<PAGE>

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                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   _________

                                   FORM 10-K
                                   _________


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

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

                  For the fiscal year ended December 31, 2000

                                      OR

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

               For the transition period from        to
                       Commission file number 000-22647

                        Peritus Software Services, Inc.
            (Exact Name of Registrant as Specified in Its Charter)

        Massachusetts                                    04-3126919
(State or Other Jurisdiction of             (I.R.S. Employer Identification No.)
Incorporation or Organization)

       112 Turnpike Road, Suite 111                      01581-2860
       Westborough, Massachusetts                        (Zip Code)
(Address of Principal Executive Offices)

       Registrant's telephone number, including area code: (508) 870-0963

          Securities registered pursuant to Section 12(b) of the Act:

    Title of Each Class                Name of Each Exchange on Which Registered

      Not Applicable                                Not Applicable

          Securities registered pursuant to Section 12(g) of the Act:

                         Common Stock, $0.01 par value

                                (Title of Class)


     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [_]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

     As of March 15, 2001, the aggregate market value of common stock held by
non-affiliates of the registrant was approximately $1,175,369. Reference is made
to Part II, Item 5 of this Annual Report on Form 10-K for a statement upon which
this calculation is based. As of that date, there were 27,319,903 shares
outstanding of the registrant's common stock, $0.01 par value.

                      DOCUMENTS INCORPORATED BY REFERENCE

None.
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                        PERITUS SOFTWARE SERVICES INC.

                                  FORM 10-K65

                                 ANNUAL REPORT

                               TABLE OF CONTENTS


<TABLE>
<CAPTION>
                                                      PART I
                                                                                                              Page
                                                                                                              ----
<S>                                                                                                           <C>
Item 1.    Business.........................................................................................     3
Item 2.    Properties.......................................................................................    10
Item 3.    Legal Proceedings................................................................................    10
Item 4.    Submission of Matters to a Vote of Security Holders..............................................    11

                                                      PART II

Item 5.    Market for the Registrant's Common Stock and Related Stockholder Matters.........................    11
Item 6.    Selected Financial Data..........................................................................    11
Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations............    13
Item 7A.   Quantitative and Qualitative Disclosures about Market Risk.......................................    28
Item 8.    Financial Statements and Supplementary Data......................................................    29
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.............    55

                                                     PART III

Item 10.   Directors and Executive Officers of the Registrant...............................................    55
Item 11.   Executive Compensation...........................................................................    57
Item 12.   Security Ownership of Certain Beneficial Owners and Management...................................    60
Item 13.   Certain Relationships and Related Transactions...................................................    61

                                                      PART IV

Item 14.   Exhibits, Financial Statement Schedules and Reports on Form 8-K..................................    62
Signatures..................................................................................................    63
</TABLE>

     Peritus is a registered trademark, Automate 2000 is a registered service
mark, AutoEnhancer, SAM Relay and CodeNine are trademarks and Renovation Quality
Evaluation and Software Asset Maintenance are service marks of Peritus Software
Services, Inc., MDI is a registered trademark, Vantage YR 2000 is a trademark
and the MDI logo is a registered service mark of Millennium Dynamics, Inc.

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

     This Annual Report may contain forward-looking statements which involve
risks and uncertainties. The Registrant's actual results may differ materially
from the results discussed in such statements. Certain factors that could cause
such a difference include, without limitation, the factors listed below in
"Factors That May Affect Future Results". The Registrant does not assume any
obligation to update any of the forward-looking statements it makes.

                                       2
<PAGE>

                                    PART I.

Item 1. Business

Company Current Condition and Current Strategy

     In the second half of 1998 and in 1999, the overall market for the year
2000 tools and services of Peritus Software Services, Inc. ("Peritus" or the
"Company") contracted dramatically, resulting in substantial financial losses.
In response, the Company substantially reduced its workforce in September and
December of 1998 and again in April of 1999. During the second and third
quarters of 1999, the Company also settled its leases for its facilities in
Cincinnati, Ohio, Lisle, Illinois and Billerica, Massachusetts and took other
efforts to reduce its fixed costs. As a result of the Company's degraded
financial condition, the Company began encountering major obstacles in obtaining
new outsourcing business. Since most outsourcing engagements are multi-year and
involve critical applications, prospective new clients, although interested in
the capabilities and technology of the Company, were reluctant or unwilling to
commit to contracts. Despite the significant reduction in the overall cost
structure as a result of the foregoing and other actions, the Company was unable
to achieve a cash flow break-even position in the years ended December 31, 1999
and 2000.

     On March 27, 2000, Rocket Software, Inc. ("Rocket"), a privately held
company, invested $4,000,000 in the Company in exchange for 10,000,000 shares
($.40 per share) of restricted common stock (37% of outstanding stock after the
investment). The Company granted Rocket certain registration rights with respect
to the shares.

     During the second and third quarters of 2000, the Company explored certain
extensions to its CodeNine tool beyond the field of application understanding
and concluded that such extensions were not feasible.

     On October 16, 2000, the Company announced that it retained The Catalyst
Group, LLC to render financial advisory and investment banking services in
connection with exploring strategic alternatives, including the potential sale
of the Company. The Company is currently engaged in exploring a number of
possibilities for potential sale or merger of the Company.

     On February 8, 2001, the Company announced that it was reducing its
workforce by nine employees effective February 23, 2001.

     The Company experienced net losses of $4,166,000, $2,583,000 and
$26,673,000 in the years ended December 31, 2000, 1999 and 1998, respectively.
Based on the Company's current forecasted cash expenditures and its cash on
hand, the Company expects to have sufficient cash to finance its operations
through the year 2001. The Company's future beyond the year 2001 is dependent
upon its ability to execute some form of organizational transaction, achieve
break-even cash flow, or raise additional financing. There can be no assurances
that the Company will be able to do so.

     The Company's primary strategy is to seek some form of organizational
transaction. Beyond that, the Company intends to continue to service its
existing outsourcing customers and to renew expiring contracts. At the same
time, the Company is pursuing new business through (i) the licensing of, and
associated consulting and training for, its software maintenance methodology
(technology transfer services), its SAM Relay tool and selectively its CodeNine
tool, and (ii) the provision of various service offerings including, without
limitation, general software consulting.

Company Overview

     Peritus provides solutions consisting of software products and services
that enable organizations to improve the productivity, quality and effectiveness
of their information technology ("IT"), systems maintenance or software
evolution functions. The Company employs software tools, methodologies and
processes, designed to automate the typically labor-intensive processes involved
in conducting mass change and other software maintenance tasks. In 1996, the
Company released its first commercially available product, its AutoEnhancer/2000
software, which was aimed at the industry's most pervasive mass change
challenge, the year 2000 problem, to value added integrators and directly to end
users. In 1996, the Company expanded its research and development efforts
through the acquisition of Vista Technologies Incorporated ("Vista"), a
developer of computer-aided engineering software. In 1997, the Company expanded
its product offerings and research and development efforts by releasing an
enhanced version of the AutoEnhancer/2000 software, which enables a client to
perform logic correction only changes with regard to year 2000 renovations, and
by acquiring substantially all of the assets and assuming certain of the
liabilities of Millennium Dynamics, Inc. ("MDI"), a software tools company with
year 2000 products for the IBM mainframe and AS/400 platforms from American
Premium Underwriters, Inc. ("APU").

                                       3
<PAGE>

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

     In the second half of 1998, the overall market for the year 2000 products
and services of the Company contracted dramatically, resulting in substantial
financial losses and, in response, the Company substantially reduced its
workforce in September and December of 1998. As a result of the Company's
degraded financial condition, the Company began encountering major obstacles in
obtaining new outsourcing business. Since most outsourcing engagements are
multi-year and involve critical applications, prospective new clients, although
interested in the capabilities and technology of the Company, were reluctant or
unwilling to commit to contracts. Based upon its continued difficulties, the
Company substantially reduced its workforce again in April 1999 and experienced
significant voluntary attrition in its workforce.

     On February 3, 1999, the Company's common stock was delisted from trading
on the Nasdaq National Market. The Company's common stock is now currently
traded on the Over The Counter ("OTC") Bulletin Board which has several
requirements for listing.

     In March 1999, the Company announced that it had retained Covington
Associates to render financial advisory and investment banking services in
connection with exploring strategic alternatives including the potential sale of
the Company. The engagement agreement was entered into in December 1998 and was
terminated in December 1999.

     During the second and third quarters of 1999, the Company settled its
leases for its facilities in Cincinnati, Ohio, Lisle, Illinois and Billerica,
Massachusetts and took other efforts to reduce its fixed costs.

     On March 27, 2000, Rocket Software, Inc. ("Rocket"), a privately held
company, invested $4,000,000 in the Company in exchange for 10,000,000 shares
($.40 per share) of restricted common stock (37% of outstanding stock after the
investment). The Company granted Rocket certain registration rights with respect
to the shares. The Company recorded a one-time charge related to the investment
of approximately $4,000,000 in the quarter ended March 31, 2000. The charge
represented the difference between the quoted market price on the commitment
date and the price paid by Rocket. Under certain sections of the Internal
Revenue Code, a change in ownership of greater than 50% within a three-year
period places an annual limitation on the Company's ability to utilize its
existing net operating loss and research and development tax credit carry-
forwards. The investment by Rocket triggered such limitation.

     During the second and third quarters of 2000, the Company explored certain
extensions to its CodeNine tool beyond the field of application understanding
and concluded that such extensions were not feasible.

     On October 16, 2000, the Company announced that it retained The Catalyst
Group, LLC to render financial advisory and investment banking services in
connection with exploring strategic alternatives, including the potential sale
of the Company. The Company is currently engaged in exploring a number of
possibilities for potential sale or merger of the Company.

     On February 8, 2001, the Company announced that it was reducing its
workforce by nine employees effective February 23, 2001.

     The Company experienced net losses of $4,166,000, $2,583,000 and
$26,673,000 in the years ended December 31, 2000, 1999 and 1998, respectively.
Based on the Company's current forecasted cash expenditures and its cash on
hand, the Company expects to have sufficient cash to finance its operations
through the year 2001. The Company's future beyond the year 2001 is dependent
upon its ability to execute some form of organizational transaction, achieve
break-even cash flow, or raise additional financing. There can be no assurances
that the Company will be able to do so.

     The Company currently derives its revenue from software maintenance
outsourcing services, software and methodology licensing and other services.
Historically, the Company's products and services have been marketed through its
direct sales force, both domestically and in Europe, and through value added
integrators operating worldwide. The Company currently has no direct sales force
representatives. Future sales will be dependent upon the sales efforts of senior
management and the use of sales agency relationships.

                                       4
<PAGE>

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 businesses or develop new business strategies.

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

Peritus Products, Services and Technology

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

 Products and Services

     Currently, the Company's product offerings include its CodeNine and SAM
Relay tools and its service offerings include software maintenance outsourcing
(SAMis and SAMsp), technology transfer and insourcing services.

 CodeNine

     The Company's CodeNine tool enables a user to understand a mainframe based
application or application set. It employs a combination of methodologies and
automated software features that enable a user to extract mainframe applications
and move the code to a PC workstation for analysis and understanding. It
provides detailed information on the application inventory and relationships
between software assets; partitions the assets into applications, business
transactions, and elementary transactions; generates application size metrics,
such as function point counts; and supports the modeling of enhancements
including function point counts. It can also provide low-level impact analysis
on individual code members. CodeNine also aids in the understanding of legacy
applications to help facilitate determining the best strategy for enabling these
applications for Internet use.

 SAM Relay

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

 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.

     The Company offers two distinct types of software maintenance outsourcing
services, SAMsp and SAMis. SAMsp is a fixed

                                       5
<PAGE>

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

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

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

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

 Technology Transfer Services

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

     The Company also provides insourcing services, which combine 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.

 Mass Change Solutions

     Technology for Mass Change. 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. The Company has received a United States Patent, Patent Number:
5,838,979 covering certain technology applicable to the Mass Change Engine.  The
Mass Change Engine is not currently marketed by the Company.

     Year 2000 Renovation Tools. The Company's year 2000 products and services
provided 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, was also designed to provide flexibility in
addressing the critical identification, correction and verification components
of a year 2000 renovation. The AutoEnhancer/2000 software was designed to be
interoperable with third-party assessment, extraction and testing tools. The
Vantage YR2000 software toolset was 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.  The Company's Year 2000 renovation tools are no longer marketed by
the Company.

     Year 2000 Renovation Quality Evaluation Tool. The Company's RQE Tool was
used to facilitate an in-house evaluation of a Year 2000 renovation of C and
COBOL code by identifying and evaluating date sensitive variables in the
renovated code. It is no longer marketed by the Company.

                                       6
<PAGE>

Technology

     The Company's core technologies consist of its CodeNine tool, SAM Relay
tool, and Mass Change Engine, (as previously described) as well as the Peritus
Intermediate Language and other computer-based tools and formal mathematical
techniques.

     The Peritus Intermediate Language. The Company has developed its Peritus
Intermediate Language to support accurate analysis of why a program functions
incorrectly. PIL is based on the mathematical theory that all computations can
be expressed in a small number of abstract instructions into which existing
computer languages can be translated. PIL consists of 13 abstract instructions
and currently the COBOL, RPG, C and PL/1 programming languages have been
translated by the Company into PIL. When data enter a computer program, their
paths can be traced by the values assigned to them by the instructions in that
program. In contrast, PIL can be used to trace the paths of all data that fall
into mathematically describable classes. As a result, if the data are in a
certain state when a program completes or aborts, it is possible, using PIL, to
determine the initial conditions of these data before the program was executed.
In addition, the use of PIL allows tools to be built that can verify whether 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. The Company has received a United
States Patent, Patent Number: 6,029,002 relating to the use of PIL.

     Other Computer-Based Tools.  Currently, the Company's other computer-based
tools include:

     Peritus Code Analyzer ("PCA"). PCA is a software maintenance assistance
tool designed to automate the process of logical code analysis. The tool is used
to discover and correct defects, implement enhancements, verify properties of
software (such as database integrity or security properties), migrate from one
language to another and update systems or programs and data for specific
enhancements (such as those required by the year 2000 problem). The Company has
received a United States Patent, Number: 6,029,002 covering certain technology
applicable to PCA.

     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.

Sales and Marketing

     Historically, the Company offered its products and services to clients
through both direct and indirect channels, including value added integrators as
well as domestic and international distributors.

 Direct Sales

In April 1999, the Company reduced its direct sales force to one sales
representative. Thereafter, the Company hired one other direct sales
representative and entered into a contract with a sales agent.  Currently, the
Company has a Vice President of Sales and Marketing but no Direct Sales
Representatives.  Future sales will be dependent upon the sales efforts of
senior management and the use of sales agency relationships. Prior to April
1999, the Company sold and supported its products and services directly in the
United States.

 Indirect Sales

     The Company has inactive agreements with value added integrators for its
Year 2000 products. During 2000, the Company had no sales from these value-added
integrators. The Company's integrators are located in the United States, Canada,
Europe and Japan and are authorized by Peritus to sublicense the Company's
products and/or services to end users or system integrators in their respective
territories.

 Marketing

     In April 1999, the Company eliminated its marketing organization to
minimize its expenses. Currently, the Company has a Vice President of Sales and
Marketing and spent a limited amount on marketing and promotional activities in
2000. Prior to April 1999, the Company's marketing organization worked closely
with product management and the sales organization in the development of Company
marketing literature, market research to assist in strategic planning and
tactical decision making, trade show programs and exhibit planning, advertising
and public relations support.

                                       7
<PAGE>

Clients

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

     To date, the Company's revenue has been dependent on a few major clients,
including American Telephone & Telegraph Company ("AT&T"), Bull HN Information
Systems, Inc. ("Bull"), Computer Sciences Incorporated ("CSC"), Compaq Computer
Corporation ("Compaq"), EMC Corporation ("EMC"), Ford Motor Company ("Ford"),
CGI Group Inc ("CGI") International Business Machines Corporation ("IBM"),
Merrill Lynch, Pierce Fenner & Smith Incorporated ("Merrill Lynch"),
Metropolitan Life Insurance Company ("Met Life"), MicroAge Computer Center, Inc.
("Microage"), and Telesector Resources Group Inc. ("NYNEX"). During 2000, Bull,
Ford, EMC, and CGI represented approximately 40.3%, 15.1%, 12.2%, and 10.4% of
the Company's total revenue, respectively. During 1999, Bull and Compaq
represented approximately 21.7% and 11.8% of the Company's total revenue,
respectively. During 1998, AT&T and Bull represented approximately 12.2% and
10.0% of the Company's total revenue, respectively. In addition, the Company's
ten largest clients represented approximately 97.6%, 70.1% and 52.4% of the
Company's total revenue in the years ended December 31, 2000, 1999 and 1998,
respectively.

     The Company has entered into agreements to provide software consulting
services and software maintenance services with Compaq, Computervision, EMC and
Bull. The Compaq agreement terminated in March 2000. The Computervision
agreement terminated in December 2000.  In December 2000, the Company received
notification that EMC will terminate its agreement effective March 31, 2001. The
Bull contract expires on December 31, 2006 but is earlier cancelable by Bull or
the Company.  The Company is currently in discussions with Bull on the
contract's principal statement of work regarding the pricing and extent of
services to be provided in the year 2002.

     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.

Client Technical Support

     In connection with the licensing of its products, the Company provides its
clients with technical support and advice, including problem resolution,
installation assistance, error corrections and product enhancements released
during maintenance. The Company provides 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 were typically 15% of license fees and were typically capped at
$400,000 annually per direct licensee. The Company notified customers of its
Vantage YR2000 software toolset that it was terminating client technical support
for that product in the first quarter of the year 2000.

Research and Product Development

     Historically, the Company has invested significantly in enhancing existing
technology and developing new products and services. As a result of the
Company's restructurings in 1998 and 1999, the majority of the Company's
research and development resources were eliminated. The Company plans to
continue limited maintenance of and enhancements to its existing products. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" for a description of research and development expenses incurred from
1998 through 2000.

     The Company has its remaining development facility at the Company's
Westborough, Massachusetts headquarters. The Company closed its development and
support center in Bangalore, India in 1999.

                                       8
<PAGE>

     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 were located in
India and Canada, to develop materials, processes, software or portions of
software for and on behalf of the Company.

Competition

     The market for the Company's software products and services 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
outsourcing service providers and software maintenance tools vendors. The
Company faces competition with its CodeNine tool from vendors whose products
include some of the functionality of CodeNine, such as Merant PLC, SEEC Inc.,
Viasoft Inc., and Relativity Technologies, Inc. The Company faces competition
with its SAM Relay tool from vendors whose products include some of the
functionality of SAM Relay, such as Instinctive Inc., Starbase Inc, Rational
Inc. and Interliant Inc.

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

     A number of the Company's competitors are more established, benefit from
greater name recognition and have substantially greater financial, technical and
marketing resources than the Company. Moreover, other than the need for
technical expertise, there are no significant proprietary or other barriers to
entry in the Company's market.

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 a trade secret
and an unpublished copyrighted work. 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 YR2000 software toolset and SAM Relay and RQE
tools source code for certain purposes. Access to the source code may increase
the likelihood of misappropriation or misuse by third parties.

     The Company's business also includes licensing of the Company's proprietary
software, methodologies and related services to end users, as well as to value
added integrators authorized to provide services to third parties. In general,
such licensing of the Company's proprietary software, methodologies and related
services to a licensee is a limited term, limited use, non-exclusive license
that contains restrictions on copying, disclosure, usage, decompiling and
transferability. In particular cases, however, a license agreement may have
certain provisions that are exclusive in some manner. Within these licensing
agreements, the Company seeks to avoid disclosure of its trade secrets,
including, but not limited to, generally requiring those persons with access to
the 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 were located in India and
Canada, to develop software or portions of software for and on behalf of the
Company. Software development by a contractor for the Company is done pursuant
to agreements that generally assign all rights to the Company and contain
nondisclosure provisions. Such software developed by a contractor may be merged
with software that the Company has developed internally using its 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.

                                       9
<PAGE>

     The Company has been granted three patents by the United States Patent and
Trademark Office (the "PTO") pertaining to technologies, processes and
methodologies used by the Company's software:  (i) United States Patent Number:
5,838,979, that covers certain technology applicable to the Mass Change Engine,
(ii) United States Patent Number: 5,911,142, that covers a system and method
that automatically converts field lengths of data fields in a data file that are
accessed by a computer program and correspond to date-related data, and (iii)
United States Patent Number: 6,029,002 that covers an analyzer for maintaining
and analyzing source code that includes a software translator for converting
source code into an intermediate language, slicing capability based upon weakest
precondition determination, dual direction flow analysis and incorporation of a
computational model to facilitate iterative code. There can be no assurance that
such patents would survive a legal challenge to their validity or provide
meaningful or significant protection to the Company. The Company has abandoned
all outstanding patent applications. 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. The Company has become aware of a patent relating to
fixing the year 2000 problem based on a "windowing" method. Certain of the
Company's technology incorporated in some of its products may infringe on such
patent.

     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 March 15, 2001, the Company employed 22 employees, 2 of whom were
part-time. It is important for the Company to 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 retain or attract 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.

Item 2. Properties

     The Company is headquartered in Westborough, Massachusetts, where it leases
approximately 11,600 square feet under a lease expiring in December 2001. The
Company has an option to extend the lease for an additional term of three years
subject to certain terms and conditions.  The extension option expires on March
31, 2001 and the Company does not expect to exercise its option. Prior to lease
termination, the Company may negotiate to extend the lease for part or all of
the existing space under lease.

Item 3. Legal Proceedings

     In December 1999, while continuing to deny any liability, the Company
agreed to settle a then-pending class action lawsuit filed in the United States
District Court for the District of Massachusetts relating to events during the
period October 22, 1997 through October 26, 1998. The settlement was funded
entirely by the Company's directors and officers liability insurer and became
final on March 29, 2000.

     On or about April 28, 1999, the Company filed a lawsuit in the United
States District Court for the District of Massachusetts against Micah Technology
Services, Inc. and Affiliated Computer Services, Inc. (collectively, "Micah").
The lawsuit principally alleged that Micah breached its contract with the
Company by failing to pay for services performed by the Company under such
contract. The lawsuit further alleged that since Micah was unjustly enriched by
the services performed by the Company, the Company was entitled to recovery
based on quantum meruit, and that Micah engaged in unfair and/or deceptive trade
practices or acts in violation of Massachusetts General Laws ("M.G.L.") Chapter
93A by allowing the Company to perform services when Micah did not pay for such
services. The lawsuit sought unspecified damages on the breach of contract and
quantum meruit claims and double or triple damages on the Chapter 93A claim.
Micah denied the Company's allegations and filed a counterclaim against the
Company principally alleging fraud, negligent misrepresentations, breach of
contract and that the Company engaged in unfair and/or deceptive trade practices
or acts in violation of M.G.L. Chapter 93A by its misrepresentations and breach
of contract. The Company denied the allegations contained in Micah's
counterclaim. A non-binding mediation hearing was held on March 17, 2000 and no
settlement was reached. On December 18, 2000, the Company and Micah agreed to
settlement terms whereby Micah agreed to pay, and has paid

                                       10
<PAGE>

$320,000 and both parties agreed to a general release from any and all claims
relating to or arising out of this litigation.

Item 4. Submission of Matters to a Vote of Security Holders

 None.

                                    PART II.

Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters

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


<TABLE>
<CAPTION>
                                                         2000                 1999
                                                         ----                 ----
                                                   High        Low       High        Low
                                                   ----        ---       ----        ---
<S>                                               <C>        <C>        <C>        <C>
First Quarter...................................  $2.2500    $0.0781    $1.1875    $0.1875
Second Quarter..................................  $1.0000    $0.2969    $0.3281    $0.1250
Third Quarter...................................  $0.3281    $0.1563    $0.3125    $0.1250
Fourth Quarter..................................  $0.1875    $0.0625    $0.1406    $0.0781
</TABLE>

     Historically, the Company has not declared or paid cash dividends on its
common stock and does not plan to pay cash dividends to its stockholders in the
foreseeable future. The Company presently intends to retain any earnings to
finance its business. As of March 15, 2001, there were 325 stockholders of
record of the Company's common stock. The number does not include shareholders
who hold their stock in "street name" or through broker or nominee accounts.

     The last per share sale price of the Company's stock on March 15, 2001 was
$0.0781. For purposes of calculating the aggregate market value of the shares of
the Company's common stock held by non-affiliates, as shown on the cover page of
the Annual Report on Form 10-K, it has been assumed that all outstanding shares
were held by non-affiliates, except for the outstanding shares beneficially held
by the Company's Directors and Executive Officers. However, this should not be
deemed to be an admission that all these persons are, in fact, affiliates of the
Company, or that there are no other persons who may be deemed to be affiliates
of the Company.

Item 6. Selected Financial Data

     The selected financial data set forth below as of December 31, 2000 and
1999, and for the each of three years ended December 31, 2000, are derived from
the Company's Consolidated Financial Statements, which appear elsewhere in this
Annual Report. The selected financial data set forth below as of December 31,
1998, 1997 and 1996 and for the years ended December 31, 1997 and 1996 are
derived from the Company's audited financial statements, which are not included
in this Annual Report. The data set forth below should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Company's Consolidated Financial Statements, including the
Notes thereto, included elsewhere in this Annual Report.

                                       11
<PAGE>

<TABLE>
<CAPTION>
                                                                            Year Ended December 31,
                                                                            -----------------------
                                                                 2000      1999       1998       1997      1996
                                                                 ----      ----       ----       ----      ----
                                                                      (In Thousands, Except Per Share Data)
<S>                                                             <C>       <C>       <C>        <C>        <C>
Statement of operations data:
Revenue:
  Outsourcing services.....................................     $ 2,664   $ 5,923   $  9,925   $ 11,447   $10,190
  License..................................................       1,045     2,087      9,444     21,255     6,526
  Other services...........................................         814     3,188     12,163      7,007     2,519
                                                                -------   -------   --------   --------   -------

   Total revenue(1)........................................     $ 4,523   $11,198   $ 31,532   $ 39,709   $19,235
                                                                -------   -------   --------   --------   -------
Cost of revenue:
  Cost of outsourcing services.............................       1,465     4,778      7,577      9,536     8,488
  Cost of license..........................................          --       238      1,631        690       162
  Cost of other services...................................         295     2,013      9,110      5,357     2,931
                                                                -------   -------   --------   --------   -------

   Total cost of revenue(1)................................       1,760     7,029     18,318     15,583    11,581
                                                                -------   -------   --------   --------   -------

Gross profit...............................................       2,763     4,169     13,214     24,126     7,654
                                                                -------   -------   --------   --------   -------
Operating expenses:
Sales and marketing........................................         368     1,450     13,244      8,864     3,116
Research and development...................................       1,189     1,316      8,528      8,324     6,033
General and administrative.................................       1,766     3,570      7,466      4,312     3,249
Write-off of acquired in-process research and development..          --        --         --     70,800        --
Impairment of long-lived assets............................          --       961      5,218         --        --
Restructuring charges (credit).............................          --      (455)     5,906         --        --
Gain on sale of assets.....................................         (24)       --         --         --        --
                                                                -------   -------   --------   --------   -------

   Total operating expenses................................       3,299     6,842     40,362     92,300    12,398
                                                                -------   -------   --------   --------   -------

Loss from operations.......................................        (536)   (2,673)   (27,148)   (68,174)   (4,744)
Interest income (expense), net.............................         342        92        485        948      (296)
                                                                -------   -------   --------   --------   -------
Loss before gain on sale of majority-owned
  subsidiary, cost of strategic investment, income
  taxes, minority interest  and equity in loss of less
  than majority owned company..............................        (194)   (2,581)   (26,663)   (67,226)   (5,040)
Gain on sale of majority-owned subsidiary..................          --        --        (11)        --        --
Cost of strategic investment...............................       4,000        --         --         --        --
Provision (benefit) for income taxes.......................         (28)        2         25        260      (143)
                                                                -------   -------   --------   --------   -------
Loss before minority interest in majority-owned
   subsidiary..............................................      (4,166)   (2,583)   (26,677)   (67,486)   (4,897)
Minority interest in majority-owned subsidiary.............          --        --         (4)         4        24
                                                                -------   -------   --------   --------   -------

Net loss...................................................     $(4,166)  $(2,583)  $(26,673)  $(67,490)  $(4,921)
                                                                =======   =======   ========   ========   =======

  Basic and diluted net loss per share.....................     $ (0.17)  $ (0.15)  $  (1.65)  $  (7.03)  $ (1.02)
                                                                =======   =======   ========   ========   =======

Weighted average shares outstanding- basic
  and diluted..............................................      24,939    16,670     16,177      9,708     5,876
                                                                =======   =======   ========   ========   =======
</TABLE>

                                       12
<PAGE>

<TABLE>
<CAPTION>
                                                                             December 31,
                                                              -----------------------------------------
                                                               2000    1999     1998     1997     1996
                                                               ----    ----     ----     ----     ----
                                                                            (In Thousands)
<S>                                                           <C>     <C>     <C>      <C>      <C>
Balance sheet data:
Cash and cash equivalents, including restricted cash...       $3,716  $2,475  $ 3,378  $11,340  $ 7,388
Short-term investments.................................        1,411      --      500    3,000       --
Working capital........................................        5,025   1,640    1,805   20,931    8,218
Total assets...........................................        7,113   4,293   13,723   39,870   17,725
Long-term debt, net of current portion.................           --      --       --      413    1,538
Redeemable stock.......................................           --      --       --       --   12,287
Stockholders' equity (deficit).........................        6,230   2,372    4,810   30,005   (3,302)
</TABLE>

-------

(1)  Revenue (in thousands) from related parties in the years ended December 31,
     2000, 1999, 1998, 1997 and 1996 was $115, $0, $1,331, $4,478, and $6,443,
     respectively. Cost of revenue from related parties in the years ended
     December 31, 2000, 1999, 1998, 1997 and 1996 was $90, $0, $806, $2,467, and
     $1,984, respectively. See the Company's Consolidated Financial Statements.

Item 7.   Management's Discussion and Analysis of Financial Condition and
          Results of Operations

Company Current Condition and Current Strategy

    In the second half of 1998 and in 1999, the overall market for the year 2000
tools and services of Peritus Software Services, Inc. ("Peritus" or the
"Company") contracted dramatically, resulting in substantial financial losses.
In response, the Company substantially reduced its workforce in September and
December of 1998 and again in April of 1999. During the second and third
quarters of 1999, the Company also settled its leases for its facilities in
Cincinnati, Ohio, Lisle, Illinois and Billerica, Massachusetts and took other
efforts to reduce its fixed costs. As a result of the Company's degraded
financial condition, the Company began encountering major obstacles in obtaining
new outsourcing business. Since most outsourcing engagements are multi-year and
involve critical applications, prospective new clients, although interested in
the capabilities and technology of the Company, were reluctant or unwilling to
commit to contracts. Despite the significant reduction in the overall cost
structure as a result of the foregoing and other actions, the Company was unable
to achieve a cash flow break-even position in the years ended December 31, 1999
and 2000.

    On March 27, 2000, Rocket Software, Inc. ("Rocket"), a privately held
company, invested $4,000,000 in the Company in exchange for 10,000,000 shares
($.40 per share) of restricted common stock (37% of outstanding stock after the
investment). The Company granted Rocket certain registration rights with respect
to the shares.

    During the second and third quarters of 2000, the Company explored certain
extensions to its CodeNine tool beyond the field of application understanding
and concluded that such extensions were not feasible.

    On October 16, 2000, the Company announced that it retained The Catalyst
Group, LLC to render financial advisory and investment banking services in
connection with exploring strategic alternatives, including the potential sale
of the Company.  The Company is currently engaged in exploring a number of
possibilities for potential sale or merger of the Company.

    On February 8, 2001, the Company announced that it was reducing its
workforce by nine employees effective February 23, 2001.

The Company experienced net losses of $4,166,000, $2,583,000 and $26,673,000 in
the years ended December 31, 2000, 1999 and 1998, respectively. Based on the
Company's current forecasted cash expenditures and its cash on hand, the Company
expects to have sufficient cash to finance its operations through the year 2001.
The Company's future beyond the year 2001 is dependent upon its ability to
execute some form of organizational transaction, achieve break-even cash flow,
or raise additional financing. There can be no assurances that the Company will
be able to do so.

    The Company's primary strategy is to seek some form of organizational
transaction.  Beyond that, the Company intends to continue to service its
existing outsourcing customers and to renew expiring contracts. At the same
time, the Company is pursuing new business through (i) the licensing of, and
associated consulting and training for, its software maintenance methodology
(technology transfer services), its SAM Relay tool and selectively its CodeNine
tool, and (ii) the provision of various service offerings including, without
limitation, general software consulting.

Company Overview

    Peritus provides solutions consisting of software products and services that
enable organizations to improve the productivity,

                                       13
<PAGE>

quality and effectiveness of their information technology ("IT"), systems
maintenance or software evolution functions. The Company employs software tools,
methodologies and processes, designed to automate the typically labor-intensive
processes involved in conducting mass change and other software maintenance
tasks. In 1996, the Company released its first commercially available product,
its AutoEnhancer/2000 software, which was aimed at the industry's most pervasive
mass change challenge, the year 2000 problem, to value added integrators and
directly to end users. In 1996, the Company expanded its research and
development efforts through the acquisition of Vista Technologies Incorporated
("Vista"), a developer of computer-aided engineering software. In 1997, the
Company expanded its product offerings and research and development efforts by
releasing an enhanced version of the AutoEnhancer/2000 software, which enables a
client to perform logic correction only changes with regard to year 2000
renovations, and by acquiring substantially all of the assets and assuming
certain of the liabilities of Millennium Dynamics, Inc. ("MDI"), a software
tools company with year 2000 products for the IBM mainframe and AS/400 platforms
from American Premium Underwriters, Inc. ("APU").

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

    In the second half of 1998, the overall market for the year 2000 products
and services of the Company contracted dramatically, resulting in substantial
financial losses, and, in response, the Company substantially reduced its
workforce in September and December of 1998. As a result of the Company's
degraded financial condition, the Company began encountering major obstacles in
obtaining new outsourcing business. Since most outsourcing engagements are
multi-year and involve critical applications, prospective new clients, although
interested in the capabilities and technology of the Company, were reluctant or
unwilling to commit to contracts. Based upon its continued difficulties, the
Company substantially reduced its workforce again in April 1999 and experienced
significant voluntary attrition in its workforce.

    On February 3, 1999, the Company's common stock was delisted from trading on
the Nasdaq National Market. The Company's common stock is now currently traded
on the Over The Counter ("OTC") Bulletin Board which has several requirements
for listing.

    In March 1999, the Company announced that it had retained Covington
Associates to render financial advisory and investment banking services in
connection with exploring strategic alternatives including the potential sale of
the Company. The engagement agreement was entered into in December 1998 and was
terminated in December 1999.

    In June 1999, the Company reached a settlement with American Financial
Group, Inc. ("AFG") and its subsidiaries and affiliates for release from its
real estate lease in Cincinnati, Ohio and certain other obligations. Under the
settlement, the Company agreed to pay $200,000 in cash and issue 300,000 shares
of Common Stock in exchange for release of its real estate lease for 20,500
square feet that required average monthly payments, excluding operating
expenses, of $36,000 through November 2002. The Company had not made any
payments since October 1998. The settlement also released the Company from net
claims for other services and disputes of $334,500.

    In August 1999, the Company executed a lease termination agreement for its
Lisle, Illinois facility. Under that agreement, the Company agreed to pay
$100,000 in cash and relinquish its $16,000 security deposit. The real estate
lease for 9,000 square feet required average lease and operating expense
payments of $18,000 per month through February 2003. The Company had not made
any payments since March 1999.

    Effective September 27, 1999, the Company relocated its corporate
headquarters from Billerica, Massachusetts to its existing facility located at
112 Turnpike Road, Westborough, Massachusetts. In September of 1999, the Company
also reached a settlement agreement with BCIA New England Holdings LLC for
release from its real estate lease at 2 Federal Street, Billerica,
Massachusetts. Under the settlement, the Company agreed to pay $200,000 in cash,
relinquish its $300,000 security deposit, issue 500,000 shares of Common Stock
and transfer miscellaneous furnishings and equipment. In exchange, the Company
was released from its real estate lease for 100,000 square feet which required
average lease and operating expense payments of $145,000 per month through
February 2006. The Company had not made any payment since July 1999.

    On March 27, 2000, Rocket Software, Inc. ("Rocket"), a privately held
company, invested $4,000,000 in the Company in exchange for 10,000,000 shares
($.40 per share) of restricted common stock (37% of outstanding stock after the
investment). The

                                       14
<PAGE>

Company granted Rocket certain registration rights with respect to the shares.
The Company recorded a one-time charge related to the investment of
approximately $4,000,000 in the quarter ended March 31, 2000. The charge
represented the difference between the quoted market price on the commitment
date and the price paid by Rocket. Under certain sections of the Internal
Revenue Code, a change in ownership of greater than 50% within a three-year
period places an annual limitation on the Company's ability to utilize its
existing net operating loss and research and development tax credit carry-
forwards. The investment by Rocket triggered such limitation.

    During the second and third quarters of 2000, the Company explored certain
extensions to its CodeNine tool beyond the field of application understanding
and concluded that such extensions were not feasible.

    On October 16, 2000, the Company announced that it retained The Catalyst
Group, LLC to render financial advisory and investment banking services in
connection with exploring strategic alternatives, including the potential sale
of the Company.  The Company is currently engaged in exploring a number of
possibilities for potential sale or merger of the Company.

    On February 8, 2001, the Company announced that it was reducing its
workforce by nine employees effective February 23, 2001.

    The Company experienced net losses of $4,166,000, $2,583,000 and $26,673,000
in the years ended December 31, 2000, 1999 and 1998, respectively. Based on the
Company's current forecasted cash expenditures and its cash on hand, the Company
expects to have sufficient cash to finance its operations through the year 2001.
The Company's future beyond the year 2001 is dependent upon its ability to
execute some form of organizational transaction, achieve break-even cash flow,
or raise additional financing. There can be no assurances that the Company will
be able to do so.

    The Company currently derives its revenue from software maintenance
outsourcing services, software and methodology licensing and other services.
Historically, the Company's products and services have been marketed through its
direct sales force, both domestically and in Europe, and through value added
integrators operating worldwide. As a result of its downsizings in 1998, 1999,
and 2001, the Company currently has no direct sales force representatives.
Future sales will be dependent upon the sales efforts of senior management and
the use of sales agency relationships.

  Revenue Recognition Policies

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

    The Company licenses its software products and methodologies to end users
and to value added integrators for their use in serving their clients. License
fees charged to end users are fixed, with the amount of the fee based on the
estimated total lines of code to be processed, the number of CPUs licensed, or
other defined factors. License fees charged to value added integrators are
generally royalties based on lines of code processed or to be processed or
number of CPUs licensed. Revenue from software licenses to end users is
recognized when licensed software and methodologies have been delivered to the
end user, a contract or purchase order has been executed, fees are fixed or
determinable, collection of the related receivable is probable, and customer
acceptance provisions do not exist. In arrangements where customer acceptance
provisions exist, the Company defers revenue recognition until customer
acceptance occurs or the acceptance provisions have lapsed. The Company
generally does not provide its customers with the right to return software
licenses and, once due, license fees are non-refundable. Revenue from software
licenses to value added integrators is recognized when the licensed software and
methodologies have been delivered to the value added integrator, the fee is
fixed or determinable and collection of the related receivable is probable.
Under arrangements combining software and services, all revenue is recorded
using the percent of completion method as described for other services below.
Under such combined arrangements, vendor specific objective evidence ("VSOE")
for software license is used for income statement classification purposes only
and is determined based upon the prices that exist or are charged for the same
software when licensed separately and distinctly. The VSOE for the service
component under combined arrangements is based upon hourly rates.

    Other services provided by the Company include direct delivery contracts as
well as technology transfer arrangements, product training, value added
integrator sales training, consulting services and software product maintenance.
Under direct delivery contracts, the Company provides full and pilot year 2000
renovations and renovation quality evaluation services for clients using the
Company's AutoEnhancer/2000, RQE tool, and/or Vantage YR2000 software. Revenue
from full year 2000 renovation and RQE contracts is recognized using the
percentage-of-completion method and is based on the ratio that labor-hours
incurred to date bear to estimated total labor-hours at completion, provided
that a contract or purchase order has been executed, fees are fixed or
determinable and

                                       15
<PAGE>

collection of the related receivable is probable. Revenue from pilot direct
delivery contracts is recognized over the duration of such contracts as work is
performed and defined milestones are attained. Adjustments to contract cost
estimates are made in the periods in which the facts which require such
revisions become known. When the revised estimates indicate a loss, such loss is
provided for currently in its entirety. In cases where VSOE of fair value of
both the license and service component exists under a direct delivery contract,
revenue recognized is allocated between license revenue and other services
revenue for income statement classification purposes based on their relative
fair values. Revenue from technology transfer arrangements, product and sales
training and consulting services is billed on a time-and-materials basis and is
recognized as the services are provided. Revenue from software product
maintenance contracts on the Company's licensed software products, including
client support bundled with the initial license fee, is deferred and recognized
ratably over the contractual periods during which the services are provided.

  Client Concentration

    For the year ended December 31, 2000, Bull, Ford, EMC, and CGI accounted for
40.3%, 15.1%, 12.2%, and 10.4% of the Company's total revenue, respectively. For
the year ended December 31, 1999, Bull and Compaq accounted for 21.7% and 11.8%
of the Company's total revenue, respectively. For the year ended December 31,
1998, AT&T and Bull accounted for 12.2% and 10.0% of the Company's total
revenue, respectively. The Company's ten largest clients in the years ended
December 31, 2000, 1999 and 1998 accounted for approximately 97.6%, 70.1% and
52.4% of the Company's total revenue, respectively.

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,
                                                                                -----------------------
                                                                                 2000     1999     1998
                                                                                 ----     ----     ----
<S>                                                                             <C>      <C>      <C>
Revenue:
 Outsourcing services.......................................................      58.9%    52.9%    31.5%
 License....................................................................      23.1     18.6     30.0
 Other services.............................................................      18.0     28.5     38.5
                                                                                ------   ------   ------

  Total revenue.............................................................     100.0    100.0    100.0
                                                                                ------   ------   ------
Cost of revenue:
 Cost of outsourcing services...............................................      32.4     42.7     24.0
 Cost of license............................................................       0.0      2.1      5.2
 Cost of other services.....................................................       6.5     18.0     28.9
                                                                                ------   ------   ------

  Total cost of revenue.....................................................      38.9     62.8     58.1
                                                                                ------   ------   ------

Gross profit................................................................      61.1     37.2     41.9
                                                                                ------   ------   ------
Operating expenses:
 Sales and marketing........................................................       8.1     12.9     42.0
 Research and development...................................................      26.3     11.8     27.1
 General and administrative.................................................      39.0     31.9     23.7
 Impairment of long-lived assets............................................       0.0      8.6     16.5
 Restructuring charges (credits)............................................       0.0     (4.1)    18.7
 Gain on sale of assets.....................................................      (0.5)      --       --
                                                                                ------   ------   ------
  Total operating expenses..................................................      72.9     61.1    128.0
                                                                                ------   ------   ------

Loss from operations........................................................     (11.9)   (23.9)   (86.1)
Interest income, net........................................................       7.6      0.8      1.5
                                                                                ------   ------   ------
Loss before gain on sale of majority-owned subsidiary, cost of strategic
 investment, income taxes, and minority interest in majority-owned
 subsidiary.................................................................      (4.3)   (23.1)   (84.6)
Gain on sale of majority-owned subsidiary...................................        --       --     (0.1)
Cost of strategic investment................................................     (88.4)      --       --
Provision (benefit) for income taxes........................................      (0.6)      --      0.1
                                                                                ------   ------   ------

Loss before minority interest...............................................     (92.1)   (23.1)   (84.6)
Minority interest in majority-owned subsidiary..............................        --       --       --
                                                                                ------   ------   ------

  Net loss..................................................................    (92.1)%  (23.1)%  (84.6)%
                                                                                ======   ======   ======
</TABLE>

                                       16
<PAGE>

Year Ended December 31, 2000 Compared to Year Ended December 31, 1999

  Revenue

    Total revenue decreased 59.6% to $4,523,000 in the year ended December 31,
2000 from $11,198,000 in the year ended December 31, 1999. This decrease in
revenue was primarily due to a decrease in outsourcing services revenue as well
as other services revenue, and to a lesser extent, the licensing of the
Company's products.

    The Company anticipates that total revenue for the year 2001 will be
substantially below the level achieved in 2000.

    Outsourcing Services. Outsourcing services revenue decreased 55.0% to
$2,664,000 in the year ended December 31, 2000 from $5,923,000 in the year ended
December 31, 1999. As a percentage of total revenue, outsourcing services
revenue increased to 58.9% in the year ended December 31, 2000 from 52.9% in the
year ended December 31, 1999. The increase in outsourcing services revenue as a
percentage of total revenue primarily reflects the decreased contribution of
other services revenue to total revenue during the year ended December 31, 2000
when compared to the prior year. The decrease in outsourcing revenue in absolute
dollars in the year ended December 31, 2000 compared to December 31, 1999 was
primarily attributable to the recording of lower amounts of revenue under
existing outsourcing engagements due to reduced workload or contract
terminations. Outsourcing revenue in 1999 included $2,068,000 associated with
six contracts that terminated during 1999. Outsourcing revenue in 2000 included
$244,000 associated with two contracts that terminated during 2000 and $546,000
associated with a contract that terminates on March 31, 2001. Outsourcing
services remain a major component of the Company's business. Without the
addition of new business, the Company's outsourcing revenue in the future will
be significantly below the $2,664,000 recorded in 2000.

    License. License revenue decreased 49.9% to $1,045,000 in the year ended
December 31, 2000 from $2,087,000 in the year ended December 31, 1999. As a
percentage of total revenue, license revenue increased to 23.1% in the year
ended December 31, 2000 from 18.6% in the year ended December 31, 1999. The
decrease in license revenue for 2000 in absolute dollars was primarily
attributable to the cessation of revenue associated with the Company's Year 2000
products. The increase in license revenue as a percentage of total revenue
primarily reflects the decreased contribution of outsourcing services and other
services revenue to total revenue during the year when compared to the prior
year. The Company will continue to pursue licenses of its outsourcing
methodology and SAM Relay product and selectively pursue licenses for its
CodeNine product.  Future revenue is dependent on the success of such efforts.

    Other Services. Other services revenue decreased 74.5% to $814,000 in the
year ended December 31, 2000 from $3,188,000 in the year ended December 31,
1999. As a percentage of total revenue, other services revenue decreased to
18.0% in the year ended December 31, 2000 from 28.5% in the year ended December
31, 1999. The decrease in other services revenue both in absolute dollars and as
a percentage of total revenue was primarily attributable to a decrease in direct
delivery, consulting and client support services relating to the Company's year
2000 products and services. The Company does not anticipate any revenue from its
Year 2000 products and services in the future. Future revenue from other
services is dependent on the Company's success in licensing its software
maintenance methodology, and its SAM Relay and CodeNine tools which would
generate maintenance, consulting, and training revenue.

  Cost of Revenue

Cost of Outsourcing Services Revenue. Cost of outsourcing services revenue
consists primarily of salaries, benefits, networking, and overhead costs
associated with delivering outsourcing services to clients. The cost of
outsourcing services revenue decreased 69.3% to $1,465,000 in the year ended
December 31, 2000 from $4,778,000 in the year ended December 31, 1999 due
primarily to reduced staffing associated with contract terminations. Cost of
outsourcing services revenue as a percentage of outsourcing services revenue
decreased to 55.0% in the year ended December 31, 2000 from 80.7% in the year
ended December 31, 1999. Costs in 1999 were negatively impacted by expenditures
made in anticipation of new business that did not materialize.

Cost of License Revenue. Cost of license revenue consists primarily of
amortization of intangibles related to the MDI acquisition and salaries,
benefits and related overhead costs associated with license-related materials
packaging and freight. Cost of license revenue was $0 in the year ended December
31, 2000. Cost of license revenue was $238,000, or 11.4% of license revenue, in
the year ended December 31, 1999. The decrease in cost of license revenue in
absolute dollars was primarily related to the termination (in the fourth

                                       17
<PAGE>

quarter of 1999) of amortization expense of intangibles related to the Company's
December 1997 acquisition of Millennium Dynamics, Inc. (MDI).

    Cost of Other Services Revenue. Cost of other services revenue consists
primarily of salaries, benefits, subcontracting costs and related overhead costs
associated with delivering other services to clients. Cost of other services
revenue decreased 85.3% to $295,000 in the year ended December 31, 2000 from
$2,013,000 in the year ended December 31, 1999 due to reduced staffing for the
Company's client support, training and consulting organizations related to fewer
customers for the Company's year 2000 products and services. Cost of other
services revenue as a percentage of other services revenue decreased to 36.2% in
the year ended December 31, 2000 from 63.1% in the year ended December 31, 1999.
The Company incurred costs in 1999 without any associated revenue in connection
with an agreement with Micah Technology Services, Inc. ("Micah").  A dispute
relating to that agreement was settled on December 18, 2000 resulting in revenue
recognition of $320,000 in the fourth quarter of 2000.

  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 decreased 74.6% to $368,000
in the year ended December 31, 2000 from $1,450,000 in the year ended December
31, 1999. As a percentage of total revenue, sales and marketing expenses
decreased to 8.1% in the year ended December 31, 2000 from 12.9% in the year
ended December 31, 1999. The decrease in sales and marketing expenses in
absolute dollars was primarily attributable to dramatically reduced staffing,
commissions and promotional activities.

    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 decreased 9.7% to $1,189,000 in the year ended December 31,
2000 from $1,316,000 in the year ended December 31, 1999. As a percentage of
total revenue, research and development expenses increased to 26.3% in the year
ended December 31, 2000 from 11.8% in the year ended December 31, 1999. The
decrease in research and development expenses in absolute dollars was primarily
attributable to a reduction in outside consulting services. The Company plans to
continue limited maintenance of and enhancements to its existing products.

    General and Administrative. General and administrative expenses consist
primarily of salaries and related costs for the finance and accounting, human
resources, legal, information systems, and other administrative departments of
the Company, as well as contracted legal and accounting services. General and
administrative expenses decreased 50.5% to $1,766,000 in the year ended December
31, 2000 from $3,570,000 in the year ended December 31, 1999. As a percentage of
total revenue, general and administrative expenses increased to 39.0% in the
year ended December 31, 2000 from 31.9% in the year ended December 31, 1999. In
the year ended December 31, 2000, the decrease in general and administrative
expenses in absolute dollars was primarily due to the reductions in staffing,
the cost of excess space, and legal and consulting fees.

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

    The Company did not record an impairment charge in the year ended December
31, 2000.

    The Company recorded impairment charges totaling $961,000 for the year ended
December 31, 1999.  For details of the 1999 charges, refer to Note 4 of Notes to
the Company's Consolidated Financial Statements.


                                       18
<PAGE>
  Restructuring Charges. An overview of the Company's restructuring activities
is presented at the beginning of Note 5 of Notes to the Company's Consolidated
Financial Statements.

    The Company had no restructuring charges in the year ended December 31,
2000.

    The Company recorded a net favorable impact to operations of $455,000
associated with its restructuring activities in the year ended December 31,
1999. For details of the 1999 activities, refer to Note 5 of Notes to the
Company's Consolidated Financial Statements.

  Gain on the Sale of Assets. For the year ended December 31, 2000, the Company
recorded a gain on the sale of assets of $24,000 that represented the excess of
the sales proceeds over the net book value of the fixed assets of the Company's
India subsidiary that were sold during the first quarter of 2000.

Interest Income (Expense), Net

Interest income and expense consists primarily of interest income from
investments and cash balances, partially offset by interest expense on debt. The
Company had interest income, net, of $342,000 in the year ended December 31,
2000 compared to interest income, net, of $92,000 in the year ended December 31,
1999. This change in interest income (expense), net, was primarily attributable
to increased interest income from interest bearing investments as a result of
the Rocket investment.

                                       19
<PAGE>


Cost of Strategic Investment

On March 27, 2000, Rocket invested $4,000,000 in the Company in exchange for
10,000,000 shares ($0.40 per share) of restricted common stock (approximately
37% of the outstanding shares of common stock after investment). For the year
ended December 31, 2000, the Company recorded a non-cash charge of $4,000,000
for the cost of this strategic investment equal to the difference between the
purchase price per share of $0.40 and the market price per share of $0.80 on
March 27, 2000.

Provision for Income Taxes

The Company's income tax provision was a credit of $28,000 for the year ended
December 31, 2000 compared to a charge of $2,000 for the year ended December 31,
1999. During the year ended December 31, 2000, the Company received refunds
totaling $28,000 for foreign taxes withheld from customer payments in 1999 and
2000. The provision of $2,000 for the year ended December 30, 1999 was for
several small city and state tax obligations.

Year Ended December 31, 1999 Compared to Year Ended December 31, 1998

  Revenue

    Total revenue decreased 64.5% to $11,198,000 in the year ended December 31,
1999 from $31,532,000 in the year ended December 31, 1998. This decrease in
revenue was primarily due to a decrease in other services revenue as well as the
licensing of the Company's products, and to a lesser extent, outsourcing
services revenue.

    Outsourcing Services. Outsourcing services revenue decreased 40.3% to
$5,923,000 in the year ended December 31, 1999 from $9,925,000 in the year ended
December 31, 1998. As a percentage of total revenue, outsourcing services
revenue increased to 52.9% in the year ended December 31, 1999 from 31.5% in the
year ended December 31, 1998. The increase in outsourcing services revenue as a
percentage of total revenue reflects the decreased contribution of other
services and license revenue to total revenue during the year ended December 31,
1999 when compared to the same period in the prior year. The decrease in
outsourcing revenue in absolute dollars in the year ended December 31, 1999
compared to December 31, 1998 was primarily attributable to the sale of a
foreign subsidiary in July 1998, and the recording of lower amounts of revenue
under existing outsourcing engagements due to reduced workload or contract
terminations. Outsourcing revenue in 1999 included $2,068,000 associated with
six contracts that terminated during the year.

    License. License revenue decreased 77.9% to $2,087,000 in the year ended
December 31, 1999 from $9,444,000 in the year ended December 31, 1998. As a
percentage of total revenue, license revenue decreased to 18.6% in the year
ended December 31, 1999 from 30.0% in the year ended December 31, 1998. The
decrease in license revenue for 1999 in absolute dollars was primarily
attributable to a decrease in the delivery of licensed software to end users and
decreased license fees from value-added integrators. The market for the
Company's year 2000 tools significantly eroded in 1998 and 1999 resulting in
substantial declines in license revenue.

    Other Services. Other services revenue decreased 73.8% to $3,188,000 in the
year ended December 31, 1999 from $12,163,000 in the year ended December 31,
1998. As a percentage of total revenue, other services revenue decreased to
28.5% in the year ended December 31, 1999 from 38.5% in the year ended December
31, 1998. The decrease in other services revenue in absolute dollars was

                                       20
<PAGE>

primarily attributable to a decrease in direct delivery, consulting and client
support services relating to the Company's year 2000 products and services.

  Cost of Revenue

    Cost of Outsourcing Services Revenue. The cost of outsourcing services
revenue decreased 36.9% to $4,778,000 in the year ended December 31, 1999 from
$7,577,000 for the year ended December 31, 1998. Cost of outsourcing services
revenue as a percentage of outsourcing services revenue increased to 80.7% in
the year ended December 31, 1999 from 76.3% in the year ended December 31, 1998.
Costs in 1999 were negatively impacted by expenditures in anticipation of and to
generate new business that did not materialize.

    Cost of License Revenue. Cost of license revenue was $238,000 in the year
ended December 31, 1999, or 11.4% of license revenue. Cost of license revenue
was $1,631,000, or 17.3% of license revenue, in the year ended December 31,
1998. The decrease in cost of license revenue in absolute dollars was primarily
related to the reduction of amortization expense of intangibles related to the
MDI acquisition as a result of the impairment charge recorded against the MDI
related intangibles by the Company in the third quarter of 1998.

    Cost of Other Services Revenue. Cost of other services revenue decreased
77.9% to $2,013,000 in the year ended December 31, 1999 from $9,110,000 in the
year ended December 31, 1998. Cost of other services revenue as a percentage of
other services revenue decreased to 63.1% in the year ended December 31, 1999
from 74.9% in the year ended December 31, 1998. Costs decreased in absolute
dollars in the year ended December 31, 1999 due to reduced staffing for the
Company's client support, training and consulting organizations related to fewer
customers for the Company's year 2000 products and services, including year 2000
renovations and RQE services.

  Operating Expenses

    Sales and Marketing. Sales and marketing expenses decreased 89.1% to
$1,450,000 in the year ended December 31, 1999 from $13,244,000 in the year
ended December 31, 1998. As a percentage of total revenue, sales and marketing
expenses decreased to 12.9% in the year ended December 31, 1999 from 42.0% in
the year ended December 31, 1998. The decrease in expenses in absolute dollars
was primarily attributable to dramatically reduced staffing, commissions and
promotional activities.

    Research and Development. Research and development expenses decreased 84.6%
to $1,316,000 in the year ended December 31, 1999 from $8,528,000 in the year
ended December 31, 1998. As a percentage of total revenue, research and
development expenses decreased to 11.8% in the year ended December 31, 1999 from
27.1% in the year ended December 31, 1998. The decrease in research and
development expenses in absolute dollars was primarily attributable to
dramatically reduced staffing for the product development efforts for the
Company's year 2000 products and services, mass change technologies and other
software tools.

    General and Administrative. General and administrative expenses decreased
52.2% to $3,570,000 in the year ended December 31, 1999 from $7,466,000 in the
year ended December 31, 1998. As a percentage of total revenue, general and
administrative expenses increased to 31.9% in the year ended December 31, 1999
from 23.7% in the year ended December 31, 1998. In the year ended December 31,
1999, the decrease in general and administrative expenses in absolute dollars
was primarily due to changes to charges related to accounts receivable and
reduced staffing. In 1999, general and administrative expenses included a
$321,000 credit associated with a reduction in the Company's allowance for
doubtful accounts as a result of the successful collection of receivables for
which specific allowances had been established in 1998. In 1998, general and
administrative expenses included a $1,481,000 increase in the Company's
allowance for doubtful accounts. In 1999, excess space that could not be
segregated and included in restructuring was charged to general and
administrative expenses. The total of such excess facility-related charges was
approximately $500,000 for the year 1999.

  Impairment of Long-Lived Assets. The Company recorded impairment charges
totaling $961,000 in the year ended December 31, 1999 and $5,218,000 in the year
ended December 31, 1998. For details of the 1999 and 1998 charges, refer to Note
4 of Notes to the Company's Consolidated Financial Statements.

  Restructuring Charges. The Company recorded a net favorable impact to
operations of $455,000 associated with its restructuring activities in the year
ended December 31, 1999. In the year ended December 31, 1998, the Company
recorded restructuring charges totaling $5,906,000. For details of the 1999 and
1998 activities, refer to Note 5 of Notes to the Company's Consolidated
Financial Statements.

                                       21
<PAGE>

  Interest Income, Net

    The Company had interest income, net, of $92,000 in the year ended December
31, 1999 compared to interest income, net, of $485,000 in the year ended
December 31, 1998. This change in interest income, net, was primarily
attributable to decreased interest income from decreased cash balances.

  Provision for Income Taxes

    The Company's income tax provision was $2,000 and $25,000 in 1999 and 1998,
respectively. The Company recorded no U.S. Federal or State tax provision in
1999 or 1998 due to the taxable losses incurred. The $2000 in 1999 was for city-
related income taxes and the $25,000 in 1998 was for foreign income tax
provisions.

  Minority Interest in Majority-owned Subsidiary

    The minority interest in majority-owned subsidiary represents the equity
interest in the operating results of Persist, the Company's majority-owned
Spanish subsidiary, held by stockholders of Persist, S.A. ("Persist') other than
the Company. The Company had no minority interest in majority-owned subsidiary
in the twelve months ended December 31, 1999 since it divested its majority
interest in July 1998. The Company established a branch in Spain in 1999 to
provide outsourcing services and its operations terminated at the end of 1999.

Liquidity and Capital Resources

    The Company has financed its operations and capital expenditures primarily
with the proceeds from sales of the Company's convertible preferred stock and
common stock, borrowings, advance payments for services from clients and
internally generated cash flows. The Company's cash balances were $3,716,000 and
$2,475,000 at December 31, 2000 and 1999, respectively. The Company's working
capital was $5,025,000 and $1,640,000, at December 31, 2000 and 1999,
respectively.

    The Company's operating activities used cash of $405,000 and $1,178,000
during the years ended December 31, 2000 and 1999, respectively. The Company's
use of cash during the year ended December 31, 2000 was primarily caused by a
net loss of $4,166,000 (less the non-cash cost of the strategic investment of
$4,000,000 by Rocket, depreciation and amortization expense of $463,000, and the
gain from the sale of assets of $24,000). Other uses included a decrease in
other accrued liabilities of $751,000, a decrease in deferred revenue of
$195,000, a decrease in billings in excess of costs and earnings on uncompleted
contracts of $95,000, an increase in accounts receivable of $33,000 and a
decrease in proceeds from customer advances of $7,000. These amounts were
partially offset by a decrease in costs and estimated earnings in excess of
billings on uncompleted contracts of $273,000, a decrease in other assets of
$55,000, a decrease in prepaid expenses and other current assets of $52,000, and
a increase in accounts payable of $23,000.

    The Company's investing activities used cash of $2,365,000 during the year
ended December 31, 2000 and provided cash of $732,000 during the year ended
December 31, 1999. Investing activities in the year ended December 31, 2000
consisted principally of the purchases of short-term investments of $1,411,000,
long-term investments of $1,000,000 and property and equipment of $11,000
partially offset by proceeds from the sale of property and equipment of $57,000.

    The Company's financing activities provided cash of $4,017,000 and $114,000
during the year ended December 31, 2000 and 1999, respectively. Financing
activities in the year ended December 31, 2000 primarily reflect an increase
from the proceeds of issuance of new common stock of $4,000,000 and the exercise
of stock options of $30,000, partially offset by payments on capital lease
obligations of $13,000.

    The Company has an accounts receivable purchase agreement with a lender to
permit borrowing against certain acceptable receivables at a rate of 80% of the
face amount of such receivables up to a maximum of $4,000,000. In exchange for
such agreement, the Company granted the lender security interest on
substantially all of its assets. There were no borrowings outstanding under the
agreement at December 31, 2000.

    On March 27, 2000, Rocket invested $4,000,000 in the Company in exchange for
10,000,000 shares ($.40 per share) of restricted common stock (approximately 37%
of the outstanding shares of stock after the investment). The Company granted
Rocket certain registration rights with respect to the shares.

    On October 16, 2000, the Company announced that it retained The Catalyst
Group, LLC to render financial advisory and investment banking services in
connection with exploring strategic alternatives, including the potential sale
of the Company.  The Company is currently engaged in exploring a number of
possibilities for potential sale or merger of the Company.

    The Company experienced net losses of $4,166,000, $2,583,000 and $26,673,000
in the years ended December 31, 2000, 1999

                                       22
<PAGE>

and 1998, respectively. Based on the Company's current forecasted cash
expenditures and its cash on hand, the Company expects to have sufficient cash
to finance its operations through the year 2001. The Company's future beyond the
year 2001 is dependent upon its ability to execute some form of organizational
transaction, achieve break-even cash flow, or raise additional financing. There
can be no assurances that the Company will be able to do so.

    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.

Foreign Currency

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

Inflation

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

Recently Issued Accounting Standards

    In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities" as amended by SFAS No.137, which
was issued in June 2000. The Company will adopt SFAS No. 133 in the first
quarter of 2001. SFAS No.133 requires that all derivative instruments be
reported on the balance sheet at their fair value. Changes in the fair value of
derivatives are recorded each period in current earnings or other comprehensive
income, depending on whether a derivative is designated as part of a hedge
transaction and, if it is, the type of hedge transaction. The Company does not
expect the adoption of SFAS No. 133 to have any impact on its financial
condition, results of operations, or business practices.

Factors That May Affect Future Results

  Failure to Achieve Cash Flow Breakeven/Strategic Initiatives

    The Company's ability to achieve a cash flow breakeven position is critical
for achieving financial stability. There can be no assurance that the Company
will achieve a cash flow breakeven in the future.

  Financing

    There can be no assurance that the Company will be able to obtain additional
funds in the future through equity and/or debt financings or borrow against its
accounts receivable financing agreement.

  Strategic Alternatives

    On October 16, 2000, the Company announced that it retained The Catalyst
Group, LLC to render financial advisory and investment banking services in
connection with exploring strategic alternatives, including the potential sale
of the Company.  There can be no assurance that the Company will be able to
implement any strategic alternatives that may be presented to the Company for
consideration.

  Risk of Current Strategy

    In the past, the Company generated significant revenues from marketing and
selling products and services that addressed the year 2000 problem. The demand
for such products and services has ended and the Company no longer actively
markets and sells year 2000 products and services. The Company's primary current
strategy is to seek some form of organizational transaction. In addition, The
Company is continuing to service its existing outsourcing customers and to renew
expiring contracts. At the same time, the Company is pursuing new business
through (i) the licensing of, and associated consulting and training for, its
software maintenance methodology (technology transfer services), its SAM Relay
tool, and selectively it CodeNine tool, and (ii) the provision of various
service offerings including, without limitation, general software consulting.

    The Company plans to continue limited maintenance of and enhancements to its
existing products. The Company has explored certain extensions of its CodeNine
tool beyond the field of application understanding and has concluded that such
extensions are not

                                       23
<PAGE>

feasible at this time.

    The failure to sell existing products or services and/or develop and sell
new products and/or services would have a material adverse effect on the
Company's business, financial condition and results of operations. There can be
no assurance that the Company will be able to grow or maintain its outsourcing
business or sell its products or services. There can be no assurance that the
Company's current strategy will generate revenues sufficient for the Company to
achieve a cash flow breakeven position.

  Over the Counter Listing

    Trading of the common stock is conducted in the over-the-counter market
which could make it more difficult for an investor to dispose of, or obtain
accurate quotations as to the market value of, the common stock. In addition,
there are additional sales practice requirements on broker-dealers who sell such
securities to persons other than established customers and accredited investors.
For transactions covered by this rule, the broker-dealer must make a special
suitability determination for the purchaser and must have received the
purchaser's written consent to the transaction prior to sale. If the trading
price of the common stock is below $5.00 per share, trading in the common stock
would also be subject to the requirements of certain rules promulgated under the
Securities Exchange Act of 1934, which require additional disclosure by broker-
dealers in connection with any trades involving a stock defined as a penny stock
(generally any non-NASDAQ equity security that has a market price of less than
$5.00 per share, subject to certain exceptions). Such rules require the
delivery, prior to any penny stock transaction, of a disclosure schedule
explaining the penny stock market and the risks associated therewith, and impose
various sales practice requirements on broker-dealers who sell penny stocks to
persons other than established customers and accredited investors (generally
institutions). For these types of transactions, the broker-dealer must make a
special suitability determination for the purchaser and have received the
purchaser's written consent to the transaction prior to sale. The additional
burdens imposed upon broker-dealers by such requirements may discourage broker-
dealers from effecting transactions in the common stock, which could severely
limit the market liquidity of the common stock and the ability of purchasers in
this offering to sell the common stock in the secondary market.

  Potential Fluctuations in Quarterly Performance

    The Company's revenue and operating results have varied significantly in the
past and are likely to vary significantly from quarter to quarter in the future.
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 sales agents; the timing of the introduction and
the market acceptance of new services, products or product enhancements by the
Company or its competitors; the relative proportions of revenue derived from
license fees and professional services; changes in the Company's operating
expenses; personnel changes; foreign currency exchange rates and fluctuations in
economic and financial market conditions.

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

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

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

    Concentration of Clients and Revenue Risk

                                       24
<PAGE>


    The Company's revenue is highly concentrated among a small number of
clients. During the year ended December 31, 2000, revenue from four clients
accounted for 78.0% of the year's revenue with one client representing 40.3%.
The contract for one of these four clients (representing 12.2% of the revenue
for the year ended December 31, 2000) will terminate in March 2001. For the year
ended December 31, 2000, license revenue of $1,045,000 was from paid-up license
revenue from two customers. The loss of, or a significant reduction in revenue
from, any of the Company's major clients would have a material adverse impact on
the Company's business, financial condition and results of operations. In
addition, with such a large percentage of the Company's revenue attributable to
a small number of clients, the loss of one or more major clients would have a
material adverse impact on the Company's liquidity.

  Competition

The market for the Company's products and services is intensely competitive and
is characterized by rapid changes in technology and user needs and the frequent
introduction of new products. In addition, the Company faces competition in the
software maintenance outsourcing services market and the software maintenance
tools 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. As a result, there
can be no assurance that the Company's products and services will compete
effectively with those of their respective competitors.

  Competitive Market for Technical Personnel

The Company depends, to a significant extent, on its ability to attract, train,
motivate and retain highly skilled software professionals, particularly project
managers, software engineers and other senior technical personnel. The Company
believes that there is a shortage of, and significant competition for, software
development professionals with the skills and experience necessary to perform
the services offered by the Company. The Company's ability to enhance its
products and services, 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 and other skills that keep pace with continuing changes in
software evolution, industry standards and technologies, client preferences and
the Company's business strategy. The inability to hire additional qualified
personnel could impair the Company's ability to satisfy its client base and to
enhance its products and services, 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 attracting new employees or retaining
current or future employees.

  Fixed-Price, Fixed-Time Contracts

    Part of the Company's business is to offer its outsourcing and technology
transfer services on fixed-price, fixed-time frame contracts, rather than
contracts in which payment to the Company is determined solely on a time-and-
materials basis. These contracts are terminable by either party generally upon
prior written notice. Although the Company uses its proprietary tools and
methodologies and its past project experience to reduce the risks associated
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 involve
key aspects of its clients' computer systems. A failure in a client's system
could result in a claim for substantial damages against the Company, regardless
of the Company's responsibility for such failure. The Company attempts to limit
contractually its liability for damages arising from negligent acts, errors,
mistakes or omissions in rendering its products and services. Despite this
precaution, there can be no assurance that the limitations of liability set
forth in its contracts would be enforceable or would otherwise protect the
Company from liability for damages. Additionally, the Company maintains general
liability insurance coverage, including coverage for errors and omissions.
However, there can be no assurance that such coverage will continue to be
available on acceptable terms, or will be available in sufficient amounts to
cover one or more large claims, or that the insurer will not disclaim coverage
as to any future claim. The successful assertion of one or more large claims
against the Company that exceed available insurance coverage or changes in the
Company's insurance policies, including premium increases or the imposition of
large deductible or co-insurance requirements, could have a material adverse
effect on the Company's business, financial condition and results of operations.
Furthermore, litigation, regardless of its outcome, could result in substantial
cost to the Company and divert management'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

                                       25
<PAGE>

    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.

                                       26
<PAGE>

  Limited Protection of Proprietary Rights

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

    The Company has entered into certain license agreements with clients that
allow these clients access to and use of the source code of certain of the
Company's software for certain purposes. Access to the Company's source code may
increase the likelihood of misappropriation or misuse by third parties.

    The Company has been granted certain patents (as previously described in
Part 1, Intellectual Property). There can be no assurance that such patents
would survive a legal challenge to their validity or provide meaningful or
significant protection to the Company. In addition, the Company has abandoned
its pending patent applications because, among other things, it has determined
that continued prosecution of such applications would be too costly, the
technologies, processes or methodologies are not critical to the Company's
business in the foreseeable future or it is unlikely that a patent will issue
with regard to a particular application. Certain of the Company's technology
incorporated in some of its products may infringe on patents held by others. Any
infringement claim or litigation against the Company could 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
certain trademarks and service marks with the United States Patent and Trademark
Office ("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 addition, the
Company has abandoned the applications of certain trademarks or service marks
that it believes are not critical to its business in the future. In some cases,
entities other than the Company are using certain trademarks and service marks
either in a jurisdiction where 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 product enhancements and services may
occur until equivalent technology is obtained. There can be no assurance that an
alternative source of suitable technology would be available or that the Company
would be able to develop an alternative product in sufficient time or at a
reasonable cost. The failure of the Company to obtain or develop alternative
technologies or products on a timely basis and at a reasonable cost could have a
material adverse effect on the Company's business, financial condition and
results of operations.

  Rapid Technological Change

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

                                       27
<PAGE>

Company will enhance its products or develop any new products or services at all
or in a timely fashion or that the Company's current or future products or
services will satisfy the needs of its target market.

  Potential Adverse Effects of Anti-Takeover Provisions; Possible Issuance of
  Preferred Stock

    The Company's Amended and Restated Articles of Organization and Amended and
Restated By-laws contain provisions that may make it more difficult for a third
party to acquire, or discourage acquisition bids for, the Company. For instance,
the Company's Amended and Restated By-laws provide that special meetings of
stockholders may be called only by the President, the Board of Directors or the
holders of at least 80% of the voting securities of the Company. In addition,
the Massachusetts General Laws provide that stockholders may take action without
a meeting only by the unanimous written consent of all stockholders. The
Company's Board of Directors is also divided into three classes, as nearly equal
in size as possible, with staggered three-year terms. The Company is also
subject to an anti-takeover provision of the Massachusetts General Laws which
prohibits, subject to certain exceptions, a holder of 5% or more of the
outstanding voting stock of the Company from engaging in certain activities with
the Company, including a merger, stock or asset sale. The foregoing provisions
could limit the price that certain investors might be willing to pay in the
future for shares of the Company's Common Stock. In addition, shares of the
Company's Preferred Stock may be issued in the future without further
stockholder approval and upon such terms and conditions, and having such rights,
privileges and preferences, as the Board of Directors may determine. The rights
of the holders of Common Stock will be subject to, and may be adversely affected
by, the rights of any holders of Preferred Stock that may be issued in the
future. The issuance of Preferred Stock, while providing desirable flexibility
in connection with possible acquisitions and other corporate purposes, could
have the effect of making it more difficult for a third party to acquire, or
discouraging a third party from acquiring, a majority of the outstanding voting
stock of the Company.

Item 7A.  Quantitative And Qualitative Disclosures About Market Risk

    As of December 31, 2000, the Company was exposed to market risks which
primarily include changes in U.S. interest rates. The Company maintains a
substantial portion of its cash, cash equivalents and investments in financial
instruments with purchased maturities of two years or less. These financial
instruments are subject to interest rate risk and will decline in value if
interest rates increase. Due to the short duration of these financial
instruments, an immediate increase in interest rates would not have a material
effect on the Company's financial condition or results of operations.

                                       28
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<S>                                                                                      <C>
Financial Statements:

 Report of Independent Accountants.....................................................  30

 Consolidated Balance Sheet as of December 31, 2000 and 1999...........................  31

 Consolidated Statement of Operations for the three years ended December 31, 2000......  32

 Consolidated Statement of Comprehensive Loss for the three years ended
  December 31, 2000....................................................................  33

 Consolidated Statement of Changes in Stockholders' Equity for the three
  years ended December 31, 2000........................................................  34

 Consolidated Statement of Cash Flows for the three years ended December 31, 2000......  35

 Notes to Consolidated Financial Statements............................................  37

Financial Statement Schedule:

 For the three years ended December 31, 2000

  II. Valuation and Qualifying Accounts................................................  65
</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.

                                       29
<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS


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

    In our opinion, the accompanying balance sheet and the related consolidated
statements of operations, comprehensive loss, changes in stockholders' equity
and of cash flows present fairly, in all material respects, the financial
position of Peritus Software Services, Inc. and its subsidiaries at December 31,
2000 and 1999, and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 2000, in conformity with
accounting principles generally accepted in the United States of America. 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
auditing standards generally accepted in the United States of America, 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 our opinion.

                                   PricewaterhouseCoopers LLP


Boston, Massachusetts
February 20, 2001

                                       30
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                          CONSOLIDATED BALANCE SHEET
                   (In Thousands, Except Share-Related Data)

<TABLE>
<CAPTION>
                                                                                                    December 31,
                                                                                                    ------------
                                                                                                  2000        1999
                                                                                                  ----        ----
<S>                                                                                             <C>         <C>
                                              ASSETS
Current assets:
 Cash and cash equivalents...................................................................   $   3,716   $   2,475
 Short-term investments......................................................................       1,411          --
 Accounts receivable, net of allowance for doubtful accounts of $25 and $25, respectively....         565         532
 Costs and estimated earnings in excess of billings on uncompleted contracts.................           8         281
 Prepaid expenses and other current assets...................................................         196         248
                                                                                                ---------   ---------
  Total current assets.......................................................................       5,896       3,536
Long-term investments........................................................................       1,000          --
Property and equipment, net..................................................................         217         702
Other assets.................................................................................          --          55
                                                                                                ---------   ---------
                                                                                                $   7,113   $   4,293
                                                                                                =========   =========

                              LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Current portion of capital lease obligations................................................   $      13   $      13
 Customer advances...........................................................................         289         296
 Accounts payable............................................................................          34          11
 Billings in excess of costs and estimated earnings on uncompleted contracts.................         158         253
 Deferred revenue............................................................................          --         195
 Other accrued expenses and current liabilities..............................................         377       1,128
                                                                                                ---------   ---------
  Total current liabilities..................................................................         871       1,896
Capital lease obligations....................................................................          12          25
                                                                                                ---------   ---------
  Total liabilities..........................................................................         883       1,921
                                                                                                ---------   ---------

Commitments and contingencies (Notes 5, 15 and 17)...........................................          --          --
Stockholders' equity:
 Common stock, $.01 par value; 50,000,000 shares authorized; 27,319,903 and
   17,173,975 shares issued and outstanding at December 31, 2000 and 1999, respectively               273         172
Additional paid-in capital...................................................................     113,208     105,279
Accumulated deficit..........................................................................    (107,237)   (103,071)
Accumulated other comprehensive loss.........................................................         (14)         (8)
                                                                                                ---------   ---------

  Total stockholders' equity.................................................................       6,230       2,372
                                                                                                ---------   ---------
                                                                                                $   7,113   $   4,293
                                                                                                =========   =========
</TABLE>

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

                                       31
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                     CONSOLIDATED STATEMENT OF OPERATIONS
                 (In Thousands, Except Per Share-Related Data)

<TABLE>
<CAPTION>

                                                                                               Year Ended December 31,
                                                                                               -----------------------

                                                                                              2000      1999       1998
                                                                                              ----      ----       ----
<S>                                                                                         <C>        <C>       <C>
Revenue:
 Outsourcing services, including $872 from related parties, in 1998.....................    $  2,664   $ 5,923   $  9,925
 License, including $255 from related parties in 1998...................................       1,045     2,087      9,444
 Other services, including $115, $0, and $204 from related parties, respectively........         814     3,188     12,163
                                                                                            --------   -------   --------
  Total revenue.........................................................................       4,523    11,198     31,532
                                                                                            --------   -------   --------
Cost of revenue:
 Cost of outsourcing services, including $750 from related parties in 1998..............       1,465     4,778      7,577
 Cost of license........................................................................          --       238      1,631
 Cost of other services, including $90, $0, and $56 from related parties, respectively..         295     2,013      9,110
                                                                                            --------   -------   --------
  Total cost of revenue.................................................................       1,760     7,029     18,318
                                                                                            --------   -------   --------
Gross profit............................................................................       2,763     4,169     13,214
                                                                                            --------   -------   --------
Operating expenses:
 Sales and marketing....................................................................         368     1,450     13,244
 Research and development...............................................................       1,189     1,316      8,528
 General and administrative.............................................................       1,766     3,570      7,466
 Impairment of long-lived assets........................................................          --       961      5,218
 Restructuring charges (credits)........................................................          --      (455)     5,906
 Gain on sale of assets.................................................................         (24)       --         --
                                                                                            --------   -------   --------
  Total operating expenses..............................................................       3,299     6,842     40,362
                                                                                            --------   -------   --------

Loss from operations....................................................................        (536)   (2,673)   (27,148)

Interest income.........................................................................         342       116        548
Interest expense........................................................................          --       (24)       (63)
                                                                                            --------    -------  --------
Loss before gain on sale of majority-owned subsidiary, cost of strategic investment,
 income taxes, and minority interest in majority-owned subsidiary.......................        (194)   (2,581)   (26,663)

Gain on sale of majority-owned subsidiary...............................................          --        --        (11)
Cost of strategic investment............................................................       4,000        --         --
Provision for income taxes..............................................................         (28)        2         25
                                                                                            --------   -------   --------
 Loss before minority interest in majority-owned subsidiary.............................      (4,166)   (2,583)   (26,677)

Minority interest in majority-owned subsidiary..........................................          --        --         (4)
                                                                                            --------   -------   --------
Net loss................................................................................    $ (4,166)  $(2,583)  $(26,673)
                                                                                            ========   =======   ========

Basic and diluted net loss per share....................................................    $  (0.17)  $ (0.15)  $  (1.65)
                                                                                            ========   =======   ========

Weighted average shares outstanding-basic and diluted...................................      24,939    16,670     16,177
                                                                                            ========   =======   ========
</TABLE>

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

                                       32
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                 CONSOLIDATED STATEMENT OF COMPREHENSIVE LOSS
                                (In Thousands)

<TABLE>
<CAPTION>
                                                     Year Ended December 31,
                                                     -----------------------
                                                     2000      1999      1998
                                                     ----      ----      ----
<S>                                                <C>       <C>       <C>
Net loss.........................................  $(4,166)  $(2,583)  $(26,673)
Other comprehensive income (loss) net of taxes:
 Foreign currency translation adjustments........       (6)       (7)        83
                                                   -------   -------   --------
Comprehensive loss...............................  $(4,172)  $(2,590)  $(26,590)
                                                   =======   =======   ========
</TABLE>

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

                                       33
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

           CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
                   (In Thousands, Except Share-Related Data)

<TABLE>
<CAPTION>
                                      Common  Stock                                                     Accumulated
                                     --------------          Additional                   Receivable       Other         Total
                                  Number                      Paid-in     Accumulated        from      Comprehensive   Stockholder's
                                  of  Shares    Amount        Capital       Deficit      Stockholder       Loss)        Equity
                                  ----------    ------        -------       -------      ----------        -----        ------
<S>                               <C>            <C>          <C>         <C>            <C>            <C>            <C>
Balance,December 31,1997...       15,366,801     $154         $103,808   $ (73,815)      $(58)          $(84)          $30,005
Sale of common stock
 pursuant
to exercise of stock options         883,185        9            1,018          --         --             --             1,027
Sale of common stock pursuant
to employee stock purchase plan      100,000        1              309          --         --             --               310
Repayment of receivable from
 stockholder...............               --       --               --          --         58             --                58
Cumulative translation adjustment         --       --               --          --         --             83                83
Net loss...................               --       --               --     (26,673)        --             --           (26,673)
                                  ----------     ----         --------   ---------       ----           ----          --------
Balance, December 31, 1998.       16,349,986      164          105,135    (100,488)        --             (1)            4,810
Sale of common stock pursuant
to exercise of stock
 options...................            1,000       --               --          --         --             --                --
Sale of common stock pursuant
to employee stock purchase
 plan.............                    22,989       --                4          --         --             --                 4
Issuance of common stock...          800,000        8              140          --         --             --               148
Cumulative translation
 adjustment................               --       --               --          --         --             (7)               (7)
Net Loss...................               --       --               --      (2,583)        --             --            (2,583)
                                  ----------     ----         --------   ---------       ----           ----          --------
Balance, December 31, 1999.       17,173,975      172          105,279    (103,071)        --             (8)            2,372
Sale of common stock pursuant
to exercise of stock options         145,928        1               29          --         --             --                30
Sale of common stock pursuant
to strategic investment....       10,000,000      100            7,900          --         --             --             8,000
Cumulative translation
 adjustment................               --       --               --          --         --             (6)               (6)
Net loss...................               --       --               --      (4,166)        --             --            (4,166)
                                  ----------     ----         --------   ---------       ----           ----          --------
Balance, December 31, 2000.       27,319,903     $273         $113,208   $(107,237)      $ --           $(14)         $  6,230
                                  ----------     ----         --------   ---------       ----           ----          --------
</TABLE>

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

                                       34
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                     CONSOLIDATED STATEMENT OF CASH FLOWS
                   (In Thousands, Except Share-Related Data)

<TABLE>
<CAPTION>
                                                                                Year Ended December 31,
                                                                                -----------------------
                                                                               2000      1999       1998
                                                                               ----      ----       ----
<S>                                                                            <C>       <C>        <C>
Increase (Decrease) in Cash and Cash Equivalents
Cash flows from operating activities:
   Net loss............................................................       $(4,166)  $(2,583)  $(26,673)
   Adjustments to reconcile net loss to net cash
    used for operating activities:
    Depreciation and amortization......................................           463     1,442      3,083
    Minority interest in majority-owned subsidiary.....................            --        --         (4)
    Impairment of long-lived assets....................................            --       961      5,218
    Gain on sale of majority-owned subsidiary..........................            --        --        (11)
    Gain on sale of assets.............................................           (24)       --         --
    Cost of strategic investment.......................................         4,000        --         --
    Changes in assets and liabilities
    Accounts receivable................................................           (33)    3,188      8,671
    Costs and estimated earnings in excess of billings on uncompleted
       contracts.......................................................           273       670      1,596
    Prepaid expenses and other current assets..........................            52       568       (137)
    Other assets.......................................................            55       116       (125)
    Accounts payable...................................................            23      (451)      (979)
    Proceeds from customer advance.....................................            (7)      296         --
    Billings in excess of costs and estimated earnings on uncompleted
       contracts.......................................................           (95)     (182)       331
    Deferred revenue...................................................          (195)   (1,695)      (928)
    Other accrued expenses and current liabilities, excluding
       accrued restructuring...........................................          (751)   (1,673)      (383)
    Accrued restructuring..............................................            --    (1,835)     2,680
                                                                              -------   -------   --------
    Net cash used for operating activities.............................          (405)   (1,178)    (7,661)
                                                                              -------   -------   --------

Cash flows from investing activities:
   Sale (purchase) of short-term investments...........................        (1,411)      500      2,500
   Sale of long-term investments.......................................         1,000        --         --
   Purchase of long-term investments...................................        (2,000)       --         --
   Cash of majority-owned subsidiary disposed, net of cash received....            --        --     (1,074)
   Proceeds from sale of property and equipment........................            57       288         --
   Purchases of property and equipment.................................           (11)      (56)    (2,739)
                                                                              -------   -------   --------
     Net cash provided by (used for) investing activities..............        (2,365)      732     (1,313)
                                                                              -------   -------   --------
</TABLE>

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

                                       35
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

               CONSOLIDATED STATEMENT OF CASH FLOWS--(Continued)
                   (In Thousands, Except Share-Related Data)

<TABLE>
<CAPTION>
                                                                            Year Ended December 31,
                                                                            -----------------------
                                                                             2000     1999      1998
                                                                             ----     ----      ----
<S>                                                                        <C>      <C>       <C>
Cash flows from financing activities:
   Restricted cash.................................................        $   --   $  569      (569)
   Principal payments on long-term debt............................            --     (269)     (292)
   Principal payments on capital lease obligations.................           (13)    (338)     (106)
   Proceeds from issuance of common stock, net of issuance costs...         4,030      152     1,337
   Proceeds from repayment of note receivable from stockholder.....            --       --        58
                                                                           ------   ------   -------
Net cash provided by financing activities..........................         4,017      114       428
                                                                           ------   ------   -------
Effects of exchange rates on cash and cash equivalents.............            (6)      (2)       15
                                                                           ------   ------   -------
Net increase (decrease) in cash and cash equivalents...............         1,241     (334)   (8,531)
Cash and cash equivalents, beginning of year.......................         2,475    2,809    11,340
                                                                           ------   ------   -------
Cash and cash equivalents, end of year.............................        $3,716   $2,475   $ 2,809
                                                                           ======   ======   =======

Supplemental Disclosure of Cash Flows:
   Cash paid for income taxes......................................            --   $   29   $    78
   Cash paid for interest..........................................            --       24        63
</TABLE>

Supplemental Disclosure of Non-cash Investing and Financing Activities:

     In the year ended December 31, 1998, the Company incurred capital lease
obligations of $458.


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

                                       36
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1. NATURE OF THE BUSINESS AND CURRENT FINANCIAL CONDITION

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

     On March 27, 2000, Rocket Software, Inc. ("Rocket"), a privately held
company, invested $4,000,000 in the Company in exchange for 10,000,000 shares
($.40 per share) of restricted common stock (37% of outstanding stock after the
investment). The Company granted Rocket certain registration rights with respect
to the shares. The Company recorded a $4,000,000 non-cash charge related to the
investment in the quarter ended March 31, 2000. The charge represented the
difference between the quoted market price on the commitment date and the price
paid by Rocket. Under certain sections of the Internal Revenue Code, a change in
ownership of greater than 50% within a three-year period places an annual
limitation on the Company's ability to utilize its existing net operating loss
and research and development tax credit carry-forwards. The investment by Rocket
triggered the limitation.

     During the second and third quarters of 2000, the Company explored certain
extensions to its CodeNine tool beyond the field of application understanding
and concluded that such extensions were not feasible.

     On October 16, 2000, the Company announced that it retained The Catalyst
Group, LLC to render financial advisory and investment banking services in
connection with exploring strategic alternatives, including the potential sale
of the Company.  The Company is currently engaged in exploring a number of
possibilities for potential sale or merger of the Company.

     On February 8, 2001, the Company announced that it was reducing its
workforce by nine employees effective February 23, 2001.

     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. The Company experienced net losses of $4,166,000, $2,583,000 and
$26,673,000 in the years ended December 31, 2000, 1999 and 1998, respectively.
Based on the Company's current forecasted cash expenditures and its cash on
hand, the Company expects to have sufficient cash to finance its operations
through the year 2001. The Company's future beyond the year 2001 is dependent
upon its ability to execute some form of organizational transaction, achieve
break-even cash flow, or raise additional financing. There can be no assurances
that the Company will be able to do so.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Principles of Consolidation

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

  Revenue Recognition

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

                                       37
<PAGE>

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


     The Company licenses its software products and methodologies to end users
and to value added integrators for their use in serving their clients. License
fees charged to end users are fixed, with the amount of the fee based on the
estimated total lines of code to be processed, the number of CPUs licensed, or
other defined factors.

     License fees charged to value added integrators are generally royalties
based on lines of code processed or to be processed or number of CPUs licensed.
Revenue from software licenses to end users is recognized when licensed software
and methodologies have been delivered to the end user, a contract or purchase
order has been executed, fees are fixed or determinable, collection of the
related receivable is probable, and customer acceptance provisions do not exist.
In arrangements where customer acceptance provisions exist, the Company defers
revenue recognition until customer acceptance occurs or the acceptance
provisions have lapsed. The Company generally does not provide its customers
with the right to return software licenses and, once due, license fees are non-
refundable. Revenue from software licenses to value added integrators is
recognized when the licensed software and methodologies have been delivered to
the value added integrator, the fee is fixed or determinable and collection of
the related receivable is probable. Under arrangements combining software and
services, all revenue is recorded using the percent of completion method as
described for other services below. Under such combined arrangements, vendor
specific objective evidence ("VSOE") for software license is used for income
statement classification purposes only and is determined based upon the prices
that exist or are charged for the same software when licensed separately and
distinctly. The VSOE for the service component under combined arrangements is
based upon hourly rates.

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

  Concentration of Credit Risk

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

  Fair Value of Financial Instruments

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

  Cash and Cash Equivalents

     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.

                                       38
<PAGE>

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


  Investments

     The Company investments are in debt securities of U.S. government agencies
and U.S. corporations. These investment grade securities are classified at
purchase as held-to-maturity. Investments with remaining maturities of less than
twelve months from the balance sheet date are classified as short-term
investments. Investments with remaining maturities of more than twelve months
are classified as long-term investments.

     The Company accounts for its investments in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain
Investments in Debt and Equity Securities." SFAS No. 115 requires the Company to
classify its investments among three categories: held-to-maturity, which are
reported at amortized cost; trading securities, which are reported at fair
value, with unrealized gains and losses included in earnings; and available-
for-sale securities, which are reported at fair value, with unrealized gains and
losses excluded from earnings and reported as a separate component of
stockholders' equity. At December 31, 2000, the Company's cash and cash
equivalents included money market accounts and overnight deposits of $2,955,000
and $492,000, respectively. At December 31, 1999, the Company's cash and cash
equivalents included money market accounts and overnight deposits of $1,151,000
and $1,197,000, respectively. These investments are classified as available for
sale and the fair market value of these investments approximated their amortized
cost.

  Property and Equipment

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

  Software Development Costs

     The Company capitalizes qualifying software development costs after
technological feasibility of the software has been established. Costs incurred
prior to the completion of a working model, which is the Company's primary basis
for determining technological feasibility, are charged to research and
development expense. Amortization of capitalized software costs, which is
charged to cost of revenue, is calculated based upon the ratio of current year
revenue from the related software to total revenue or ratably over the useful
life of the software, whichever is greater. During the years ended December 31,
2000, 1999 and 1998, costs subject to capitalization were not significant and
therefore, were not capitalized. At December 31, 2000 and 1999 there were no
unamortized capitalized software development costs. Amortization expense related
to capitalized software development costs for the years ended December 31, 2000,
1999 and 1998 was $0, $8,000 and $46,000, respectively.

  Accounting for Impairment of Long-Lived Assets

     In accordance with SFAS No. 121, "Accounting for the Impairment of Long-
Lived Assets and Long-Lived Assets to be Disposed Of," the Company records
impairment losses on long-lived assets used in operations when indicators of
impairment are present and the undiscounted cash flows estimated to be generated
by those assets are less than the assets' carrying amount. The Company recorded
impairment charge of $961,000 during the year ended December 31, 1999. (Note 4).

  Foreign Currency

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

  Advertising Expense

     The Company recognizes advertising expense as incurred. Advertising expense
was approximately $842,000 in the year ended December 31, 1998.


Accounting for Stock-Based Compensation

                                       39
<PAGE>

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


     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," and related Interpretations, 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 Loss Per Share

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

     Antidilutive potential common stock excluded from the 2000, 1999, and 1998
diluted earnings per share computation includes approximately 3,234,000,
3,212,000, and 4,036,000 of common stock shares, respectively, issuable upon the
exercise of stock options.

  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 revenue based on
percentage-of-completion, the valuation allowance on deferred tax assets, cash
flow projections and salvage value of assets used in impairment analyses and the
timing and amount of future sublease income on restructured facilities. Actual
amounts could differ from those estimates.

  Recently Issued Accounting Standards

     In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities" as amended by SFAS No.137, which
was issued in June 2000. The Company will adopt SFAS No. 133 in the first
quarter of 2001. SFAS No.133 requires that all derivative instruments be
reported on the balance sheet at their fair value. Changes in the fair value of
derivatives are recorded each period in current earnings or other comprehensive
income, depending on whether a derivative is designated as part of a hedge
transaction and, if it is, the type of hedge transaction. The Company does not
expect the adoption of SFAS No. 133 to have any impact on its financial
condition, results of operations, or business practices.

3. INVESTMENTS

     The Company's investments are held-to-maturity securities.  The following
table summarizes the composition of these short and long-term investments at
December 31, 2000:

               U.S. corporate debt securities.........    $  476,000
               U.S. government agencies...............       935,000
                                                          ----------
               Total due within one year..............    $1,411,000

               U.S. government agencies...............    $1,000,000
                                                          ----------
               Total due after one year...............    $1,000,000

At December 31, 2000, the estimated fair value of each investment approximated
its amortized costs and therefore, there were no material unrealized gains or
losses.

                                       40
<PAGE>

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


There were no short or long term investments at December 31, 1999.

4. IMPAIRMENT OF LONG-LIVED ASSETS

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

  Year Ended 1999

     In June 1999, as a result of the continuing downsizing of the Company's
operations and continuing decline in operating results, the Company reviewed the
carrying amount of its property and equipment and committed to a plan to dispose
certain of its assets, primarily excess computer equipment and furniture
relating to its restructured operations, either by sale or by abandonment. The
fair value of the assets to be disposed of was measured at management's best
estimate of salvage value, by using the current market values or the current
selling prices for similar assets. Based upon management's review, the carrying
amount of assets having a net book value of $1,143,000 was written-down to a
total amount of $389,000, representing the lower of carrying amount or fair
value (salvage value) and the Company recorded an impairment charge totaling
$754,000. The reduction in depreciation expenses resulting from this write-down
was approximately $82,000 on a quarterly basis beginning in the third quarter of
1999. The Company completed its sale of assets associated with its June 1999
impairment charge in the third quarter of 1999 and the sale proceeds received
were not significantly different from original estimates.

     During the third quarter of 1999, the Company made a decision to transfer
the research and development responsibility for its CodeNine tool from India to
the United States. As a result of that decision, the personnel of its Indian
subsidiary were no longer required and were transferred (with the exception of
one) to another company without cost. After the personnel transfer which
occurred in September 1999, the Company ceased using the assets and anticipated
no future productive use for such assets. Accordingly, the Company recorded an
impairment charge of $145,000 against assets having a net book value of $182,000
to write down the assets involved, which consisted of primarily of leasehold
improvements and computer equipment, to their estimated fair value (salvage
value) of $37,000. The estimated salvage value of 20% of book value was
determined through discussions with the Company's subsidiary manager in India
regarding selling prices for similar assets. The Company concluded a sale
agreement for the assets in February 2000 for $55,000 and the facility lease in
India was extended by one month to facilitate completion of the sale of assets.
The reduction in depreciation expense from the asset write-down was
approximately $10,000 on a quarterly basis beginning in the fourth quarter of
1999.

     Also, in the third quarter of 1999, the Company completed its review of its
product offering going forward. This review included its patent associated with
its mass change engine that had a remaining capitalized cost of $62,000. The
Company concluded that it could not afford and, therefore, would not develop any
future products based upon the patented technology. Further, the Company was no
longer generating revenue from its existing products based on the patented
technology. In addition, during the third quarter, the Company investigated
whether there was an opportunity to generate any income from the pursuit of
possible patent infringements and concluded such generation was unlikely. The
Company does not believe there is any opportunity to sell or license its
patented mass change engine technology. Therefore, according to Paragraphs 6 and
7 of SFAS 121, the Company recorded an impairment charge for the entire
remaining capitalized cost. The write-down was included in the third quarter
impairment charge. Savings in amortization expense from this write-down was
$17,000 on a quarterly basis beginning in the fourth quarter of 1999.

     The combination of the $754,000 impairment charge in June 1999 for
writedown of the Company's assets in the United States, the $145,000 impairment
charge in September of 1999 for writedown of the Company's assets in India, and
the $62,000 impairment charge for the remaining patent book value resulted in a
total impairment charge of $961,000 for the year ended December 31, 1999.

Year Ended 1998

                                       41
<PAGE>

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


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

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

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

     The combination of the $4,294,000 impairment charge recorded in September
1998 and the $924,000 recorded in December of 1998 resulted in a total
impairment charge of $5,218,000 for the year ended December 31, 1998.

5. RESTRUCTURING CHARGES

  Overview

     Under the Company's restructurings in 1998 and 1999, the Company terminated
more than 220 people. Severance benefits generally included salary continuation
for varying periods of up to one year, benefit continuation over the same
period, and outplacement support. Under the Company's severance offerings,
employees were required to sign a release before receiving any payments. In
addition, salary continuation benefits stopped if a person obtained other
employment.

     The Company's facility related restructuring charges included amounts
related to closure or reduction in space for facilities in Billerica,
Massachusetts; Westborough, Massachusetts; Cincinnati, Ohio; Lisle, Illinois;
and Nashua, New Hampshire. In most cases, the Company had many years remaining
under non-cancelable leases. The Company's largest lease was for its 100,000
square foot headquarters facility in Billerica which had a lease termination in
February 2006. Under its restructuring accruals, the Company recorded charges
for the estimated difference between anticipated sublease income and the
estimated expenses that would be incurred for the space in the future. The
estimates included the following factors:

     (1) the difference between estimated sublease income and rent payments
     (2) estimated time the space would remain unoccupied earning no sublease
         income

                                       42
<PAGE>

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


     (3) estimated marketing costs including brokerage commissions
     (4) estimated building operating expense charges in the future
     (5) estimated costs to make the facilities ready for sublease

     The estimates were complicated by the fact that the facilities were located
in several different real estate markets. The Company's estimates included input
from the Company's real estate brokers.

     Due to the Company's degrading financial condition, there was a change
between the original estimates and the final charges incurred. Rather than
sublease the buildings, the Company entered into settlement agreements with the
landlords for its Nashua, Cincinnati, Lisle and Billerica facilities. The
Company believes that the settlements were very favorable to the Company
(resulting in releases from the restructuring accrual) because the Company had
ceased making rent payments for three facilities (Cincinnati, Lisle and
Billerica), and had discussed filing for protection from creditors in its public
filings. If the Company had not settled the leases under such distressed
conditions, the charges incurred would undoubtedly have been higher resulting in
a lower or zero release.

  Year Ended 1999

     On March 29, 1999, the Company announced its intention to restructure. The
restructure plan was finalized on March 31, 1999 and the Company recorded a
charge of $291,000, consisting of severance payments associated with the
termination of approximately 30% of the Company's employees representing
substantially all of its sales, marketing and year 2000 delivery personnel (40
employees). Payments related to terminated employees were completed by May 28,
1999. The restructuring resulted in a quarterly reduction of approximately
$1,000,000 in salary and related costs beginning in the third quarter of 1999.

     The amounts accrued to and payments against the accrued restructuring
during the first quarter of 1999 and the composition of the remaining balance at
March 31, 1999 were as follows:

<TABLE>
<CAPTION>
                                                            Balance         Q1 1999    Q1 1999      Balance
                                                       December 31, 1998    Accrual   Payments   March 31, 1999
                                                       -----------------    -------   --------   --------------
                                                                              (in thousands)
<S>                                                    <C>                  <C>       <C>        <C>
Provision for severance and benefit payments to
terminated employees.............................           $  536            $291      $(212)       $  615
Provisions related to closure of facilities and
reduction of occupied space......................            2,144              --       (361)        1,783
                                                            ------            ----      -----        ------
 Total...........................................           $2,680            $291      $(573)       $2,398
                                                            ======            ====      =====        ======
</TABLE>

     In April 1999, the Company decided to further reduce the amount of space it
occupied in its Billerica, Massachusetts headquarters facility. The space
consolidation was completed in the second quarter of 1999 and the Company
increased the amount of space it was offering for sublease from 50,000 to 75,000
square feet. Accordingly, in June 1999, the Company recorded an additional
restructure accrual of $517,000 consisting primarily of the cost of lease
expenses and real estate commissions associated with the additional vacated
25,000 square feet net of estimated sublease income. The assumptions underlying
the charge for the newly vacated space and the space vacated in previous
quarters were modified from previous assumptions based on the progress in
marketing the vacated space and changes in market conditions. The estimated
sublease date was changed from December 1, 1999 to January 1, 2000. The assumed
sublease discount from the lease-related payments due under lease was lowered to
12%. The assumption regarding the discount period was changed to cover the
entire lease term. Finally, estimated construction costs and commissions were
also updated. The additional restructuring resulted in a quarterly reduction in
lease-related costs of approximately $87,000 beginning in the third quarter of
1999.

     Due to the Company's degraded financial condition, in June 1999, the
Company reached a settlement with American Financial Group, Inc. ("AFG") and its
subsidiaries and affiliates for release from its real estate lease in
Cincinnati, Ohio and certain other obligations. The Company had completely
vacated the facility by June 30, 1999 and had no remaining obligations or
liabilities associated with the facility. Of the total settlement, $136,000 was
associated with the real estate lease and is included within the restructuring
payments and reclassifications during the second quarter of 1999. The settlement
was more favorable than the Company's original sublease assumptions and resulted
in a release of $272,000 from the original estimated charges. The second quarter
payments and reclassifications also includes a $296,000 adjustment to reclassify
the rent levelization accrual associated with the vacated space in its Billerica
headquarters facility from other accrued expenses into the restructure accrual.

                                       43
<PAGE>

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


The Company's lease for its Billerica, MA facility that commenced in February
1998 contained lower rent payments during the early years offset by higher
payments in later years. In accordance with paragraph 15 of SFAS 13, the Company
therefore recorded monthly rent expense on a straight-line (levelized) basis
(total of all months' rent divided by the number of lease months). Through June
1999, the rent expense recorded exceeded the rent payments due under the lease
and the difference between the two amounts was credited to a rent levelization
accrual. The presumption underlying this accounting was that the Company would
eventually pay rents that exceeded the levelized rent and draw down the
liability. In the second quarter of 1999, the Company concluded that the
levelization liability associated with space included in restructuring should
have been relieved at the time the space was included in restructuring. It
therefore reclassified the rent levelization liability associated with the
vacated portion of the building to the restructuring accrual. Of the total
adjustment, $142,000 related to the 25,000 square feet that was added to
restructuring in the second quarter of 1999 and the balance of the $154,000 was
associated with earlier restructurings. The levelization liability associated
with the portion of the building, which was still being used by the Company,
remained as part of operating liabilities.

     The total facilities related payments/reclassifications for the second
quarter of 1999 were as follows:

     Rent levelization reclassification...........       $ 296,000
     Cincinnati settlement (facility portion).....        (136,000)
     All other net payments.......................         (55,000)
                                                         ---------
       Total......................................       $ 105,000
                                                         =========

At the end of the second quarter of 1999, the Company re-evaluated its estimated
costs associated with its previous restructure charges based upon activity and
experience to date. This evaluation included a re-estimate of the remaining
costs to be incurred in the future under the previous restructurings. The
$813,000 release in the second quarter of 1999 represented the difference
between the remaining restructure accrual and the future estimated costs. Of the
total release, $75,000 was related to the provision of severance and benefit
payments for terminated employees and $738,000 was related to the provision
related to the closure of facilities and the reduction of occupied space. The
$75,000 employee-related release resulted from differences in actual experience
and original estimates due primarily to the fact that several employees obtained
early employment or did not sign releases, and therefore, received lesser or no
payments.

     The $738,000 facility related release in the second quarter of 1999 broke
down as follows:

     Billerica related............................       $(502,000)
     Cincinnati related...........................        (272,000)
     Lisle related................................          36,000
                                                         ---------
       Total......................................       $(738,000)
                                                         =========

     The Billerica related release resulted from the change in sublease
assumptions discussed above. The Cincinnati related release resulted from the
favorable settlement discussed above. The Lisle related negative amount was due
to the fact that a settlement agreement had been negotiated (but not concluded)
and it exceeded the remaining accrual.

     The combination of the 1999 second quarter accrual of $517,000 and the 1999
second quarter release of $813,000 resulted in a net favorable impact of
$296,000 to the results of operations for the three months ended June 30, 1999


                                       44
<PAGE>

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


     The amounts accrued to and released from and payments and adjustments made
against the restructure accrual during the second quarter of 1999 along with the
composition of the remaining balance at June 30, 1999 were as follows:

<TABLE>
<CAPTION>
                                                                       Q2 1999
                                                      Balance         Payments/       Q2 1999  Q2 1999     Balance
                                                  March 31, 1999  Reclassifications   Accrual  Release   June 30, 1999
                                                  --------------  ------------------  -------  --------  -------------
                                                                           (in thousands)
<S>                                               <C>             <C>                 <C>      <C>       <C>
Provisions for severance and benefit
 payments to terminated employees..............       $  615            $(425)         $ --     $ (75)       $  115
Provision related to closure of facilities
 and reduction of occupied space...............        1,783              105           517      (738)        1,667
                                                      ------            -----          ----     -----        ------
   Total.......................................       $2,398            $(320)         $517     $(813)       $1,782
                                                      ======            =====          ====     =====        ======
</TABLE>

     In August 1999, the Company executed a lease termination agreement for its
Lisle, Illinois facility. Under the agreement, the Company paid $100,000 and
relinquished its $16,000 security deposit. These amounts were charged against
the accrued restructuring liability during the third quarter of 1999.

     During the third quarter of 1999, the Company developed a workable plan to
relocate its headquarters from Billerica to its existing facility in
Westborough, Massachusetts. The plan, along with the Company's degraded
financial condition, enabled the Company to negotiate a favorable settlement of
its Billerica lease. In September 1999, the Company entered into a settlement
agreement with BCIA New England Holdings LLC. Under the settlement, the Company
agreed to pay $200,000 in cash, relinquish its $300,000 security deposit, issue
500,000 shares of common stock and provide $71,000 of furniture and equipment.
All of these items were charged against the accrued restructuring liability
during the third quarter of 1999. The Company also charged the liability for a
$734,000 write-off of leasehold improvements and other fixed assets directly
tied to its Billerica facility. The favorable Billerica settlement resulted in a
release from the restructuring accrual of $392,000.

     The third quarter payments and reclassifications also include a $110,000
payment for the settlement of two telephone leases and the elimination of the
associated $270,000 capital lease liability, and a $149,000 adjustment to
reclassify the remaining rent levelization accrual for the Billerica facility
from other accrued expenses into the restructure accrual.

The total facilities related restructuring payments/reclassifications for the
third quarter of 1999 broke down as follows:

     Lisle settlement.........................................   $(116,000)
     Billerica cash payment...................................    (200,000)
     Billerica security deposit...............................    (300,000)
     Billerica stock issued (valued at 90% of closing price)..     (89,000)
     Rent levelization reclassification.......................     149,000
     All other net payments...................................     (30,000)
                                                                 ---------
       Total..................................................   $(586,000)
                                                                 ==========

     The total payments/reclassifications related to write-off of fixed assets,
leasehold improvements, and telephone lease related items for the third quarter
of 1999 broke down as follows:

     Billerica furniture provided.............................   $ (71,000)
     Leasehold and other fixed asset write-off................    (734,000)
     Telephone leases settlement payment......................    (110,000)
     Elimination of telephone capital leases..................     270,000
                                                                 ---------
       Total..................................................   $(645,000)
                                                                 =========

The $436,000 facility related release in the third quarter of 1999 broke down as
follows:

     Billerica related........................................   $(392,000)
     Lisle related............................................     (44,000)
                                                                 ---------
       Total..................................................   $(436,000)
                                                                 =========

     The Lisle related release resulted from the settlement of the Lisle
telephone system lease for less than the capitalized lease liability.

     In total, the Company recorded a net favorable impact of $450,000
associated with restructuring to the results of operations for the three months
ended September 30, 1999.

     The amounts accrued to and released from and payments and adjustments made
against the restructure accrual during the third quarter of 1999 along with the
composition of the remaining balance at September 30, 1999 were as follows:

                                       45
<PAGE>

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


<TABLE>
<CAPTION>
                                                               Q3 1999
                                              Balance         Payments/          Q3 1999            Balance
                                           June 30, 1999  Reclassifications      Release      September 30, 1999
                                           -------------  ------------------     --------     -------------------
                                                                              (in thousands)
<S>                                        <C>            <C>                 <C>             <C>
Provisions for severance and benefit
 payments to terminated employees......        $  115         $  (101)            $ (14)            $   --
Provision related to closure of
 facilities and reduction of
 occupied space........................         1,667            (586)             (436)               645
Write-off of fixed assets, leasehold
 improvements, and telephone
 lease related items...................            --            (645)               --               (645)
                                               ------         -------             -----             ------
  Total................................        $1,782         $(1,332)            $(450)            $   --
                                               ======         =======             =====             ======
</TABLE>

  Year Ended 1998

     In March 1998, the Company announced its intention for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, and recorded a total charge of $1,439,000. The charge
included severance-related payments of $947,000 associated with the termination
of approximately 12% of the Company's employees in April 1998 (48 employees). At
June 30, 1998, all 48 employees had been terminated with no further terminations
remaining under the restructuring. In addition, $165,000 of the total
restructuring charge related to support costs for a discontinued product. The
final $327,000 of the restructuring charge related to the closure of two
research and development and outsourcing centers (Westborough, Massachusetts,
and Nashua, New Hampshire) consisting primarily of accrual of lease costs, net
of estimated sublease income. Under its plan, the Company committed to vacate
the majority of its Westborough facility effective June 1998. The $162,000
accrued for Westborough was computed as 100% of the lease- related payments for
the period from June 1998 through the expiration of the lease for only that
portion of the facility which was vacated. The Company estimated that it would
be unable to sublease the space prior to the expiration of lease in December
1998, primarily due to the short period of time for which the space would be
available to potential sublessees. The lease did expire in December 1998 and was
not renewed. The assumption underlying the $165,000 charge recorded for the
Nashua facility was that it would remain unoccupied for nine months and that it
would be subleased thereafter at a 20% discount from the lease-related payments
due under the Company's lease. Payments related to terminated employees were
completed in June 1998 for 45 employees and were completed by September 1999 for
the remaining 3 employees. Payments related to the closure and reduction of
facilities were originally expected to be complete by April 2003. However,
payments ended as of December 31, 1998, upon the execution of a settlement
agreement with the Company's Nashua landlord. The restructuring resulted in a
reduction of approximately $950,000 in salary and related costs and $90,000 in
facility-related costs on a quarterly basis beginning in second quarter of 1998.

     In September 1998, the Company announced its intention to restructure and
recorded a total restructuring charge of $3,372,000. The charge included
$1,909,000 for severance-related payments associated with the termination of
approximately 33% of the Company's employees at that time (89 employees). At
September 30, 1998, all 89 employees had been terminated with no further
terminations remaining under the restructuring. The charge also included
$1,463,000 related to the closure of two research and development centers
(Cincinnati, Ohio and Lisle, Illinois) and a 30,000 square foot reduction of
occupied space at the Company's headquarters facility in Billerica, MA. The
accrual consisted primarily of estimated lease costs, net of estimated sublease
income. The $837,000 charge associated with Billerica, assumed that the vacated
space would remain empty for nine months and would be subsequently subleased
thereafter at a 20% discount from the lease-related payments due under the
Company's lease for the following four years. Thereafter, for the last two and
one-half years of the lease, the Billerica sublease income was estimated to
equal the amounts due under the Company's lease. The assumption for the
Cincinnati charge of $442,000 and the Lisle charge of $184,000 was that space
would remain empty for six months and would be subsequently subleased thereafter
at a 20% discount from the lease-related payments due under the Company's lease
until lease termination. Payments related to terminated employees were completed
by December 1998 for 82 employees and were completed by September 1999 for the
remaining 7 employees. Payments related to the closure of facilities and
reduction of occupied space were originally expected to be completed by June
2003; however, payments ended as of September 30, 1999 upon the execution of a
settlement agreement with the Company's Billerica landlord. The restructuring
resulted in a reduction of approximately $1,900,000 in salary and related

                                       46
<PAGE>

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


costs and $250,000 in lease-related costs on a quarterly basis beginning in the
fourth quarter of 1998.

     In December 1998, the Company announced its intention to restructure and
recorded a total restructuring charge of $1,316,000. The charge included
$408,000 for severance-related payments associated with the termination of
approximately 22% of the Company's employees at that time (45 employees). At
December 31, 1998, all 45 employees had been terminated with no further
terminations remaining under the restructuring. In addition, $908,000 of the
restructuring charge related to its Billerica headquarters facility including a
further reduction (20,000 additional square feet) of occupied space and
consisted primarily of accrual of lease costs, net of estimated sublease income
generally consistent with previous assumptions. However, the assumption on the
amount of time the total 50,000 square feet of vacated space would remain
unoccupied was extended from June 30, 1999 until November 30, 1999 based on the
progress of the marketing efforts to date. Payments related to the terminated
employees were completed by December 31, 1998. Payments related to the reduction
of occupied space were originally expected to be complete by June 2003; however,
payments ended as of September 30, 1999 upon the execution of a settlement
agreement with the Company's Billerica landlord. The restructuring resulted in a
reduction of approximately $950,000 in salary and related costs and $70,000 in
lease-related costs on a quarterly basis beginning in the first quarter of 1999.
In December of 1998, through its marketing activity, the Company found a new
tenant for its Nashua, New Hampshire facility and executed a settlement
agreement with its landlord rather than entering into a sublease. The settlement
resulted in a $58,000 release from the restructuring accrual.

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

<TABLE>
<CAPTION>
                                             Balance        1998         1998           Other           Balance
                                        December 31, 1997  Accrual     Charges       Adjustments   December 31, 1998
                                        -----------------  -------     --------      ------------  -----------------
                                                                    (in thousands)
<S>                                     <C>                <C>      <C>              <C>           <C>
Provision for severance and
  benefit payments to
  terminated employees..............         $ --          $3,264      $(2,558)          $(170)           $  536
Provisions related to closure
  of facilities and reduction of
  occupied space....................           --           2,698         (503)            (51)            2,144
Support costs for discontinued
  Product...........................           --             165         (165)             --                --
                                             ----          ------      -------           -----            ------
     Total..........................         $ --          $6,127      $(3,226)          $(221)           $2,680
                                             ====          ======      =======           =====            ======
</TABLE>

6.  DISPOSITION OF MAJORITY-OWNED SUBSIDIARY

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

                                       47
<PAGE>

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


7.   PROPERTY AND EQUIPMENT

Property and equipment consist of the following:

<TABLE>
<CAPTION>
                                                       Estimated
                                                         Useful
                                                         Lives          December 31,
                                                                        ------------
                                                        (Years)        2000        1999
                                                        -------        ----        ----
  <S>                                                  <C>         <C>         <C>
  Equipment.........................................         3-7   $1,480,000  $  1,734,000
  Furniture, fixtures and internal use
   software.........................................         5-7    1,040,000     1,040,000
  Leasehold improvements............................         2-5       43,000        43,000
                                                                   ----------  ------------

                                                                    2,563,000     2,817,000
  Less: Accumulated depreciation and
   amortization.....................................                2,346,000     2,115,000
                                                                   ----------  ------------
                                                                   $  217,000  $    702,000
                                                                   ==========  ============
 </TABLE>

     Equipment under capital leases at December 31, 2000 and 1999 was $53,000
and $53,000 with related accumulated depreciation of $26,000 and $15,000,
respectively. Amortization expense related to assets under capital leases was
$11,000, $69,000 and $48,000 for the years ended December 31, 2000, 1999 and
1998, respectively. Depreciation expense on all fixed assets amounted to
$463,000, $1,166,000 and $2,063,000 for the years ended December 31, 2000, 1999
and 1998, respectively.


8.   OTHER ACCRUED EXPENSES AND CURRENT LIABILITIES

  Other accrued expenses and current liabilities consist of the following:

<TABLE>
<CAPTION>
                                                                      December 31,
                                                                      ------------
<S>                                                               <C>       <C>
                                                                    2000        1999
                                                                    ----        ----

  Sales and use tax accrual.................................      $ 90,000  $  484,000
  Employee-related costs....................................        57,000     223,000
  Professional costs........................................        96,000     168,000
  Miscellaneous accruals....................................       134,000     253,000
                                                                  --------  ----------
                                                                  $377,000  $1,128,000
                                                                  ========  ==========
</TABLE>

     Miscellaneous accruals include items such as warranty costs exposure and
accruals for expenses where no invoices had been received.


9.   RELATED PARTY TRANSACTIONS

     For the year ended December 31, 2000, the Company recorded revenue of
$90,000 and $25,000 related to other services revenue with shareholders, Rocket
Software Inc, and Mr. Dominic Chan, respectively. At December 31, 2000, there
were no balances in accounts receivable or in costs and estimated earnings in
excess of billings on uncompleted contracts with related parties.

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

     For the years ended December 31, 1998 and 1997, Persist, S.A. ("Persist'),
the Company's majority-owned Spanish

                                       48
<PAGE>

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


subsidiary, recorded revenue of $872,000 and $1,183,000, respectively, related
to outsourcing services to a corporation owning a majority of and 27% of the
outstanding stock of Persist at December 31, 1998 and 1997, respectively. The
Company divested 100% of its equity interest in Persist in July of 1998.

10.  ACCOUNTS RECEIVABLE PURCHASE AGREEMENT

     The Company concluded an accounts receivable purchase agreement in 1999
with a lender to permit borrowing against certain acceptable receivables at a
rate of 80% of the face amount of such receivables up to a maximum of
$4 million. In exchange for such agreement, the Company granted the lender a
security interest in substantially all of its assets. There can be no assurance
that the Company will be able to successfully borrow against such agreement,
negotiate other borrowing arrangements or raise additional funds through bank
borrowings and/or debt and/or equity financings. To date, the Company has not
had any borrowings under this agreement.

11.  INCOME TAXES

     The components of loss before income taxes are as follows:

<TABLE>
<CAPTION>

                                    Year Ended December 31,
                                    -----------------------
                               2000          1999           1998
                               -----         ----           ----
<S>                        <C>           <C>           <C>
  Domestic...............  $(4,199,000)  $(2,222,000)  $(26,393,000)
  Foreign................        5,000      (359,000)      (255,000)
                           -----------   -----------   ------------
                           $(4,194,000)  $(2,581,000)  $(26,648,000)
                           ===========   ===========   ============
</TABLE>

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

<TABLE>
<CAPTION>
                                          Year Ended December 31,
                                          -----------------------
                                       2000        1999         1998
                                       ----        ----         ----
<S>                               <C>           <C>         <C>
  Current:
  Federal.......................  $        --   $      --    $        --
  State.........................           --          --             --
  Foreign.......................      (28,000)      2,000         25,000
                                  -----------   ---------   ------------
                                      (28,000)      2,000         25,000
                                  -----------   ---------   ------------
  Deferred:
  Federal.......................   (1,550,000)   (513,000)    (9,546,000)
  State.........................     (245,000)     37,000     (1,902,000)
                                  -----------   ---------   ------------
                                   (1,795,000)   (476,000)   (11,448,000)
  Change in deferred tax asset
  valuation allowance...........    1,795,000     476,000     11,448,000
                                  -----------   ---------   ------------
                                  $   (28,000)  $   2,000   $     25,000
                                  ===========   =========   ============
</TABLE>

     No current federal or state income taxes were payable in the years ended
December 31, 2000, 1999 or 1998 as a result of taxable losses incurred.

                                       49
<PAGE>

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


The components of deferred tax assets and liabilities follow:

<TABLE>
<CAPTION>
                                                                   December 31,
                                                                   ------------
                                                               2000           1999
                                                               ----           ----
<S>                                                        <C>            <C>
  Deferred tax assets:
  Net operating loss carry-forwards......................  $ 36,718,000   $ 33,703,000
  Tax credit carry-forwards..............................       746,000        778,000
  Nondeductible accrued expenses and reserves............       166,000        525,000
  Other deferred tax assets..............................       165,000      1,106,000
                                                           ------------   ------------
  Gross deferred tax assets..............................    37,795,000     36,112,000
                                                           ------------   ------------

  Deferred tax liabilities:
  Estimated costs and earnings in excess of billings on
     uncompleted contracts...............................        (4,000)      (116,000)

  Gross deferred tax liabilities.........................        (4,000)      (116,000)
                                                           ------------   ------------

  Net deferred tax (liabilities) assets..................    37,791,000     35,996,000
  Deferred tax asset valuation allowance.................   (37,791,000)   (35,996,000)
                                                           ------------   ------------
                                                           $         --   $         --
                                                           ============   ============
</TABLE>

     At December 31, 2000 and 1999, the Company has provided a valuation
allowance for the full amount of its net deferred tax assets since, based on the
weight of available evidence, management has concluded that it is more likely
than not (defined as a likelihood of slightly more than 50%) that these future
benefits will not be realized. If the Company achieves profitability, these net
deferred tax assets may be available to offset future income tax liabilities and
expense.

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

<TABLE>
<CAPTION>
                                                               Year Ended December 31,
                                                               -----------------------
                                                            2000        1999          1998
                                                            ----        ----          ----
  <S>                                                   <C>           <C>         <C>
  Loss at statutory rate..............................  $(1,468,000)  $(903,000)  $(9,327,000)
  Tax credit carry-forwards...........................           --          --      (655,000)
  Permanent differences and other, net................      (96,000)    571,500       191,000
  State tax benefit, net of federal effect............     (259,000)   (142,500)   (1,632,000)
   Change in deferred tax asset valuation allowance...    1,795,000     476,000    11,448,000
                                                        -----------   ---------   -----------
                                                        $   (28,000)  $   2,000   $    25,000
                                                        ===========   =========   ===========
</TABLE>

     At December 31, 2000, the Company had available net operating loss carry-
forwards of approximately $89.1 million and $89.4 million for federal and state
income tax reporting purposes, respectively. At December 31, 2000, the Company
had research and development credit carry-forwards of $508,000 and $237,000
available to offset future federal and state income tax, respectively. These
carry-forwards and credits will expire at various times during the period 2001
through 2019 if not utilized.

     In accordance with certain provisions of the Internal Revenue Code, a
change in ownership of greater than 50% within a three-year period places an
annual limitation on the Company's ability to utilize its existing net operating
loss and research and development tax credit carry-forwards. As a result of the
$4 million investment by Rocket Software, Inc. on March 27, 2000, the limitation
was triggered.

12.  STOCK PLANS

1992 Long-Term Incentive Plan and 1997 Stock Incentive Plan

                                       50
<PAGE>

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


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, 2000, 3,950,000 shares of common stock were authorized
under the 1997 Incentive Plan, and no further grants may be made under the 1992
Incentive Plan. Incentive stock options are granted at an exercise price equal
to the fair market value of the Company's common stock at the grant date (or no
less than 110% of the fair market value in the case of optionees holding more
than 10% of the voting stock of the Company) and expire 10 years from the date
of grant or upon termination of employment. Non-qualified stock options are
granted at an exercise price determined by the Board of Directors and expire 10
years from the date of grant. Both the incentive and non-qualified stock options
are exercisable at various dates as determined by the Board of Directors.
Through December 31, 1999, 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

The Company's 1997 Director Stock Option Plan (the "Director Plan") was adopted
by the Board of Directors and approved by the stockholders of the Company in May
1997. Under the terms of the Director Plan, directors of the Company who are not
employees of the Company or any subsidiary of the Company are eligible to
receive non-statutory options to purchase shares of Common Stock. A total of
200,000 shares of Common Stock were initially available for issuance upon
exercise of options granted under the Director Plan. On March 24, 2000, the
Board of Directors amended the Director Plan to increase the number of shares
available for issuance thereunder to 600,000. The Director Plan was also amended
to provide (i) that commencing in 2001, on the last trading day in April,
options to purchase 25,000 shares will be granted to each director serving on
the Board of Directors on such date who has been a director for the entire
preceding twelve months, (ii) for an initial grant of options to purchase 25,000
shares to each new non-employee director elected after April 1, 2000, and (iii)
for a grant of options to purchase 50,000 shares on the first trading day in
April 2000 for each director serving on the Board of Directors on such date.

Summary of Activity Under Stock Option Plans

     At December 31, 2000, there were 1,651,944 options available for future
grant under the 1997 Incentive Plan and the Director Plan.

The following table summarizes stock option activity during the years ended
December 31, 2000, 1999, 1998:

<TABLE>
<CAPTION>
                                                    Year Ended December 31,
                                                    -----------------------
                                    2000                  1999                   1998
                            --------------------  ---------------------  ---------------------
                                        Weighted               Weighted               Weighted
                                        Average                Average                Average
                                        Exercise               Exercise               Exercise
                            Shares      Price     Shares       Price     Shares       Price
                            ---------   --------  ----------   --------  ----------   --------
<S>                         <C>         <C>       <C>          <C>       <C>          <C>
Outstanding at beginning
 of year..................  2,874,418    $1.2135   4,331,572    $4.0008   4,160,967    $5.9797
Granted...................    920,000     0.5723   1,823,500     0.2026   3,166,340     3.9877
Exercised.................   (145,928)    0.2077      (1,000)    0.0004    (883,185)    1.1507
Forfeited.................   (416,629)    1.4200  (3,279,654)    4.2350  (2,112,550)    9.0704
                            ---------             ----------             ----------

Outstanding at end of
 year.....................  3,231,861     1.0498   2,874,418     1.2135   4,331,572     4.0008
                            =========             ==========             ==========

Options exercisable at
 end of year..............  2,859,826     0.9754   1,508,288     1.2605   1,254,326     2.7785
                            =========             ==========             ==========
</TABLE>


                                       51
<PAGE>

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

The following summarizes information regarding stock options outstanding and
exercisable at December 31, 2000:

<TABLE>
<CAPTION>
                               Options Outstanding               Options Exercisable
                            -------------------------            -------------------
                                           Weighted
                                           Average     Weighted                       Weighted
                                          Remaining    Average                        Average
                              Number     Contractual   Exercise        Number         Exercise
Range of Exercise Prices    Outstanding  Life (years)   Price        Outstanding       Price
--------------------------  -----------  ------------  --------  -------------------  --------
<S>                         <C>          <C>           <C>       <C>                  <C>
  $0.000-- $0.100.........      154,375          2.2     $ 0.10           154,375      $ 0.10
  $0.101-- $0.250.........    1,872,736          7.6     $ 0.19         1,837,736      $ 0.19
  $0.251-- $0.500.........       50,250          9.2     $ 0.44               250      $ 0.48
  $0.501-- $1.000.........      716,800          6.4     $ 0.87           521,800      $ 0.87
  $1.001-- $2.000.........       17,000          4.1     $ 1.60            17,000      $ 1.60
  $2.001-- $5.000.........      278,230          5.8     $ 2.91           215,930      $ 2.91
  $5.001--$10.000.........       91,220          6.4     $ 8.14            61,610      $ 8.43
  $10.001--$15.000........       15,000          0.1     $13.00            15,000      $13.00
  $15.001--$20.000........       36,250          5.5     $16.47            36,125      $16.47
                              ---------          ---     ------        ----------      ------
                              3,231,861          6.8     $ 1.05         2,859,826      $ 0.98
                              =========                                ==========
</TABLE>

No compensation expense was recorded under APB No. 25 during the years ended
December 31, 2000, 1999 and 1998. Had compensation cost been determined based
upon the fair value of options at their grant dates as prescribed in SFAS No.
123, the Company's net loss and basic and diluted net loss per share would have
been as follows:

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                           ----------------------------------------
                                              2000          1999           1998
                                           -----------   -----------   ------------
  <S>                                      <C>           <C>           <C>
  Net loss:
  As reported............................  $(4,166,000)  $(2,583,000)  $(26,673,000)
  Pro forma..............................  $(5,756,000)   (7,671,000)   (36,204,000)

  Basic and diluted net loss per share:
  As reported............................  $     (0.17)  $     (0.15)  $      (1.65)
  Pro forma..............................  $     (0.23)        (0.46)         (2.24)
</TABLE>

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

<TABLE>
<CAPTION>
                                                                     Year Ended
                                                                    December 31,
                                                             ---------------------------
                                                              2000       1999      1998
                                                             ------     ------    ------
  <S>                                                        <C>        <C>       <C>
  Expected life (years)....................................      2          2         5
  Volatility...............................................    224%       198%       90%
  Risk-free interest rate..................................   6.26%      5.43%     5.02%
  Dividend yield...........................................      0%         0%        0%
  Fair value of option grants-exercise price equal to the
   fair value of the related stock.........................  $0.51      $0.17     $2.90
</TABLE>

1997 Employee Stock Purchase Plan

In May 1997, the Board of Directors adopted the 1997 Employee Stock Purchase
Plan (the "Purchase Plan"). As amended, the Purchase Plan provided for the
issuance of up to 300,000 shares of the Company's common stock to participating
employees. All

                                       52
<PAGE>

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


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 were eligible to participate in the Purchase Plan.
Under the terms of the Purchase Plan, the option price was 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 was lower. As
amended, the Purchase Plan provided for four consecutive six-month offering
periods beginning with the six-month period extending from October 1, 1997
through March 31, 1998. A total of 50,000 and 50,000 shares were sold on April
1, 1998 and October 1, 1998, respectively, under the Purchase Plan. No awards
were made under the Purchase Plan in 1997. The Board of Directors terminated the
Purchase Plan on April 1, 1999.

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. For the years ended December
31, 2000, 1999 and 1998, the Company contributed $53,000, $89,000 and $251,000
respectively, to the Plan.

14. SEGMENT, GEOGRAPHIC, AND PRODUCT INFORMATION

The Company operates in one reportable segment due to its centralized structure
and single industry segment: software maintenance, tools and services. The
Company currently derives its revenue from software maintenance outsourcing
services, software and methodology licensing and other services. Information by
geographic area at December 31, 2000, 1999 and 1998 and for the years then
ended, is summarized below (in thousands):

<TABLE>
<CAPTION>
                    Outsourcing Services             License Revenue      Other Services Revenue   LongLived
                  ------------------------           ---------------     ------------------------
                  Unaffiliated  Affiliated   Unaffiliated    Affiliated  Unaffiliated  Affiliated   Assets
                  ------------  ----------  ---------------  ----------  ------------  ----------  ---------
<S>               <C>           <C>         <C>              <C>         <C>           <C>         <C>

2000
United States...        $2,664  $       --  $         1,045  $       --       $   699  $      115     $  217
Foreign.........            --          --               --          --            --          --         --
                        ------  ----------  ---------------  ----------       -------  ----------     ------

                        $2,664  $       --  $         1,045  $       --       $   699  $      115     $  217
                        ======  ==========  ===============  ==========       =======  ==========     ======


1999
United States...        $5,923  $       --  $         2,087  $       --       $ 3,188  $       --     $  668
Foreign.........            --          --               --          --            --          --         34
                        ------  ----------  ---------------  ----------       -------  ----------     ------

                        $5,923  $       --  $         2,087  $       --       $ 3,188  $       --     $  702
                        ======  ==========  ===============  ==========       =======  ==========     ======


1998
United States...        $8,802  $       --  $         9,189  $      255       $11,850  $      204     $4,027
Foreign.........           251         872               --          --           109          --        211
                        ------  ----------  ---------------  ----------       -------  ----------     ------

                        $9,053  $      872  $         9,189  $      255       $11,959  $      204     $4,238
                        ======  ==========  ===============  ==========       =======  ==========     ======
</TABLE>

The geographic classification of revenue is determined based on the country in
which the legal entity providing the services is located. Revenue from no single
foreign country was greater than 10% of the consolidated revenues of the Company
in 2000, 1999 or 1998.

Significant Customers

Revenue from four customers, Bull, Ford Motor Company, EMC Corporation, and CGI
Group Inc., accounted for 40%, 15%, 12% and 10% of the Company's total revenue
for the year ended December 31, 2000, respectively. For the year ended December
31, 1999, Bull and Compaq represented 22% and 12%, respectively, of the
Company's total revenue. Revenue from two customers, AT&T and Bull, accounted
for 12% and 10%, respectively, of the Company's total revenue for the year ended
December 31, 1998. At December 31, 2000, the Company had billed accounts
receivable from Bull, Ford Motor Company, EMC Corporation, and CGI Group Inc.,
of $135,000, $0, $134,000 and $0, respectively. At December 31, 2000, the
Company had

                                       53
<PAGE>

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

billings in excess of costs and estimated earnings in excess of billings on
uncompleted contracts with Bull and EMC of $29,000 and $129,000, respectively,
and $8,000 of unbilled revenue with Bull. At December 31, 1999, the Company had
accounts receivable from Bull of $236,000 for billed accounts receivable,
$59,000 for costs and estimated earnings in excess of billings on uncompleted
contracts and $116,000 for unbilled revenue. At December 31, 1999, the Company
had no amounts receivable from Compaq. At December 31, 1998, the Company had
amounts receivable from Bull of $164,000 for billed accounts receivable,
$114,000 for costs and estimated earnings in excess of billings on uncompleted
contracts and $77,000 for unbilled revenue.

15. COMMITMENTS

The Company leases its operating facilities and certain equipment under non-
cancelable operating and capital lease agreements. Rent expense for the years
ended December 31, 2000, 1999 and 1998 was $315,000, $850,000 and $2,244,000,
respectively. Future minimum lease payments under non-cancelable leases as of
December 31, 2000 are as follows:

<TABLE>
<CAPTION>
                                                 Operating  Capital
     Year Ending December 31,:                     Leases    Leases
     -------------------------                   ---------  -------
     <S>                                         <C>        <C>

     2001.....................................    270,000    13,000
     2002.....................................         --    12,000
                                                 --------    ------
                                                  270,000    25,000
     Less--Amount representing interest.......         --     1,000
                                                 --------    ------
     Present value of minimum lease payments..    270,000    24,000
                                                 ========    ======
</TABLE>

16 SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

(In Thousands, Except Share-Related Data)

<TABLE>
<CAPTION>
                                       Q1 2000   Q2 2000   Q3 2000   Q4 2000
                                       --------  --------  --------  --------
<S>                                    <C>       <C>       <C>       <C>
Total revenue........................  $ 1,565    $  926    $1,047    $  985
Gross Profit.........................      985       467       678       633
Net income (loss)....................   (3,810)     (433)       41        36
Net income (loss) per basic and
diluted share........................  $ (0.21)   $(0.02)   $ 0.00    $ 0.00
</TABLE>

<TABLE>
<CAPTION>
                                       Q1 1999   Q2 1999   Q3 1999   Q4 1999
                                       -------   -------   -------   -------
<S>                                    <C>       <C>       <C>       <C>
Total revenue........................  $ 4,667    $3,113    $1,960    $1,458
Gross Profit.........................    1,620     1,156       835       558
Net loss.............................   (1,959)     (528)      (71)      (25)
Net loss per basic and diluted
share................................  $ (0.12)   $(0.03)   $(0.00)   $(0.00)
</TABLE>


17. LEGAL PROCEEDINGS

     In December 1999, while continuing to deny any liability, the Company
agreed to settle a then-pending class action lawsuit filed in the United States
District Court for the District of Massachusetts relating to events during the
period October 22, 1997 through October 26, 1998. The settlement was funded
entirely by the Company's directors and officers liability insurer and became
final on March 29, 2000.

     On or about April 28, 1999, the Company filed a lawsuit in the United
States District Court for the District of Massachusetts against Micah Technology
Services, Inc. and Affiliated Computer Services, Inc. (collectively, "Micah").
The lawsuit principally alleged that Micah breached its contract with the
Company by failing to pay for services performed by the Company under such
contract. The lawsuit further alleged that since Micah was unjustly enriched by
the services performed by the Company, the

                                       54
<PAGE>

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

Company was entitled to recovery based on quantum meruit, and that Micah engaged
in unfair and/or deceptive trade practices or acts in violation of Massachusetts
General Laws ("M.G.L.") Chapter 93A by allowing the Company to perform services
when Micah did not pay for such services. The lawsuit sought unspecified damages
on the breach of contract and quantum meruit claims and double or triple damages
on the Chapter 93A claim. Micah denied the Company's allegations and filed a
counterclaim against the Company principally alleging fraud, negligent
misrepresentations, breach of contract and that the Company engaged in unfair
and/or deceptive trade practices or acts in violation of M.G.L. Chapter 93A by
its misrepresentations and breach of contract. The Company denied the
allegations contained in Micah's counterclaim. A non-binding mediation hearing
was held on March 17, 2000 and no settlement was reached. On December 18, 2000,
the Company and Micah agreed to settlement terms whereby Micah agreed to pay,
and has paid $320,000 and both parties agreed to a general release from any and
all claims relating to or arising out of this litigation.

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

Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

None.


PART III.

Item 10. Directors and Executive Officers of the Registrant

Directors and Executive Officers

  For each member of the Board of Directors and each person serving as an
executive officer of the Company, there follows information given by each
concerning his principal occupation and business experience for the past five
years, the names of other publicly held companies of which such person serves as
a director and such person's age and length of service as a director of the
Company.

Dominic K. Chan, age 52, has served on the Board of Directors since July 1999.
Dr. Chan also served as a Director of the Company from its inception until April
1999 and as Chairman of the Board from December 1996 to April 1999. From
November 1998 to April 1999, Dr. Chan served as the Company's President and
Chief Executive Officer. From October 1997 to November 1998, he served as the
Company's Chief Technology Officer. From December 1996 to October 1997, Dr. Chan
served as the Company's Chief Executive Officer. He co- founded the Company in
1991 and served as its President from inception until December 1996. Since 2000,
Mr. Chan has been Chairman and Chief Executive Officer of Univessence Digital
Studios, a privately owned company. Prior to co-founding the Company, Dr. Chan
held the position of Executive Vice President of Research and Development for
Bull HN Information Systems Inc., a manufacturer of computer products.

Axel Leblois, age 52, has served on the Board of Directors of the Company since
February 1995. Since January 1996, Mr. Leblois has served as the Chairman of
World Times Inc., a publishing company. From July 1997 to December 2000, he
served as President and Chief Executive Officer of ExecuTrain Corp., a computer
training company. From May 1991 to December 1995, he served as President and
Chief Executive Officer of Bull HN Information Systems Inc. Mr. Leblois is a
director of IDG Books, Inc., an online book publisher. Mr. Leblois is a member
of the Audit Committee and Compensation Committee of the Board of Directors of
the Company.

Johan Magnusson, age 42, has served on the Board of Directors of the Company
since April 2000. He was selected Director pursuant to the terms of a Common
Stock Purchase Agreement dated March 27, 2000 between the Company and Rocket
Software, Inc., a privately held company ("Rocket"). Rocket is the Company's
largest stockholder. Mr. Magnusson has served as the Chief Operating Officer of
Rocket since January 1999 and has served as a member of the Board of Directors
of Rocket since 1990.

Roland D. Pampel, age 66, has served on the Board of Directors of the Company
since November 1995. Mr. Pampel is retired. From March 1994 to January 1997, Mr.
Pampel held the positions of President, Chief Executive Officer and director of
Microcom, Inc. ("Microcom "), a manufacturer of computer equipment. From October
1991 to September 1993, prior to joining

                                       55
<PAGE>

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

Microcom, Mr. Pampel was President and Chief Executive Officer of Nicolet
Instrument Inc., a manufacturer of medical instruments. He currently serves on
the Board of Directors of Infinium Software, Inc., a provider of client-server
business software applications. Mr. Pampel is a member of the Audit Committee
and Compensation Committee of the Board of Directors of the Company.

Andrew Youniss, age 39, has served on the Board of Directors of the Company
since April 2000. He was selected Director pursuant to the terms of a Common
Stock Purchase Agreement dated March 27, 2000 between the Company and Rocket.
Rocket is the Company's largest stockholder. Mr. Youniss is the President and
Chief Executive Officer and a member of the Board of Directors of Rocket and has
served in those capacities since 1990. Prior to founding Rocket, he was the
Development Manager for DB View, Inc., a software company specializing in DB2
database utilities.

Christopher R.M. Bailey, age 49, co-founded the Company and since April 1999 has
served as its Vice President, Research and Development. From 1995 through 1999,
Mr. Bailey served as a director in the R&D organization of the Company.  From
1992 through 1995, he was responsible for working on various outsourcing
engagements for the Company. Prior to joining the Company, Mr. Bailey was
previously employed at Bull HN Information Systems from 1977 to 1992.

Andrea C. Campbell, age 49, co-founded the Company and since May 1999 has served
as its Vice President, Sales and Marketing. From June 1998 to May 1999, she
served as its Vice President, Outsourcing Research and Development. She served
as the Company's Vice President, Outsourcing Operations from June 1996 to June
1998 and as Vice President, Consulting and Technology Transfer Services from
September 1992 to June 1996. Ms. Campbell was previously employed as Human
Resources Director at Bull HN Information Systems Inc., a manufacturer of
computer products, from March 1990 to August 1992.

James F. Dunleavy, age 59, joined the Company in September 1994 as a Director of
Outsourcing Services and since May 1999 has served as Vice President of
Outsourcing Services.  From December 1996 to April 1999 he served as Director of
Engineering as well as a Director of Outsourcing Services.  Prior to joining the
Company, Mr. Dunleavy held various positions at Bull HN Information Systems,
where he most recently served as a Director of Hardware and Software development
and maintenance.

Ronald C. Garabedian, age 49, joined the Company in February 1999 and has served
as its Vice President and Treasurer since April 1999.  Mr. Garabedian was
engaged as an outside consultant for the Company from November 1998 until
February 1999.  From 1995 to 1998, Mr. Garabedian was the Treasurer and
Controller of Japonica Partners, a private investment company.  From 1980 to
1994, he held various positions at Bull HN Information Systems Inc., a
manufacturer of computer products, where he most recently served as Controller
of Public Sector Operations.

John D. Giordano, age 44, has served as the Company's President and Chief
Executive Officer since April 1999 and has served on the Board of Directors
since April 2000. He joined the Company in September 1998 as Vice President,
Finance and Chief Financial Officer and still holds those offices. From March
1997 to December 1997, Mr. Giordano served on the Board of Directors of the
Company. Prior to joining the Company and since 1978, Mr. Giordano held various
positions at Bull HN Information Systems Inc., a manufacturer of computer
products, where he most recently served as Vice President, Chief Financial
Officer and Treasurer.

Patrick J. Manning, age 57, joined the Company in September 1999 and has served
as its Controller since March 2000. From 1996 to 1999, Mr. Manning was the
Corporate Controller of KAO Infosystems Company, a software manufacturing and
services company. From 1990 to 1995, he served as a Group Controller for certain
North American operations for Logica, a United Kingdom based software company.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), requires the Company's directors, executive officers and holders of more
than 10% of the Company's Common Stock ("Reporting Persons") to file with the
Securities and Exchange Commission initial reports of ownership and reports of
changes in ownership of Common Stock and other equity securities of the Company.
Based solely on its review of copies of reports filed by Reporting Persons with
the Securities and Exchange Commission or written representations from certain
Reporting Persons that no outstanding Form 5 filing was required for such
person, the Company believes that, during 2000, all filings required to be made
by its Reporting Persons were timely made in accordance with the requirements of
the Exchange Act.

                                       56
<PAGE>

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

Item 11. Executive Compensation

Director Compensation

  All directors are reimbursed for expenses incurred in connection with their
attendance at Board of Directors and committee meetings.

  The Company's 1997 Director Stock Option Plan (the "Director Plan") was
adopted by the Board of Directors and approved by the stockholders of the
Company in May 1997. Under the terms of the Director Plan, directors of the
Company who are not employees of the Company or any subsidiary of the Company
are eligible to receive non-statutory options to purchase shares of Common
Stock. A total of 200,000 shares of Common Stock were initially available for
issuance upon exercise of options granted under the Director Plan. On March 24,
2000, the Board of Directors amended the Director Plan to increase the number of
shares available for issuance thereunder to 600,000. The Director Plan was also
amended to provide (i) that commencing in 2001, options to purchase 25,000
shares on the last trading day in April will be granted to each director serving
on the Board of Directors on such date who has been a director for the preceding
year, (ii) for an initial grant of options to purchase 25,000 shares to each new
non-employee director elected after April 1, 2000, and (iii) for a grant of
options to purchase 50,000 shares on first trading day in April 2000 for each
director serving on the Board of Directors on such date who has served as a
director since January 1, 2000.

  On June 10, 1998, each of Messrs. Leblois and Pampel received an option to
purchase 3,000 shares of the Company's Common Stock at an exercise price of
$4.19 per share.  On April 3, 2000, each of Messrs. Leblois and Pampel received
an option to purchase 50,000 shares of the Company's Common Stock at an exercise
price of $0.88 per share. On July 1, 1999, Mr. Chan received an option to
purchase 15,000 shares of the Company's Common Stock at an exercise price of
$0.17 per share. On April 3, 2000, Mr. Chan received an option to purchase
50,000 shares of the Company's Common Stock at an exercise price of $0.88 per
share.  On April 14, 2000, each of Messrs. Magnusson and Youniss received an
option to purchase 25,000 shares of the Company's Common Stock at an exercise
price of $0.44 per share.  All options granted under the Director 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.  The
exercise price per share of such stock options will be the closing price of
Common Stock on the date of the grant.


                                       57
<PAGE>

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

Executive Compensation

  The following table sets forth the total compensation paid or accrued for the
three years ended December 31, 2000 for the Company's Chief Executive Officer
and the Company's four most highly compensated executive officers in 2000 (such
Chief Executive Officer and such other executive officers are hereinafter
referred to as the "Named Executive Officers"):

                           Summary Compensation Table
<TABLE>
<CAPTION>

                                                                                                  Long-term
                                                                                                 Compensation
                                                                                                    Awards
                                                          Annual Compensation(1)                  Securities
Name and Principal                                        ----------------------                  Underlying        All Other
Position(2)                                         Year          Salary             Bonus(3)     Options(4)     Compensation(5)
-----------                                         ----          ------            ---------   ---------------  ---------------
<S>                                                 <C>   <C>                      <C>         <C>              <C>
John D. Giordano..................................  2000           196,500            160,000          300,000            3,400
 President, Chief Executive                         1999           195,000            250,000          300,000               --
  Officer and Chief Financial                       1998            56,250 (6)        125,000          220,000               --
  Officer

Christopher R.M. Bailey...........................  2000           136,014                 --               --            2,840
 Vice President, Research                           1999           134,706             12,000          150,000            2,359
  & Development                                     1998           120,350                 --           56,400            2,247

Andrea C. Campbell................................  2000           139,846                 --               --            2,782
Vice President, Sales &                             1999           166,000                 --          150,000            3,300
 Marketing                                          1998           166,500                 --          100,000            1,770

James F. Dunleavy.................................  2000           136,014                 --               --            2,677
 Vice President, Outsourcing                        1999           125,776             11,450          150,000            2,111
 Services                                           1998           118,261              6,800           54,800            2,024

Ronald C. Garabedian..............................  2000           131,769                 --               --            2,620
 Vice President and Treasurer                       1999           107,308             27,500          150,000              300
</TABLE>

(1)  Excludes perquisites and other personal benefits because the aggregate
     amount of such compensation was in all cases less than the lesser of
     $50,000 or 10% of the total of annual salary and bonus for the Named
     Executive Officer.
(2)  Unless otherwise noted, lists principal position with the Company as of
     December 31, 2000.
(3)  Amounts in this column represent bonuses earned under the Company's
     executive compensation, retention or other bonus programs during 2000,
     1999, and 1998.
(4)  Reflects the grant of options to purchase Common Stock. The Company has
     never granted stock appreciation rights.
(5)  Consists of the Company's matching contributions to the Company's 401(k)
     Plan.
(6)  Mr. Giordano joined the Company as an executive officer in September 1998.


          The following table sets forth certain information concerning grants
     of stock options to each of the Named Executive Officers during the year
     ended December 31, 2000:

     Option Grants, Exercises and Year-End Values

                       Option Grants in Last Fiscal Year
<TABLE>
<CAPTION>
                                                 Individual Grants
                                                 -----------------
                                                                              Potential Realizable
                                                                                Value at Assumed
                                                                                 Annual Rates of
                       Number of     Percent of                                    Stock Price
                      Securities    Total Options                                Appreciation for
                      Underlying     Granted to     Exercise of                   Option Term(3)
                       Options     Employees in     Base Price      Expiration ------------------
                     Granted(1)     Fiscal Year    Per Share(2)        Date       5%       10%
                     ----------   -------------    -----------         ----       --       ---
<S>                  <C>          <C>             <C>               <C>        <C>       <C>
John D. Giordano...     300,000       41.67          0.1406         01/13/10   26,531    67,236
</TABLE>

(1)  Mr. Giordano's options were granted pursuant to the 1997 Incentive Plan
     and, unless otherwise noted, grant a right to purchase shares of Common
     Stock. Mr. Giordano's options vested on December 31, 2000.
(2)  Represents the per share fair market value of the Common Stock, as
     determined by the Board of Directors, on the date of grant.
(3)  Amounts reported in these columns represent amounts that may be realized
     upon exercise of the options immediately prior to the expiration of their
     term assuming the specified compound rates of appreciation (5% and 10%) on
     the market value of the Common Stock on the date of option grant over the
     term of the options. These numbers are calculated based on rules
     promulgated by the Securities and Exchange Commission and do not reflect
     the Company's estimate of future stock price growth. Actual gains, if any,
     on stock option exercises and Common Stock holdings are dependent on the
     timing of such exercise and the future performance of the Common Stock.
     There can be no assurance that the rates of appreciation assumed in this
     table can be achieved or that the amounts reflected will be received by the
     individuals. No gain to the optionees is possible without an appreciation
     in stock price, which will benefit all stockholders commensurately. A zero
     percent stock price appreciation will result in zero gain for the optionee.

                                       58
<PAGE>

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


The following table sets forth certain information concerning stock options
exercised during 2000 and stock options held by each of the Named Executive
Officers on December 31, 2000:

Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option
Values

<TABLE>
<CAPTION>
                                                     Number of Shares
                            Shares                Underlying Unexercised           Value of Unexercised
                           Acquired                 Options at Fiscal              In-the-Money Options
                              on        Value            Year-End                  at Fiscal Year-End(2)
Name                       Exercise  Realized(1)    Exercisable/Unexercisable    Exercisable/Unexercisable
----                       --------  -----------  -----------------------------  -------------------------
<S>                        <C>       <C>          <C>                            <C>
John D. Giordano.........         0         0                  760,000 / 60,000                       0/ 0
Christopher R.M. Bailey..         0         0                  223,267 /  3,950                       0/ 0
Andrea C. Campbell.......         0         0                  466,652 / 12,500                       0/ 0
James F. Dunleavy........         0         0                  226,775 /  2,400                       0/ 0
Ronald C. Garabedian.....         0         0                  150,000 /      0                       0/ 0
</TABLE>

(1)  Value represents the difference between the exercise price and the fair
     market value of the Common Stock on the date of exercise, as determined by
     the Board of Directors of the Company.
(2)  Value based on the closing sales price per share ($0.0625) of the Company's
     Common Stock on December 31, 2000, as reported on the Over the Counter
     Bulletin Board, less the exercise price.

Employment Agreements

     On March 15, 1996, the Company entered into a Non-Competition Agreement
with Dominic K. Chan (the "Chan Agreement") which terminated on April 1, 2000,
the first anniversary of the date on which Mr. Chan's employment with the
Company terminated. The Chan Agreement provided for severance payments to Mr.
Chan in quarterly installments over a one-year period following termination, in
an aggregate amount not to exceed the amount paid to Mr. Chan by the Company in
combined salary and bonus for the 12-month period immediately preceding the date
of termination. The Company's obligation to pay such severance was conditional
upon Mr. Chan's continued compliance with the terms of the Chan Agreement. The
Chan Agreement prohibited Mr. Chan, during the term thereof, from engaging in
any business activity that was directly or indirectly competitive in the United
States with any of the products or services being developed or otherwise
provided by the Company at the date of his termination. Mr. Chan terminated his
employment with the Company on April 1, 1999. He was elected as a Director of
the Company on July 1, 1999.

     On August 13, 1998, the Company entered into an employment agreement with
John D. Giordano that was subsequently amended on September 9, 1999, October 5,
1998, April 9, 1999 and January 21, 2000 (the "Giordano Employment Agreement").
The term of the Giordano Employment Agreement expires on January 21, 2003 unless
earlier terminated thereunder. The Giordano Employment Agreement (i) is
terminable by either party without cause upon 30 days' prior notice, (ii)
terminates upon a change of control of the Company, (iii) is terminable by
either party pursuant to a breach of the Giordano Employment Agreement by the
other party and failure to remedy the breach by such party upon 30 days' prior
notice, (iv) is terminable immediately by the Company with cause (as defined),
or (v) terminates upon the death or disability of the employee. The employment
agreement provides for an annual base salary of $195,000 as well as bonus
compensation to be determined in accordance with the Company's policies, with a
minimum bonus of $25,000 for 1998. If Mr. Giordano's employment is terminated by
the Company without cause (as defined) or terminates upon a change of control of
the Company, he will be entitled to receive (i) a severance payment equal to his
base compensation for one year, and (ii) benefits in accordance with the
Company's then current policies until the earlier of the date of one year
following the termination date or the date Mr. Giordano commences employment or
consulting with a third party. The Giordano Employment Agreement also provides
for the vesting of all of Mr. Giordano's unvested options and for the extension
of the date to exercise those options for up to one year after termination of
his employment if his employment is terminated by the Company without cause or
terminates upon a change of control of the Company. The Giordano Employment
Agreement contains a non-solicitation covenant and a non-competition covenant
pursuant to which Mr. Giordano, during the term of his employment, is prohibited
from engaging in any business activity that would compete directly or indirectly
with products or services of the kind or type developed by the Company. The non-
competition and non solicitation covenants extend for a one-year period after
termination. The Giordano Employment Agreement provided for retention payments
of $60,000, $40,000, $30,000 and $30,000 on December 1, 1998, January 1, 1999,
February 1, 1999 and March 1, 1999, respectively, together with a payment

                                       59
<PAGE>

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


of $280,000 minus the foregoing payments, if made, in the event of a change in
control of the Company. The Giordano Employment Agreement provided for the
payment of a retention bonus of $120,000 on September 30,1999. The foregoing
retention bonus was in place of the change in control payment referenced above.
The Giordano Employment Agreement provided for a retention payment of $70,000 on
January 1, 2000. The Employment Agreement also provided for retention payments
of $60,000 and $100,000 on April 1, 2000 and July 1, 2000.

Item 12.  Security Ownership of Certain Beneficial Owners and Management

Voting Securities and Principal Holders Hereof

The following table sets forth certain information as of March 16, 2001 (unless
otherwise specified) with respect to the beneficial ownership of shares of
Common Stock by (i) each person or entity known to the Company to own
beneficially more than 5% of the outstanding shares of Common Stock, (ii) the
directors of the Company, (iii) each Named Executive Officer and (iv) all
directors and executive officers of the Company as a group.

<TABLE>
<CAPTION>
                                                                            Number of Shares      Percentage of
                                                                             of Common Stock       Common Stock
Beneficial Owner                                                          Beneficially Owned(1)   Outstanding(2)
------------------------------------------------------------------------  ---------------------  ----------------
<S>                                                                       <C>                    <C>
Rocket Software, Inc.(3)................................................             10,016,668           34.1%
One Innovation Drive
Natick, MA 01760
Dominic K. Chan(4)......................................................              2,130,030            7.3%
c/o Peritus Software Services, Inc.
112 Turnpike Road, Suite 111
Westborough, MA 01581-2860
John D. Giordano(5).....................................................                760,000            2.6%
Andrea C. Campbell(6)...................................................                466,652            1.6%
Christopher R.M. Bailey(7)..............................................                352,367            1.2%
James F. Dunleavy(8)....................................................                235,975              *
Ronald C. Garabedian(9).................................................                150,000              *
Roland D. Pampel(10)....................................................                 89,667              *
Axel Leblois(11)........................................................                 54,167              *
Johan Magnusson(3)......................................................             10,016,668           34.1%
c/o Rocket Software, Inc.
One Innovation Drive
Natick, MA 01760
Mathew Kelley(3)........................................................             10,016,668           34.1%
c/o Rocket Software, Inc.
One Innovation Drive
Natick, MA 01760
Andrew Youniss(3).......................................................             10,016,668           34.1%
c/o Rocket Software, Inc.
One Innovation Drive
Natick, MA 01760
All executive officers and directors, as
a group (11 persons)(12)................................................             14,308,026           48.7%
</TABLE>

*  Less than 1% of outstanding Common Stock.

(1)  The number of shares beneficially owned by each stockholder is determined
     under rules promulgated by the Securities and Exchange Commission, and the
     information is not necessarily indicative of beneficial ownership for any
     other purpose. Share ownership is based upon information as of March 15,
     2001 provided by EquiServe, the Company's transfer agent. Under such rules,
     beneficial ownership includes any shares as to which the individual has
     sole or shared voting power or investment power and also any shares which
     the individual has the right to acquire within 60 days of March 15, 2001
     through the

                                       60
<PAGE>

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


     exercise of any stock option, warrant or other right. The inclusion herein
     of such shares, however, does not constitute an admission that the named
     stockholder is a direct or indirect beneficial owner of such shares.
(2)  Number of shares of Common Stock deemed outstanding represents 27,319,903
     shares issued and outstanding as of March 15, 2001 plus any shares subject
     to options held by the referenced beneficial owner(s).
(3)  Rocket Software acquired 10,000,000 shares of Common Stock on March 27,
     2000 pursuant to a Common Stock Purchase Agreement dated as of March 27,
     2000. Johan Magnusson, Matthew Kelley and Andrew Youniss may be deemed
     controlling persons with respect to Rocket. Represents 10,000,000 shares of
     Common Stock and includes 16,668 shares of Common Stock held equally by
     Mrssrs. Magnusson and Youniss subject to outstanding stock options which
     are exercisable within 60 days of March 15, 2001.
(4)  Represents 2,108,363 shares of Common Stock held jointly with his wife,
     Marsha C. Chan and 21,667 shares of Common Stock subject to outstanding
     stock options which are exercisable within 60 days of March 15, 2001.
(5)  Includes 760,000 shares of Common Stock subject to outstanding stock
     options which are exercisable within 60 days of March 15, 2001.
(6)  Includes 466,652 shares of Common Stock subject to outstanding stock
     options which are exercisable within 60 days of March 15, 2001.
(7)  Represents 126,000 shares of Common Stock held by Mr. Bailey and 1,500
     shares held by his daughter, Gillian Z. Bailey and 224,867 shares of Common
     Stock subject to outstanding stock options which are exercisable within 60
     days of March 15, 2001.
(8)  Represents 8,000 shares of Common Stock and 227,975 shares of Common Stock
     subject to outstanding stock options which are exercisable within 60 days
     of March 15, 2001.
(9)  Includes 150,000 shares of Common Stock subject to outstanding stock
     options which are exercisable within 60 days of March 15, 2001.
(10) Represents 17,300 shares of Common Stock and 1,200 shares of Common Stock
     held by four trusts of which Carol P. Pampel, Mr. Pampel's wife, is sole
     trustee, as to which shares Mr. Pampel disclaims beneficial ownership. Also
     includes 71,167 shares of Common Stock subject to outstanding stock options
     which are exercisable within 60 days of March 15, 2001.
(11) Represents 8,000 shares of Common Stock and 46,167 shares of Common Stock
     subject to outstanding stock options which are exercisable within 60 days
     of March 15, 2001.
(12) Includes an aggregate of 2,037,663 shares of Common Stock subject to
     outstanding options which are exercisable within 60 days of March 15, 2001.


Item 13.  Certain Relationships and Related Transactions

Certain Relationships and Related Transactions

     On March 27, 2000, Rocket, a privately held company, invested $4 million in
the Company in exchange for 10,000,000 shares of Common Stock of the Company.
The Company granted certain registration rights to Rocket with respect to such
shares. Pursuant to the terms of Common Stock Purchase Agreement dated March 27,
2000, Rocket may nominate two persons to serve on the Company's Board of
Directors and the Company will use its best efforts to elect such nominees and
to fix the number of the members of the Board of Directors at not more than six.

     For the year ended December 31, 2000, the Company recorded revenue of
$90,000 and $25,000 related to other services revenue with shareholders, Rocket
Software Inc, and Mr. Dominic Chan, respectively. At December 31, 2000, there
were no balances in accounts receivable or in costs and estimated earnings in
excess of billings on uncompleted contracts with related parties.

     For a description of certain employment and other arrangements between the
Company and its executive officers and directors, see "Item 11--Executive
Compensation, Employment Agreements."

     The Company has adopted a policy providing that all material transactions
between the Company and its officers, directors and other affiliates must (i) be
approved by a majority of the members of the Company's Board of Directors and by
a majority of the disinterested members of the Company's Board of Directors and
(ii) be on terms no less favorable to the Company than could be obtained from
unaffiliated third parties.

                                       61
<PAGE>

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

                                   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 50 and incorporated herein by
reference.

(a)(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.

(a)(3) Exhibits

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

(b) Reports on Form 8-K

     A Current Report on Form 8-K dated October 16, 2000 was filed by the
Company October 19, 2000. The Company reported under Item 5 (Other Events) that
it retained The Catalyst Group, LLC to render financial advisory and investment
banking services in connection with exploring strategic alternatives including
the potential sale of the Company.


          REPORT OF INDEPENDENT ACCOUNTANTS ON THE FINANCIAL STATEMENT
                                   SCHEDULES

To the Board of Directors of Peritus Software Services, Inc.:

     Our audits of the consolidated financial statements referred to in our
report dated February 20, 2001 appearing in the December 31, 2000 Annual Report
to Stockholders of Peritus Software Services, Inc. also included an audit of the
financial statement schedules listed in Item 14 (a)(2) of this Form 10-K. In our
opinion, these financial statement schedules present fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements.


/s/ PRICEWATERHOUSECOOPERS LLP
Boston, Massachusetts
February 20, 2001

                                       62
<PAGE>

                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                         Peritus Software Services, Inc.

                                         By:  /s/ John Giordano
                                              ----------------------------------
                                                          John Giordano
                                              President, Chief Executive Officer
                                                  and Chief Financial Officer

                                                         March 20, 2001
                                                             (Date)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.

                                  By: /s/ John D. Giordano
                                      ------------------------------------------
                                                    John D. Giordano,
                                           President, Chief Executive Officer,
                                          Chief Financial Officer and Director
                                      (Principal Executive Officer and Principal
                                                    Financial Officer)

                                                     March 20, 2001
                                                         (Date)

                                  By: /s/ Patrick J. Manning
                                      ------------------------------------------
                                                  Patrick J. Manning,
                                                 Corporate Controller,
                                            (Principal Accounting Officer)

                                                     March 20, 2001
                                                         (Date)

                                  By: /s/ Axel Leblois
                                      ------------------------------------------
                                                     Axel Leblois,
                                                       Director

                                                    March 20, 2001
                                                        (Date)

                                  By: /s/ Roland D. Pampel
                                      ------------------------------------------
                                                  Roland D. Pampel,
                                                      Director

                                                   March 20, 2001
                                                      (Date)

                                  By: /s/ Dominic K. Chan
                                      ------------------------------------------
                                                  Dominic K. Chan,
                                                     Director

                                                  March 20, 2001
                                                      (Date)


                                  By: /s/ Johan Magnusson
                                      ------------------------------------------
                                                 Johan Magnusson,
                                                     Director

                                                  March 20, 2001
                                                     (Date)

                                       63
<PAGE>

                                  By: /s/ Andrew Youniss
                                      ------------------------------------------
                                                 Andrew Youniss,
                                                    Director

                                                 March 20, 2001
                                                     (Date)

                                       64
<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, 1998...  Allowance for doubtful accounts                $    95      $1,481    $  (850)  $   --      $   726
December 31, 1999...  Allowance for doubtful accounts                $   726      $ (321)   $  (380)  $   --      $    25
December 31, 2000...  Allowance for doubtful accounts                $    25      $   --    $    --   $   --      $    25
</TABLE>

<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, 1998...  Net deferred tax assets valuation allowance    $24,072  $       --    $11,448   $   --      $35,520
December 31, 1999...  Net deferred tax assets valuation allowance    $35,520  $       --    $   476   $   --      $35,996
December 31, 2000...  Net deferred tax assets valuation allowance    $35,996  $       --    $ 1,795   $   --      $37,791
</TABLE>

                                       65
<PAGE>

Exhibit
  No.     Description
  ---     -----------

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

10.5(1)   License Agreement dated as of July 29, 1996 between the Registrant and
          Bull HN Information Inc., as amended.

10.6(1)   Master License Agreement dated as of October 21, 1996, as amended,
          between the Registrant and Merrill Lynch, Pierce, Fenner & Smith
          Incorporated.

10.7(1)   License and Alliance Agreement dated as of May 1, 1996, as amended,
          between the Registrant and CSC Consulting, Inc., as amended.

10.8(1)   Agreement and Plan of Merger among the Registrant, Vista Technologies
          Incorporated and its stockholders, dated January 29, 1996.

10.9(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").

*10.10(3) Employment Agreement dated August 13, 1998 between the Company and
          John Giordano.

10.11(3)  Share Purchase Agreement dated July 20, 1998 between the Company and
          Persist S.A.

*10.12(4) Addendum to Employment Agreement dated October 5, 1998 between the
          Company and John Giordano.

*10.13(4) Letter Agreement dated April 9, 1999 between the Company and John
          Giordano.

10.14(5)  Settlement Agreement and Release dated July 29, 1999 by and among the
          Company, American Financial Group, Inc. ("AFG") and affiliates of AFG.

10.15(6)  Settlement Agreement dated September 15, 1999 by and between the
          Company and BCIA New England Holdings LLC.

10.16(6)  Agreement for Termination of Lease dated August 12, 1999 between the
          Company and The Prudential Insurance Company of America.

*10.17(6) Amended Employment Agreement between the Company and John Giordano
          dated as of September 9, 1999.

*10.18(6) Addendum to Employment Agreement between the Company and John Giordano
          dated as of September 9, 1999.

                                       66
<PAGE>

10.19(6)  Letter Agreement dated September 30, 1999 between the Company and
          Siemens Credit Corporation.

10.20(6)  Lease dated February 2, 1999, as amended, between the Company and
          OTR.

*10.21(7) Addendum to Employment Agreement between the Company and John Giordano
          dated January 21, 2000.

*10.22(7) Amended Employment Agreement between the Company and John Giordano
          dated January 21, 2000.

10.23(7)  Asset Purchase Agreement dated as of January 31, 2000, as amended, by
          and among Peritus Software Services (India) Private Limited, LTP
          (India) Pvt. Ltd. and Lisle Technology Partners L.L.C.

10.24(7)  Accounts Receivable Purchase Agreement dated as of November 19, 1999
          by and between the Company and Silicon Valley Bank.

10.25(7)  Intellectual Property Security Agreement dated as of November 19, 1999
          by and between the Company and Silicon Valley Bank.

10.26(7)  Common Stock Purchase Agreement dated as of March 27, 2000 by and
          between the Company and Rocket Software, Inc.

10.27(7)  Registration Rights Agreement dated as of March 27, 2000 by and
          between the Company and Rocket Software, Inc.

10.28(8)  Consulting Services Agreement dated as of June 22, 2000 by and between
          the Company and Dominic K.Chan

10.29(8)  Consulting Services Agreement dated as of July 1, 2000 for the IBM/SBC
          and Other Projects between the Company and Rocket Software, Inc.

10.30(8)  Mainframe Equipment Use Agreement dated as of July 1, 2000 by and
          between the Company and Rocket Software, Inc

10.31(8)  Consulting Services Agreement for Professional/Administrative Services
          dated as of May 1, 2000 by and between the Company and Rocket
          Software, Inc

21  Subsidiaries of the Registrant.

23  Consent of PricewaterhouseCoopers LLP.

___________________
(1)  Incorporated by reference to Registrant's Registration Statement on Form S-
     1, Commission file number 333-27087.
(2)  Incorporated by reference to Registrant's Current Report on Form 8-K dated
     December 16, 1997.
(3)  Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
     dated December 14, 1998.
(4)  Incorporated by reference to Registrant's Annual Report on Form 10-K dated
     April 14, 1999.
(5)  Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
     dated August 11, 1999.
(6)  Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
     dated November 12, 1999.
(7)  Incorporated by reference to Registrant's Annual Report on Form 10-K dated
     March 30, 2000.
(8)  Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
     dated November 9, 2000.

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

                                       67