsuits 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 complaints.
 
 
                                      17
<PAGE>
 
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
 
  The selected consolidated financial data set forth below as of December 31,
1997 and 1996, and for the three years ended December 31, 1997, are derived
from the Company's Consolidated Financial Statements, which appear elsewhere
in this Annual Report and which have been audited by PricewaterhouseCoopers
LLP, independent accountants. The selected financial data set forth below as
of December 31, 1995 and 1994 and for the year ended December 31, 1994 are
derived from the Company's audited financial statements, which are not
included in this Annual Report. The selected financial data as of and for the
year ended December 31, 1993 is derived from the Company's unaudited financial
statements, which are not included in this Annual Report. In the opinion of
management, the unaudited financial statements have been prepared on a basis
consistent with the Consolidated Financial Statements which appear elsewhere
in this Annual Report and include all adjustments, consisting only of normal
recurring adjustments, necessary for a fair statement of the financial
position and results of operations for this unaudited period. 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,
                                      ------------------------------------------
                                       1997*     1996     1995     1994    1993
                                      --------  -------  -------  ------  ------
                                      (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                   <C>       <C>      <C>      <C>     <C>
STATEMENT OF OPERATIONS DATA:
Revenue:
 Outsourcing services...............  $ 11,447  $10,190  $16,400  $7,130  $1,798
 License............................    21,255    6,526      --      --      --
 Other services.....................     7,007    2,519    2,105     742     433
                                      --------  -------  -------  ------  ------
   Total revenue(1).................  $ 39,709   19,235   18,505   7,872   2,231
                                      --------  -------  -------  ------  ------
Cost of revenue:
 Cost of outsourcing services.......     9,536    8,488    9,602   4,700     841
 Cost of license....................       690      162      --      --      --
 Cost of other services.............     5,357    2,931    2,421     319     306
                                      --------  -------  -------  ------  ------
   Total cost of revenue............    15,583   11,581   12,023   5,019   1,147
                                      --------  -------  -------  ------  ------
Gross profit........................    24,126    7,654    6,482   2,853   1,084
                                      --------  -------  -------  ------  ------
OPERATING EXPENSES:
Sales and marketing.................     8,864    3,116    2,129     366     265
Research and development............     8,324    6,033    1,703     560     196
General and administrative..........     4,312    3,249    2,357   1,283     428
Write-off of acquired in-process
 research and development...........    70,800      --       --      --      --
                                      --------  -------  -------  ------  ------
   Total operating expenses.........    92,300   12,398    6,189   2,209     889
                                      --------  -------  -------  ------  ------
Income (loss) from operations.......   (68,174)  (4,744)     293     644     195
Interest income (expense), net......       948     (296)    (203)    (63)    --
                                      --------  -------  -------  ------  ------
Income (loss) before income taxes,
 minority interest and equity in
 loss of less than majority-owned
 company............................   (67,226)  (5,040)      90     581     195
Provision (benefit) for estimated
 income taxes.......................       260     (143)      (8)    179       7
                                      --------  -------  -------  ------  ------
Income (loss) before minority
 interest and equity in loss of less
 than majority-owned company........   (67,486)  (4,897)      98     402     188
Minority interest in consolidated
 subsidiary.........................         4       24       43     --      --
Equity in loss of less than
 majority-owned company.............       --       --       --       97     --
                                      --------  -------  -------  ------  ------
Net income (loss)...................  $(67,490) $(4,921) $    55  $  305  $  188
                                      ========  =======  =======  ======  ======
Net income (loss) per share:(2)
 Basic..............................  $  (7.03) $ (1.02) $  0.01  $ 0.06  $ 0.04
                                      ========  =======  =======  ======  ======
 Diluted............................  $  (7.03) $ (1.02) $  0.01  $ 0.05  $ 0.03
                                      ========  =======  =======  ======  ======
Weighted average shares
 outstanding:(2)
 Basic..............................     9,708    5,876    5,078   4,950   4,866
                                      ========  =======  =======  ======  ======
 Diluted............................     9,708    5,876    6,456   5,873   5,673
                                      ========  =======  =======  ======  ======
Pro forma basic and diluted net loss
 per share (unaudited)..............  $  (5.83) $ (0.67)
                                      ========  =======
Pro forma basic and diluted average
 shares outstanding (unaudited).....    11,574    7,394
                                      ========  =======
</TABLE>
 
                                      18
<PAGE>
 
<TABLE>
<CAPTION>
                                                DECEMBER 31,
                                   ------------------------------------------
                                    1997*     1996     1995    1994    1993
                                   -------  --------  ------  ------  -------
                                               (IN THOUSANDS)
<S>                                <C>      <C>       <C>     <C>     <C>
BALANCE SHEET DATA:
Cash and cash equivalents......... $11,340   $ 7,388  $  264  $  339  $     2
Short-term investments............   3,000       --      --      --       --
Working capital...................  20,931     8,218   2,218   1,267      338
Total assets......................  39,870    17,725   7,179   2,924    1,075
Long-term debt, net of current
 portion..........................     413     1,538   1,792     777      491
Redeemable stock..................     --     12,287     --      --       --
Stockholders' equity (deficit)....  30,005    (3,302)  1,802     867      498
</TABLE>
--------
 * Restated--See Note 16 to Consolidated Financial Statements
 
(1) Revenue (in thousands) from related parties in the years ended December
    31, 1997, 1996, 1995, 1994 and 1993 was $4,478, $6,443, $10,114, $4,317
    and $824, 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
acquisition of MDI 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 following unaudited pro forma basic and
diluted net loss per share data 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 (see Note 2 to the
consolidated financial statements) and assumes the 2,175,000 shares issued in
connection with the acquisition were outstanding for the entire periods
presented.
 
<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)     $ (0.21)     $ (1.02)     $ (0.59)
  Diluted..................      $ (7.03)     $ (0.21)     $ (1.02)     $ (0.59)
</TABLE>
--------
* Restated--See Note 16 to the Consolidated Financial Statements
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
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
 
                                      19
<PAGE>
 
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.
 
  In 1997, the Company derived 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
distributors, and its clients included primarily Fortune 1000 companies and
similarly sized business and government organizations worldwide. The Company's
products and services are marketed through its direct sales force, both
domestically and in Spain, through value added integrators operating worldwide
and through international distributors in Canada, Europe and Japan.
 
  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 plans 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-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 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.
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.
 
 Restatement of 1997 Results of Operations
 
  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, the Company determined that the Company's results of operations for the
year ended December 31, 1997 required restatement. The restatement 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 has restated its 1997
results to remove the $592,000 of revenue involved and has not recorded this
revenue in any subsequent period.
 
                                      20
<PAGE>
 
  In the opinion of management, all adjustments necessary to revise the 1997
financial statements have been recorded. Below is a summary of the results of
operations for the year ended December 31, 1997 (in thousands, except per
share-related data):
 
<TABLE>
<CAPTION>
                                                                     YEAR ENDED
                                                                    DECEMBER 31,
                                                                        1997
                                                                    ------------
   <S>                                                              <C>
   As previously reported:
     Revenues......................................................   $ 40,301
     Loss from operations..........................................    (67,582)
     Net loss......................................................    (66,910)
     Basic and diluted net loss per share..........................   $  (6.97)
   As restated:
     Revenue.......................................................   $ 39,709
     Loss from operations..........................................    (68,174)
     Net loss......................................................    (67,490)
     Basic and diluted net loss per share..........................   $  (7.03)
</TABLE>
 
 Revenue Recognition Policies
 
  The Company's outsourcing services are generally offered under multi-year,
fixed-price, fixed-time frame contracts. In connection with the delivery of
its outsourcing services, the Company assesses a client's IT costs and agrees
to provide services at a price generally below the internal costs of the
client. Revenue under these 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. Because the labor-hours associated with
the Company's outsourcing services are typically higher in the early phases of
the contract, revenue is also typically higher in such phases and declines
over the term of the contract. Under the percentage-of-completion method, the
Company updates on a quarterly basis its completion estimates of each contract
to reflect changes in projected completion costs or dates. The cumulative
impact of any revision in estimates is reflected in each quarterly financial
reporting period in which the change in the estimate becomes known. When the
revised estimates indicate a loss on the contract, such loss is provided for
currently in its entirety. As the Company bears the risk of cost overruns and
inflation associated with multi-year, fixed-price, fixed-time frame contracts,
the Company's operating results may be adversely affected by inaccurate
estimates of contract completion costs and dates. These contracts may be
revised by the Company and the client when a significant change in the scope
or cost of a project arises that neither the Company nor the client had
anticipated. These contracts 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.
 
  The Company licenses its software products and methodologies directly and
indirectly (via distributors) 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. Revenue from end-user licenses is
recognized when software and methodologies have been delivered to the end
user, all significant contractual obligations have been met and collection of
the related receivable is probable. License fees charged to value added
integrators and distributors are generally royalties based on lines of code
processed or to be processed or number of CPUs licensed. Revenue derived from
these usage-based or CPU licenses is recognized when licensed software has
been delivered, the fee is fixed or determinable, all significant contractual
obligations have been met and collection of the related receivable is
probable.
 
  Other services provided by the Company include technology transfer
engagements, product training, value added integrator and distributor sales
training, consulting services and software product maintenance. Other services
also include direct delivery contracts, in which the Company provides full
year 2000 renovations and pilot year 2000 renovations for clients using the
Company's AutoEnhancer/2000 and/or Vantage YR2000
 
                                      21
<PAGE>
 
software. Pilot projects are generally priced to the client at the Company's
estimated cost of providing such services. Revenue from direct delivery
contracts is recognized over the duration of such contracts as work is
performed and defined milestones are attained. Any estimated losses on direct
delivery contracts are recorded in their entirety in the period in which they
become known. Revenue from technology transfer engagements, 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 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.
 
 Client Concentration
 
  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 accounted for 29.0%, 14.6% and 12.1% of the Company's total
revenue. During 1995, revenue from three clients accounted for 50.3%, 12.9%
and 11.0% of the Company's total revenue. The largest client in both 1996 and
1995 was a related party of the Company. See Note 9 of Notes to the Company's
Consolidated Financial Statements. The Company's ten largest clients in the
year ended December 31, 1997, 1996 and 1995 accounted for approximately 63.8%,
77.9% and 90.5% of the Company's total revenue, respectively. The Company
anticipates that this concentration of clients as a percentage of the
Company's total revenue will diminish in the future but that the Company will
continue to depend to a significant extent upon revenue from a small number of
clients. In 1997, approximately fifty percent, and, in 1996 and 1995
substantially all, of the Company's international revenue has been
attributable to revenue generated by Persist.
 
                                      22
<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,
                                                        ----------------------
                                                        1997*    1996    1995
                                                        ------   -----   -----
<S>                                                     <C>      <C>     <C>
Revenue:
  Outsourcing services................................    28.8%   53.0%   88.6%
  License.............................................    53.5    33.9     --
  Other services......................................    17.7    13.1    11.4
                                                        ------   -----   -----
    Total revenue(1)..................................   100.0   100.0   100.0
                                                        ------   -----   -----
Cost of revenue:
  Cost of outsourcing services........................    24.0    44.1    51.9
  Cost of license.....................................     1.7     0.8     --
  Cost of other services..............................    13.5    15.3    13.1
                                                        ------   -----   -----
    Total cost of revenue.............................    39.2    60.2    65.0
                                                        ------   -----   -----
Gross profit..........................................    60.8    39.8    35.0
                                                        ------   -----   -----
Operating expenses:
  Sales and marketing.................................    22.3    16.2    11.5
  Research and development............................    21.0    31.4     9.2
  General and administrative..........................    10.9    16.9    12.7
  Write-off of acquired in-process research and
   development........................................   178.3     --      --
                                                        ------   -----   -----
    Total operating expenses..........................   232.5    64.5    33.4
                                                        ------   -----   -----
Income (loss) from operations.........................  (171.7)  (24.7)    1.6
Interest income (expense), net........................     2.4    (1.5)   (1.1)
                                                        ------   -----   -----
Income (loss) before income taxes and minority
 interest in consolidated subsidiary..................  (169.3)  (26.2)    0.5
Provision (benefit) for estimated income taxes........     0.7    (0.7)    --
                                                        ------   -----   -----
Income (loss) before minority interest in consolidated
 subsidiary...........................................  (170.0)  (25.5)    0.5
Minority interest in consolidated subsidiary..........     --     (0.1)   (0.2)
                                                        ------   -----   -----
    Net income (loss).................................  (170.0)% (25.6)%   0.3%
                                                        ======   =====   =====
</TABLE>
--------
*  Restated--See Note 16 to the Consolidated Financial Statements.
 
(1) Revenue from related parties in the years ended December 31, 1997, 1996
    and 1995 represented 11.3%, 33.5% and 54.7% of total revenue,
    respectively.
 
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
 
                                      23
<PAGE>
 
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. 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 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 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 $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.
 
  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
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 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 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,
 
                                      24
<PAGE>
 
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 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 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 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 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 and other Intangible Assets. As discussed
in Note 3 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. In addition, the Company recorded intangible assets of
$5,503,000, which included approximately $4,800,000 of developed technology.
The amounts allocated to intangible assets are being amortized on a straight-
line basis over their expected useful lives of five years. 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 failure 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-progress research and development. A response
to the Company's letter has not yet been received from the SEC. 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.
 
  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
 
                                      25
<PAGE>
 
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. The Company has provided a valuation
allowance for the full amount of the net deferred tax assets, since the
realization of these future benefits was not sufficiently assured. If the
Company achieves profitability, these deferred tax assets may be available to
offset future income tax liabilities and expense.
 
  Minority Interest in Consolidated Subsidiary. The minority interest in
consolidated 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
consolidated subsidiary decreased to a loss of $4,000 in the year ended
December 31, 1997 from a loss of $24,000 in the year ended December 31, 1996.
This change was the result of the increased profitability of Persist. At
December 31,1997 and 1996, the Company held a 63.0% equity interest in
Persist.
 
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
 
 Revenue
 
  Total revenue increased 3.9% to $19,235,000 in 1996 from $18,505,000 in
1995. This increase was primarily due to the initial licensing of the
Company's AutoEnhancer/2000 software in 1996, as well as from an increase in
other services revenue, which was offset by a significant decrease in
outsourcing services revenue. International revenue increased 66.8% to
$1,800,000 in 1996 from $1,079,000 in 1995. As a percentage of total revenue,
international revenue increased to 9.4% in 1996 from 5.8% in 1995.
Substantially all of the Company's international revenue during 1995 and 1996
was attributable to revenue generated by Persist.
 
  Outsourcing Services. Outsourcing services revenue decreased 37.9% to
$10,190,000 in 1996 from $16,400,000 in 1995. As a percentage of total
revenue, outsourcing services revenue decreased to 53.0% in 1996 from 88.6% in
1995. The decrease in outsourcing services revenue was primarily attributable
to the recognition of lesser amounts of revenue under the percentage-of-
completion method on two significant contracts that were in their later
phases. In addition, as the Company began to focus more of its efforts in 1996
on the licensing of its AutoEnhancer/2000 software, the Company did not add a
sufficient number of new outsourcing contracts to offset this decline in
outsourcing services revenue.
 
  License. License revenue was $6,526,000 in 1996, or 33.9% of total revenue.
License revenue was generated in 1996 from the introduction of the Company's
AutoEnhancer/2000 software and was primarily attributable to three licenses,
one of which was with a related party.
 
  Other Services. Other services revenue increased 19.7% to $2,519,000 in 1996
from $2,105,000 in 1995. As a percentage of total revenue, other services
revenue increased to 13.1% in 1996 from 11.4% in 1995. The increase in other
services revenue was primarily attributable to an increase in technology
transfer revenue as well as the introduction of consulting and product
training services for the Company's AutoEnhancer/2000 software. These
increases were partially offset by a decrease in direct delivery services for
one significant pilot year 2000 renovation.
 
 Cost of Revenue
 
  Cost of Outsourcing Services Revenue. Cost of outsourcing services revenue
decreased 11.6% to $8,488,000 in 1996 from $9,602,000 in 1995. Cost of
outsourcing services revenue increased as a percentage of outsourcing services
revenue to 83.3% in 1996 from 58.5% in 1995. Although cost of outsourcing
services revenue declined in absolute dollars from 1995 to 1996, the decline
did not keep pace with the decreases in outsourcing services revenue. The
increase in cost of outsourcing services revenue as a percentage of
outsourcing services revenue was due primarily to the underutilization of
personnel resulting from the lack of significant new
 
                                      26
<PAGE>
 
outsourcing contracts in 1996, and, to a lesser extent, to cost overruns
associated with a significant contract. In the third and fourth quarters of
1996, the Company re-deployed resources dedicated to outsourcing services from
the delivery of those services to client support, consulting support and
research and development.
 
  Cost of License Revenue. Cost of license revenue was $162,000 in 1996, or
2.5% of license revenue. There was no cost of license revenue in 1995. These
costs were attributable to the introduction of the Company's AutoEnhancer/2000
software.
 
  Cost of Other Services Revenue. Cost of other services revenue increased
21.1% to $2,931,000 in 1996 from $2,421,000 in 1995. Cost of other services
revenue also increased as a percentage of other services revenue to 116.4% in
1996 from 115.0% in 1995. Costs exceeded revenue in both years as a result of
expected cost overruns for one significant pilot direct delivery client, which
subsequently became a product licensee, as well as the increase in staffing of
both client support and product training in anticipation of future revenue.
 
 Operating Expenses
 
  Sales and Marketing. Sales and marketing expenses increased 46.4% to
$3,116,000 in 1996 from $2,129,000 in 1995. As a percentage of total revenue,
sales and marketing expenses increased to 16.2% in 1996 from 11.5% in 1995.
The increase in sales and marketing expenses during 1996 was primarily
attributable to increased staffing, commissions, including an increase of
approximately $350,000 in sales referral fees to third parties, and
promotional activities in conjunction with the launch of the Company's
AutoEnhancer/2000 software, as well as increased staffing to build third-party
channels for the Company's products and services.
 
 Research and Development. Research and development expenses increased 254.3%
to $6,033,000 in 1996 from $1,703,000 in 1995. As a percentage of total
revenue, research and development expenses increased to 31.4% in 1996 from
9.2% in 1995. The increase in research and development expenses was primarily
attributable to significant product development efforts relating to the
Company's year 2000 products and services and mass change technologies,
including an increase in staffing effected through new hires, the acquisition
of Vista in January 1996 and internal transfers. At December 31, 1996, there
were 59 full-time employees in research and development compared to 17 at
December 31, 1995.
 
  General and Administrative. General and administrative expenses increased
37.8% to $3,249,000 in 1996 from $2,357,000 in 1995. As a percentage of total
revenue, general and administrative expenses increased to 16.9% in 1996 from
12.7% in 1995. The increase in general and administrative expenses was
primarily due to additions to the Company's administrative staff to support
growth, higher professional fees and increases in other general corporate
expenses.
 
  Interest Income (Expense), Net. Interest expense, net, increased 45.8% to
$296,000 in 1996 from $203,000 for 1995. The increase was primarily
attributable to increased average borrowings by the Company.
 
  Provision (Benefit) for Income Taxes. The Company's benefit for estimated
income taxes increased to $143,000 in 1996 from $8,000 in 1995. The increase
was the result of an increase in gross deferred tax assets, caused primarily
by additional net operating loss carryforwards and tax credit carryforwards,
which resulted in the reversal of the net deferred tax liability recorded as
of December 31, 1995.
 
  Minority Interest in Consolidated Subsidiary. The minority interest in
consolidated subsidiary decreased 44.2% to $24,000 in 1996 from $43,000 in
1995. The decrease was the result of the decreased profitability of Persist,
partially offset by a decrease in the Company's equity interest in Persist. At
December 31, 1996, the Company held a 63.7% equity interest in Persist
compared to a 69.5% equity interest at December 31, 1995.
 
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
 
                                      27
<PAGE>
 
from clients and internally generated cash flows. The Company's cash balances
were $11,340,000 and $7,388,000 at December 31, 1997 and 1996, respectively.
The Company's working capital was $20,931,000 and $8,218,000, at December 31,
1997 and 1996, 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 research and development, working
capital and general corporate purposes.
 
  The Company's operating activities provided cash of $226,000 and used cash
of $2,342,000 during the years ended December 31, 1997 and 1996, respectively.
The Company's generation of cash during the year ended December 31, 1997 was
primarily caused by net income of $3,310,000 (excluding the non-cash write-off
of acquired in process research and development of $70,800,000) plus non-cash
depreciation and amortization expense of $1,327,000, a decrease in unbilled
license revenue from related parties of $1,400,000 and an increase in accrued
expenses and other liabilities of $885,000. These increases were partially
offset by an increase in accounts receivable of $6,193,000.
 
  The Company used cash of $36,368,000 and $1,059,000 for investing activities
during the years ended December 31, 1997 and 1996, respectively. Investing
activities in 1997 consisted principally of the MDI acquisition and purchases
of short-term investments and property and equipment, most notably computer
equipment and software to support the growing employee base and corporate
infrastructure. Although the Company has no significant commitments for
capital expenditures in 1998, the Company expects to continue to purchase
property and equipment to further develop its infrastructure.
 
  The Company's financing activities provided cash of $40,158,000 and
$10,555,000 during the years ended December 31, 1997 and 1996, respectively.
As discussed above, the 1997 period includes the net proceeds of the Company's
initial public offering. In March 1996, the Company raised aggregate net
proceeds of $5,408,000 in private placements of the Company's convertible
preferred stock and common stock. Net proceeds from the sales of such shares
were used for the Company's general working capital needs, to make scheduled
debt payments and for treasury stock acquisitions.
 
  In May 1995, the Company issued a secured subordinated note payable for
$924,000 with a face value of $1,000,000 and interest payable at 10% per
annum. The note is subordinate to any bank debt and is collateralized by a
second security interest in all of the assets of the Company. In addition, the
note carries a prepayment premium and contains various restrictive covenants
including, but not limited to, minimum earnings and limitations on certain
interest coverage, debt and equity ratios. The note also included warrants
with an ascribed value of $76,000 for the purchase of up to 312,500 shares of
common stock for $1.60 per share. These warrants were exercised in July 1997.
In July 1997, the Company used a portion of the net proceeds from the exercise
of the detachable warrants and the initial public offering to repay the note
in full.
 
  In September 1996, the Company obtained a revolving line of credit facility
from a bank which bears interest at the bank's prime rate plus 0.5% (9.0% at
December 31, 1997). The maximum borrowing under this line of credit is
$3,500,000 and is limited to 75% of certain receivables plus 50% of costs and
estimated earnings in excess of billings on uncompleted contracts, as defined
by the line of credit agreement. The line of credit, which was extended on
June 20, 1997, expires and all borrowings are payable in full on June 30,
1998. 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 June 30, 1997. Ratable principal and
interest payments are payable during the period July 1, 1997 through June 1,
2000, and bear interest at the bank's prime rate plus 1% (9.5% at December 31,
1997). In November 1997, the bank agreed to amend certain financial covenants
in connection with the MDI acquisition. Both of these agreements require the
Company to comply with certain financial covenants and are secured by all of
the assets of the Company. As of December 31, 1997, there were no
 
                                      28
<PAGE>
 
borrowings outstanding, and $3,500,000 remained available, under the revolving
credit facility and $561,000 was outstanding under the equipment financing
agreement.
 
  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.
 
  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, 1997 and the nine months ended September 30, 1998 and
anticipates a net loss in the fourth quarter of 1998, which raise doubt about
its ability to continue as a going concern after 1998. The Company believes
that it has sufficient cash to finance its operations through 1998.
Thereafter, the Company's cash flow requirements will depend on the results of
future operations. There can be no assurance that these expectations will be
realized. After 1998, 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 implemented a restructuring plan on December
2, 1998 to further reduce its expenses which included the elimination of
approximately 45 employees and related facilities costs. The Company is also
exploring strategic initiatives to raise additional funds. In addition, the
Nasdaq Stock Market, Inc. has several requirements for listing on the Nasdaq
National Market or the Nasdaq SmallCap Market. Failure to meet listing
requirements may result in the Company being moved from the National Market to
the SmallCap market or being delisted. There can be no assurance that the
Company will not be de-listed.
 
  The Company's bank has indicated that it will not renew or further extend
its revolving line of credit facility and demanded that cash collateral be
provided for all amounts outstanding under its equipment financing agreement
with the Company since the Company was in default of certain financial and
operating covenants thereunder. There are no amounts outstanding under the
revolving credit facility and the Company has provided cash collateral for all
amounts outstanding under the equipment financing agreement and for a $300,000
standby letter of credit issued by the bank. There can be no assurance that
the Company will achieve a cash flow breakeven position or that it will be
able to raise additional funds through bank borrowings and/or debt and/or
equity financings.
 
  Reductions in expenses on the sale of assets may no 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 of 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
would adversely impact the Company's ability to continue as a going concern
after 1999.
 
  The Company began an assessment of certain of its internal computer hardware
and software in connection with the year 2000 problem and expects to complete
its assessment of such hardware and software in 1998. The Company expects that
its business systems installed in 1997 will be year 2000 compliant through
upgrades and maintenance thereto. The Company expects that costs related to
providing that its internal computer hardware and software will be year 2000
compliant will not be material to the financial condition or results of
operations of the Company and are not expected to be significant.
 
  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 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
may have a material adverse effect on the Company's business, financial
condition and results of operations. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Factors That May Affect
Future Results--Potential for Contract Liability" and "Software Errors or
Bugs."
 
                                      29
<PAGE>
 
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.
 
ACCOUNTING PRONOUNCEMENTS
 
  In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, "Reporting Comprehensive Income." This statement establishes
standards for the reporting and display of comprehensive income and its
components. Comprehensive income is defined as the change in equity of a
business enterprise during a period from transactions and other events and
circumstances from non-owner sources. It includes all changes in equity during
a period except those resulting from investments by owners and distributions
to owners. This standard will require that an enterprise display an amount
representing total comprehensive income for the period. SFAS No. 130 will be
effective for the Company's year ending December 31, 1998. Adoption of SFAS
No. 130 is for presentation only and will not affect the Company's financial
position or results of operations.
 
  In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information" which supersedes SFAS No. 14. This
statement changes the way that public business enterprises report segment
information, including financial and descriptive information about their
selected segment information. Operating segments are defined as revenue-
producing components of the enterprise which are generally used internally for
evaluating segment performance. SFAS No. 131 will be effective for the
Company's year ending December 31, 1998 and will not affect the Company's
financial position or results of operations.
 
  In October 1997, the Accounting Standards Executive Committee ("AcSEC") of
the American Institute of Certified Public Accountants 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 is effective for transactions entered into
during fiscal years beginning after December 15, 1997. On March 18, 1998, the
FASB cleared a new SOP that provides for the one-year deferral of certain
provisions of SOP 97-2 pertaining to its requirements for what constitutes
vendor specific evidence of the fair value of multiple elements included in an
arrangement. It is AcSEC's intention to immediately begin a project to
consider whether guidance is needed on any restrictions that should be placed
on what constitutes evidence of fair value and, if so, what the guidance
should be. Because of the uncertainties with respect to the outcome of any
such project, the Company believes that the impact of the deferred provisions
of SOP 97-2 on its financial position or results of operations upon expiration
of the one-year deferral period is not currently determinable. However, the
Company believes that those provisions of SOP 97-2 that have not been
deferred, and therefore are applicable commencing January 1, 1998, will not
materially affect its financial position or results of operations.
 
  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.
 
FACTORS THAT MAY AFFECT FUTURE RESULTS
 
  From time to time, information provided by the Company 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.
 
                                      30
<PAGE>
 
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 Form 10-K may contain forward looking statements which involve risks
and uncertainties. The Company'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 following:
 
 Limited Operating History
 
  The Company was founded in August 1991 and began operations in 1992. Most of
the Company's revenue to date has been attributable to software maintenance
outsourcing and other services, and the Company had no license revenue prior
to 1996. The Company's software maintenance AutoEnhancer/2000 and VANTAGE
YR 2000 software, which the Company anticipates will provide the principal
source of new license revenue for the foreseeable future, 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. 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.
 
 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. In
addition, as the Company begins to derive a greater proportion of total
revenue from license revenue, the Company may realize a disproportionate
amount of its revenue and income in the last month of each quarter and, as a
result, the magnitude of quarterly fluctuations may not become evident until
late in, or at the end of, a given quarter. Accordingly, delays in product
delivery or in the closing of sales near the end of a quarter could cause
quarterly revenue and, to a greater degree, operating results to fall
substantially short of anticipated levels. 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.
 
 
                                      31
<PAGE>
 
  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 may be unable to adjust spending in a timely manner to
compensate for any unexpected revenue shortfall. Accordingly, any significant
shortfall in revenue 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. The timing of any expense increases in
research and development, client technical support and professional services
staff, sales force and administrative infrastructure and the rate at which new
personnel become productive could cause material fluctuations in quarterly and
annual 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 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 could be materially adversely affected.
 
 Dependence on Year 2000 Market
 
  The growth in the Company's revenue in 1996 and 1997 resulted primarily from
increased demand for the Company's services and products relating to
resolution of the year 2000 problem. Although the Company believes that the
market for products and services relating to the year 2000 problem will grow
as the year 2000 approaches, there can be no assurance that this market will
develop to the extent anticipated by the Company, if at all. Significant
expense for sales and marketing may be required to inform potential clients of
the year 2000 problem and the need for products and services addressing the
problem. There can be no assurance that the year 2000 solution providers will
devote the resources necessary to effectively inform potential clients of this
problem or that potential clients will understand or acknowledge the problem.
In addition, affected organizations may not be willing or able to allocate the
resources, financial or otherwise, to address the problem in a timely manner.
Many organizations may attempt to resolve the problem internally rather than
contract with outside firms such as the Company and value added integrators to
which the Company licenses its software products. Due to these factors,
development of the market for year 2000 products and services is uncertain and
unpredictable. If the market for year 2000 products and services fails to
grow, or grows more slowly than anticipated, the Company's business, financial
condition and results of operations could be materially adversely affected.
 
 Need to Develop Additional Products and Services
 
  The Company currently generates significant revenue from, and devotes
significant resources to, products and services that address the year 2000
problem. Although the Company believes that the demand for its products and
services relating to the year 2000 problem will continue to exist for some
time after the year 2000, this demand will diminish significantly over time
and will eventually disappear. There can be no assurance that the Company will
be able to expand successfully its business beyond the year 2000 market.
Specifically, there can be no assurance that mass change markets such as those
associated with Europe's expected conversion to the euro currency or Japan's
anticipated telephone number expansion will develop or reach the size
currently estimated or that the Company will successfully develop or market
products and services capable of handling such mass changes. 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,
Bull, Stratus, Computervision, Met Life, IBM and Merrill Lynch. 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
 
                                      32
<PAGE>
 
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 could 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 could have
a material adverse effect on the Company's liquidity.
 
 Management of Growth
 
  The Company's business has grown significantly in size and complexity over
the past three years. In addition, the number of employees increased during
the same period, and the Company may hire additional personnel in the future.
The growth in the size and complexity of the Company's business as well as its
client base has placed and is expected to continue to place a significant
strain on the Company's management and operations. Certain members of the
Company's senior management team have been with the Company for a limited time
and the Company's senior management has had limited experience in managing
publicly traded companies. The Company anticipates that continued growth, if
any, will require it to recruit and hire a substantial number of new
development, managerial, finance, sales and marketing and support personnel.
Competition for such personnel is intense, and there can be no assurance that
the Company will be successful in hiring or retaining such personnel. The
Company's ability to compete effectively and to manage future growth, if any,
will depend on its ability to continue to implement and improve operational,
financial and management information systems on a timely basis and to expand,
train, motivate and manage its work force. There can be no assurance that the
Company's personnel, systems, procedures and controls will be adequate to
support the Company's operations.
 
 Dependence Upon Third-Party Channels; Potential for Channel Conflict
 
  The Company offers its products and services directly to end users through
its sales force and indirectly through third-party channels, which include
value added integrators and distributors. The Company expects to rely to a
significant degree on its value added integrators and distributors to provide
sales and marketing presence and name recognition, as well as the resources
necessary to offer large-scale, comprehensive software maintenance solutions,
including solutions relating to the year 2000 problem. Although the Company
dedicates significant resources to develop its indirect channels, there can be
no assurance that the Company will be able to attract and retain a sufficient
number of qualified firms to successfully sell and market its products. While
the Company has granted exclusive marketing rights to certain distributors in
defined geographic territories, these firms are not prohibited from entering
into similar arrangements with the Company's competitors. The failure of the
Company to maintain its current third-party channels or develop other third-
party channels, the Company's inability to adequately support the requirements
of its third-party channels, the development of competitive products and
services by the Company's value added integrators and distributors or the
entry by such firms into alliances with competitors of the Company would
substantially limit the Company's ability to provide its products and services
and, accordingly, would have a material adverse effect on the Company's
business, financial condition and results of operations.
 
  Selling through indirect channels may also limit the Company's contacts with
end users of its products and services. As a result, the Company's ability to
accurately forecast sales, evaluate client satisfaction and recognize emerging
client requirements may be hindered. The Company's strategy of selling its
products directly to end users and indirectly through third-party channels may
result in distribution channel conflicts. The Company's direct sales efforts
may compete with those of its indirect channels and, to the extent different
value added integrators and distributors target the same clients, they may
also come into conflict with each other. There can be no assurance that
channel conflicts will not materially adversely affect its relationship with
existing value
 
                                      33
<PAGE>
 
added integrators or distributors or adversely affect its ability to attract
new value added integrators and distributors. In addition, if the Company is
successful in increasing product sales through third-party channels, the
Company expects that any material increase in the Company's indirect sales as
a percentage of total revenue may materially adversely affect the Company's
average selling prices and gross margins due to potentially lower average
license fees from indirect channels.
 
 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 anticipated growth in the mass
change and year 2000 industries is expected to attract additional 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. 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 future success of the Company's growth strategy will depend 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 growing 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.
 
 Fixed-Price, Fixed-Time Contracts
 
  As a core element of its business philosophy, the Company's strategy 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 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
 
                                      34
<PAGE>
 
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.
 
 Integration of Acquisitions
 
  In December 1997, the Company acquired certain assets and assumed certain
liabilities of the MDI business from APU and in January 1996, the Company
acquired Vista, a developer of computer-aided engineering software. Although
the Company has no existing commitments or agreements regarding any
acquisitions, it may in the future seek acquisitions of businesses, products
and technologies that are complementary to those of the Company. There can be
no assurance that the Company will ultimately effect any such acquisition, or
that the Company will be able to integrate successfully into its operations
any business that it may acquire. The process of integrating an acquired
company's business into the Company's operations may result in ongoing and
extraordinary operating difficulties and expenditures, may absorb significant
management attention that would otherwise be available for the ongoing
development of the Company's business and may result in charges to operating
results. In addition, future acquisitions by the Company could result in
potentially dilutive issuances of equity securities, the incurrence of debt
and contingent liabilities and amortization expenses related to goodwill and
other intangible assets, any of which could have a material adverse effect on
the Company's business, financial condition and results of operations.
Acquisitions also involve other risks, including entering markets in which the
Company has limited or no direct prior experience and the potential loss of
key employees. There can be no assurance that a given acquisition, whether or
not consummated, would not have a material adverse effect on 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
 
                                      35
<PAGE>
 
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 source code for certain purposes. Access to the Company's
source code may increase the likelihood of misappropriation or misuse by third
parties.
 
  At March 31, 1998, the Company had filed six patent applications with the
United States Patent and Trademark Office (the "PTO") pertaining to
technologies, processes and methodologies with respect to the Company's
software. One of these patents has been granted and 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. 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
and 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
 
                                      36
<PAGE>
 
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 rapidly due to unforeseen
changes in the features and functionality of competing products. The Company's
future success will depend in part upon its ability to enhance its existing
products and services and to develop and introduce new products and services
to meet changing client requirements. 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 successfully complete the development of new products in a
timely fashion or that the Company's current or future products will satisfy
the needs of its target market.
 
 Risks Associated with International Operations
 
  At March 31, 1998, the Company had subsidiaries in Spain and India and
distributors in Canada, Europe and Japan, and intends to expand its
international sales activities as part of its business strategy. In 1997,
about fifty percent, and in 1996 and 1995 substantially all, of the Company's
international revenue has been attributable to revenue generated by the
Company's majority-owned Spanish subsidiary, Persist. S.A. In order to expand
international sales, the Company must establish additional foreign operations,
hire additional personnel and establish relationships with additional value
added integrators and distributors. This will require significant management
attention and financial resources and could have a material adverse effect on
the Company's business, financial condition and results of operations. In
addition, there can be no assurance that the Company will be able to address
international market demand for the Company's products and services. The
Company's international sales are primarily denominated in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make the Company's products more expensive and, therefore, potentially less
competitive in those markets. In addition, the Company's international
business may be subject to a variety of risks, including difficulties in
collecting international accounts receivable or obtaining U.S. export
licenses, potentially longer payment cycles, increased costs associated with
maintaining international marketing efforts, the introduction of non-tariff
barriers and higher duty rates and difficulties in enforcement of contractual
obligations and intellectual property rights. There can be no assurance that
such factors will not have a material adverse effect on the Company's future
international sales and, consequently, on the Company's business, financial
condition or results of operations.
 
 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.
 
                                      37
<PAGE>
 
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.
 
 Immigration Issues
 
  The Company believes that its success in part has resulted from its ability
to attract and retain persons with technical and project management skills
from other countries. Certain of the Company's U.S.-based employees were
working for the Company in the H-1B, non-immigrant work permitted visa
classification. There is a limit on the number of new H-1B petitions that the
Immigration and Naturalization Service may approve in any government fiscal
year, and in years in which this limit is reached, the Company may be unable
to obtain H-1B visas necessary to bring critical foreign employees to the U.S.
Compliance with existing U.S. immigration laws, or changes in such laws making
it more difficult to hire foreign nationals or limiting the ability of the
Company to retain H-1B employees in the U.S., could require the Company to
incur additional unexpected labor costs and expenses. Any such restrictions or
limitations on the Company's hiring practices could have a material adverse
effect on the Company's business, financial condition and results of
operations.
 
 Dependence on Government Contracts
 
  One of the Company's strategies is to sell its products and services
directly or indirectly to state, federal and foreign government agencies. Any
failure to obtain a contract award, or a delay on the part of a government
agency in making the award or of ordering products and services under an
awarded contract, could have a material adverse effect on the financial
performance of the Company within a given period. Other risks involved in
government sales are the larger discounts (and thus lower margins) typically
involved in government sales, the dependence of the Company on the ability of
the prime contractor to obtain the award, the unpredictability of funding for
various government programs, the ability of the government agency to
unilaterally terminate the prime contract, and the dependence on the
creditworthiness of the prime contractor (some of which are relatively small
organizations without substantial funds). The Company anticipates that
government sales may constitute a significant but fluctuating portion of its
revenue in the future.
 
                                      38
<PAGE>
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                        PERITUS SOFTWARE SERVICES, INC.
 
                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
<TABLE>
<S>                                                                         <C>
Financial Statements:
  Report of Independent Accountants........................................  40
  Consolidated Balance Sheet as of December 31, 1997 and 1996..............  41
  Consolidated Statement of Operations for the three years ended December
   31, 1997................................................................  42
  Consolidated Statement of Changes in Stockholders' Equity for the three
   years ended December 31, 1997...........................................  43
  Consolidated Statement of Cash Flows for the three years ended December
   31, 1997................................................................  45
  Notes to Consolidated Financial Statements...............................  47
Financial Statement Schedule:
  For the three years ended December 31, 1997
    II. Valuation and Qualifying Accounts..................................  67
</TABLE>
 
  All other schedules are omitted because they are not applicable or the
required information is shown in the consolidated financial statements or
notes thereto.
 
                                      39
<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, after the restatement described in Note 16, present
fairly, in all material respects, the financial position of Peritus Software
Services, Inc. and its subsidiaries at December 31, 1997 and 1996, and the
results of their operations and their cash flows for each of the three years
in the period ended December 31, 1997, 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.
 
  As described in Note 16, the Company's continued existence after 1998 is
dependent upon its ability to achieve a cash flow breakeven position and/or to
obtain additional sources of financing.
 
PricewaterhouseCoopers LLP
 
Boston, Massachusetts
January 27, 1998, except as to Note 16,
 which is as of December 2, 1998
 
                                      40
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
                           CONSOLIDATED BALANCE SHEET
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                             -----------------
                                                              1997*     1996
                                                             --------  -------
                           ASSETS
                           ------
<S>                                                          <C>       <C>
Current assets:
 Cash and cash equivalents.................................. $ 11,340  $ 7,388
 Short-term investments.....................................    3,000      --
 Accounts receivable, net of allowance for doubtful
  accounts of $95 and $30, respectively and including
  amounts receivable from related parties of $289 and $260,
  respectively..............................................   12,627    4,163
 Costs and estimated earnings in excess of billings on
  uncompleted contracts, including amounts on uncompleted
  contracts with related parties of $250 and $562,
  respectively..............................................    2,547    2,195
 Unbilled license revenue from related parties..............      --     1,400
 Prepaid expenses and other current assets..................      710      119
                                                             --------  -------
   Total current assets.....................................   30,224   15,265
 Property and equipment, net................................    3,859    1,970
 Intangible and other assets, net...........................    5,787      490
                                                             --------  -------
                                                             $ 39,870  $17,725
                                                             ========  =======
<CAPTION>
   LIABILITIES, REDEEMABLE STOCK AND STOCKHOLDERS' EQUITY
                         (DEFICIT)
   ------------------------------------------------------
<S>                                                          <C>       <C>
Current liabilities:
 Current portion of capital lease obligations............... $     51  $    74
 Current portion of long-term debt..........................      292      225
 Accounts payable...........................................    1,650      497
 Billings in excess of costs and estimated earnings on
  uncompleted contracts.....................................      976      902
 Deferred revenue...........................................    2,818    3,262
 Other accrued expenses and current liabilities.............    3,506    2,087
                                                             --------  -------
   Total current liabilities................................    9,293    7,047
Capital lease obligations...................................      144      201
Long-term debt..............................................      269    1,337
                                                             --------  -------
   Total liabilities........................................    9,706    8,585
                                                             --------  -------
Minority interest in consolidated subsidiary................      159      155
                                                             --------  -------
Commitments (Note 15).......................................      --       --
                                                             --------  -------
Redeemable convertible preferred stock, no par value:
 Series A--0 shares authorized, issued and outstanding at
  December 31, 1997; 1,903,525 shares authorized, issued
  and outstanding at issuance cost plus accretion and
  accrued dividends (liquidation preference $7,281) at
  December 31, 1996.........................................      --     5,912
 Series B--0 shares authorized, issued and outstanding at
  December 31, 1997; 1,818,182 shares authorized, issued
  and outstanding at issuance cost plus accretion and
  accrued dividends (liquidation preference $6,000) at
  December 31, 1996.........................................      --     6,107
 Redeemable common stock right..............................      --       268
                                                             --------  -------
                                                                  --    12,287
                                                             --------  -------
Stockholders' equity (deficit):
 Class A common stock, no par value; 0 and 13,295,000
  shares authorized at December 31, 1997 and 1996,
  respectively; 0 and 6,033,614 shares issued and
  outstanding, at December 31, 1997 and 1996,
  respectively..............................................      --     2,207
 Class B non-voting common stock, no par value; 0 and
  275,000 shares authorized at December 31, 1997 and 1996,
  respectively; 0 and 101,196 shares issued and outstanding
  at December 31, 1997 and 1996, respectively...............      --       164
 Common stock, $.01 par value; 50,000,000 shares
  authorized; 15,361,800 and 0 shares issued and
  outstanding at December 31, 1997 and 1996, respectively...      154      --
Additional paid-in capital..................................  103,808      --
Accumulated deficit.........................................  (73,815)  (5,593)
Note receivable from stockholder............................      (58)     (58)
Cumulative translation adjustment...........................      (84)     (22)
                                                             --------  -------
   Total stockholders' equity (deficit).....................   30,005   (3,302)
                                                             --------  -------
                                                             $ 39,870  $17,725
                                                             ========  =======
</TABLE>
--------
*Restated--See Note 16
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       41
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
                      CONSOLIDATED STATEMENT OF OPERATIONS
                 (IN THOUSANDS, EXCEPT PER SHARE-RELATED DATA)
 
<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                                   ---------------------------
                                                    1997*      1996     1995
                                                   --------  --------  -------
<S>                                                <C>       <C>       <C>
Revenue:
 Outsourcing services, including $4,478, $4,943
  and $10,114 from related parties,
  respectively.................................... $ 11,447  $ 10,190  $16,400
 License, including $0, $1,500 and $0 from
  related parties, respectively...................   21,255     6,526      --
 Other services...................................    7,007     2,519    2,105
                                                   --------  --------  -------
   Total revenue..................................   39,709    19,235   18,505
                                                   --------  --------  -------
Cost of revenue:
 Cost of outsourcing services, including $2,467,
  $1,984 and $3,318 from related parties,
  respectively....................................    9,536     8,488    9,602
 Cost of license..................................      690       162      --
 Cost of other services...........................    5,357     2,931    2,421
                                                   --------  --------  -------
   Total cost of revenue..........................   15,583    11,581   12,023
                                                   --------  --------  -------
Gross profit......................................   24,126     7,654    6,482
                                                   --------  --------  -------
Operating expenses:
 Sales and marketing..............................    8,864     3,116    2,129
 Research and development.........................    8,324     6,033    1,703
 General and administrative.......................    4,312     3,249    2,357
 Write off of acquired in-process research and
  development.....................................   70,800       --       --
                                                   --------  --------  -------
   Total operating expenses.......................   92,300    12,398    6,189
                                                   --------  --------  -------
   Income (loss) from operations..................  (68,174)   (4,744)     293
Interest income...................................    1,163        48       18
Interest expense..................................     (215)     (344)    (221)
                                                   --------  --------  -------
 Income (loss) before income taxes and minority
  interest in consolidated subsidiary.............  (67,226)   (5,040)      90
Provision (benefit) for estimated income taxes....      260      (143)      (8)
                                                   --------  --------  -------
 Income (loss) before minority interest in
  consolidated subsidiary.........................  (67,486)   (4,897)      98
Minority interest in consolidated subsidiary......        4        24       43
                                                   --------  --------  -------
 Net income (loss)................................  (67,490)   (4,921)      55
Accrual of dividends on Series A and B preferred
 stock............................................      675       689      --
Accretion to redemption value of redeemable
 stock............................................       57       413      --
                                                   --------  --------  -------
Net income (loss) available to common
 stockholders..................................... $(68,222) $ (6,023) $    55
                                                   ========  ========  =======
Net income (loss) per share:
 Basic............................................ $  (7.03) $  (1.02) $  0.01
                                                   ========  ========  =======
 Diluted.......................................... $  (7.03) $  (1.02) $  0.01
                                                   ========  ========  =======
Weighted average shares outstanding:
 Basic............................................    9,708     5,876    5,078
                                                   ========  ========  =======
 Diluted..........................................    9,708     5,876    6,456
                                                   ========  ========  =======
Pro forma basic and diluted net loss per share
 (unaudited)...................................... $  (5.83) $  (0.67)
                                                   ========  ========
Pro forma basic and diluted average shares
 outstanding (unaudited)..........................   11,574     7,394
                                                   ========  ========
</TABLE>
--------
*Restated--See Note 16
 
 
 
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       42
<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                COMMON STOCK       COMMON STOCK
                  ---------------- ADDITIONAL -----------------  ----------------                       RECEIVABLE  CUMULATIVE
                   NUMBER           PAID-IN    NUMBER             NUMBER           ACCUMULATED TREASURY    FROM     TRANSLATION
                  OF SHARES AMOUNT  CAPITAL   OF SHARES  AMOUNT  OF SHARES AMOUNT    DEFICIT    STOCK   STOCKHOLDER ADJUSTMENT
                  --------- ------ ---------- ---------  ------  --------- ------  ----------- -------- ----------- -----------
<S>               <C>       <C>    <C>        <C>        <C>     <C>       <C>     <C>         <C>      <C>         <C>
Balance,
December 31,
1994............     --     $  --    $  --    5,011,325  $  492       --   $ --      $   375    $ --       $ --        $ --
Purchase of
95,537 shares of
Class A common
stock for
treasury........                                                                                 (153)
Issuance of
common stock....                                                    4,375      7
Sale of common
stock pursuant
to employee
stock purchase
plan............                                                   95,537    153
Purchase of 625
shares of Class
B common stock
for treasury....                                                                                   (1)
Effect of
accelerating
vesting of
certain common
stock options...                                             36
Issuance of
common stock
warrants........                                             76
Sale of common
stock pursuant
to stock
agreement.......                                512,500     758
Sale of common
stock pursuant
to exercise of
stock options...                                  1,250    (146)                                  150
Net income......                                                                          55
                     ---    ------   ------   ---------  ------   -------  -----     -------    -----      -----       -----
Balance,
December 31,
1995............     --        --       --    5,525,075   1,216    99,912    160         430       (4)       --          --
Purchase of
189,588 shares
of Class A
common stock for
treasury........                                                                                 (531)
Issuance of
common stock....                                431,515   1,027                                   201
Exercise of
employee stock
options,
including
related
receivable from
stockholder.....                                 36,250      58                                              (58)
Effect of
accelerating
vesting of
certain common
stock options...                                            118
Sale of common
stock pursuant
to exercise of
stock options...                                158,587     118     1,909      5                    3
Retirement of
treasury stock..                               (117,813)   (330)     (625)    (1)                 331
Accrual of
cumulative
dividends on
redeemable
convertible
preferred stock
and accretion to
redemption value
on redeemable
stock...........                                                                      (1,102)
Cumulative
translation
adjustment......                                                                                                         (22)
Net loss........                                                                      (4,921)
                     ---    ------   ------   ---------  ------   -------  -----     -------    -----      -----       -----
Balance,
December 31,
1996............     --     $  --    $  --    6,033,614  $2,207   101,196  $ 164     $(5,593)   $ --       $ (58)      $ (22)
<CAPTION>
                      TOTAL
                  STOCKHOLDER'S
                     EQUITY
                    (DEFICIT)
                  -------------
<S>               <C>
Balance,
December 31,
1994............     $   867
Purchase of
95,537 shares of
Class A common
stock for
treasury........        (153)
Issuance of
common stock....           7
Sale of common
stock pursuant
to employee
stock purchase
plan............         153
Purchase of 625
shares of Class
B common stock
for treasury....          (1)
Effect of
accelerating
vesting of
certain common
stock options...          36
Issuance of
common stock
warrants........          76
Sale of common
stock pursuant
to stock
agreement.......         758
Sale of common
stock pursuant
to exercise of
stock options...           4
Net income......          55
                  -------------
Balance,
December 31,
1995............       1,802
Purchase of
189,588 shares
of Class A
common stock for
treasury........        (531)
Issuance of
common stock....       1,228
Exercise of
employee stock
options,
including
related
receivable from
stockholder.....         --
Effect of
accelerating
vesting of
certain common
stock options...         118
Sale of common
stock pursuant
to exercise of
stock options...         126
Retirement of
treasury stock..         --
Accrual of
cumulative
dividends on
redeemable
convertible
preferred stock
and accretion to
redemption value
on redeemable
stock...........      (1,102)
Cumulative
translation
adjustment......         (22)
Net loss........      (4,921)
                  -------------
Balance,
December 31,
1996............     $(3,302)
</TABLE>
 
                                       43
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
    CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY--(CONTINUED)
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)
 
<TABLE>
<CAPTION>
                                                    CLASS A             CLASS B
                    COMMON STOCK                  COMMON STOCK        COMMON STOCK
                  ----------------- ADDITIONAL -------------------  -----------------                        RECEIVABLE
                  NUMBER OF          PAID-IN   NUMBER OF             NUMBER            ACCUMULATED  TREASURY    FROM
                    SHARES   AMOUNT  CAPITAL     SHARES    AMOUNT   OF SHARES  AMOUNT    DEFICIT     STOCK   STOCKHOLDER
                  ---------- ------ ---------- ----------  -------  ---------  ------  -----------  -------- -----------
<S>               <C>        <C>    <C>        <C>         <C>      <C>        <C>     <C>          <C>      <C>
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...........                                                                            (732)
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........                                                                         (67,490)*
                  ----------  ----   --------  ----------  -------  --------   -----    --------        ----   ------
Balance,
December 31,
1997............  15,361,800  $154   $103,808         --   $   --        --    $ --     $(73,815)*    $--      $  (58)
                  ==========  ====   ========  ==========  =======  ========   =====    ========      ====     ======
<CAPTION>
                                  TOTAL
                  CUMULATIVE  STOCKHOLDER'S
                  TRANSLATION    EQUITY
                  ADJUSTMENT    (DEFICIT)
                  ----------- -------------
<S>               <C>         <C>
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)
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)*
                  ----------- -------------
Balance,
December 31,
1997............    $  (84)     $ 30,005 *
                  =========== =============
</TABLE>
-----
 * Restated--See Note 16
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       44
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
                      CONSOLIDATED STATEMENT OF CASH FLOWS
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)
 
<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER 31,
                                                           --------------------------
     INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS       1997*     1996     1995
     ------------------------------------------------      --------  -------  -------
<S>                                                        <C>       <C>      <C>
Cash flows from operating activities:
  Net income (loss)....................................... $(67,490) $(4,921) $    55
  Adjustments to reconcile net income (loss) to net cash
   provided by (used for) operating activities:
    Non-cash sale of services and other non-cash
     expenses.............................................      --       --        12
    Depreciation and amortization.........................    1,327      854      443
    Minority interest in consolidated subsidiary..........        4       24       43
    Write off of acquired in process research and
     development..........................................   70,800      --       --
    Non-cash employee compensation........................      --       118       83
    Changes in assets and liabilities, net of effects from
     acquisitions:
      Accounts receivable.................................   (6,193)  (1,690)  (1,354)
      Costs and estimated earnings in excess of billings
       on uncompleted contracts...........................       (9)     501   (1,635)
      Unbilled license revenue from related parties.......    1,400   (1,400)     --
      Prepaid expenses and other current assets...........     (438)     177     (218)
      Accounts payable....................................      495     (222)     226
      Billings in excess of costs and estimated earnings
       on uncompleted contracts...........................       74      192      509
      Deferred revenue....................................     (629)   3,262      --
      Other accrued expenses and current liabilities......      885      949      732
      Deferred income taxes...............................      --      (186)       7
                                                           --------  -------  -------
        Net cash provided by (used for) operating
         activities.......................................      226   (2,342)  (1,097)
                                                           --------  -------  -------
Cash flows from investing activities:
  Purchase of short-term investments......................   (3,000)     --       --
  Cash paid for acquisition of businesses, and related
   costs, net of cash acquired............................  (31,350)     174      (43)
  Partial sale of investment in consolidated subsidiary...      --         8      --
  Purchases of property and equipment.....................   (2,018)  (1,240)    (824)
  Acquisition of patents..................................      --        (1)    (105)
                                                           --------  -------  -------
        Net cash used for investing activities............  (36,368)  (1,059)    (972)
                                                           ========  =======  =======
</TABLE>
--------
* Restated--See Note 16.
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
 
                                       45
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
               CONSOLIDATED STATEMENT OF CASH FLOWS--(CONTINUED)
                   (IN THOUSANDS, EXCEPT SHARE-RELATED DATA)
 
<TABLE>
<CAPTION>
                                                       YEAR ENDED DECEMBER
                                                               31,
                                                      ------------------------
                                                       1997*    1996     1995
                                                      -------  -------  ------
<S>                                                   <C>      <C>      <C>
Cash flows from financing activities:
  Proceeds from (principal payments on) line of
   credit borrowings, net............................ $   --   $  (440) $  550
  Proceeds from long-term debt.......................     200      450   1,000
  Principal payments on long-term debt...............  (1,201)    (686)   (198)
  Principal payments on capital lease obligations....     (80)    (107)   (110)
  Proceeds from exercise of stock options............      75      126       4
  Proceeds from sale of common stock pursuant to
   purchase agreement................................     --       --      746
  Proceeds from sale of redeemable convertible
   preferred stock and redeemable common stock.......     --    11,184     --
  Proceeds from sale of common stock.................  40,664      500     156
  Proceeds from sale of subsidiary common stock......     --        59     --
  Proceeds from exercise of common stock warrants....     500      --      --
  Treasury stock acquired............................     --      (531)   (154)
                                                      -------  -------  ------
        Net cash provided by financing activities....  40,158   10,555   1,994
                                                      -------  -------  ------
Effects of exchange rates on cash and cash
 equivalents.........................................     (64)     (30)    --
                                                      -------  -------  ------
Net increase (decrease) in cash and cash
 equivalents.........................................   3,952    7,124     (75)
Cash and cash equivalents, beginning of year.........   7,388      264     339
                                                      -------  -------  ------
Cash and cash equivalents, end of year............... $11,340  $ 7,388  $  264
                                                      =======  =======  ======
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS:
  Cash paid for income taxes......................... $   115  $   --   $   31
  Cash paid for interest.............................     215      327     227
</TABLE>
 
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
  In the years ended December 31, 1997, 1996 and 1995, the Company incurred
capital lease obligations of $0, $39 and $399, 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.
 
  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.
 
--------
* Restated--See Note 16.
 
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      46
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. NATURE OF THE BUSINESS
 
  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. In 1997, the Company derived 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 distributors, and its clients included primarily Fortune 1000
companies and similarly sized business and government organizations worldwide.
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 Principles of Consolidation
 
  The consolidated financial statements include the accounts of the Company
and its majority-owned domestic and foreign subsidiaries (Note 3). All
significant intercompany balances and transactions are eliminated.
 
 Revenue Recognition
 
  Revenue associated with performance under contracts to provide outsourced
software maintenance, reengineering and development services is recognized
utilizing the percentage-of-completion method in 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. The costs of providing warranties
and follow-on customer support related to services performed are not
significant and have been accrued. 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.
 
  Revenue from end-user licenses is recognized when an agreement has been
executed, software and methodologies have been delivered, all significant
contractual obligations have been met and collection of the related receivable
is probable. Revenue from usage-based licenses is recognized when licensed
software has been delivered, the fee is fixed or determinable, all significant
contractual obligations have been met and collection of the related receivable
is probable.
 
  Post contract customer support revenue, including that bundled with initial
license fees, is deferred and recognized ratably over the contractual periods
the services are provided. Revenue from consulting and training services is
recognized as the services are provided.
 
 Significant Customers
 
  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
accounted for 29%, 15% and 12% of the Company's total revenue for the year
ended December 31, 1996. At December 31, 1996, the Company had amounts
receivable from the first customer, a related party, of $123,000 for billed
accounts receivable, $501,000 for costs and estimated earnings in excess of
billings on uncompleted contracts and $1,400,000 for unbilled license revenue
(Note 9). At December 31, 1996, the Company had amounts receivable from the
second customer of $115,000 for billed accounts receivable and from the third
customer of $17,000 for billed accounts receivable and $797,000 for costs and
estimated earnings in excess of billings on uncompleted contracts. Revenue
from three customers accounted for 50%, 13% and 11% of the Company's total
revenue for the year ended December 31, 1995.
 
                                      47
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 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 and such
losses, in the aggregate, have not exceeded management's expectations.
 
 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 and long-term debt. The carrying amounts of these
instruments at December 31, 1997 approximate their fair values.
 
 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
shareholders' equity. At December 31, 1997, the Company held short-term
investments in corporate bonds of $3,000,000 and are classified as available-
for-sale. At December 31, 1997, the Company's cash equivalents included
commercial paper and corporate bonds of $5,000,000 and $1,000,000,
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. Capitalized software costs are amortized ratably over the
estimated useful life of the software, generally three years, and are charged
to cost of revenue. During the years ended December 31, 1997, 1996 and 1995,
costs subject to capitalization were not significant and therefore, were not
capitalized. At December 31, 1997 and 1996, the Company had $54,000 and
$104,000, 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, 1997, 1996 and 1995 was $50,000, $108,000 and $63,000,
respectively, of which $50,000, $45,000 and $0, respectively, related to the
capitalized software acquired from Vista.
 
                                      48
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Intangible Assets
 
  Intangible assets relate primarily to the MDI acquisition (Note 3) and are
being amortized on a straight-line basis over their expected useful lives of
five 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 years ended December 31, 1996 or 1995. For the year ended
December 31, 1997, the Company recorded $12,000 of amortization expense
relating to capitalized patent costs.
 
 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. No such
significant impairments have occurred through December 31, 1997.
 
 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.
 
 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 12). All stock-based awards to
non-employees are accounted for at their fair value in accordance with SFAS
No. 123.
 
 Net Income (Loss) Per Share
 
  In February 1997, the Financial Accounting Standards Board (the "FASB")
issued SFAS No. 128, "Earnings per Share", which supersedes APB No. 15 and
specifies the computation, presentation and disclosure requirements of
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
 
                                      49
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
periods presented. During the period from January 1, 1995 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.
 
  The Company adopted SFAS No. 128 and SAB No. 98 in the fourth quarter of
1997 and has restated earnings per share amounts for all periods presented
herein, as required.
 
  Antidilutive potential common stock excluded from the 1997, 1996 and 1995
diluted earnings per share computation includes approximately 4,121,000,
3,238,000 and 200,000 of common stock shares, respectively, issuable upon the
exercise of stock options and warrants.
 
  As described in Note 11, 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 two years ended
December 31, 1997 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 income
(loss) per share and unaudited pro forma diluted net income (loss) per share
for the years indicated.
 
<TABLE>
<CAPTION>
                                                   YEAR ENDED DECEMBER 31,
                                                ------------------------------
                                                   1997      1996      1995
                                                ---------- --------- ---------
<S>                                             <C>        <C>       <C>
Diluted weighted average shares outstanding:
  Attributable to common stock outstanding.....  9,708,000 5,876,000 5,078,000
  Attributable to common stock options and
   warrants....................................        --        --  1,378,000
                                                ---------- --------- ---------
                                                 9,708,000 5,876,000 6,456,000
                                                ========== ========= =========
Unaudited pro forma basic and diluted weighted
 average shares outstanding:
  Attributable to common stock outstanding.....  9,708,000 5,876,000
  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 revenue and expenses during the
reporting period. Areas particularly subject to estimation include the
allowance for doubtful accounts, revenue based on percentage-of-completion and
the valuation allowance on deferred tax assets, as well as the fair values of
equity instruments issued by the Company. Actual amounts could differ from
those estimates.
 
 Recently Issued Accounting Standards
 
  In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income." This statement establishes standards for the reporting and display of
comprehensive income and its components. Comprehensive income is defined as
the change in equity of a business enterprise during a period from
transactions and other events and circumstances from non-owner sources. It
includes all changes in equity during a period except those
 
                                      50
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
resulting from investments by owners and distributions to owners. This
standard will require that an enterprise display an amount representing total
comprehensive income for the period. SFAS No. 130 will be effective for the
Company's fiscal year ending December 31, 1998. Adoption of SFAS No. 130 is
for presentation only and will not affect the Company's financial position or
results of operations.
 
  In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information" which supersedes SFAS No. 14. This
statement changes the way that public business enterprises report segment
information, including financial and descriptive information about their
selected segment information. Operating segments are defined as revenue-
producing components of the enterprise which are generally used internally for
evaluating segment performance. SFAS No. 131 will be effective for the
Company's fiscal year ending December 31, 1998 and will not affect the
Company's financial position or results of operations.
 
  In October 1997, the Accounting Standards Executive Committee ("AcSEC") of
the American Institute of Certified Public Accountants 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 is effective for transactions entered into
during fiscal years beginning after December 15, 1997. On March 18, 1998, the
FASB cleared a new SOP that provides for the one-year deferral of certain
provisions of SOP 97-2 pertaining to its requirements for what constitutes
vendor specific evidence of the fair value of multiple elements included in an
arrangement. It is AcSEC's intention to immediately begin a project to
consider whether guidance is needed on any restrictions that should be placed
on what constitutes evidence of fair value and, if so, what the guidance
should be. Because of the uncertainties with respect to the outcome of any
such project, the Company believes that the impact of the deferred provisions
of SOP 97-2 on its financial position or results of operations upon expiration
of the one-year deferral period is not currently determinable. However, the
Company believes that those provisions of SOP 97-2 that have not been
deferred, and therefore are applicable commencing January 1, 1998, will not
materially affect its financial position or results of operations.
 
  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.
 
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
 
                                      51
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
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>
   <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 of five years.
 
  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. Such costs are expected to be paid in
1998.
 
                                      52
<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 following unaudited pro forma basic and
diluted net loss per share data 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) and assumes the
2,175,000 shares issued in connection with the acquisition were outstanding
for the entire periods presented.
 
<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) $     (0.21) $     (1.02) $     (0.59)
     Diluted.............. $      (7.03) $     (0.21) $     (1.02) $     (0.59)
</TABLE>
--------
* Restated--See Note 16.
 
 Persist
 
  At December 31, 1994, the Company owned a 40% voting interest in Persist,
S.A. ("Persist"), a Spanish corporation which provides software maintenance
services, and used the equity method to account for the investment. In 1995,
the Company made additional investments in Persist in the form of cash of
$11,000 and forgiveness by the Company of accounts receivable owed by Persist
of $180,000, of which $123,000 related to 1995 billings and $57,000 related to
1994 billings. Consequently, the Company's ownership was increased to
approximately 69%, resulting in a change in financial reporting from the
equity method to consolidation beginning January 1, 1995. As a result of
equity transactions during 1996 and 1997, the Company's ownership was reduced
to approximately 63%.
 
  The Persist acquisition was accounted for under the purchase method of
accounting in 1995. Accordingly, the purchase price was allocated based on the
estimated fair value of assets purchased and liabilities assumed upon
acquisition. The excess of cost over the fair value of net assets acquired of
$74,000 is being amortized over five years. The Company's results of
operations for the years ended December 31, 1997, 1996 and 1995 include the
operating results of Persist less the minority stockholders' pro rata share of
net income.
 
 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 has been 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.
 
                                      53
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
4. PROPERTY AND EQUIPMENT
 
  Property and equipment consist of the following:
 
<TABLE>
<CAPTION>
                                             ESTIMATED       DECEMBER 31,
                                            USEFUL LIVES ---------------------
                                              (YEARS)       1997       1996
                                            ------------ ---------- ----------
<S>                                         <C>          <C>        <C>
Equipment..................................     3-7      $4,235,000 $2,406,000
Furniture and fixtures.....................     5-7       1,876,000    787,000
Leasehold improvements.....................       5         260,000    149,000
                                                         ---------- ----------
                                                          6,371,000  3,342,000
Less: Accumulated depreciation and
 amortization..............................               2,512,000  1,372,000
                                                         ---------- ----------
                                                         $3,859,000 $1,970,000
                                                         ========== ==========
</TABLE>
 
  Equipment under capital leases at December 31, 1997 and 1996 was $239,000
with related accumulated depreciation of $234,000 and $151,000, respectively.
Furniture and fixtures under capital leases at December 31, 1997 and 1996 was
$271,000, with related accumulated depreciation of $110,000 and $77,000,
respectively. Amortization expense related to assets under capital leases was
$116,000, $130,000 and $79,000 for the years ended December 31, 1997, 1996 and
1995, respectively. Depreciation expense on all fixed assets amounted to
$1,140,000, $677,000 and $376,000 for the years ended December 31, 1997, 1996
and 1995, respectively.
 
5. INTANGIBLE AND OTHER ASSETS
 
  Intangible and other assets consist of the following:
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                          ---------------------
                                                             1997       1996
                                                          ----------  ---------
   <S>                                                    <C>         <C>
   Acquired technology................................... $4,950,000  $ 150,000
   Assembled workforce...................................    600,000        --
   Goodwill..............................................    338,000    235,000
   Other.................................................    249,000    268,000
                                                          ----------  ---------
                                                           6,137,000    653,000
   Less: Accumulated amortization........................   (350,000)  (163,000)
                                                          ----------  ---------
                                                          $5,787,000  $ 490,000
                                                          ==========  =========
</TABLE>
 
  Amortization expense related to intangible assets was $187,000, $163,000 and
$0 for the years ended December 31, 1997, 1996 and 1995, respectively.
 
6. OTHER ACCRUED EXPENSES AND CURRENT LIABILITIES
 
  Other accrued expenses and current liabilities consist of the following:
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                          ---------------------
                                                             1997       1996
                                                          ---------- ----------
   <S>                                                    <C>        <C>
   Bonus and commissions................................. $1,317,000 $1,280,000
   Acquisition costs.....................................    435,000        --
   Other.................................................  1,765,000    807,000
                                                          ---------- ----------
                                                          $3,517,000 $2,087,000
                                                          ========== ==========
</TABLE>
 
 
                                      54
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
7. REVOLVING LINE OF CREDIT
 
  In September 1996, the Company repaid a revolving line of credit facility
with a bank with proceeds obtained from the Company's new line of credit
described below. The repaid line of credit allowed for a maximum borrowing of
$1,500,000, payable on demand, and expired on May 30, 1997. Interest was
payable monthly in arrears at the bank's prime rate plus 1%.
 
  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% (9.00% at December 31, 1997). The maximum borrowing 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 expires and all
outstanding amounts thereunder are payable on June 30, 1998. Under the
Revolver agreement, the Company is required to comply with certain financial
covenants. There were no borrowings outstanding, and $3,500,000 was available,
under the Revolver at December 31, 1997.
 
8. LONG-TERM DEBT
 
  Long-term debt consists of the following:
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                            -------------------
                                                              1997      1996
                                                            -------- ----------
   <S>                                                      <C>      <C>
   Secured subordinated note payable to bank (described
    further below), with interest only payable quarterly
    through June 30, 1998 at 10% per annum. Paid in full in
    July 1997.............................................. $    --  $  943,000
   Term loan payable to bank in monthly principal
    installments of $24,000 with interest at prime plus 1%
    (9.50% at December 31, 1997), through January 2000.....  561,000    619,000
                                                            -------- ----------
                                                             561,000  1,562,000
   Less--Current portion...................................  292,000    225,000
                                                            -------- ----------
                                                            $269,000 $1,337,000
                                                            ======== ==========
</TABLE>
 
 Equipment Line of Credit
 
  In September 1996, the Company 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.
Ratable principal and interest payments on any borrowings under the Equipment
Line are payable during the period July 1, 1997 through June 1, 2000.
Borrowings under the Equipment Line take a form of a term loan and bear
interest at the bank's prime rate plus 1% (9.5% at December 31, 1997) and are
collateralized by the assets of the Company. Under the Equipment Line, the
Company is required to comply with certain financial covenants. Borrowings
outstanding under the Equipment Line, which expired on June 30, 1997, were
$561,000 at December 31, 1997.
 
 Secured Subordinated Note Payable
 
  In May 1995, the Company issued a secured subordinated note payable for
$924,000, having a face value of $1,000,000 with interest payable at 10% per
annum. The note was subordinate to the bank debt and was collateralized by a
second security interest in all assets of the Company.
 
                                      55
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The note also included detachable warrants with an ascribed value of $76,000
for purchase of up to 312,500 shares of common stock for $1.60 per share. The
warrant value was recorded as a discount from the face value of the note.
Amortization of this discount for the years ended December 31, 1997, 1996 and
1995 was $57,000, $13,000 and $6,000, respectively, which amounts are included
in interest expense. Upon the closing of the Company's initial public offering
in July 1997, the holder exercised the detachable warrants and the Company
repaid the note in full using proceeds from the warrant exercise and its
initial public offering.
 
 Maturities
 
  The future aggregate annual principal payments on long-term debt as of
December 31, 1997 for each of the years ended December 31 are as follows:
 
<TABLE>
       <S>                                                            <C>
       1998..........................................................  $292,000
       1999..........................................................   236,000
       2000..........................................................    33,000
                                                                      ---------
                                                                      $ 561,000
                                                                      =========
</TABLE>
 
9. RELATED PARTY TRANSACTIONS
 
  For the years ended December 31, 1997, 1996 and 1995, the Company recorded
revenue of $3,319,000, $5,579,000 and $9,313,000, respectively, related to
outsourcing and license agreements with a significant shareholder, Bull HN
Information Systems Inc. ("Bull"). At December 31, 1997 and 1996, $289,000 and
$123,000, respectively, was included in accounts receivable from related
parties with respect to this stockholder and $233,000 and $501,000,
respectively, 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.
 
  For the years ended December 31, 1997 and 1996, Persist recorded revenue of
$1,183,000 and $776,000, respectively, related to outsourcing services to a
corporation owning 27% of the outstanding stock of Persist at December 31,
1997 (Note 3).
 
  For the years ended December 31, 1996 and 1995, the Company recorded revenue
of $137,000 and $402,000, respectively, related to software services to a
customer. A director of the Company was also an officer and director of the
customer from 1994 through 1996.
 
  For the years ended December 31, 1997, 1996 and 1995, the Company recorded
revenue of $2,640,000, $1,501,000 and $1,717,000, respectively, related to
software services and licensing to a customer. An employee and officer of the
Company, hired in September 1996, was previously employed by the customer as
an employee and officer until August 1996.
 
  For the year 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.
 
 
                                      56
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
10. INCOME TAXES
 
  The components of income (loss) before income taxes are as follows:
 
<TABLE>
<CAPTION>
                                            YEAR ENDED DECEMBER 31,
                                      ----------------------------------------
                                          1997*           1996         1995
                                      -------------   ------------   ---------
   <S>                                <C>             <C>            <C>
   Domestic.......................... $ (67,323,000)  $ (5,141,000)  $ (45,000)
   Foreign...........................        97,000        101,000     135,000
                                      -------------   ------------   ---------
                                      $ (67,226,000)  $ (5,040,000)  $  90,000
                                      =============   ============   =========
</TABLE>
--------
* Restated--See Note 16.
 
  The provision (benefit) for estimated income taxes consists of the following:
 
<TABLE>
<CAPTION>
                                               YEAR ENDED DECEMBER 31,
                                          -----------------------------------
                                             1997*         1996        1995
                                          ------------  -----------  --------
     <S>                                  <C>           <C>          <C>
     Current:
       Federal........................... $    150,000  $       --   $(14,000)
       State.............................       53,000          --     (1,000)
       Foreign...........................       57,000       43,000       --
                                          ------------  -----------  --------
                                               260,000       43,000   (15,000)
     Deferred:
       Federal...........................  (18,538,000)  (1,798,000)    3,000
       State.............................   (3,356,000)    (435,000)    4,000
                                          ------------  -----------  --------
                                           (21,894,000)  (2,233,000)    7,000
     Deferred tax asset valuation
      allowance..........................   21,894,000    2,047,000       --
                                          ------------  -----------  --------
                                                   --      (186,000)    7,000
                                          ------------  -----------  --------
                                          $    260,000  $  (143,000) $ (8,000)
                                          ============  ===========  ========
</TABLE>
--------
* Restated--See Note 16.
 
  No current federal or state income taxes were payable in the years ended
December 31, 1996 and 1995 as a result of losses incurred.
 
                                       57
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 
  The components of deferred tax assets and liabilities follow:
 
<TABLE>
<CAPTION>
                                                      DECEMBER 31,
                                                ----------------------------
                                                    1997            1996
                                                -------------    -----------
   <S>                                          <C>              <C>
   Deferred tax assets:
     In-process research and development....... $  22,903,000 *  $       --
     Net operating loss carryforwards..........       752,000 *    2,641,000
     Tax credit carryforwards..................       867,000        531,000
     Deferred revenue..........................       161,000        238,000
     Nondeductible accrued expenses............       102,000         64,000
     Unexercised stock options.................        45,000         56,000
     Other.....................................        14,000         11,000
                                                -------------    -----------
   Gross deferred tax assets...................    24,844,000 *    3,541,000
                                                -------------    -----------
   Deferred tax liabilities:
     Estimated earnings on uncompleted
      contracts................................      (722,000)    (1,317,000)
     Capitalized research and development
      costs, net...............................       (50,000)       (46,000)
                                                -------------    -----------
     Gross deferred tax liabilities............      (772,000)    (1,363,000)
                                                -------------    -----------
   Net deferred tax (liabilities) assets.......    24,072,000 *    2,178,000
   Deferred tax asset valuation allowance......   (24,072,000)*   (2,178,000)
                                                -------------    -----------
                                                $         --     $       --
                                                =============    ===========
</TABLE>
--------
* Restated--See Note 16.
 
  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 income (loss) before income taxes and minority interest in
consolidated subsidiary follows:
 
<TABLE>
<CAPTION>
                                                YEAR ENDED DECEMBER 31,
                                           -----------------------------------
                                              1997*         1996        1995
                                           ------------  -----------  --------
   <S>                                     <C>           <C>          <C>
   Income (loss) at statutory rate.......  $(23,529,000) $(1,699,000) $ 31,000
   Federal research and development
    credits..............................      (237,000)    (251,000)  (53,000)
   Income (losses) of foreign subsidiary
    not subject to taxation..............           --           --     13,000
   Permanent differences and other,
    net..................................     5,355,000       70,000    (3,000)
   State tax benefit, net of federal
    effect...............................    (3,223,000)    (310,000)    4,000
   Change in deferred tax asset valuation
    allowance............................    21,894,000    2,047,000
                                           ------------  -----------  --------
                                           $    260,000  $  (143,000) $ (8,000)
                                           ============  ===========  ========
</TABLE>
--------
* Restated--See Note 16.
 
  The Company has provided a valuation allowance for the full amount of the
net deferred tax assets, since the realization of these future benefits was
not sufficiently assured at December 31, 1997 and 1996. If the Company
achieves profitability, these deferred tax assets may be available to offset
future income tax liabilities and expense.
 
                                      58
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  At December 31, 1997, the Company had available net operating loss
carryforwards of approximately $1,887,000* and $1,494,000* for federal and
state income tax reporting purposes, respectively. At December 31, 1997, the
Company had research and development credit carryforwards of $508,000 and
$381,000 available to offset future federal and state income tax,
respectively. These carryforwards will expire in the years 2008 through 2012
if not utilized. The Company also has federal alternative minimum tax credit
carryforwards of $99,000.*
--------
* Restated--See Note 16.
 
  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 federal net
operating loss and research and development tax credit carryforwards. A future
change in ownership could result in such a limitation.
 
11. REDEEMABLE STOCK AND COMMON STOCK
 
 Redeemable Convertible Preferred Stock
 
  During March and October 1996, the Company issued 1,903,525 shares of Series
A redeemable convertible preferred stock and 1,818,182 shares of Series B
redeemable convertible preferred stock ("Series A and B preferred stock") for
cash proceeds of $5,207,000 and $5,776,000, respectively, net of issuance
costs of $123,000 and $224,000, respectively.
 
 Redeemable Common Stock Right
 
  In connection with the 1996 issuance of Series A preferred stock, the
Company sold from treasury 71,775 shares of its Class A common stock to
certain purchasers of the Series A preferred stock for cash proceeds of
$201,000. Also in connection with this issuance, an officer of the Company
sold 625,000 shares of the Company's Class A common stock to certain
purchasers of the Series A preferred stock. In conjunction with any redemption
of the Series A preferred stock, the holders of the Series A preferred stock
must redeem, at a redemption price equal to $2.80 per share, 0.366 shares of
Class A common stock for each redeemed share of the Series A preferred stock.
The Company incurred during 1996 a charge to accumulated deficit of $66,000 to
reflect the accretion of this Class A common stock to redemption value. The
carrying value of the redeemable common stock right reflects the cash proceeds
to the Company for the underlying Class A common stock, plus accretion to
redemption value.
 
 Common Stock
 
 In April and March 1995, the Company amended its Articles of Organization to
create two classes of common stock, Class A and Class B, with 6,250,000 and
100,000 shares authorized, respectively. Class A and Class B shares maintain
identical rights in all respects except that Class B shares are non-voting and
convert to Class A common stock upon the closing of an initial public offering
with proceeds greater than $10,000,000. Upon adoption of the amended Articles
of Organization, each share of common stock then outstanding was converted to
one share of common stock.
 
  On December 31, 1996, the Company retired all Class A and Class B common
stock remaining in treasury as a result of various previous repurchases.
 
  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. The Company used a portion of the net proceeds to
repay a secured subordinated note payable (Note 8). The Company also used a
portion of the proceeds to acquire Millennium Dynamics, Inc. (Note 3) and
plans to use remaining proceeds for research and development, working capital
and general corporate purposes.
 
                                      59
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  In connection with closing the initial public offering, the Company amended
its Articles of Organization to authorized 50,000,000 shares of Common Stock,
$0.01 par value, 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.
 
12. 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, 1997,
1,950,000 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. At
December 31, 1997, 1996 and 1995, 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.
 
  At December 31, 1997, there were 915,650 options available for future grant
under the 1997 Incentive Plan and the Director Plan.
 
                                      60
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The following table summarizes stock option activity during the years ended
December 31, 1997, 1996 and 1995:
 
<TABLE>
<CAPTION>
                                          YEAR ENDED DECEMBER 31,
                          -----------------------------------------------------------
                                 1997                1996                1995
                          ------------------- ------------------- -------------------
                                     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 Period..............  2,925,667   $ 1.88  1,606,025   $0.64   1,356,700   $0.23
Granted.................  1,511,613    12.92  1,558,292    3.04     455,250    1.96
Exercised...............   (217,783)    0.34   (198,533)   0.92     (95,000)   0.05
Forfeited...............    (79,530)    2.70    (40,117)   1.20    (110,925)   1.58
                          ---------           ---------           ---------
Outstanding at end of
 period.................  4,139,967     5.94  2,925,667    1.88   1,606,025    0.64
                          =========           =========           =========
Options exercisable at
 end of period..........  1,453,740   $ 1.33  1,030,036   $0.47     692,462   $0.21
                          =========           =========           =========
</TABLE>
 
  The following summarizes information regarding stock options outstanding and
exercisable at December 31, 1997:
 
<TABLE>
<CAPTION>
                                OPTIONS OUTSTANDING               OPTIONS EXERCISABLE
                          --------------------------------- ---------------------------------
                                       WEIGHTED                          WEIGHTED
                                        AVERAGE    WEIGHTED               AVERAGE    WEIGHTED
                                       REMAINING   AVERAGE               REMAINING   AVERAGE
                            NUMBER    CONTRACTUAL  EXERCISE   NUMBER    CONTRACTUAL  EXERCISE
RANGE OF EXERCISE PRICES  OUTSTANDING LIFE (YEARS)  PRICE   OUTSTANDING LIFE (YEARS)  PRICE
------------------------  ----------- -----------  -------- ----------- -----------  --------
<S>                       <C>         <C>          <C>      <C>         <C>          <C>
$0.01-0.10..............     515,250      5.0       $0.09      515,250      5.0       $0.09
 0.15-0.24..............     174,075      5.5        0.02      174,075      5.5        0.23
 0.48-0.80..............     240,595      6.5        0.65      182,186      6.5        0.66
 1.60...................      90,750      7.1        1.60       48,562      7.1        1.60
 2.60-3.30..............   1,634,947      8.8        3.01      489,917      8.8        2.95
 4.65...................     175,000      9.1        4.65       43,750      9.1        4.65
 8.20-11.00.............     547,500      9.4        9.76          --       9.4         --
 13.00-18.13............     741,350      9.8       16.93          --       9.8         --
 23.50-28.75............      20,500      9.7       25.82          --       9.7         --
                           ---------                         ---------
                           4,139,967                         1,453,740
                           =========                         =========
</TABLE>
 
  In accordance with APB 25, the Company recognized $0, $118,000 and $83,000
in compensation expense related to stock-based compensation awards for the
years ended December 31, 1997, 1996 and 1995, respectively. 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 income (loss) and
basic and diluted net income (loss) per share would have been as follows:
 
<TABLE>
<CAPTION>
                                                YEAR ENDED DECEMBER 31,
                                            ----------------------------------
                                               1997*         1996       1995
                                            ------------  -----------  -------
   <S>                                      <C>           <C>          <C>
   Net income (loss):
     As reported........................... $(67,490,000) $(4,921,000) $55,000
     Pro forma.............................  (69,668,000)  (5,050,000)  36,000
   Basic and diluted net income (loss) per
    share:
     As reported........................... $      (7.03) $     (1.02) $  0.01
     Pro forma.............................        (7.25)       (1.05)    0.01
</TABLE>
--------
* Restated--See Note 16.
 
                                      61
<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, will
include an expected volatility factor, additional option grants are expected
to be made subsequent to December 31, 1997 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 date of grant was estimated using the Black-
Scholes option pricing model with the following weighted average assumptions:
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED
                                                            DECEMBER 31,
                                                          -------------------
                                                          1997   1996   1995
                                                          -----  -----  -----
   <S>                                                    <C>    <C>    <C>
   Expected life (years).................................     5      5      5
   Risk-free interest rate...............................  6.05%  6.25%  7.37%
   Dividend yield........................................     0%     0%     0%
   Fair value of option grants--exercise price equal to
    the fair value of the related stock.................. $7.79  $0.52  $0.35
   Fair value of option grants--exercise price less than
    the fair value of the related stock.................. $ --   $ --   $0.14
</TABLE>
 
  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 subsequent to this date. 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") which provides for the issuance of up to 200,000
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. 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. No
awards were made under the Purchase Plan in 1997.
 
13. 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 year ended December 31,
1997, the Company contributed $213,000 to the Plan. There were no
contributions made by the Company to the Plan during the years ended December
31, 1996 and 1995.
 
14. INDUSTRY SEGMENT AND GEOGRAPHIC INFORMATION
 
  The Company operates in a single industry segment: software maintenance,
tools and services.
 
                                      62
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The Company operates in diverse geographic areas. Intercompany sales and
transfers between geographic areas are accounted for at prices which are
designed to be representative of unaffiliated party transactions. Information
by geographic area at December 31, 1997, 1996 and 1995 and for the years then
ended, is summarized below:
 
<TABLE>
<CAPTION>
                                         GEOGRAPHIC AREAS
                         ---------------------------------------------------
                            NORTH
                          AMERICA(1)      EUROPE   ELIMINATIONS    TOTAL
                         ------------   ---------- ------------ ------------
<S>                      <C>            <C>        <C>          <C>
1997
Revenue to unaffiliated
 customers.............. $ 37,781,000 * $1,928,000  $     --    $ 39,709,000 *
Intercompany revenue....       40,000      299,000   (339,000)           --
                         ------------   ----------  ---------   ------------
  Total revenue.........   37,821,000 *  2,227,000   (339,000)    39,709,000 *
Income (loss) from
 operations.............  (68,221,000)*     47,000        --     (68,174,000)*
Identifiable assets.....   38,725,000 *  1,828,000   (683,000)    39,870,000 *
Capital expenditures....    1,935,000       83,000        --       2,018,000
Depreciation and
 amortization...........    1,308,000       19,000        --       1,327,000
1996
Revenue to unaffiliated
 customers.............. $ 17,435,000   $1,800,000  $     --    $ 19,235,000
Intercompany revenue....          --        84,000    (84,000)           --
                         ------------   ----------  ---------   ------------
  Total revenue.........   17,435,000    1,884,000    (84,000)    19,235,000
Income (loss) from
 operations.............   (4,821,000)      77,000        --      (4,744,000)
Identifiable assets.....   16,635,000    1,575,000   (485,000)    17,725,000
Capital expenditures....    1,227,000       13,000        --       1,240,000
Depreciation and
 amortization...........      850,000        4,000        --         854,000
1995
Revenue to unaffiliated
 customers.............. $ 17,426,000   $1,079,000  $     --    $ 18,505,000
Intercompany revenue....      159,000          --    (159,000)           --
                         ------------   ----------  ---------   ------------
  Total revenue.........   17,585,000    1,079,000   (159,000)    18,505,000
Income from
 operations.............      164,000      129,000        --         293,000
Identifiable assets.....    6,977,000      430,000   (228,000)     7,179,000
Capital expenditures....      804,000       20,000        --         824,000
Depreciation and
 amortization...........      441,000        2,000        --         443,000
</TABLE>
--------
*Restated--See Note 16.
(1)  For purposes of the above presentation, the operating results and other
     financial data of the Company's wholly-owned subsidiary, Peritus Software
     Services (India) Private Limited, are considered immaterial and are
     included in North America.
 
                                      63
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
15. COMMITMENTS
 
 Operating and Capital 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, 1997, 1996 and 1995 was $1,101,000, $999,000 and
$839,000, respectively. Future minimum lease payments under noncancelable
leases as of December 31, 1997 are as follows:
 
<TABLE>
<CAPTION>
                                                            OPERATING  CAPITAL
   YEAR ENDING DECEMBER 31,                                  LEASES     LEASES
   ------------------------                                ----------- --------
   <S>                                                     <C>         <C>
   1998................................................... $ 1,662,000 $ 73,000
   1999...................................................   1,582,000  133,000
   2000...................................................   1,775,000    9,000
   2001...................................................   1,937,000    6,000
   2002...................................................   1,933,000      --
   Thereafter.............................................   4,150,000      --
                                                           ----------- --------
                                                           $13,039,000  221,000
                                                           ===========
   Less--Amount representing interest.....................               26,000
                                                                       --------
   Present value of minimum lease payments................             $195,000
                                                                       ========
</TABLE>
 
16. SUBSEQUENT EVENTS
 
 Restatement of 1997 Results of Operations
 
  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 auditors, PricewaterhouseCoopers
LLP, the Company determined that the Company's results of operations for the
year ended December 31, 1997 required restatement. The restatement 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 has restated its 1997
results to remove the $592,000 of revenue involved and has not recorded this
revenue in any subsequent period.
 
  In the opinion of management, all adjustments necessary to revise the 1997
financial statements have been recorded. Below is a summary of the results of
operations for the year ended December 31, 1997 (in thousands, except per
share-related data):
 
<TABLE>
<CAPTION>
                                                                     YEAR ENDED
                                                                    DECEMBER 31,
                                                                        1997
                                                                    ------------
   <S>                                                              <C>
   As previously reported:
     Revenue.......................................................   $ 40,301
     Loss from operations..........................................    (67,582)
     Net loss......................................................    (66,910)
     Basic and diluted net loss per share..........................   $  (6.97)
   As restated:
     Revenue.......................................................   $ 39,709
     Loss from operations..........................................    (68,174)
     Net loss......................................................    (67,490)
     Basic and diluted net loss per share..........................   $  (7.03)
</TABLE>
 
                                      64
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Company Status
 
  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, 1997 and the nine months ended September 30, 1998 and
anticipates a net loss in the fourth quarter of 1998, which raises doubt about
its ability to continue as a going concern after 1998. The Company believes
that it has sufficient cash to finance its operations through 1998.
Thereafter, the Company's cash flow requirements will depend on the results of
future operations. There can be no assurance that these expectations will be
realized. After 1998, 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 implemented a restructuring plan on December
2, 1998 to further reduce its expenses which included the elimination of
approximately 45 employees and related facilities costs. The Company is also
exploring strategic initiatives to raise additional funds. In addition, the
Nasdaq Stock Market, Inc. has several requirements for listing on the Nasdaq
National Market or the Nasdaq SmallCap Market. Failure to meet listing
requirements may result in the Company being moved from the National Market to
the SmallCap Market or being de-listed. There can be no assurance that the
Company will not be de-listed.
 
  The Company's bank has indicated that it will not renew or further extend
its revolving line of credit facility and demanded that cash collateral be
provided for all amounts outstanding under its equipment financing agreement
with the Company since the Company was in default of certain financial and
operating covenants thereunder. There are no amounts outstanding under the
revolving credit facility and the Company has provided cash collateral for all
amounts outstanding under the equipment financing agreement and for a $300,000
standby letter of credit issued by the bank. There can be no assurance that
the Company will achieve a cash flow breakeven position or that it will be
able to raise additional funds through bank borrowings and/or debt and/or
equity financings. 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 financings would adversely impact the Company's ability to
continue as a going concern after 1998.
 
 In-Process Research and Development
 
  As described in Note 3, the Company expensed $70,800,000 relating to in-
process research and development in connection with the acquisition of MDI
during 1997. During 1998, the Company has 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 not yet been received from the SEC.
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.
 
 Legal Proceedings
 
  The Company and certain of its officers and directors have been 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 Downey complaint alleges a class period of October 22,
1997 to March 27, 1998. The Cohen, Bonnett, Wijntjes and Lee complaints allege
a class period of January 27, 1998 to March 27, 1998. The Lindsay, Teague and
Johnson
 
                                      65
<PAGE>
 
                        PERITUS SOFTWARE SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
complaints allege a class period of January 28, 1998 to March 27, 1998. The
Howard complaint alleges a class period of July 3, 1997 to March 27, 1998. The
complaints principally allege 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 alleges 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 names
Montgomery Securities, Inc., Wessels, Arnold & Henderson, and H.C. Wainwright
& Co., Inc. as defendants. The complaints further allege that certain officers
and/or directors of the Company sold stock in the open market during the class
periods and seek 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. Although the Company believes
that it and the other defendants have meritorious defenses to the claims made
in the complaints and intends to contest the lawsuits vigorously, an adverse
resolution of the lawsuits 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 complaints.
 
                                      66
<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, 1995....... Allowance for doubtful accounts              $    30     $--     $    --      $--     $     30
December 31, 1996....... Allowance for doubtful accounts              $    30     $--     $    --      $--     $     30
December 31, 1997....... Allowance for doubtful accounts              $    30     $65     $    --      $--     $     95
<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, 1995....... Net deferred tax assets valuation allowance  $   --      $--     $    --      $--     $    --
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)
</TABLE>
 
                                       67
<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 39 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 below, 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
0-22647.
 
<TABLE>
<CAPTION>
  EXHIBIT
    NO.                                 DESCRIPTION
  -------  --------------------------------------------------------------------
 <C>       <S>
   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/  Note and Warrant Purchase Agreement dated as of May 30, 1995 between
           the Registrant and Massachusetts Capital Resource Company.
  10.9/1/  Common Stock Purchase Warrant, due May 30, 1995.
  10.10/1/ Secured Subordinated Note due 2002, dated May 30, 1995.
</TABLE>
 
                                      68
<PAGE>
 
<TABLE>
<CAPTION>
  EXHIBIT
    NO.    DESCRIPTION
  -------  ------------
 <C>       <S>
  10.11/1/ Voting Agreement dated as of May 30, 1995 among the Registrant,
           Dominic K. Chan and Massachusetts Capital Resource Company.
  10.12/1/ Security Agreement dated as of May 30, 1995 between the Registrant
           and Massachusetts Capital Resource Company.
  10.13/1/ Series A Convertible Preferred Stock and Class A Common Stock
           Purchase Agreement dated as of March 15, 1996 among the Registrant
           and the purchasers named in Schedule I thereto.
  10.14/1/ Registration Rights Agreement dated as of March 15, 1996, as
           amended, among the Registrant and the stockholders listed on the
           signature pages thereto.
  10.15/1/ Stock Restriction Agreement dated as of March 15, 1996, as amended,
           among the Registrant, Dominic K. Chan and Marsha C. Chan and the
           stockholders listed on the signature pages thereto.
  10.16/1/ Voting Agreement dated as of March 15, 1996 among the Registrant and
           the stockholders listed in the signature pages thereto.
  10.17/1/ Stock Option Agreement dated as of March 15, 1996 among the
           Registrant, Dominic K. Chan and Marsha C. Chan.
 *10.18/1/ Non-Competition Agreement dated as of March 15, 1996 between the
           Registrant and Dominic K. Chan.
 *10.19/1/ Series B Convertible Preferred Stock Purchase Agreement dated as of
           October 28, 1996 among the Registrant and the purchasers named in
           Schedule I thereto.
 *10.20/1/ Employment Agreement dated as of December 30, 1996 between the
           Registrant and Douglas A. Catalano.
 *10.21/1/ Employment Agreement dated as of January 27, 1997 between the
           Registrant and Robert D. Savoia.
 *10.22/1/ Letter Agreement dated as of August 15, 1996 between the Registrant
           and Leonard Miller.
  10.23/1/ Master Software Services Agreement dated as of February 3, 1992
           between the Registrant and Bull HN Information Systems, Inc.
  10.24/1/ License Agreement dated as of July 29, 1996 between the Registrant
           and Bull HN Information Inc., as amended.
  10.25/1/ Master License Agreement dated as of October 21, 1996, as amended,
           between the Registrant and Merrill Lynch, Pierce, Fenner & Smith
           Incorporated.
  10.26/1/ Engineering Consultant Services Agreement, as amended, between
           Stratus Computer, Inc. and the Registrant, dated November 30, 1993.
  10.27/1/ Letter Agreement dated September 6, 1996 between the Registrant and
           Fleet National Bank.
  10.28/1/ Promissory Note between the Registrant and Fleet National Bank in
           the amount of $3,500,000, dated September 6, 1996.
  10.29/1/ Promissory Note between the Registrant and Fleet National Bank in
           the amount of $675,000, dated September 6, 1996.
           Promissory Note between the Registrant and Fleet National Bank in
  10.30/1/ the amount of $825,000, dated September 6, 1996.
  10.31/1/ Inventory, Accounts Receivable and Intangibles Security Agreement
           between the Registrant and Fleet National Bank, dated September 6,
           1996.
  10.32/1/ Supplemental Security Agreement between the Registrant and Fleet
           National Bank, dated September 6, 1996.
  10.33/1/ Security Agreement (Trademarks) between the Registrant and Fleet
           National Bank, dated September 6, 1996.
</TABLE>
 
 
                                       69
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
   NO.                                               DESCRIPTION
 -------   ------------------------------------------------------------------------------------------------
<S>        <C>
 10.34/1/  Security Agreement (Patents) between the Registrant and Fleet National Bank, dated
           September 6, 1996.
 10.35/1/  Subordination Agreement between Massachusetts Capital Resource Company and Fleet National
           Bank dated September 6, 1996.
 10.36/1/  License and Alliance Agreement dated as of May 1, 1996, as amended, between the Registrant and
           CSC Consulting, Inc., as amended.
 10.37/1/  Agreement and Plan of Merger among the Registrant, Vista Technologies Incorporated and its
           stockholders, dated January 29, 1996.
 10.38/1/  Letter of Intent dated May 9, 1997 between the Registrant and VIASOFT, Inc.
 10.39/1/  Joint Marketing Agreement effective as of June 12, 1997 between the Registrant and VIASOFT, Inc.
 10.40/1/  Letter Agreement dated March 30, 1997 between the Registrant and Fleet National Bank.
 10.41/1/  Letter Agreement dated June 20, 1997 between the Registrant and Fleet National Bank.
 10.42     Letter Agreement dated November 26, 1997 between the Registrant and Fleet National Bank.
 10.43/2/  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").
 10.44/2/  Registration Rights Agreement dated December 1, 1997 by and among the Registrant and APU.
*10.45     Employment Agreement dated as of January 20, 1998 between the Registrant and Adarsh Arora.
*10.46     Employment Agreement dated as of January 19, 1998 between the Registration and Donald Beck.
*10.47     Promissory Note of Donald Beck payable to the Registrant dated January 30, 1998.
 10.48     License Agreement dated October 25, 1997 between MDI and Chiquita Brands International, Inc.
 10.49     License Agreement dated December 31, 1996 between MDI and Windsor Group.
 10.50     License Agreement dated March 17, 1997 between MDI and Provident Bank.
 10.51     License Agreement dated November 11, 1997 between MDI and Great American Insurance Company.
 11        Restated Statement regarding computation of earnings per common share.
 21        Subsidiaries of the Registrant at March 31, 1998.
 23        Consent of PricewaterhouseCoopers LLP dated January 5, 1999.
 27.1      Restated Financial Data Schedule.
 27.2      Restated Financial Data Schedule for the three months ended March 31, 1997.
 27.3      Restated Financial Data Schedule for the three months ended June 30, 1997.
 27.4      Restated Financial Data Schedule for the six months ended June 30, 1997.
 27.5      Restated Financial Data Schedule for the three months ended September 30, 1997.
 27.6      Restated Financial Data Schedule for the nine months ended September 30, 1997.
</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.
*Management Contract or compensatory plan or arrangement filed in response to
   Item l4(a)(3) of the instructions to the Annual Report on Form 10-K.
 
                                       70
<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.
 
                                             /s/  John D. Giordano
                                          By___________________________________
                                            John D. Giordano
                                            Vice President, Finance and
                                            Chief Financial Officer
                                            (Principal Financial Officer)
                                            January 5, 1999
 
                                      71