<PAGE>
 
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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                ---------------
                                        
                                   FORM 10-K
                 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934
                                        
      For the Fiscal Year Ended                     Commission File Number:
          January 31, 1999                                 000-21287
                                        
                                ---------------
                          PEERLESS SYSTEMS CORPORATION
             (Exact name of registrant as specified in its charter)
                                        
                  Delaware                           95-3732595
       (State or other jurisdiction of            (I.R.S. Employer
        incorporation or organization)           Identification No.)

                  2381 Rosecrans Avenue, El Segundo, CA 90245
          (Address of principal executive offices, including zip code)
                                 (310) 536-0908
              (Registrant's telephone number, including area code)

       Securities registered pursuant to Section 12(b) of the Acts: None

          Securities registered pursuant to Section 12(g) of the Act:
                    Common Stock, $.001 Par Value Per Share

  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

                               Yes [X]     No[_]

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

  The approximate aggregate market value of the Common Stock held by non-
affiliates of the Registrant, based upon the last sale price of the Common Stock
reported on the Nasdaq National Market on April 13, 1999 was approximately
$66,719,574.

  The number of shares of Common Stock outstanding as of April 13, 1999 was
11,204,099.

                      DOCUMENTS INCORPORATED BY REFERENCE
  Certain parts of the Peerless Systems Corporation Proxy Statement relating to
the annual meeting of stockholders to be held on June 17, 1999 (the "Proxy
Statement") are incorporated by reference into Part III of this Annual Report
on Form 10-K.

================================================================================
<PAGE>
 
                   SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
                                        

This Report on Form 10-K contains forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Act of 1934 which are subject to the "safe harbor" created by those sections.
The forward-looking statements include, but are not limited to, statements
related to industry trends and future growth in the markets for digital document
products, embedded imaging systems and enterprise networks; the Company's
strategies for reducing its customers' costs and time-to-market; the Company's
product development efforts; the Company's efforts to secure and protect the
rights to its proprietary technology; the effect of GAAP accounting
pronouncements on the Company's recognition of revenues; the effect of the Year
2000 Issue on the Company's operations; market risk; the Company's future
research and development expenditures; the availability of future rental space;
the payment of dividends; and the sufficiency of the Company's capital
resources. Discussions containing such forward-looking statements may be found
in "Business", "Properties", "Market for Registrant's Common Equity and Related
Stockholder Matters" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations". These forward-looking statements involve
certain risks and uncertainties that could cause actual results to differ
materially from those in such forward-looking statements. The Company disclaims
any obligation to update these forward-looking statements as a result of
subsequent events. The risks and uncertainties on pages 20 through 24, among
other things, should be considered in evaluating the Company's prospects and
future financial performance.

                                       2
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                          PEERLESS SYSTEMS CORPORATION

                          1999 FORM 10-K ANNUAL REPORT
                                        
                               TABLE OF CONTENTS
<TABLE>
<CAPTION>
                                                                  Page
                                                                  ----
<C>          <S>                                                  <C>
                                PART I

Item 1.      BUSINESS.............................................. 4
Item 2.      PROPERTIES............................................13
Item 3.      LEGAL PROCEEDINGS.....................................13
Item 4.      SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...13

                                PART II

Item 5.      MARKET FOR THE REGISTRANT'S COMMON EQUITY RELATED
             STOCKHOLDER MATTERS...................................14
Item 6.      SELECTED FINANCIAL DATA...............................15
Item 7.      MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
             CONDITION AND RESULTS OF OPERATIONS...................16
Item 8.      FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...........25
Item 9.      CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
             ACCOUNTING AND FINANCIAL DISCLOSURE...................25

                               PART III

Item 10.     DIRECTORS AND EXECUTIVE OFFICERS......................26
Item 11.     EXECUTIVE COMPENSATION................................27
Item 12.     SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
             MANAGEMENT............................................27
Item 13.     CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS........27

                                PART IV

Item 14.     EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
             ON FORM 8-K...........................................28
</TABLE>


                                  TRADEMARKS

Memory Reduction Technology(R), PEERLESS SYSTEMS(R), WINEXPRESS(R),
PeerlessPrint(R) and QuickPrint(R) are registered trademarks of Peerless Systems
Corporation. PeerlessPowered/TM/, CPL/TM/, PicturePrint/TM/, Acceleprint/TM/ and
Synthesys/TM/ are trademarks of Peerless Systems Corporation and are subjects of
applications pending for registration with the United States Patent and
Trademark Office. Peerless Systems (in English and Japanese Katakana), Peerless
(in logo) and P (in logo) are registered service marks with the Japanese Patent
Office. Peerless/TM/ (in logo) and P/TM/ (in logo), Peerless Systems/TM/,
PEERLESSPRINT and PEERLESSPAGE/TM/ (all in English and Japanese Katakana), are
trademarks of Peerless Systems Corporation and are subjects of applications
pending for registration with the Japanese Patent Office. This Form 10-K also
refers to various products and companies by their trademark names. In most, if
not in all cases, these designations are claimed as trademarks or registered
trademarks by their respective companies.

                                       3
<PAGE>
 
PART I

Item 1 -- Business.

  Peerless Systems Corporation ("Peerless" or the "Company") is a leading
provider of software-based embedded imaging systems to original equipment
manufacturers ("OEMs") of digital document products. Digital document products
include printers, copiers, fax machines and scanners, as well as multifunction
products ("MFPs") that perform a combination of these imaging functions. In
order to process digital text and graphics, digital document products rely on a
core set of imaging software and supporting electronics, collectively known as
an embedded imaging system. Peerless' technology and engineering services
provide advanced embedded imaging solutions that enable the Company's OEM
customers to develop digital printers, copiers and MFPs quickly and cost
effectively. The Company markets its solutions directly to OEM customers such as
Canon, IBM, Minolta and Ricoh. Peerless was incorporated in California in 1982
and reincorporated in Delaware in September 1996.

Industry Background

  Embedded Imaging Systems

  Today's office environment is increasingly dependent on a variety of
electronic imaging products such as printers, copiers, fax machines and
scanners, collectively known as digital document products. These imaging
products also are becoming common in the home environment. Historically, most
electronic imaging products in the office environment have been stand-alone,
monochrome (black-and-white) machines, based on analog technology and dedicated
to a single print, copy, fax or scan function. However, with the proliferation
of personal computers, desktop publishing software and network computing,
documents increasingly are being created, stored and transmitted digitally,
thereby creating the need for digital document production.

  Digital documents are becoming increasingly complex and may include digital
text, line art or photographic images. In order to process and render these
documents, digital document products rely upon a core set of imaging software
and supporting electronics collectively known as an embedded imaging system.
With advances in digital imaging engines such as laser printing engines in the
mid-1980s, a common imaging technology foundation for multiple market sectors
has emerged. To date, a majority of embedded imaging systems have been developed
and produced internally by digital document product manufacturers such as
Hewlett-Packard ("HP"), Xerox and Canon. The Company estimates the digital
document market, based in part upon data and projections provided by
International Data Corporation ("IDC"), was approximately $35 billion in 1998.

  Developments in the Digital Document Products Market

  Rapid changes in technology and end-user requirements have created increased
challenges for digital document product manufacturers, particularly in the area
of embedded imaging systems. These changes include increased technical
complexity, the increased role of networking, the emergence of MFPs and the
demand for color imaging. As a result, OEMs increasingly are relying on outside
embedded imaging systems suppliers to provide their embedded imaging system
solutions.

  Increased Technical Complexity. Initially, the software written for embedded
imaging systems supported only monochrome, single-function, low-resolution
capabilities. This software was relatively simple and resided on a low-end 8-bit
microprocessor platform. However, as technology and end-user requirements have
evolved, the embedded imaging task has become significantly more complex. Today,
digital imaging engines operate at resolutions of 1,200 dots per inch and
greater, require the support of a variety of document handling options, operate
at increased speeds and are beginning to offer high-quality color output. In
addition, computers and application software create increasingly sophisticated
documents that incorporate complex graphical content. The data files for these
digital documents can be very large and, if left in raw form, can overwhelm the
memory and processing power of the digital document product. In response,
embedded imaging systems have evolved from 8-bit to 32-bit platforms that 

                                       4
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often must employ special techniques to manage large data files and minimize
memory costs. Most embedded imaging systems use compression techniques to reduce
the size of data files, which can result in reduced image quality. The increased
complexity of digital document products, the rapid pace of technological change
and the increased memory requirements have created increased challenges for
digital document product manufacturers, particularly in the core areas of image
processing and operating system architecture.

  Increased Reliance on Outsourcing. In addition to the engineering challenges
generated by changing technology, digital document product manufacturers are
continually subject to a variety of market pressures. Competition in the
marketplace, coupled with end-user demand for greater performance at reduced
cost has created a growing need to reduce time-to-market and engineering costs.
This increased competition is forcing digital document product manufacturers to
outsource imaging software and supporting electronics design to embedded imaging
systems suppliers in order to include new imaging technologies and minimize
development time and cost. The increased role of networking, the emergence of
MFPs, the demand for color imaging and the increased technical complexity
associated with products meeting these market changes have accelerated the trend
toward outsourcing. As digital document product manufacturers move to
incorporate imaging technologies from outside suppliers, their internal
resources are freed to focus on their core competencies in product
differentiation, marketing and distribution. Additionally, there has been no
established comprehensive embedded imaging system standard for the digital
document product industry to date. However, as the digital document product
market sectors converge and the complexity of imaging technology intensifies,
Peerless believes digital document product manufacturers will realize
significant cost and time-to-market advantages by utilizing a single open
embedded imaging system standard across multiple digital document product market
sectors. See "Competition" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" for a discussion of these 
forward-looking statements.

  Demand for Color Imaging. Although many office computers have color displays,
and the graphical content available to office users via the Internet and
advanced office applications make heavy use of color, most digital document
products found in today's office environment still generate monochrome output.
In the 1990s, color inkjet printers were introduced into the small office/home
office (SOHO) market and color laser printers were introduced into the office
marketplace. In the SOHO market, most color inkjet printers are typically
limited by output speeds of one or fewer pages per minute. In the office market,
color laser printers have been limited by technology and unit costs that remain
significantly higher than monochrome laser printers.  In addition, the printing
speeds for color continue to be significantly slower than monochrome laser
printers. Furthermore, digital document product manufacturers are developing
tandem engines, which are comprised of multiple imaging stations dedicated to
individual colors used in the printing process. Although these products hold the
promise of raising desktop office color printing speeds to monochrome levels of
performance, cost effective embedded imaging systems that can produce high
quality output from these tandem engines are limited in the market. As a result,
market pressures for advanced embedding imaging systems that enable high quality
and improved price/performance for both SOHO and office color products remain
high. In addition, new digital appliances such as digital cameras are creating
an intensified need for photoquality color printing capabilities. Although
digital document engine manufacturers have developed color hardware technology
that is now capable of supporting high speed photoquality color printing, the
output produced by today's digital document products, in many cases, continues
to be limited by existing embedded imaging systems. Today's embedded imaging
systems are challenged by the transition from monochrome to color output because
the simultaneous implementation of four planes of color coupled with up to 8
bits per pixel at increased resolution significantly increases the size of the
digital document data stream. As a result, there is a need for embedded imaging
systems that can support the accelerated performance requirements of high-
density color output.

  Emergence of Multifunction Products. The advent of MFPs has eroded the
boundaries between the previously distinct printer, copier, fax and scanner
market sectors. MFPs, ranging from small home products to large office devices,
offer several of these functions for significantly less cost than would
otherwise be incurred by purchasing these products separately. Each of the
dominant vendors in the printer, copier and fax markets have now introduced
MFPs, which have required each of them to broaden their imaging expertise. At
the same time, the need for 

                                       5
<PAGE>
 
concurrent processing of multiple digital document product functions has created
the need for real-time, multitasking operating system support.

  Increased Role of Networking. Within the office environment, digital document
products increasingly are deployed in a networked configuration. According to
projections by IDC, 74% of laser printers sold in the United States in 1996 were
estimated to have been connected to enterprise networks, and this percentage is
expected to increase to 81% by 2002 Because multiple local area network
protocols and network operating systems are deployed in the corporate network
environment, networked digital document products must support a broad array of
networking technologies to maximize accessibility by various user groups. The
network environment is also changing rapidly and becoming increasingly complex,
with a growing requirement for remote network management that extends across
local area networks, wide area networks and the Internet. In addition, because
the majority of office digital document products are networked, the image
processing intelligence may be partitioned and located anywhere within the
network: at the site of document or image origination, at a server, or, as is
typically the case today, inside the digital document product itself. In some
instances, such as when printing to a remote location, it can be advantageous to
perform image pre-processing and compression at the document origination site
prior to transmission over usage-sensitive or congested facilities. In other
instances, such as when printing from a graphics workstation, it can be
advantageous to perform most of the image processing at the printer in order to
offload a host computer that is under a heavy workload. In order to accommodate
the emerging needs of the networked office environment, an optimal embedded
imaging system must employ a modular architecture capable of serving and
managing distributed corporate resources.

  Advent of Digital Photography. The emergence of digital cameras capable of
producing images of near-film quality and the increasing popularity of these
devices has created a need for editing and directly printing these images to a
variety of digital document products without an intermediary computer. Many of
today's digital camera manufacturers are restricted to a single specific printer
to which their camera can print directly.  This limitation may restrict the
appeal of their products to potential buyers. The lack of a standard embedded
imaging solution to accomplish these tasks has created new technical challenges
for both digital camera manufacturers and the digital document product market.

Peerless Products And Solutions

  Peerless is a leading provider of embedded imaging systems for the digital
document product market. The Company's technology and engineering services
provides advanced embedded imaging solutions that enable the Company's OEM
customers to develop digital printers, copiers and MFPs quickly and cost
effectively. The Company delivers its products to its OEM customers in multiple
ways: 1) licensing of the Company's standard imaging technology for the OEM's
internal product development; 2) turnkey product development whereby the Company
provides the technology and the additional engineering services necessary to
integrate the appropriate technology into a complete embedded imaging system
solution optimized to the OEM's specific requirements or 3) a co-development
relationship that combines the licensing of Peerless technology with joint
Peerless and OEM engineering resources.

  Products and Services

  The Company has designed its embedded imaging technology with a modular
architecture that addresses a broad spectrum of digital document product
solutions tailored to an individual OEM's requirements. Peerless offers its OEMs
the flexibility to selectively optimize solutions for monochrome and color,
networking support, languages or multifunction features for their digital
document products. Peerless also offers engineering services to allow OEMs to
outsource the development of the entire embedded imaging system for a digital
document product. The Company's products include the following technologies and
services:

  Object-Based Imaging System. PeerlessPage is a complete object-based imaging
system including a high-performance real-time operating system kernel, printing
engine driver, object-based image processing model, 

                                       6
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graphics library, font management, hard disk management, print job management
and user control panel interface. The scaleable nature of the Company's
technology enables it to serve both the low cost and high performance sectors of
the market. The multitasking operating system enables the Company to manage
concurrent processing of digital document product tasks for the MFP marketplace.
For added performance and flexibility, the Company's imaging system may be
implemented to operate in a distributed fashion, allowing for portions of the
imaging processing task to take place in the originating host computer, in the
digital document product or elsewhere in the network. Color extensions to
PeerlessPage support the unique requirements of color printers. Extensions to
support MFPs have been developed to provide multitasking capability.

  Page Description Languages. The Company provides OEMs with support for the
most widely used and standard page description languages ("PDLs"), Adobe's
PostScript Software and Hewlett-Packard's Printer Control Language ("PCL"). The
Company offers PeerlessPrint technology, which emulates Hewlett-Packard's PCL.
The complete range of printing language products includes PeerlessPrint5E, 5C
and 6. PeerlessPrint5E provides compatibility with HP's PCL 5e language utilized
in their LaserJet 5P, 5Si, LJ4000 and LJ5000 laser printer products, as well as
enhancements to support higher resolutions and added paper handling options.
PeerlessPrint5C is designed to provide compatibility with HP's PCL 5C utilized
in its Color LaserJet 4500 and high-end inkjet products. PeerlessPrint6 provides
monochrome and color compatibility with HP's latest PCL 6 language. As a third-
party co-developer, the Company provides an optimized, high performance
integration of Adobe PostScript 3 into the PeerlessPage imaging system for
customers desiring to license PostScript from Adobe Systems Incorporated
("Adobe"). The Company's WinEXPRESS languages have been designed to provide 
host-based printing solution for low cost monochrome and color printers and MFPs
and ACCELEPRINT combines a host-based printing solution with an industry
standard PCL solution to provide a highly optimized method for printing
documents.

  PC Software. The Company provides a complete set of PeerlessPrint drivers that
optimize the printing process in the Windows 3.1, 95, 98 and the NT 4.0
environments.  Windows NT 5.0 is currently under development and planned for
future release.

  ASICs and Integrated Processors. The Company designs application specific
integrated circuit ("ASIC") solutions for the office and SOHO sectors of the
digital document product marketplace.  These ASICs provide a silicon-based
implementation of key components of its imaging software. Peerless has licensed
these designs to semiconductor manufacturers, such as IBM Microelectronics and
Motorola who, in turn, have the right to manufacture and sell these ASICs
directly to digital document product manufacturers. The Company's QuickPrint
line of imaging ASIC co-processors and integrated processors incorporate basic
components of the Company's imaging system into a silicon solution to reduce
controller costs and enhance overall performance. For the high performance
sector of the office market, the Company offers specialized co-processors that
accelerate the Peerless imaging software and incorporate controller
functionality and imaging features to provide both cost savings and performance
enhancements. The Company currently markets the QP 1700, QP 1800 and QP +401
ASICs. The QP +401 is a "system on a chip" solution which integrates the
processor and co-processor on a single chip.  Additionally, the Company has
introduced the QP 1900 family of ASICs to address the multiple color planes of
high-speed color printing as well as very high-speed monochrome printing.

  In addition, the Company, in partnership with Conexant Systems, Inc.
("Conexant"), formerly Rockwell Semiconductor Systems, Inc., has developed an
integrated processor solution for the multifunction SOHO color inkjet market
which will incorporate Peerless' object-based imaging system and Rockwell's fax
technology into a low cost chipset solution.

  Networking Technology. The Company has designed a standardized networking
interface, the Peerless Standard Input/Output ("PSIO") interface, to enable its
digital document product OEMs to reduce custom development costs for their
networking solutions through third parties. In addition, Peerless supports a
broad array of networking protocols, allowing its OEM customers to address the
majority of end-user networking requirements. To accommodate the need for remote
network management of digital document products over LANs and across wide area
networks, including intranets, the Company supplies management information base
("MIB") tables that may be
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utilized by open industry-standard network management systems. Most recently,
Peerless has agreed to merge, subject to final closing, with a networking
company that enables the Company to provide cost-effective embedded networking
solutions. The embedded network solution eliminates the need for a network
interface card and provides low cost embedded networking solutions for cost
sensitive market segments. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations" for further discussion of the
acquisition.

  Engineering Services. For those OEMs that wish to outsource the development of
some or all of the embedded imaging system for a digital document product, the
Company offers engineering services. This can include controller design and
custom engineering for vendor-specific features that complement the Company's
standard imaging technology. In addition, during fiscal 1998 the Company
established the Peerless Development Partner Program to give Peerless and OEM
customers the option of using an independent development partner closely allied
with Peerless for product development and integration services.

Solutions

  The Company's technology can be leveraged to provide a wide range of scaleable
solutions:

  Monochrome Solution. The Company's monochrome solution targets low cost,
networkable office laser printers. The Company's color imaging technology also
provides photographic quality image printing on monochrome products.

  Multifunction Solution. The Company's MFP imaging solutions target lower-cost
color inkjet, fax or laser-based workgroup MFP products and high-speed copier-
based MFP products. The lower-cost inkjet solutions will combine Peerless
imaging technology and Conexant fax technology. The higher-end solutions combine
the Company's networkable imaging products with MFP-specific extensions to
facilitate printing, copying, faxing and scanning in the same digital document
product. The Company's solutions provide multifunction capability, but the
Company does not provide stand-alone fax or copier solutions  During fiscal
1999, the Company, in partnership with Ricoh, announced 35 and 45 PPM copier
based MFP solutions.

  Color Solution. The Company's color imaging solutions target OEM requirements
for a broad range of color imaging devices. The Company's proprietary object-
based imaging system reduces memory requirements for printing  color pages while
simultaneously accelerating the document imaging process and increasing print
quality. During fiscal 1999, the Company announced eight new color products
shipping in the market with Peerless technology.  OEMs shipping these new
products include Minolta, Kyocera and Tektronix.

Technology

  The Company develops unique technologies for the embedded imaging systems
marketplace that provide meaningful improvements in performance, cost and time
to market for Peerless' OEMs. The Company's proprietary embedded, object-based
imaging system reduces the size of digital document product imaging files with
virtually no noticeable loss of visual quality. This proprietary technology
enables the Company's OEM customers to reduce memory cost and increase print
quality and speed while eliminating or reducing the need for incremental
compression technology. When optimized, this component of the embedded imaging
system can provide significant cost savings and performance differentiation to
digital document product manufacturers. The Company incorporates complementary
technologies, or makes its technologies compatible with third-party
technologies, in order to provide its customers with a more comprehensive
imaging solution.

  Object-Based Image Processing. Most other embedded imaging systems utilize
similar methods of processing document imaging information. They convert a file
that represents a document page into a bitmap and then process all page elements
as a collection of pixels. Because bitmaps generate large files, the image
processing task can become time-consuming, requiring subsequent document pages
to be stored in memory while previous pages are being processed. To accommodate
memory limitations, file compression technologies are often utilized. These

                                       8
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compression technologies frequently result in a loss of clarity and detail in
the printed document and require significant processing power.

  Peerless has developed a proprietary approach to the embedded imaging task.
Rather than recognizing a page image as a collection of pixels, the Peerless
object-based image processing technology recognizes basic imaging elements in
the document, differentiating between text, line art and photographs much as the
human eye does. Peerless' software then creates a display list of image objects
as an intermediate representation of the document to be printed. This display
list is a more concise means of representing the imaging information of the
document, enabling complex imaging data to be processed more quickly and with
less memory, typically without resorting to compression techniques that degrade
the image. For high performance applications, the display list can be processed
in real time with assistance from a Peerless-designed graphics co-processor
embedded in the digital document product. Because Peerless technology can enable
the page image to be processed in real time, concurrent with the transmission of
the document print file, memory requirements can be reduced and performance can
be enhanced. Furthermore, the image quality or resolution can be reduced to
accommodate limitations in the digital document product's memory, or
progressively enhanced by installation of additional digital document product
memory. The Company's object-based image processing technology provides more
significant benefits as the image processing workload increases, which occurs
with increased resolution or a transition from monochrome to color. The Company
holds six patents in the United States protecting the intellectual property
within certain aspects of its object-based imaging approach.

  Systems Architecture. The Company has developed standardized interfaces for
the Company's family of products that enable the Company's imaging solution to
be ported to a variety of platforms, languages and applications. For example,
the standardized PeerlessPage interface provides the ability to support multiple
printing languages. The PeerlessPage object-based imaging system is both
platform- and device-independent and is able to accommodate a variety of print
engines and controller architectures. The Company has also developed an
applications interface that enables the support of features such as spooling,
stored macros, stored forms, electronic collation and stapling.

  Technology Partners. The Company has established relationships that permit it
to offer to its customers complementary technologies through technology
partners. For example, Peerless has licensed (for internal development purposes)
the right to use Adobe's PostScript Software to enable the Company's products to
be used with Adobe's PostScript Software. The Company's relationship with Adobe
permits the Company to offer a convenient and optimized Adobe PostScript-enabled
solution. In addition, the Company incorporates font rasterizers into its
imaging solution to enable its OEMs to license font technology from providers
such as Agfa and Bitstream. The Company has also established semiconductor
agreements with leading developers and manufacturers of RISC microprocessors in
order to offer integrated processor and co-processor solutions. The integrated
processors combine the Company's basic imaging sending functionality with an
industry-standard microprocessor.

  In October 1996, the Company entered into an agreement with Conexant, a major
developer and manufacturer of communication chips, relating to the licensing of
Peerless technologies and engagement of Peerless technical personnel for
engineering development services. The agreement covers a joint development
effort between Conexant and Peerless to specify, design and produce an
integrated semiconductor solution for multifunction products that combines
Conexant's fax technology and Peerless' embedded imaging technology. The
combined technology has been embedded into an OEM's SOHO MFP product that is
expected to be shipping in the marketplace by the second quarter of calendar
year 1999.

  Digital Device Technology. The Company is in the early stages of core
technology development for a digital device and is focusing primarily on digital
photography.  Future revenue associated with this digital device technology will
depend on the success of the Company's underlying development and marketing
efforts.

                                       9
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Customers and Markets

  Customers

  Peerless markets its imaging technology to OEMs manufacturing digital document
products for the high performance sector of the office market and to
semiconductor OEMs in the low cost sector of the office and personal use market.
In addition, the Company markets its imaging technology to technology partners,
which incorporate certain components of the Company's technology into integrated
product offerings that are ultimately marketed to digital document OEMs. With
the exception of technology partners such as Adobe and Conexant, the Company has
derived substantially all of its revenues in recent years from direct sales to
digital document product OEMs.

  The Company's customers that individually comprised more than 10% of the
Company's total revenues for fiscal 1999 were Adobe, Canon, Conexant, IBM,
Minolta, Ricoh. Revenues from the Company's top four customers accounted for
58%, 60% and 60% of the Company's total revenues for fiscal years 1999, 1998 and
1997, respectively. The Company anticipates that its future revenues will be
similarly concentrated with a limited number of customers. The Company's largest
customers vary to some extent from year to year as product cycles end,
contractual relationships expire and new products and customers emerge. Many of
the engineering services and licensing arrangements with the Company's customers
are provided on a project-by-project basis, are terminable with limited or no
notice, and in certain instances, are not governed by long-term agreements.

  Markets

  Enterprise Office Market. The office sector of the digital document product
market is characterized by digital document products ranging in price from
approximately $1,000 to in excess of $20,000 each. These products typically
offer high performance differentiated by customized features. In many cases,
digital document product manufacturers demand turnkey, customized embedded
imaging solutions that include imaging software, controller design and network
interface card design. As a result of these unique requirements, Peerless
typically addresses the high performance sector of the digital document product
market via direct OEM relationships with individual digital document product
manufacturers.  The Company's major customers in the office market in the fiscal
year ended January 31, 1999 included Adobe, Canon, IBM, Minolta and Ricoh.

  Small Office/Home Office Market. The low-cost sector of the digital document
product market, sometimes called the Small Office/Home Office ("SOHO") market,
is characterized by digital document products with prices under $1,000 that
typically emphasize price/performance over customized features. For the SOHO
market, Peerless has entered into a joint development agreement with Conexant to
produce a chipset that integrates components of the Company's imaging software
and Rockwell's fax technology into semiconductor firmware. Peerless has licensed
its technology to Conexant, which has the rights to manufacture and sell this
chipset directly to digital document product manufacturers. Conexant is
presently the Company's primary customer in the SOHO market. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations" for
discussion on the Company's dependence on sole source providers.

  International Markets.  Revenues from customers outside the United States
accounted for 61%, 46% and 38% of the Company's total revenues for fiscal years
1999, 1998 and 1997, respectively.  Further, the Company expects that sales to
customers located outside the United States may increase in absolute dollars in
the future.  Peerless' international customers  are comprised primarily of
companies headquartered in Japan.  These Japanese customers sell products
containing Peerless' technology primarily in the North America and European
marketplaces.  Despite a continued downturn in the Asian economy, the Company
has not experienced a decrease in its sales to Asian customers.  See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" for further discussion on Asian markets.

                                       10
<PAGE>
 
  All of the Company's contracts with international customers are, and the
Company expects that in the future will be, denominated in U.S dollars.  As a
result, the Company is currently not subject to foreign currency transaction and
translation gains and losses.

Seasonality

  The Company believes that its business may be subject to seasonal trends.  See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" for further discussion on seasonality.

Sales and Marketing

  The Company markets its products to the leading OEMs that sell digital
document products into the worldwide market. The Company directs most of its
sales efforts through its headquarters in California and its subsidiary in
Japan. Sales to European digital document product manufacturers are conducted
out of the Company's California headquarters.

  The Company markets directly to OEMs and through focused public relations and
branding programs. Direct OEM marketing consists of focused public relations
activities and the development of sales collateral, mailers, trade show
attendance and sales support. The Company focuses its public relations effort on
media read by OEM customers. The Company directs its branding programs toward
building the Company's brand awareness. These programs consist of public
relations and Peerless product branding on its silicon and software products.

Product Development and Engineering Services

  The Company's product development activities are located at the Company's
headquarters in El Segundo, California. These activities primarily consist of
new product development, enhancement of existing products, product testing and
technical documentation development. Accordingly, the Company's engineering
personnel are divided into two primary development areas: research and
development, which focuses on development and enhancement of the Company's core
technologies; and engineering services, which focuses on customized customer
design activities.

  The Company's engineering services personnel work closely with OEMs that
desire a turnkey solution, developing customized interfaces and applications
specific to individual OEMs. The Company typically receives a fee for such
engineering services. As part of its corporate strategy, the Company leverages
its engineering services capability to penetrate emerging market sectors where
applications and interfaces have not fully evolved.

Intellectual Property and Proprietary Rights

  The Company's success is heavily dependent upon its proprietary technology. To
protect its proprietary rights, the Company relies on a combination of patent,
copyright, trade secret and trademark laws as well as nondisclosure and other
contractual restrictions. The Company holds six patents issued in the United
States, one of which is also issued in France, Germany and Great Britain. The
issued patents relate to techniques developed by the Company for generating
output for continuous synchronous raster output devices, such as laser printers.
The Company has four applications pending in Japan, three applications pending
in the European Patent Office and three applications pending in the United
States. There can be no assurance that patents held by the Company will not be
challenged or invalidated, that patents will issue from any of the Company's
pending applications or that any claims allowed from existing or pending patents
will be of sufficient scope or strength (or issue in the countries where
products incorporating the Company's technology may be sold) to provide
meaningful protection or any commercial advantage to the Company. In any event,
effective protection of intellectual property rights may be unavailable or
limited in certain countries. The status of United States patent protection in
the software industry is not well defined and will evolve as the United States
Patent and Trademark Office grants additional patents. Patents have been 

                                       11
<PAGE>
 
granted to fundamental technologies in software after the development of an
industry around such technologies and patents may be issued to third parties
that relate to fundamental technologies related to the Company's technology.

  As part of its confidentiality procedures, the Company generally enters into
nondisclosure agreements with its employees, consultants, OEMs and strategic
partners and limits access to and distribution of its software and other
proprietary information. Despite these efforts, the Company may be unable to
effectively protect its proprietary rights and, in any event, enforcement of the
Company's proprietary rights may be expensive. The Company's source code also is
protected as a trade secret. However, the Company from time to time licenses its
source code to OEMs, which subjects the Company to the risk of unauthorized use
or misappropriation despite the contractual terms restricting disclosure. In
addition, it may be possible for unauthorized third parties to copy the
Company's products or to reverse engineer or obtain and use the Company's
proprietary information.

  As the number of patents, copyrights, trademarks and other intellectual
property rights in the Company's industry increases, products based on its
technology increasingly may become the subjects of infringement claims. There
can be no assurance that third parties will not assert infringement claims
against the Company in the future. Any such claims, regardless of merit, could
be time consuming, result in costly litigation, cause product shipment delays or
require the Company to enter into royalty or licensing agreements. Such royalty
or licensing agreements, if required, may not be available on terms acceptable
to the Company, or at all, which could have a material adverse affect on the
Company's operating results. In addition, the Company may initiate claims or
litigation against third parties for infringement of the Company's proprietary
rights or to establish the validity of the Company's proprietary rights.
Litigation to determine the validity of any claims, whether or not such
litigation is determined in favor of the Company, could result in significant
expense to the Company and divert the efforts of the Company's technical and
management personnel from productive tasks. In addition, the Company may lack
sufficient resources to initiate a meritorious claim. In the event of an adverse
ruling in any litigation regarding intellectual property, the Company may be
required to pay substantial damages, discontinue the use and sale of infringing
products, expend significant resources to develop non-infringing technology or
obtain licenses to infringing or substituted technology. The failure of the
Company to develop, or license on acceptable terms, a substitute technology if
required could have a material adverse effect on the Company's operating
results.

Competition

  The market for embedded imaging systems for digital document products is
highly competitive and characterized by continuous pressure to enhance
performance, add functionality, reduce costs and accelerate the release of new
products. The Company competes on the basis of technology expertise, product
functionality, development time and price. The Company's technology and services
primarily compete with solutions developed internally by OEMs. Virtually all of
the Company's OEMs have significant investments in their existing solutions and
have the substantial resources necessary to enhance existing products and to
develop future products. These OEMs have or may develop competing embedded
imaging systems technologies and may implement these systems into their
products, thereby replacing the Company's current or proposed technologies,
eliminating a need for the Company's services and products and limiting future
opportunities for the Company. The Company therefore is required to persuade
these OEMs to outsource the development of their embedded imaging systems and to
provide products and solutions to these OEMs that cost-effectively compete
favorably with their internally developed products. The Company also competes
with software and engineering services provided in the digital document product
marketplace by other systems suppliers to OEMs. In this regard, the Company
competes with, among others, Electronics for Imaging and Xionics Document
Technologies.

  As the industry continues to develop, the Company expects that competition and
pricing pressures will increase from OEMs, existing competitors and other
companies may enter the Company's existing or future markets with similar or
substitute solutions that may be less costly or provide better performance or
functionality. The Company anticipates increasing competition for its color and
multifunction products, particularly as new competitors develop and enter
products in this emerging market. Some of the Company's existing competitors,
many of its potential competitors and virtually all of the Company's OEMs have
substantially greater financial, technical, marketing and 

                                       12
<PAGE>
 
sales resources than the Company. In the event that price competition increases,
competitive pressures could cause the Company to reduce the amount of royalties
received on new licenses and to reduce the cost of its engineering services in
order to maintain existing business and generate additional product licensing
revenues, which could reduce profit margins and result in losses and a decrease
in market share. No assurance can be given as to the ability of the Company to
compete favorably with the internal development capabilities of its current and
prospective OEM customers or with other third-party embedded imaging system
suppliers, and the inability to do so would have a material adverse effect on
the Company's operating results.

Employees

  As of January 31, 1999, the Company had a total of approximately 170 employees
and independent contractors. None of the Company's employees is represented by a
labor union, and the Company has never experienced any work stoppage. The
Company considers its relations with its employees to be good.



Item 2 -- Properties.

  The Company leases its principal facilities in El Segundo, California. The
Company expanded its facilities during the fiscal year ended January 31, 1999
from 47,000 square feet to 56,000 square feet as part of an amendment to the
existing lease agreement.  The lease, as amended, expires in March 2007. The
Company also leases office space in Japan. The Company believes that suitable
additional facilities or alternative space will be available in the future on
commercially reasonable terms as needed.

Item 3 -- Legal Proceedings.

  The Company is not a party to any material litigation or legal proceedings.

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

  No matters were submitted to a vote of the Company's stockholders during the
fourth quarter of fiscal 1999.

                                       13
<PAGE>
 
PART II


ITEM 5 - Market for Registrant's Common Equity and Related Stockholder Matters.

    The Company's common stock is traded on the Nasdaq National Market under the
symbol "PRLS".  The table below sets forth, during the periods indicated, the
high and low sales price for the Company's common stock as reported on the
Nasdaq National Market.


<TABLE>
<CAPTION>
                                                               Year Ended
                                   -----------------------------------------------------------------
                                          January 31, 1999                   January 31, 1998
                                   -----------------------------      ------------------------------
             <S>                   <C>             <C>                <C>             <C>
             Quarter                    High           Low                  High           Low
             -------               ------------    -------------      -------------   --------------

             First                     $21.250        $11.000              $20.750        $ 8.500
             Second                    $24.375        $15.500              $17.000        $10.250
             Third                     $21.375        $ 2.813              $17.250        $12.500
             Fourth                    $10.875        $ 6.750              $16.375        $ 9.000
 
</TABLE>



    As of April 13, 1999, there were approximately 145 holders of record of the
Company's common stock.


Dividend Policy

    The Company has not declared or paid any cash dividends on its common stock
during any period for which financial information is provided in this Annual
Report on Form 10-K. The Company currently intends to retain future earnings, if
any, to fund the development and growth of its business and does not anticipate
paying any cash dividends on its common stock in the foreseeable.

                                       14
<PAGE>
 
ITEM 6 - Selected Financial Data

    The statement of operations data for the years ended January 31, 1999, 1998
and 1997 and the balance sheet data at January 31, 1999 and 1998, are derived
from, and should be read in conjunction with, the audited financial statements
and notes thereto included elsewhere in this Form 10-K.  The statement of
operations data for the years ended December 31, 1995 and 1994 and the balance
sheet data at January 31, 1997 and 1996 and December 31, 1995 and 1994 are
derived from audited financial statements not included in this Form 10-K.  The
data set forth below (in thousands, except per share data) are qualified in
their entirety by, and should be read in conjunction with, "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Financial Statements and Notes thereto included elsewhere in this Form 10-K.

<TABLE>
<CAPTION>
                                                                                                    Years Ended
                                                 Years Ended January 31, (1)                         December 31,
                                            -------------------------------------           ----------------------------
                                               1999         1998          1997                 1995              1994
                                            ----------   ----------    ----------           ----------        ----------
<S>                                         <C>          <C>           <C>                  <C>               <C>
Statement of Operations Data:
    Revenues:
         Product licensing                    $20,882      $15,806       $ 8,322             $  4,774          $  4,394
         Engineering services and       
              maintenance                      11,701        9,557         7,699                5,639             4,942
                                            ----------   ----------    ----------           ----------        ----------- 
              Total revenues                   32,583       25,363        16,021               10,413             9,336
                                            ----------   ----------    ----------           ----------        -----------
    Cost of revenues:
         Product licensing                        139          141           144                  143               218
         Engineering services and              
              maintenance                      10,526        7,974         6,123                5,111             5,457
                                            ----------   ----------    ----------           ----------        -----------
              Total cost of revenues           10,665        8,115         6,267                5,254             5,675
                                            ----------   ----------    ----------           ----------        -----------
                   Gross margin                21,918       17,248         9,754                5,159             3,661
                                            ----------   ----------    ----------           ----------        -----------
    Operating expenses:
         Research and development               7,220        4,604         2,701                2,088             1,767
         Sales and marketing                    4,212        3,732         2,746                2,142             1,878
         General and administrative             4,797        2,915         2,546                1,293             1,000
                                            ----------   ----------    ----------           ----------        -----------
              Total operating expenses         16,229       11,251         7,993                5,523             4,645
                                            ----------   ----------    ----------           ----------        -----------
    Income (loss) from operations               5,689        5,997         1,761                 (364)             (984)
    Interest income (expense), net              1,333        1,391           186                 (176)             (118)
                                            ----------   ----------    ----------           ----------        -----------
         Income (loss) before income         
              taxes                             7,022        7,388         1,947                 (540)           (1,102)
    Provision (benefit) for income taxes        2,458        2,444        (2,500)                  99               124
                                            ----------   ----------    ----------           ----------        -----------
    Net income (loss)                         $ 4,564      $ 4,944       $ 4,447             $   (639)          $(1,226)
                                            ==========   ==========    ==========           ==========        ===========
    Net income (loss) per share - 
         assuming dilution (2)                $  0.39      $  0.42       $  0.46             $  (0.24)          $ (0.47)
                                            ==========   ==========    ==========           ==========        ===========
    Shares used in per share 
         calculation (2)                       11,821       11,652         9,893                2,664             2,599
                                            ==========   ==========    ==========           ==========        ===========
</TABLE>

<TABLE>
<CAPTION>
                                                               January 31, (1)                                December 31,
                                         --------------------------------------------------------     -------------------------
                                              1999           1998          1997         1996             1995           1994
                                         ------------   ------------   -----------  -------------     -----------   -----------
<S>                                      <C>            <C>            <C>          <C>               <C>           <C>
Balance Sheet Data:                                                                 
        Cash and cash equivalents           $ 5,250        $ 3,199       $24,162       $    722        $  1,184       $    393
        Working capital (deficit)            31,084         23,713        25,056         (2,608)         (2,307)        (3,192)
        Total assets                         47,174         40,095        35,109          4,041           4,185          3,541
        Long-term obligations                 1,625            421           317          4,286           4,299          2,594
        Redeemable Preferred Stock                -              -             -          5,932           5,931          6,645
        Total stockholders' equity                                                  
             (deficit)                       39,799         33,807        28,064        (11,867)        (11,596)       (11,941)
</TABLE>

--------------
(1) The Company changed its fiscal year end to January 31, beginning February 1,
    1996.
(2) See Note 7 of Notes to Financial Statements for a description of the
    computation of the net income per share and the number of shares used in the
    per share calculation for the years ended January 31,1999, 1998 and 1997.

 

                                       15
<PAGE>
 
Selected Quarterly Financial Data (Unaudited):

<TABLE>
<CAPTION>
                                        Year Ended January 31, 1999                  Year Ended January 31, 1998
                                -----------------------------------------      ---------------------------------------
Quarter                           Fourth    Third     Second      First           Fourth    Third    Second    First
                                -----------------------------------------      ---------------------------------------
<S>                              <C>       <C>       <C>        <C>              <C>       <C>      <C>       <C>
Revenues                          $8,387    $7,313    $8,454     $8,429           $7,853    $6,423   $5,959    $5,128
Gross margin                       5,904     4,738     5,987      5,289            5,386     4,237    3,992     3,633
Gross margin %                        70%       65%       71%        63%              69%       66%      67%       71%
Income from operations            $1,490    $  538    $1,907     $1,754           $2,220    $1,460   $1,355    $  962
Net income                         1,181       556     1,456      1,371            1,958     1,145    1,046       795
Net income per common share       $ 0.10    $ 0.05    $ 0.12     $ 0.12           $ 0.17    $ 0.11   $ 0.09    $ 0.07
</TABLE>

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

    This Report on Form 10-K contains forward-looking statements that involve
risks and uncertainties.  The statements contained in this report that are not
purely historical are forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934, including without limitation, statements regarding the Company's
expectations, beliefs, intentions or strategies regarding the future.  All
forward-looking statements included in this document are based on current
expectations, estimates, forecasts and projections about the industry in which
Peerless operates, management's beliefs and assumptions made by management.
These statements are not guarantees of future performance and involve certain
risks, uncertainties and assumptions which are difficult to predict.  Therefore,
actual outcomes and results may differ materially from what is expressed or
forecasted in such forward-looking statements.  The Company undertakes no
obligation to update publicly any forward-looking statements, whether as a
result of new information, future events or otherwise.

Highlights

    .   Fiscal 1999 revenues grew 28%, an increase of $7.2 million, over fiscal
        1998
    .   Fiscal 1999 gross profit grew 27% over the previous fiscal year.
    .   The Company invested an incremental $2.6 million in research and
        development, an increase of 65% over the previous fiscal year.

    The Peerless solution is based on a combination of software and imaging
ASICs, which together form a low cost-effective embedded imaging system that
addresses virtually all sectors of the printing market, from low-end SOHO
inkjets to high end laser digital color copiers and printers. The low-cost, 
high-performance printers and MFPs that the Company's imaging solutions drive 
are increasingly replacing expensive standalone copiers and printers in 
corporate offices. Peerless' markets are continuing to expand, driven by the 
transition from analog to digital in the copier sector, by improving price-
performance, and by the broadening role of color in office printing.


                                       16
<PAGE>
 
    During fiscal 1999, Peerless continued to enhance its technical solution for
the digital camera sector.  Peerless' PicturePrint technology, together with
technology that the Company has recently licensed from FotoNation, can be
embedded into electronic consumer appliance products to enable image capture
from some of the most popular digital cameras and can output to a variety of
photo quality inkjet printers and color laser devices.  After OEMs have mastered
the major image quality barriers into the digital camera market, the Company
believes it will be able to capitalize on benefits that universal printing
functionality can deliver.

    In the fourth quarter of fiscal 1999, the Company announced a strategic
development agreement with Minolta that encompasses a range of future products
spanning printers to digital copiers and includes monochrome and color
technologies. This agreement will ultimately encompass at least two entire
Minolta product families and that will yield multiple products from each product
family. This agreement was made possible by the scalable nature of Peerless'
embedded imaging solution, which can span low-end inkjets priced under $500 to
high-end production copier/printers priced over $20,000.

    During fiscal 1999, Peerless increased its focus and success in selling its
source code development kits, which allow the OEMs to access Peerless'
technology and perform their own customization.  The development kit sales
increase the OEMs commitment to Peerless' embedded imaging technology from a
single point product solution to a broad product platform solutions for multiple
printing products.

    During fiscal 1999, the Company focused on implementing structural and
process improvements in the engineering services group. This effort started to
become visible when the Company hired a new Vice President of Technical
Operations, David Emmett, in mid-fiscal 1999. As a result of Mr. Emmett's
guidance, the Company was able to deliver a record number of products to OEMs in
the last two quarters of fiscal 1999. Management expects that, under Mr.
Emmett's leadership, the Company will be able to improve productivity, quality
control and time to market which should reflect positively in the Company's
results of operations for fiscal 2000.

    As part of Peerless' efforts to focus on increasing its market penetration
in the embedded imaging industry, the Company seeks to strategically acquire
selected companies that complement its existing product offerings and its
internal product development efforts. On April 6, 1999, Peerless entered into a
merger agreement with Auco, Inc. ("Auco"), a privately held developer of
embedded networking technology based in Redwood City, California. The
transaction is structured as a merger in which the Company will exchange 2.5
million shares of its common stock for all currently outstanding shares of Auco
capital stock, on a fully-diluted basis, and its convertible note payable. It is
expected that the merger will be accounted for as a pooling of interests. As a
result of the merger, Auco will become a subsidiary of the Company. Consummation
of the merger is subject to terms and conditions customary for a transaction of
this type, including approval of certain matters by the shareholders of the
Company and Auco. The Company estimates that it will incur transaction costs,
consisting primarily of fees for investment bankers, attorneys, accountants,
consultants, financial printing and other related charges, of approximately $2.3
million which will be expensed upon consummation of the merger.

Results of Operations

    The following table sets forth, for the periods indicated, the percentage
relationship of certain items from the Company's statements of operations to
total revenues.

                                       17
<PAGE>
 
<TABLE>
<CAPTION>
                                                                           Percentage of Total Revenues
                                                                  ----------------------------------------------
                                                                              Years Ended January 31,
                                                                  ----------------------------------------------
                                                                     1999              1998              1997
                                                                  -----------       -----------       ------------
<S>                                                               <C>               <C>               <C>       
Statement of Operations Data:
        Revenues:
                Product licensing                                     64.1%             62.3%             51.9%
                Engineering services and maintenance                  35.9              37.7              48.1
                                                                  -----------       -----------       ------------
                        Total revenues                               100.0             100.0             100.0
                                                                  -----------       -----------       ------------

        Cost of revenues:
                Product licensing                                      0.4               0.6               0.9
                Engineering services and maintenance                  32.3              31.4              38.2
                                                                  -----------       -----------       ------------
                        Total cost of revenues                        32.7              32.0              39.1
                                                                  -----------       -----------       ------------
                                Gross margin                          67.3              68.0              60.9
                                                                  -----------       -----------       ------------
        Operating expenses:
                Research and development                              22.2              18.2              16.9
                Sales and marketing                                   12.9              14.7              17.1
                General and administrative                            14.7              11.5              15.9
                                                                  -----------       -----------       ------------
                        Total operating expenses                      49.8              44.4              49.9
                                                                  -----------       -----------       ------------
        Income from operations                                        17.5              23.6              11.0
        Interest income, net                                           4.1               5.5               1.2
                                                                  -----------       -----------       ------------
                Income before income taxes                            21.6              29.1              12.2
        Provision (benefit) for income taxes                           7.6               9.6             (15.6)
                                                                  -----------       -----------       ------------
        Net income                                                    14.0%             19.5%             27.8%
                                                                  ===========       ===========       ============
</TABLE>


     Comparison of Fiscal 1999 and 1998

    Fiscal 1999 revenues increased 28% over the previous year. The revenue
growth was driven by a 32% increase in product licensing revenues and a 22%
increase in engineering services and maintenance revenues over the prior fiscal
year. Product licensing revenues increased due to an increase in the number of
products shipped into the marketplace incorporating Peerless' imaging technology
and an increase in the market penetration of existing products. Most of the
increase in recurring license fees can be attributed to an increase in
penetration in the color and multi-function markets. Adding to the product
licensing revenues were strong sales of source code development kits. The growth
in engineering services and maintenance revenues was the direct result of an
increase in the dollar value of engineering services design wins in fiscal 1999
over fiscal 1998.

    The Company's gross margin as a percentage of total revenues decreased to
67% in fiscal 1999 from 68% in fiscal 1998. Although the current year revenue
mix included a higher percentage of licensing fees, which have relatively low
costs associated with the revenues being recognized, the margin on engineering
services and maintenance declined in 1999. The deterioration in the engineering
services margins from 17% in fiscal 1998 to 10% in fiscal 1999 was attributable
to a mid-year refocusing of the engineering services department. This change
yielded a record number of product deliveries, but resulted in lower margins as
additional resources were allocated to projects in process in an effort to
reduce the time-to-market.

                                       18
<PAGE>
 
    Peerless continues to invest heavily in the future by funding the research
and development of new technology solutions.  Research and development expenses
increased 57% between fiscal 1999 and 1998.  The expense increases resulted
primarily from a growth in the development staff headcount and the use of
outside development partners.  The increased funding was used for, among other
things, development programs associated with the Company's color technology,
multi-function technology, application specific integrated circuit ("ASIC")
designs and digital photography technology. Management anticipates that research
and development costs will continue to increase.

    Sales and marketing expenses increased 13% between fiscal years 1999 and
1998. The increase reflected a growth in the sales and marketing headcount and
an expanded emphasis on penetrating new OEM customers. As a result of this
additional effort, the Company added several new OEMs to its customer list
during fiscal 1999. Sales and marketing expenses, however, decreased to 13% of
total revenues for fiscal 1999 from 15% for fiscal 1998.

    General and administrative expense for fiscal 1999 increased 65% over fiscal
1998. The expense growth related primarily to an increase in personnel and
expenses necessary to support the growth in the Company's operations, which
included the formation of a new mergers and acquisition department in support of
the Company's strategy to acquire complimentary technology. A portion of the
expense growth related to professional costs associated with proposed
transactions that were terminated.

    Interest income earned in fiscal years 1999 and 1998 was attributable to
interest and investment income earned on cash and cash equivalents and
investment balances resulting primarily from the $26.3 million in proceeds
received upon the closing of the Company's initial public offering in September
1996.

    The Company's effective tax rate for fiscal 1999 was 35%. Due to a reduction
in the valuation allowance, the Company's effective tax rate for fiscal 1998 was
33%. As of January 31, 1999, the Company had $673,000 of foreign tax credits
available to offset future federal taxes otherwise payable. Once the foreign tax
credits are fully utilized, the Company will be subject to an estimated annual
tax rate in the range of 35% to 40%.

Comparison of Fiscal 1998 and 1997

    The 58% increase in revenues in fiscal 1998 over fiscal 1997 was driven by
an increase in product licensing revenues of 90%. This increase in product
licensing revenues was generated by an increase in the shipments and number of
products incorporating Peerless' imaging technology, as well as high, one-time
licensing fees for source code. Most of the growth in the fiscal 1998 can be
attributed to new color laser printers introduced by the Company's OEMs in early
fiscal 1998 and an increase in the market penetration of existing products.
Growth in the Company's engineering services and maintenance revenues also
contributed to the increase in total revenues during the current fiscal year
with an increase of 24% over the prior fiscal year. The growth in engineering
services and maintenance revenues was the direct result of an increase in the
number of design wins in fiscal 1998 over fiscal 1997.

    The Company's gross margin as a percentage of total revenues increased to
68% for fiscal 1998 from 61% for fiscal 1997. The improvements in gross margin
in the current fiscal year are primarily attributable to a shift in the revenue
mix toward product licensing revenues, which have relatively low costs
associated with the revenues being recognized. Product licensing revenues as a
percentage of total revenues increased to 62% in fiscal 1998 from 52% in fiscal
1997.

    Research and development expenses increased 71% between fiscal years 1998
and 1997. The expense increases resulted primarily from a growth in the
development staff headcount. The increased funding was used for, among other
things, development programs associated with the Company's color technology,
multi-function technology and ASIC designs. Additionally, the Company began
investing in digital photography technology during fiscal 1998.

                                       19
<PAGE>
 
    Sales and marketing expenses increased 36% between fiscal years 1998 and
1997.  The increase reflected a growth in the sales and marketing headcount and
an expanded emphasis on industry trade shows and other opportunities to promote
the Company's embedded imaging.

    General and administrative expense for fiscal 1998 increased 15% over fiscal
1997.  The expense growth related primarily to an increase in personnel and
expenses, necessary to support the growth in the Company's operations.

    Interest income earned in fiscal 1998 was attributable to interest and
investment income earned on cash and cash equivalents and investment.  Interest
income of $329,000 earned for the fiscal 1997 was offset by $143,000 of interest
expense associated with borrowings under the Company's line of credit and the
convertible notes payable, which converted to shares of common stock upon the
closing of the Company's initial public offering in September 1996.

    Due to a reduction in the valuation allowance during fiscal, 1997, the
Company's financial statements reflect a benefit for income taxes rather than a
provision for income taxes for that fiscal year.  A further reduction in the
valuation allowance in fiscal 1998 resulted in an effective tax rate of 33%.
 
Liquidity and Capital Resources
 
    Compared to January 31, 1998, total assets at January 31, 1999 grew 18% to
$47.2 million and stockholders' equity grew 18% to $39.8 million.  The Company's
cash and short-term investment portfolio was $21.4 million at January 31, 1999
and the current ratio was 6.4:1.  The Company's operations generated cash of
$707,000 during fiscal 1999.

    During fiscal 1998, the Company began an expansion of its operating
facilities from 30,000 square feet to 47,000 square feet in order to accommodate
the current and expected growth in operations. As part of the expansion, which
was completed in early fiscal 1999, the Company made leasehold improvements in
the amount of $1.4 million and $1.8 million in fiscal years 1999 and 1998,
respectively. The remaining additions to property and equipment of $407,000 and
$1.4 million for fiscal years 1999 and 1998, respectively, related to furniture,
computer and equipment purchases associated with the growth in headcount.
Investments in securities generated net cash of $1.8 million in fiscal 1999
while a net $20 million was invested in fiscal 1998. It is the Company's policy
to invest the majority of its unused cash in low-risk government and commercial
debt securities. The Company has not historically purchased, nor does it expect
to purchase in the future, derivative instruments or enter into hedging
transactions.

    Net cash provided by financing activities during fiscal years 1999 and 1998
related to the issuance of common stock under the Company's employee stock
purchase plan and the exercise of common stock options.

Risks and Uncertainties

    While Peerless' management is optimistic about the Company's long-term
prospects, the following risks and uncertainties, among other things, should be
considered in evaluating the growth outlook:

    Future Growth Rate and Operating Results:  The revenue growth rate in fiscal
2000 may not approach the level attained in fiscal 1999.  Further, although the
Company has been profitable since the quarter ended December 31, 1995, there can
be no assurance that the Company will maintain profitability on a quarterly or
annual basis in the future. Factors noted below, as well as others in the
aggregate, may have a material adverse affect on the Company's future revenue
growth and/or results of operations.

    Engineering Services Results:  In the past, the Company has experienced
significant fluctuations in quarterly engineering services results that have
been caused by many factors including: product development delays (see 

                                       20
<PAGE>
 
below), third party delays (see below), increases in the estimated hours to
complete particular engineering services projects; cancellation or redirection
of engineering services projects by the Company's OEMs and delays in the
availability or stability of third-party technology that the Company's OEMs are
also incorporating into the same product for which the Company is performing
engineering services. There can be no assurance that similar factors will not
impact future engineering services results.

    Product Development Delays: The Company in the past has experienced, and may
experience in the future, delays in product development. Prior delays have
resulted from numerous factors such as changing OEM product specifications,
difficulties in hiring and retaining necessary personnel, difficulties in
reallocating engineering resources and other resource limitations, difficulties
with independent contractors, changing market or competitive product
requirements and unanticipated engineering complexity. In addition, the
Company's software and hardware have in the past, and may in the future, contain
undetected errors or failures that become evident upon product introduction or
as product production volumes increase. There can be no assurance, despite
testing by the Company and its OEMs that the Company's new products and
technology will meet performance specifications under all conditions or for all
anticipated applications. Given the short product life cycles in the digital
document products market, any delay or unanticipated difficulty associated with
new product introductions or product enhancements could have a material adverse
effect on the Company's operating results.

    Third Party Delays: Quarterly revenues would be adversely impacted if one or
more key OEM transactions, milestones or OEM product shipments that are
scheduled to be realized by the Company or its OEMs at the end of a quarter were
to be delayed until a subsequent quarter.

    Seasonality:  The Company believes that its business may be subject to
seasonal trends. In the digital document product industry, it is not unusual for
vendors to experience an increase in demand in the fourth calendar quarter
followed by a significant decrease in the following quarter. Although the
Company has attempted to manage this risk with the incorporation of guaranteed
minimum royalty commitments, the Company's product licensing revenues may be
negatively impacted by seasonality, if any, of unit shipments experienced by its
OEMs.

    Recurring Product Licensing Reporting:  The recurring product licensing
revenues reported by the Company are dependent, in part, on the timing and
accuracy of product sales reports received from the Company's OEM customers.
These reports are provided only on a calendar quarter basis and, in any event,
are subject to delay and potential revision by the OEM. Therefore, the Company
is required to estimate all of the recurring product licensing revenues for the
last month of each fiscal quarter and to further estimate all of its quarterly
revenues from an OEM when the report from such OEM is not received in a timely
manner.  In the event the Company is unable to estimate such revenues accurately
prior to public announcement of the Company's quarterly results, the Company may
be required to restate its recognized revenues or adjust revenues for subsequent
periods.

    Dependence on Third Parties: With the exception of Adobe and Conexant
substantially all of the Company's revenues in recent years have been derived
from digital document product OEMs. The Company's revenues are dependent upon,
among other things, the ability and willingness of these OEMs to timely develop
and promote digital document products that incorporate the Company's technology.
Additionally, many of these OEMs are concurrently developing and promoting
products that do not incorporate the Company's technology. In such cases, the
OEMs may have profitability or other incentives to promote internal solutions or
competing products in lieu of products incorporating the Company's technology.
No assurance can be given as to the ability or willingness of the Company's OEMs
to continue developing, marketing and selling products incorporating the
Company's technology.

    Concentration of Revenues:  Historically, a limited number of customers have
provided a substantial portion of Peerless' revenues.  There presently are only
a limited number of customers in the digital document product market to which
the Company markets its technology and services. Therefore, the ability of the
Company to replace a lost customer or offset a significant decrease in the
revenues from a customer may be significantly limited.

                                       21
<PAGE>
 
    Technology Licensing:  The Company's larger customers at times have required
that the Company offer new technology directly to them prior to offering it to
other customers and have attempted to restrict the Company from licensing the
technology utilized by these customers to customers developing potentially
competing products. Although the Company has not granted exclusive rights with
respect to its core technologies, the Company has granted exclusive rights in
unusual circumstances with respect to derivative software developed by the
Company in support of a specific customer's proprietary products or
technologies. No assurance can be given, however, that the Company will not, in
the future, grant broader exclusive rights to its technology in order to enter
into a licensing agreement with a customer, or that an unwillingness to grant
such exclusive rights will prevent the Company from entering into such a
licensing agreement.

    Technological Changes: The market for the Company's products and services is
characterized by rapidly changing technology, evolving industry standards and
needs, and frequent new product introductions. The Company's success will depend
on, among other things: market acceptance of the Company's technology and the
digital document products of the Company's OEM customers; the ability of the
Company and its OEM customers to meet industry changes and market demands in a
timely manner; achievement of new design wins by the Company followed by the
OEMs' development of associated new digital document products; and the regular
and continued introduction of new and enhanced technology and services by the
Company and its OEMs on a timely and cost-effective basis. There can be no
assurance that the products and technology of competitors of the Company or its
OEMs will not render the Company's technology or its OEMs' products
noncompetitive or obsolete. Any failure by the Company or its OEMs to anticipate
or respond adequately to the rapidly changing technology and evolving industry
standards and needs, or any significant delay in development or introduction of
new and enhanced products and services, could result in a loss of
competitiveness or revenues, which could have a material adverse effect on the
Company's operating results.

    Dependence on Sole Source Providers: The Company is dependent on three
independent parties, Motorola, IBM Microelectronics and Intel, each of which
provides unique application specific integrated circuits ("ASICs")
incorporating the Company's imaging technology to certain of the Company's OEMs.
Additionally, the Company has a set of relationships with Adobe that address
many critical aspects of the Company's OEM customers' needs. The Company has
licensed (for internal development purposes) from Adobe the right to use Adobe's
PostScript Software to enable the Company's products to be used with Adobe's
PostScript Software, has licensed to Adobe several of the Company's technologies
and has developed technologies for Adobe for which the Company receives
royalties and engineering services fees. These sole source providers are subject
to materials shortages, excess demand, reduction in capacity and/or other
factors that may disrupt the flow of goods to the Company's customers and
thereby adversely affect the Company's customer relationships. Any such
disruption could limit or delay production or shipment of the products
incorporating the Company's technology, which could have a material adverse
effect on the Company's operating results.

    Costs and Expenses: A substantial portion of the Company's costs and
expenses is related to costs of engineering services and maintenance, product
development, other personnel costs, marketing programs and facilities. The level
of spending for such costs and expenses cannot be adjusted quickly and is based,
in significant part, on the Company's expectations of future revenues and
anticipated OEM commitments. If such commitments do not materialize or are
terminated or if revenues are below expectations, the Company's quarterly and
annual operating results will be adversely affected.

    Dependence on Key Personnel: The Company is largely dependent upon the
skills and efforts of its senior management and other officers and key
employees. The Company believes that its future success will depend in large
part upon its ability to attract and retain highly skilled managerial,
engineering, sales, marketing and operations personnel, many of whom are in
great demand. Competition for such personnel recently has increased
significantly. The Company does not maintain any key person life insurance
policies. The loss of key personnel or the inability to hire or retain qualified
personnel could have a material adverse effect on the Company's operating
results.

                                       22
<PAGE>
 
    International Activities: Peerless is substantially dependent on its
international business activities and the Company expects that sales to
customers located outside the United States may increase in absolute dollars in
the future. The international market for products incorporating the Company's
technology is highly competitive, and the Company expects to face substantial
competition in this market from established and emerging companies and
technologies developed internally by its OEMs. Risks inherent in the Company's
international business activities also include currency fluctuations, changes in
the economic condition of foreign countries, the imposition of government
controls, tailoring of products to local requirements, trade restrictions,
changes in tariffs and taxes, and the burdens of complying with a wide variety
of foreign laws and regulations, any of which could have a material adverse
effect on the Company's operating results. Although all of the Company's
contracts are, and the Company expects that its future contracts will be,
denominated in U.S. dollars, there can be no assurance that its contracts with
international OEMs in the future will be denominated in U.S. dollars. In the
event that one or more contracts are denominated in foreign currencies, the
Company will be subject to additional risks associated with currency
fluctuations, which could have a material adverse effect on the Company's
operating results.

    During the past few years, the Asian economy has been financially depressed.
As a result, some members of the imaging industry have reported negative
financial impacts attributable to a decrease in demand from Asian customers.
Peerless' Asian customers are comprised primarily of companies headquartered in
Japan. These Japanese customers sell products containing Peerless' technology
primarily in the North American and European marketplaces. There can be no
assurance that revenues from Asian customers will not decline in future
quarters.

    Volatility of Stock Price: The Company's common stock has experienced
significant price volatility and such volatility may occur in the future.
Factors that could affect the trading price of the common stock include
variations in quarterly results of operations, announcements of new products by
the Company or its competitors, developments or disputes with respect to
proprietary rights, general trends in the industry, overall market conditions
and other factors. In addition, the stock market historically has experienced
extreme price and volume fluctuations, which have particularly affected the
market price of securities of many high technology companies and which at times
have been unrelated or disproportionate to the operating performance of such
companies.

    Year 2000 Compliance: The Year 2000 Issue is the result of computer programs
being written using two digits rather than four to define the applicable year.
Any of the Company's computer programs that have date-sensitive software may
recognize a date using "00" as the year 1900 rather than the year 2000.  This
could result in a system failure or miscalculations causing disruptions of
operations, including, among other things, a temporary inability to process
transactions, send invoices, or engage in similar normal business activities.

    The Company has divided its review of the Year 2000 Issue into three major
areas: (1) internal systems, (2) Company products and (3) potential year 2000
problems associated with outside development partners, vendors and customers.
The Company has substantially completed its review of its internal system,
including its development tools and business critical applications such as
general ledger, accounts payable, accounts receivable, job cost, and purchasing.
The Company has identified certain systems that require updating and has begun
to purchase and install updates that have been certified as year 2000 compliant
by vendors. The Company expects to complete its review of internal systems by
July 31, 1999 and does not expect the review to uncover a risk that would result
in a material adverse effect on its operations.

    The Company is in the process of reviewing the year 2000 compliance of its
products developed for OEMs.  Based on an initial review, the Company believes
that its products do not contain date sensitive fields.  Testing to validate
this assumption is expected to be completed in July 31, 1999.  At this time, the
Company does not believe that product updates will be necessary.

    The Company is in the process of identifying any potential year 2000
problems from outside development partners who work on engineering services
projects, vendors whose facilities manufacture ASICs that incorporate the
Company's technology or whose systems interface with the Company's internal
systems as well as customers whose products contain technology licensed from the
Company. The Company expects to complete its review by 

                                       23
<PAGE>
 
July 31, 1999. However, since third-party year 2000 compliance is not within the
Company's control, the Company cannot assure the stockholders that the year 2000
problems affecting the systems of other companies will not have a material
adverse effect on the Company's operations. This impact could include, among
other things, product time to market delays caused by year 2000 problems
associated with development partners which would negatively impact engineering
services revenues and delays in customer shipments which could negatively impact
the Company's recurring licensing revenues.

    Costs to address the Year 2000 Issue include hardware, software and
implementation costs for internal work are not expected to exceed $200,000.  To
date, the Company has incurred approximately $75,000 of these costs, all of
which have been expensed.

    The Company presently believes that with the identified modifications, the
Year 2000 Issue can be mitigated.  However, if the modifications are not made,
or are not completed timely, the Year 2000 Issue could have a material impact on
the operations of the Company.  Further, there can be no guarantee that the
systems of other companies on which the Company's systems rely will be timely
converted, or that a failure to convert by another company, or a conversion that
is incompatible with the Company's systems, would not have a material adverse
effect on the Company.

    Market Risk:  The Company is exposed to various market risks including
changes in interest rates.  Market risk is the potential loss arising from
adverse changes in market rates and prices, such as interest rates.  The Company
is not at risk from adverse changes in foreign currency exchange rates as all
transactions are denominated in U.S. dollars.  The Company does not
enter into derivatives or other financial instruments for trading purposes.

    Peerless' exposure to market rate risk for changes in interest rates relates
primarily to the Company's investment portfolio. The Company invests its excess
cash in fixed rate debt instruments of the U.S. Government and high-quality
corporate issuers as well as floating rate money market funds. The Company, by
policy, limits the amount of credit exposure to any one issuer. Investments in
both fixed rate and floating rate interest earning instruments carry a degree of
interest rate risk. Fixed rate securities may have their fair market value
adversely impacted due to a rise in interest rates, while floating rate
securities may produce less income than expected if interest rates fall. Due in
part to these factors, Peerless' future investment income may fall short of
expectations due to changes in interest rates, or Peerless may suffer losses in
principal if forced to sell securities which have declined in market value due
to changes in interest rates.

Future Developments

    In December 1998, the American Institute of Certified Public Accountants
issued Statement of Position 98-9, Modification of SOP 97-2, "Software Revenue
Recognition," with Respect to Certain Transactions ("SOP 98-9").  SOP 98-9
retains the limitations of SOP 97-2 on what is considered vendor-specific
objective evidence (VSOE) of fair value in a software arrangement.  Accordingly,
the limitation on VSOE of fair value that were deferred by SOP 98-4 will be
effective for transactions entered into in fiscal years beginning after December
15, 1998.  In order to recognize revenue upon delivery of individual elements,
VSOE of the fair value of each element (which is limited to the vendor's selling
price of each element when sold separately or the price established by
management when it is probable that the established price will not change) will
be required.  The adoption of SOP 98-9 is not expected to have a material impact
on the Company's results of operations, financial position or cash flows.

    In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 requires that all
derivative instruments be recorded on the balance sheet at their fair value.
Changes in the fair value of derivatives will be 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. SFAS No. 133 is effective for fiscal years beginning after June 15,
1999. The adoption of SFAS No. 133 will not have a material impact on the
Company's results of operations, financial position or cash flows.

                                       24
<PAGE>
 
ITEM 8 - Financial Statements and Supplementary Data.

  See Index to Financial Statements on page F-1.


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

  Not applicable.

                                       25
<PAGE>
 
                                   PART III
                                        
Item 10 -- Directors and Executive Officers.

    The information required by this item, insofar as it relates to the
Company's directors, will be contained under the captions "Election of
Directors" and "Section 16 Beneficial Ownership Reporting Compliance" in the
Proxy Statement and is incorporated herein by reference. The information
relating to the Company's executive officers as of January 31, 1999 is contained
in the following table:

<TABLE>
<CAPTION>
Name                      Age              Position
----                      ---              --------
<S>                       <C>              <C>
Edward A. Gavaldon        53               President, Chief Executive Officer and Chairman of the Board
David M. Emmett           57               Senior Vice President, Engineering and Technical Operations
David R. Fournier         45               Vice President, Sales, Marketing and Field Operations
Thomas B. Ruffolo         45               Vice President, Corporate Development
Charles R. Boelig         45               Senior Vice President, Sales, Marketing and Field Operations
</TABLE>

    Edward A. Gavaldon has served the Company as President, Chief Executive
Officer and a director since January 1995 and as Chairman of the Board since
July 1996. Prior to joining the Company, Mr. Gavaldon worked at Xerox
Corporation for 23 years in various positions including: Manager, Strategy and
Programs for Printing Products; Chief Engineer, High Speed Laser Printers; Vice
President, Worldwide Marketing, Laser Printers; and most recently as Vice
President/General Manager in the Desktop Laser Printer Business Unit. Mr.
Gavaldon received an M.B.A. degree from the University of Southern California
and a B.A. degree in economics from the University of California at Los Angeles.

    David M. Emmett  has served the Company as Vice President of Engineering and
Technical Operations since July 1998.  Mr. Emmett was promoted to the position
of Senior Vice President in February 1999.  Prior to joining the Company, Mr.
Emmett served as Vice President of Engineering for the Printing & Systems
Division at Adobe Systems.  During his tenure at Adobe, Mr. Emmett was also Vice
President of Engineering for Enterprise Printing Systems and Vice President of
Acrobat Production Unit and Director of Acrobat Capture.  Prior to his 4 years
at Adobe, Mr. Emmett was Vice President of Product Operations for PixelCraft;
Director of Engineering at Sunpics and   Vice President of Engineering for
Calera Recognition Systems.  Mr. Emmet received his M.B.A. degree from
Pepperdine University and studied Physics and Pure Mathematics at Exeter
University in England.

    David R. Fournier has served the Company as Vice President, Sales, Field
Operations and Marketing since November 1997, as Vice President of Sales and
Field Operations from January 1994 to November 1997 and served as Director of
Sales from November 1991 to January 1994. Prior to joining the Company, Mr.
Fournier held various sales management positions at Hamilton/Avnet, a
semiconductor and computer systems distribution company, and Wyle Lab, a
semiconductor and computer systems distribution company. Mr. Fournier resigned
from the Company in March 1999, however, he will be acting as a consultant to
the Company as needed.

    Thomas B. Ruffolo has served the Company as Vice President, Corporate
Development since November 1997, as Vice President, Marketing from August 1994
to November 1997 and as Director of Marketing from August 1991 to August 1994.
Prior to joining the Company, Mr. Ruffolo was Director of Marketing at NewGen
Systems, a page printer manufacturer, which he co-founded in 1988. Mr. Ruffolo
received an M.B.A. degree from Pepperdine University and a B.S. degree in
computer science from Colorado State University.

    Charles R. Boelig was appointed Senior Vice President, Sales, Marketing and
Field Operations upon Mr. Fournier's resignation from the Company in March 1999.
Prior to joining Peerless, Mr. Boelig served for a year as President and Chief
Operating Officer of Spacetec IMC (now Labtec), a supplier of interactive motion
control input hardware and software.  In addition, Mr. Boelig spent ten years at
Bitstream, Inc.  where he held various positions, 

                                       26
<PAGE>
 
including his most recent role as Chairman, President and Chief Executive
Officer. Bitstream is a leading supplier of technologies and portable font
resources for the embedded marketplace and the Internet. Prior to joining
Bitstream, he spent seven years in various sales and sales management positions.
Mr. Boelig received a B.A in Business Administration from the University of New
Hampshire.

Item 11 -- Executive Compensation.

    The information required by this item will be contained in the Proxy
Statement under the caption "Executive Compensation" and is incorporated
herein by reference.

Item 12 -- Security Ownership of Certain Beneficial Owners and Management.

    The information required by this item will be contained in the Proxy
Statement under the caption "Security Ownership of Certain Beneficial Owners
and Management" and is incorporated herein by reference.

Item 13 -- Certain Relationships and Related Transactions.

    The information required by this item will be contained in the Proxy
Statement under the caption "Certain Transactions" and is incorporated herein
by reference. 

                                       27
<PAGE>
 
                                    PART IV
                                        
Item 14 -- Exhibits, Financial Statement Schedules and Reports on Form 8-K.

(a) Documents filed as a part of this Form 10-K:

(1) Financial Statements

Report of PricewaterhouseCoopers LLP, Independent Accountants
Statements of Income
Balance Sheets
Statements of Stockholders' Equity
Statements of Cash Flows
Notes to Financial Statements

(2) Financial Statement Schedules:

        The following financial statement schedule of Peerless Systems
Corporation is filed as part of this Report and should be read in conjunction
with the Financial Statements of Peerless Systems Corporation.

Schedule                                                     Page
--------                                                     ----

II   Valuation and Qualifying Accounts                     S-2

        Schedules not listed above have been omitted because they are not
applicable or are not required or the information required to be set forth
therein is included in the Financial Statements or Notes thereto.

(b) Reports on Form 8-K.

No reports on Form 8-K were filed during the last quarter of the fiscal year
ended January 31, 1999.

(c) Exhibits. The following exhibits are filed as part of, or incorporated by
reference into, this Form 10-K.

Exhibit
Number
------
3.1(1)          Certificate of Incorporation of the Company.
3.2(4)          Amended and Restated Bylaws of the Company.
4.1             Instruments defining the rights of security holders. Reference
                        is made to Exhibits 3.1 and 3.2.
4.2(4)          Rights Agreement, dated October 7, 1998, between the Company and
                        Norwest Bank Minnesota, N.A., as Rights Agent.
10.1(1)         Form of Indemnity Agreement.
10.2(1)(2)      1992 Stock Option Plan (the "Option Plan"), as amended.
10.3(1)(2)      1996 Equity Incentive Plan.
10.4(1)(2)      Form of Incentive Stock Option.
10.5(1)(2)      Form of Nonstatutory Stock Option.
10.6(1)(2)      1996 Employee Stock Purchase Plan.
10.7(1)         Third Party Development and License Agreement (the "Adobe Third
                        Party License"), dated September 18, 1992, between the
                        Registrant and Adobe Systems Incorporated ("Adobe").
10.8(1)(3)      Reference Post Appendix #2 to the Adobe Third Party License,
                        dated February 11, 1993.
10.9(1)         Amendment No. 1 to the Adobe Third Party License, dated November
                        29, 1993.

                                       28
<PAGE>
 
10.10(1)(3)     PCL Development and License Agreement (the "PCL License"), dated
                        June 14, 1993, between the Registrant and Adobe.
10.11(1)(3)     Amendment No. 1 to the PCL License, dated October 31, 1993.
10.12(1)(3)     Letter Modification to the PCL License, dated August 5, 1994.
10.13(1)(3)     Addendum No. 1 to the PCL License, dated March 31, 1995.
10.14(1)(3)     Letter Modification to the PCL License, dated August 30, 1995.
10.15(1)        Lease Agreement between the Company and Continental Development
                        Corporation, dated February 6, 1992, and Addendum, dated
                        February 6, 1992.
10.16(1)        First Amendment to Office Lease, dated December 1, 1995, between
                        the Company and Continental Development Corporation.
10.18(1)(2)     Employment Agreement with Lauren Shaw.
10.19(1)(2)     Employment Agreement with Edward Gavaldon.
10.20(5)        Second Amendment to Office Lease, dated April 8, 1997, between
                        the Company and Continental Development Corporation.
10.21(5)        Third Amendment to Office Lease dated, December 16, 1997,
                        between the Company and Continental Development
                        Corporation.
10.22           Fourth Amendment to Office Lease, dated April 22, 1998, between
                        the Company and Continental Development Corporation.
23.1            Consent of PricewaterhouseCoopers LLP.
24.1            Power of Attorney. Reference is made to page 30.
27.1            Financial Data Schedule.
_____________
(1)  Previously filed in the Company's Registration Statement on Form S-1 (File
     No. 333-09357), as amended and incorporated herein by reference.
(2)  Management contract or compensatory plan or arrangement.
(3)  Subject to Confidential Treatment Order.
(4)  Previously filed in the Company's Current Report on Form 8-K, filed October
     8, 1998, and incorporated herein by reference.
(5)  Previously filed in the Company's 1998 Annual Report filed on Form 10-K,
     filed April 24, 1998, and incorporated herein by reference.

                                       29
<PAGE>
 
                                  SIGNATURES
                                        
    Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of
1934, as amended, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized, on the 23rd day of April,
1999.


                                           Peerless Systems Corporation


                                        By:    /s/ EDWARD A. GAVALDON
                                           ----------------------------------- 
                                                    Edward A. Gavaldon
                                         President, Chief Executive Officer,
                                         Chairman of the Board  and acting Chief
                                         Financial Officer
                                             (duly authorized representative)



    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 date indicated.


      Signature                       Title                           Date
      ---------                       -----                           ----


   /s/ EDWARD A. GAVALDON    President, Chief Executive         April 23, 1999
 -------------------------   Officer, Chairman of the Board
       Edward A. Gavaldon    and acting Chief Financial Officer
                             (Principal Executive Officer)


  /s/ ROBERT V. ADAMS        Director                           April 23, 1999
 -------------------------                                                  
      Robert V. Adams



  /s/ ROBERT G. BARRETT      Director                           April 23, 1999
  ------------------------                                                   
      Robert G. Barrett



  /s/ ROBERT L. NORTH        Director                           April 23, 1999
   -----------------------
       Robert L. North

                                       30
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                   Page
                                                                   ----
<S>                                                                <C>
Report of PricewaterhouseCoopers LLP, Independent Accountants      F-2
 
Statements of Income                                               F-3
 
Balance Sheets                                                     F-4
 
Statements of Stockholders' Equity                                 F-5
 
Statements of Cash Flows                                           F-6
 
Notes to Financial Statements                                      F-8
</TABLE>

                                      F-1
<PAGE>
 
                       REPORT OF INDEPENDENT ACCOUNTANTS



To the Board of Directors and Stockholders
 of Peerless Systems Corporation

In our opinion, the accompanying balance sheets and the related statements of
income, stockholders' equity, and cash flows present fairly, in all material
respects, the financial position of Peerless Systems Corporation at January 31,
1999 and 1998, and the results of its operations and its cash flows for each of
the three years in the period ended January 31, 1999, in conformity with
generally accepted accounting principles.  These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.



PRICEWATERHOUSECOOPERS LLP


Woodland Hills, California
March 5, 1999, except for the subsequent event
               described in Note 14 as to which
               the date is April 6, 1999

                                      F-2
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                             STATEMENTS OF INCOME
                   (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                                 Years Ended January 31,
                                                        -----------------------------------------
                                                          1999            1998             1997
                                                        --------        --------         --------
<S>                                                     <C>             <C>              <C> 
Revenues:
       Product licensing                                $20,882         $15,806          $ 8,322
       Engineering services and maintenance              11,701           9,557            7,699
                                                        -------         -------          -------
              Total revenues                             32,583          25,363           16,021
                                                        -------         -------          -------
                                                                                    
Cost of revenues:                                                                   
       Product licensing                                    139             141              144
       Engineering services and maintenance              10,526           7,974            6,123
                                                        -------         -------          -------
              Total cost of revenues                     10,665           8,115            6,267
                                                        -------         -------          -------
              Gross margin                               21,918          17,248            9,754
                                                        -------         -------          -------
                                                                                    
Operating expenses:                                                                 
       Research and development                           7,220           4,604            2,701
       Sales and marketing                                4,212           3,732            2,746
       General and administrative                         4,797           2,915            2,546
                                                        -------         -------          -------
              Total operating expenses                   16,229          11,251            7,993
                                                        -------         -------          -------
Income from operations                                    5,689           5,997            1,761
Interest income, net                                      1,333           1,391              186
                                                        -------         -------          -------
Income before income taxes                                7,022           7,388            1,947
Provision (benefit) for income taxes                      2,458           2,444           (2,500)
                                                        -------         -------          -------
              Net income                                $ 4,564         $ 4,944          $ 4,447
                                                        =======         =======          =======
                                                                                    
Net income per common share                               $0.42           $0.47            $0.90
                                                        =======         =======          =======
Net income per common share, assuming dilution            $0.39           $0.42            $0.46
                                                        =======         =======          =======
                                                                                    
Weighted average common shares outstanding               10,958          10,608            4,964
                                                        =======         =======          =======
Weighted average common shares outstanding and                                      
       dilutive shares                                   11,821          11,652            9,893
                                                        =======         =======          =======
</TABLE>
                                                                                
   The accompanying notes are an integral part of these financial statements
                                        

                                      F-3
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                                BALANCE SHEETS
                                (in thousands)

<TABLE>
<CAPTION>
                                                                                       January 31,
                                                                            ----------------------------------
                                                                              1999                      1998
                                                                            --------                  --------
<S>                                                                         <C>                       <C> 
                                  ASSETS
Current assets:
      Cash and cash equivalents                                             $ 5,250                   $ 3,199 
      Short term investments                                                 16,158                    16,982 
      Trade accounts receivable, less allowance for doubtful accounts of
         $175 in 1999 and $100 in 1998                                        9,186                     5,577
      Unbilled receivables                                                    2,994                     1,386
      Deferred tax asset                                                      2,615                     1,544
      Prepaid expenses and other current assets                                 631                       892
                                                                            -------                   -------
            Total current assets                                             36,834                    29,580
Investments                                                                   4,605                     5,501
Property and equipment, net                                                   5,186                     4,426
Deferred tax asset                                                                -                       249
Other assets                                                                    549                       339
                                                                            -------                   -------
      Total assets                                                          $47,174                   $40,095
                                                                            =======                   =======

                   LIABILITIES AND STOCKHOLDERS' EQUITY                                       
Current liabilities:                                                       
      Accounts payable                                                      $   672                   $ 1,149
      Accrued wages                                                           1,557                     1,065
      Accrued compensated absences                                              672                       501
      Other current liabilities                                                 867                       392
      Income taxes payable                                                      788                       406
      Deferred rent, current portion                                             76                        76
      Deferred revenue, current portion                                       1,118                     2,278
                                                                            -------                   -------
            Total current liabilities                                         5,750                     5,867
Deferred tax liability                                                          394                         -
Deferred rent                                                                   431                       421
Deferred revenue                                                                800                         -
                                                                            -------                   -------
      Total liabilities                                                       7,375                     6,288
                                                                            -------                   -------
                                                                           
Commitments and contingencies (Note 5)                                     
                                                                           
Stockholders' equity:                                                      
Common stock, $.001 par value, 30,000 shares authorized, 11,084 shares     
      issued and outstanding in 1999 and 10,696 in 1998                          11                        11
Additional paid-in capital                                                   39,293                    37,952
Deferred compensation                                                          (188)                     (275)
Retained earnings (deficit)                                                     683                    (3,881)
                                                                            -------                   -------
      Total stockholders' equity                                             39,799                    33,807
                                                                            -------                   -------
      Total liabilities and stockholders' equity                            $47,174                   $40,095
                                                                            =======                   =======
</TABLE>
                                                                                
   The accompanying notes are an integral part of these financial statements
                                        
                                        

                                      F-4
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                      STATEMENTS OF STOCKHOLDERS' EQUITY
                                (in thousands)

<TABLE> 
<CAPTION> 
                                                   Common Stock
                                              ---------------------      Additional                     Retained         Total
                                              Number of                   Paid-In        Deferred       Earnings     Stockholders'
                                               Shares        Amount       Capital      Compensation     (Deficit)   Equity (Deficit)
                                              ---------      ------      ----------    ------------     ---------   ----------------
<S>                                           <C>            <C>         <C>           <C>              <C>         <C> 
Balances, January 31, 1996                      2,837         $ 3         $ 1,394                       $(13,264)       $(11,867)
  Issuance of common stock for cash,
   less issuance costs of $1,302                2,698           3          26,292                                         26,295
  Exercise of stock options                       150                         149                                            149
  Conversion of convertible notes payable
   to share of common stock, less
   unamortized issuance costs of $68            1,169           1           3,001                                          3,002
  Conversion of Series A and Series B
   Preferred Stock to shares of common
   stock                                        2,647           3           5,937                                          5,940
  Conversion of warrants to shares of
   common stock                                   983
  Deferred compensation related to stock
   option grants                                                              452         $(452)                               -
  Amortization of deferred compensation                                                     106                              106
  Increase in redemption value of Series
   A and Series B Preferred Stock                                                                             (8)             (8)
  Net income                                                                                               4,447           4,447
                                               ------         ---         -------         -----         --------        --------
Balances, January 31, 1997                     10,484          10          37,225          (346)          (8,825)         28,064
  Issuance of common stock for cash                26           1             406                                            407
  Exercise of stock options                       186                         329                                            329
  Amortization of deferred compensation                                                      63                               63
  Cancellation of stock options granted                                        (8)            8                                -
  Net income                                                                                               4,944           4,944
                                               ------         ---         -------         -----         --------        --------
Balances, January 31, 1998                     10,696          11          37,952          (275)          (3,881)         33,807
  Issuance of common stock                         72                         481                                            481
  Exercise of stock options                       316                         860                                            860
  Amortization of deferred compensation                                                      87                               87
  Net income                                                                                               4,564           4,564
                                               ------         ---         -------         -----         --------        --------
Balances, January 31, 1999                     11,084         $11         $39,293         $(188)        $    683        $ 39,799
                                               ======         ===         =======         =====         ========        ========
</TABLE> 

   The accompanying notes are an integral part of these financial statements

                                      F-5
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                           STATEMENTS OF CASH FLOWS
                                (in thousands)
                                        
<TABLE>
<CAPTION>
                                                                            Years Ended January 31,
                                                                 ----------------------------------------------
                                                                   1999               1998               1997
                                                                 --------           --------           --------
<S>                                                              <C>                <C>                <C> 
Cash flows from operating activities:
  Net income                                                     $  4,564           $  4,944           $ 4,447
  Adjustments to reconcile net income to net cash provided by 
   operating activities
    Depreciation and amortization                                   1,144                832               488
    Amortization of investment discounts and premiums                (125)              (247)                -
    Amortization of deferred compensation                              87                 63               106
    Compensation expense on common stock issued to employees           78                  -                 -
    Allowance for bad debt                                             75                  -                 -
    Changes in operating assets and liabilities:
      Trade accounts receivable                                    (3,684)            (2,263)           (1,301)
      Unbilled receivables                                         (1,608)            (1,023)             (118)
      Prepaid expenses and other assets                               (48)              (666)             (151)
      Deferred income taxes                                          (428)             1,106            (2,899)
      Accounts payable                                               (477)               581               137
      Accrued wages                                                   492                354                88
      Accrued compensated absences                                    171                156                35
      Other current liabilities                                       475                 55               128
      Income taxes payable                                            382                306               100
      Deferred rent                                                   (31)                (9)              (74)
      Deferred revenue                                               (360)            (2,413)               20
                                                                 --------           --------           -------
        Net cash provided by operating activities                     707              1,776             1,006
                                                                 --------           --------           -------
 
Cash flows from investing activities:
  Purchases of property and equipment                                (407)            (1,444)           (1,105)
  Purchases of leasehold improvements                              (1,357)            (1,795)
  Purchases of held-to-maturity securities                              -            (24,244)                -
  Purchases of available-for-sale securities                      (18,155)            (2,992)           (2,000)
  Proceeds from held-to-maturity securities                        12,000              7,000                 -
  Proceeds from available-for-sale securities                       8,000                  -                 -
  Purchase of software license                                          -                  -              (250)
                                                                 --------           --------           -------
        Net cash provided (used) by investing activities               81            (23,475)           (3,355)
                                                                 --------           --------           -------
 
Cash flows from financing activities:
  Proceeds from issuance of common stock                              403                407            26,295
  Proceeds from exercise of common stock options                      860                329               149
  Payments on obligations under capital leases                          -                  -              (655)
                                                                 --------           --------           -------
        Net cash provided by financing activities                   1,263                736            25,789
                                                                 --------           --------           -------
        Net increase (decrease) in cash and cash equivalents        2,051            (20,963)           23,440
Cash and cash equivalents, beginning of period                      3,199             24,162               722
                                                                 --------           --------           -------
Cash and cash equivalents, end of period                         $  5,250           $  3,199           $24,162
                                                                 ========           ========           =======
</TABLE> 

   The accompanying notes are an integral part of these financial statements

                                      F-6
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                     STATEMENTS OF CASH FLOWS (Continued)
                                (in thousands)
 
<TABLE> 
<CAPTION> 
                                                                                    Years Ended January 31,
                                                                              -----------------------------------
                                                                               1999          1998           1997
                                                                              -----          -----         ------
<S>                                                                           <C>            <C>           <C> 
Supplemental disclosure of cash flow information:
  Cash paid during the year for:
    Income taxes                                                              $2,268         $ 151         $  321
                                                                              ======         =====         ======
    Interest                                                                  $    -         $   -         $  250
                                                                              ======         =====         ======
 
Supplemental schedule of noncash investing and financing activities:
  Tenant improvements paid by the Company's landlord                          $   41         $ 213         $    -
                                                                              ======         =====         ======
  Common stock issued to employees                                            $   78         $   -         $    -
                                                                              ======         =====         ======
  Cancellation of stock options granted with exercise prices below
   market on the date of grant                                                $    -         $   8         $    -
                                                                              ======         =====         ======
  Increase in redemption value of Series A and Series B Preferred Stock       $    -         $   -         $    8
                                                                              ======         =====         ======
  Conversion of convertible notes payable to shares of common stock,
   less unamortized issuance costs of $68                                     $    -         $   -         $3,002
                                                                              ======         =====         ======
  Conversion of Series A and Series B Preferred stock to shares of
   common stock                                                               $    -         $   -         $5,940
                                                                              ======         =====         ======
  Security deposits applied to fixed asset purchases                          $    -         $   -         $   94
                                                                              ======         =====         ======
  Software and equipment acquired under capital lease obligation              $    -         $   -         $  360
                                                                              ======         =====         ======
  Deferred compensation related to stock option grants                        $    -         $   -         $  452
                                                                              ======         =====         ======
</TABLE> 

   The accompanying notes are an integral part of these financial statements 

                                      F-7
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                         NOTES TO FINANCIAL STATEMENTS
                   (in thousands, except per share amounts)

1. Organization and Summary of Significant Accounting Policies:

    Organization:

    Peerless Systems Corporation ("Peerless" or the "Company") was
incorporated in the state of California in April 1982 and reincorporated in the
state of Delaware in September 1996. Peerless develops and licenses embedded
imaging software and supporting electronic technologies and provides custom
engineering services to Original Equipment Manufacturers ("OEMs"), located
primarily in the United States and Japan. These OEMs sell monochrome and color
printers and copiers, as well as multifunction products that combine printer,
fax, copier and scanner capabilities.

    Use of Estimates:

    The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. Actual results could differ from those estimates.

    Investments:

    The Company's investments at January 31, 1999 and 1998 consisted of held-to-
maturity and available-for-sale U.S. government debt, corporate debt, and other
debt securities

    Held-to-maturity securities are carried at amortized cost.  Amortization of
the purchase discounts and premiums is included in interest income.  Available-
for-sale securities are carried at fair value.  Unrealized gains and losses, if
material, are reported as a separate component of stockholders' equity.
Realized gains and losses and declines in value judged to be other than
temporary are included in results of operations.  Realized gains and losses are
calculated using the specific identification method and were not material to the
Company's results of operations in any period presented.

    Property and Equipment:

    Property and equipment, including any assets under capital leases, are
stated at cost, less accumulated depreciation and amortization. Depreciation on
property and equipment is calculated using the straight-line method as follows:

<TABLE> 
          <S>                                <C>
          Computers and equipment            3 to 5 years
          Furniture                          10 years
          Leasehold improvements             shorter of useful life or lease term
</TABLE> 

    Maintenance and repairs are expensed as incurred, while renewals and
betterments are capitalized. Upon the sale or retirement of property and
equipment, the accounts are relieved of the cost and the related accumulated
depreciation or amortization, and any resulting gain or loss is included in
results of operations.

    Long-Lived Assets:

    The Company identifies and records impairment of long-lived assets when 
events and circumstances indicate that such assets may be impaired. To date, no 
such impairment has been recorded.

    Capitalization of Software Development Costs:

    The Company follows the working model approach to determine technological

technological feasibility are immaterial and, therefore, the Company expenses
all costs associated with the development of its products as such costs are
incurred.

                                      F-8
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


    Revenue Recognition:

    Development license revenue from the licensing of source code for the
Company's standard products is recognized upon delivery and customer acceptance
of the source code if no significant modification or customization of the
software is required and collection of the resulting receivable is probable. If
modification or customization is essential to the functionality of the software,
revenue is recognized over the course of the modification work or deferred until
the modification is complete.  Recurring licensing revenue is recognized when
due from the Company's customers based on the number of products shipped
incorporating the Company's technology.  In certain cases, the fixed or
determinable portion of the recurring licensing fee is recognized as revenue
upon delivery and customer acceptance of the underlying technology.

    The Company also enters into engineering services contracts with OEMs to
adapt the Company's software and supporting electronics to specific OEM
requirements. Revenue on such contracts is recognized over the course of the
development work on a percentage-of-completion basis. The Company provides for
any anticipated losses on such contracts in the period in which such losses are
first determinable. Maintenance revenues are recognized ratably over the term of
the maintenance contract.

    Deferred revenue consists of prepayments of recurring licensing royalties,
and payments billed to customers in advance of revenue recognized on engineering
services contracts. Unbilled receivables arise when the revenue recognized on a
contract exceeds billings due to timing differences related to billing
milestones as specified in the contract.

    Research and Development Costs:

    Research and development costs are expensed as incurred.

    Income Taxes:

    The Company accounts for income taxes in accordance with Statement of 
Financial Accounting Standards No. 109 ("SFAS No. 109"), "Accounting For Income
Taxes." Under this method, deferred income taxes are recognized for the tax
consequences in future years resulting from differences between the tax bases of
assets and liabilities and their financial reporting amounts at each year-end
based on enacted tax laws and statutory rates applicable to the periods in which
the differences are expected to reverse. Valuation allowances are established,
when necessary, to reduce deferred income tax assets to the amount expected to
be realized. Income tax provision (benefit) is the tax payable for the period
and the change during the period in deferred income tax assets and liabilities.

    2-for-3 Reverse Stock Split:

    On July 25, 1996, the board of Directors approved a 2-for-3 reverse split of
the then outstanding common stock, series A and Series B Preferred Stock, stock
options and warrants. All share and per share amounts have been adjusted to give
retroactive effect to this reverse split for all periods presented.

    Net Income Per Common Share:

    Net income per common share ("basic EPS") is computed by dividing net income
available to common stockholders (the numerator) by the weighted average number
of common shares outstanding (the denominator) during the period. The
computation of net income per common share - assuming dilution ("diluted EPS")
is similar to the computation of basic EPS except that the denominator is
increased to include the number of additional common shares that would have been
outstanding if the dilutive potential common shares had been issued. In
addition, in computing the dilutive effect of convertible securities, the
numerator is adjusted to add back the after-tax amount of interest recognized in
the period associated with any convertible debt. A reconciliation of basic EPS
to diluted EPS is presented in Note 7 to the Company's financial statements.

                                      F-9
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


    Common Stock Options:

    During 1997, the Company implemented the disclosure requirements of SFAS No.
123, "Accounting for Stock-Based Compensation." This statement sets forth
alternative standards of recognition of the cost of stock-based compensation and
requires that the Company's financial statements include certain disclosures
about stock-based employee compensation arrangements regardless of the method
used to account for them.  As permitted by this statement, the Company continues
to apply Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock
Issued to Employees," and related interpretations in recording compensation
related to its plans.  The supplemental disclosure requirements and further
information related to the Company's stock option plans are presented in Note 9
to the Company's financial statements.

    Segment Reporting:

    The Company adopted SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information" for the year ended January 31, 1999. SFAS
No. 131 requires that companies report financial and descriptive information
about operating segments and establishes disclosures about products and
services, geographic areas, and major customers. Operating segments are
components of an enterprise about which separate financial information is
available that is evaluated regularly by the chief operating decision-maker in
deciding how to allocate resources and in assessing performance. The Company
believes that is operates in only one reportable business segment, the
development and sale of embedded imaging software and related services. The
Company's adoption of SFAS No. 131 did not affect the results or disclosure of
segment information as the Company's management financial information provides
for only one segment.

    Cash and Cash Equivalents:

    Cash and cash equivalents represent cash and highly liquid investments with
an original maturity of three months or less.

    Reclassifications:

    Certain previously reported financial information has been reclassified to
conform to the fiscal 1999 presentation.

    Future Developments:

    In December 1998, the American Institute of Certified Public Accountants
issued Statement of Position 98-9, Modification of SOP 97-2, "Software Revenue
Recognition," with Respect to Certain Transactions ("SOP 98-9").  SOP 98-9
retains the limitations of SOP 97-2 on what is considered vendor-specific
objective evidence (VSOE) of fair value in a software arrangement.  Accordingly,
the limitation on VSOE of fair value that were deferred by SOP 98-4 will be
effective for transactions entered into in fiscal years beginning after December
15, 1998.  In order to recognize revenue upon delivery of individual elements,
VSOE of the fair value of each element (which is limited to the vendor's selling
price of each element when sold separately or the price established by
management when it is probable that the established price will not change) will
be required.  The adoption of SOP 98-9 is not expected to have a material impact
on the Company's results of operations, financial position or cash flows.

    In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities".  SFAS No. 133
requires that all derivative instruments be recorded on the balance sheet at
their fair value.  Changes in the fair value of derivatives will be 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.  SFAS No. 133 is effective for fiscal years
beginning after June 15, 1999.  The adoption of SFAS No. 133 will not have a
material impact on the Company's results of operations, financial position or
cash flows.

                                      F-10
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


2. Investments:

     Investments at January 31 consisted of the following:

<TABLE>
<CAPTION>
                                                                        1999                    1998
                                                                      --------                --------
<S>                                                                   <C>                     <C>
Held-to-maturity securities:
        Maturities within one year:
                U.S. government debt securities                       $  5,503                $  6,007
                Corporate debt securities                                  -                     3,979
                Certificates of deposit                                    -                     2,000
                                                                      --------                --------
                                                                         5,503                  11,986

        Maturities after one year through five years:
                U.S. government debt securities                            -                     5,501
                                                                      --------                --------
                        Total held-to-maturity securities                5,503                  17,487
                                                                      --------                --------
Available-for-sale securities:
        Maturities within one year:
                U.S. government debt securities                            979                     -
                Corporate debt securities                                4,976                   2,996
                Other debt securities                                    2,000                     -
                                                                      --------                --------
                                                                         7,955                   2,996
                                                                      --------                --------
        Maturities after one year through five years:
                U.S. government debt securities                          1,503                     -
                Corporate debt securities                                3,102                     -
                                                                      --------                --------
                                                                         4,605                     -
                                                                      --------                --------
        Maturities after ten years:
                U.S. government debt securities                          2,700                     -
                Other debt securities                                      -                     2,000
                                                                      --------                --------
                                                                         2,700                   2,000
                                                                      --------                --------
                        Total available-for-sale securities             15,260                   4,996
                                                                      --------                --------
Total investments                                                     $ 20,763                $ 22,483
                                                                      ========                ========

</TABLE> 

 
 
    In February 1999, $2,700 of U.S. government securities with maturities in
excess of ten years was sold and the proceeds were invested in short-term,
available-for-sale securities. Accordingly, the securities have been classified
as current in the 1999 balance sheet.

    The fair value of held-to-maturity securities at January 31, 1999 and 1998
approximated amortized cost.  Unrealized gains or losses on available-for-sale
securities were immaterial for all periods presented.

                                      F-11
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


3. Property and Equipment:

    Property and equipment at January 31 consisted of the following:

<TABLE>
<CAPTION>
 



                                                                       1999             1998
                                                                    ----------       ----------
        <S>                                                         <C>              <C>
        Computers and other equipment                                 $ 4,852          $ 3,671
        Furniture                                                         361              182
        Leasehold improvements                                          2,202                3
        Construction-in-progress                                          -              1,795
                                                                    ----------       ----------
                                                                        7,415            5,651

        Less, accumulated depreciation and amortization                (2,229)          (1,225)
                                                                    ----------       ----------
                                                                      $ 5,186          $ 4,426
                                                                    ==========       ==========



</TABLE>


    Depreciation and amortization for the years ended January 31, 1999, 1998 and
1997 was $1,004, $691 and $426, respectively.


4. Convertible Notes Payable:

    In October 1995, the Company issued 7.00% Senior Convertible Subordinated
Debentures ("Debentures") to holders of the Company's Preferred Stock, with an
aggregate principal amount of $3,070 and a maturity date of June 1, 2001. The
Debentures had a stated interest rate of 7% per annum with interest due June 1
and December 1 of each year. The Debentures were convertible, at the option of
the holder, to shares of common stock at a specified conversion price of $2.63
per common share, subject to dilution adjustments. The Debentures were
subordinate to all bank indebtedness. In September 1996, upon the closing of the
Company's initial public offering, the Debentures automatically converted to
1,169 shares of the Company's common stock.


5. Commitments and Contingencies:

    Operating Leases:

    The Company leases its offices and certain operating equipment under
operating leases that expire through 2007. The principal operating lease,
covering the office space for the Company's headquarters, contains certain
predetermined rent increases calculated at the inception of the lease based on
the lessor's estimate of expected increases in the fair market value of the
leased space. This lease does not specifically provide for renewal options.

                                      F-12
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


    Future minimum rental payments under long-term operating leases are as
follows:

<TABLE> 
<CAPTION> 
                 For the Years
                Ending January 31,
               --------------------
               <S>                              <C>
                       2000                     $ 1,087
                       2001                       1,072
                       2002                       1,179
                       2003                       1,214
                       2004                       1,255
                       Thereafter                 5,375
                                               ---------
                                                $11,182
                                               =========
</TABLE> 
 

    Total rental expense was $1,101, $881 and $906 for the years ended January
31, 1999, 1998 and 1997, respectively.

    In conjunction with an expansion of its leased office space, subsequent to
year-end, the Company entered into certain contracts to improve and furnish the
new space. The Company expects that the cost of these commitments will total
$800.

    Concentration of Credit Risk:

    The Company had cash and certificates of deposit on deposit at banks at
certain times throughout the year that were in excess of federally-insured
limits.

    The Company's credit risk in accounts receivable, which are generally not
collateralized, is concentrated with customers which are OEMs of laser printers
and printer peripheral technologies. The financial loss, should a customer be
unable to meet its obligation to the Company, would be equal to the recorded
accounts receivable. At January 31, 1999 and 1998, three customers collectively
represented 50% and 64% of total accounts receivable, respectively. For the
years ended January 31 the following customers, not necessarily the same from
year to year, represented greater than ten percent of total revenues:

<TABLE> 
<CAPTION> 
                         1999              1998              1997
                   ----------------  ----------------  -----------------
<S>                <C>               <C>               <C>
Customer A           $6,665   20%      $5,444   21%      $3,123   19%
Customer B            4,637   14%       3,544   14%       2,767   17%
Customer C            3,986   12%       3,216   13%       2,243   14%
Customer D            3,925   12%       3,134   12%       
Customer E            3,691   11%       2,898   11%
Customer F            3,289   10%

</TABLE> 

                                        
    Legal Proceedings:

    The Company is not a party to any pending legal proceedings which management
believes will have a material adverse effect on the financial position, results
of operations or cash flows of the Company.

                                      F-13
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)

                                        
6. Income Taxes:

The income tax provision (benefit) for the years ended January 31, consists of:

<TABLE>
<CAPTION>
                                                1999                    1998                    1997
                                              --------                --------                --------
                <S>                           <C>                     <C>                     <C>
                Current:
                     Federal                  $ 1,804                 $   786                 $    64
                     State                        380                     461                      15
                     Foreign                      702                      92                     320
                                              --------                --------                --------
                                                2,886                   1,339                     399
                                              --------                --------                --------

                Deferred:
                     Federal                     (491)                    887                  (2,151)
                     State                         63                     218                    (748)
                                              --------                --------                --------
                                                 (428)                  1,105                  (2,899)
                                              --------                --------                --------
                                              $ 2,458                 $ 2,444                 $(2,500)
                                              ========                ========                ======== 

</TABLE>

    The foreign tax provision is comprised of foreign withholding taxes on
license fees and royalty payments.

    Temporary differences that give rise to the deferred tax provision (benefit)
for the years ended January 31, consist of:

<TABLE>
<CAPTION>
                                                                 1999            1998            1997
                                                               --------        --------        --------
<S>                                                            <C>             <C>             <C>
Property and equipment                                         $   172         $   125         $    19
Accrued liabilities                                               (162)            (58)             13            
Allowance for doubtful accounts                                    (32)              -             (43)
Deferred revenue                                                  (848)            698             149
Deferred expenses                                                   76             (86)             32
State taxes                                                       (141)            (69)            249
Tax credit carryforwards                                           623             823            (497)
Net operating loss carryforwards                                     -           1,315             908
Other                                                                -              (2)            (20)
                                                               --------        --------        --------
                                                                  (312)         (2,746)            810

Change in valuation allowance                                     (116)         (1,641)         (3,709)
                                                               --------        --------        --------
                Net deferred income tax provision (benefit)    $  (428)        $ 1,105         $(2,899) 
                                                               ========        ========        ========
</TABLE>

                                      F-14
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


    Temporary differences at January 31 which give rise to deferred income tax
assets and liabilities are as follows:
 
<TABLE>
<CAPTION>
                                                                        1999                    1998
                                                                      --------                --------
<S>                                                                   <C>                     <C>
Deferred tax assets:                                                   
        Accrued liabilities                                           $   368                 $   206
        Allowance for doubtful accounts                                    75                      43
        Deferred revenue                                                2,023                   1,175
        Deferred expenses                                                 136                     213
        Tax credit carryforwards                                          673                   1,274
        Other                                                             -                        22
                                                                      --------                --------
                Total deferred tax assets                               3,275                   2,933
                                                                      --------                --------
Deferred tax liabilities:
        Property and equipment                                           (342)                   (171)
        State taxes                                                       (39)                   (180)
                                                                      --------                --------
                Total deferred tax liabilities                           (381)                   (351)
                                                                      --------                --------
        Subtotal                                                        2,894                   2,582
Valuation allowance                                                      (673)                   (789)
                                                                      --------                --------
                Net deferred income tax asset                         $ 2,221                 $ 1,793
                                                                      ========                ========

</TABLE>

     The Company periodically evaluates the sufficiency of its deferred tax
asset valuation allowance, which is adjusted as deemed appropriate based on
operating results.
 
     The provision (benefit) for income taxes for the years ended January 31,
differs from the amount that would result from applying the federal statutory
rate as follows:

<TABLE>
<CAPTION>
                                                                1999             1998            1997
                                                            ------------     ------------    ------------

<S>                                                         <C>               <C>            <C>
Statutory regular federal income tax rate                        34.0%            34.0%           34.0%
Foreign provision                                                10.0              1.2            16.4
Nondeductible expenses                                            0.5              0.4             1.2
State tax                                                         4.0              8.2               -
Foreign tax and research and experimentation credits            (12.1)               -           (13.3)
Change in valuation allowance                                    (1.7)           (12.3)         (168.2)
Other                                                             0.3              1.6             1.5
                                                            ------------     ------------    ------------
        Provision (benefit) for income taxes                     35.0%            33.1%         (128.4)%
                                                            ============     ============    ============
</TABLE>

    As of January 31, 1999, the Company has foreign tax credits of approximately
$673 for federal purposes, which begin to expire in 1999.

                                      F-15
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


7.  Net Income Per Common Share:
    Net income per common share for the years ended January 31, is calculated as
follows:

<TABLE>
<CAPTION>
 
                                                        1999                                    1998                             
                                          ----------------------------------      ----------------------------------
                                            Net                    Per-Share        Net                    Per-Share
                                          Income       Shares       Amount        Income       Shares       Amount
                                          -------      ------      ---------      -------      ------      ---------

<S>                                       <C>         <C>          <C>            <C>          <C>         <C>
Basic EPS
Net income available to the common
      stockholders                         $4,564      10,958         $0.42       $4,944       10,608        $0.47
                                                                    ========                               =========

Effect of Dilutive Securities
Options                                        -          863                        -          1,044
Warrants                                       -           -                         -            -
Convertible preferred stock                    -           -                         -            -
7% convertible notes payable                   -           -                         -            -
                                          --------     --------                  ---------    ---------

Diluted EPS
Net income available to common
      stockholders with assumed
      conversions                          $4,564      11,821         $0.39       $4,944       11,652        $0.42
                                          ========    =========     ========     =========    =========    =========

</TABLE>

<TABLE>
<CAPTION>

                                                            1997
                                          ----------------------------------------
                                               Net                    Per-Share
                                             Income       Shares       Amount
                                             -------      -------     ---------
<S>                                          <C>          <C>         <C>
Basic EPS
Net income available to the common
      stockholders                           $4,447        4,964        $0.90
                                                                      =========
Effect of Dilutive Securities
Options                                         -          1,729
Warrants                                        -            655
Convertible preferred stock                     -          1,765
7% convertible notes payable                    143          780
                                             -------      -------

Diluted EPS
Net income available to common
      stockholders with assumed
      conversions                            $4,590        9,893        $0.46
                                             =======      =======     =========

</TABLE>

    Options to purchase 629 shares of common stock at $13.50 to $22.38 and 157
shares of common stock at $14.63 to $18.50 per share were outstanding during the
years ended January 31, 1999 and 1998, respectively, but were not included in
the computation of diluted EPS because the options' exercise prices were greater
than the average market price of the common shares. All potentially dilutive
securities were included in the calculation of diluted EPS for the year ended
January 31, 1997.

8. Convertible, Redeemable Preferred Stock:

    Prior to September 1996, the Company had authorized 15,000 shares of
Preferred Stock, of which 1,736 were designated as Series A Preferred Stock,
1,736 were designated as Series A1 Preferred Stock, 3,200 were designated as
Series B Preferred Stock, 3,200 were designated as Series B1 Preferred Stock,
and 5,128 were undesignated.

    During 1991, the Company issued 1,111 shares of Series A Preferred Stock at
a price of $2.25 per share in exchange for $2,500 of cash, less $51 of offering
expenses.

    During 1993, the Company issued 1,501 shares of Series B Preferred Stock at
a per share price of $2.33 in exchange for $1,435 of convertible notes payable,
including $27 of accrued interest, and $2,055 of cash, less $85 of offering
expenses.

    In September 1996, upon the closing of the Company's initial public
offering, all outstanding shares of Series A Preferred Stock and Series B
Preferred Stock converted to 1,126 and 1,521 shares, after adjustment for
redemption premiums, of the Company's common stock, respectively.


9. Warrants and Stock Options:

    Warrants:

    In September 1996, upon the closing of the Company's initial public
offering, all outstanding warrants were converted to 983 shares of the Company's
common stock on a cashless basis.

                                      F-16
<PAGE>

                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


    Stock Option Plans:

    During 1992, the Board of Directors authorized a nonstatutory stock option
program for the purpose of granting options to purchase a total of 222 shares of
the Company's common stock to employees. The Board of Directors reduced the
number of shares authorized to 133 during 1994. Options vest annually, pro rata
over a five-year period, retroactive to the date of hire for each recipient.

    The following represents option activity for the years ended January 31
under the nonstatutory option plan:

<TABLE>
<CAPTION>


                                                        1999                          1998                           1997
                                               ----------------------        -----------------------       ------------------------
                                                            Weighted                       Weighted                        Weighted
                                                            Average                        Average                         Average
                                                           Per Share                      Per Share                       Per Share
                                                Number of   Exercise          Number of    Exercise         Number of      Exercise
                                                 Options      Price            Options      Price            Options        Price
                                                --------   ---------          ---------   ---------         ---------     ---------
<S>                                             <C>        <C>                <C>         <C>               <C>           <C>
Options outstanding at beginning of year              2      $0.20                 22      $0.50                65          $0.52
Options exercised                                    (2)     $0.20                 (20)    $0.53               (42)         $0.53
Options forfeited                                     -                             -                           (1)         $0.53
                                                --------                      ---------                     ---------
Options outstanding at year-end                       -                              2     $0.20                22          $0.50
                                                ========                      =========                     =========
Options exercisable at year-end                       -                              2     $0.20                22          $0.50
                                                ========                      =========                      =========
Options available for future grant                    -                             -                           -
                                                ========                      =========                      =========
</TABLE>


    During 1992, the Board of Directors authorized the 1992 Stock Option Plan
for the purpose of granting options to purchase the Company's common stock to
employees, directors and consultants. The Board of Directors determines the
form, term, option price and conditions under which each option becomes
exercisable. Options to purchase a total of 1,055 shares of common stock have
been authorized by the Board under this plan.

    The following represents option activity for the years ended January 31
under the 1992 Stock Option Plan:

<TABLE>
<CAPTION>
                                                          1999                          1998                          1997
                                                 -----------------------       -----------------------       -----------------------
                                                               Weighted                      Weighted                      Weighted
                                                                Average                       Average                       Average
                                                               Per Share                     Per Share                     Per Share
                                              Number of        Exercise        Number of     Exercise        Number of     Exercise
                                               Options           Price          Options        Price          Options        Price
                                             -------------     ---------       ---------     ---------       ---------     ---------
<S>                                           <C>              <C>             <C>           <C>             <C>           <C>
Options outstanding at beginning of year              683        $1.33            810          $1.36            774          $1.26
Options granted                                         -                           -                           188          $1.65
Options exercised                                    (202)       $1.42           (120)         $1.07           (100)         $1.19
Options forfeited                                     (37)       $1.41             (7)         $1.02            (52)         $1.22
                                             -------------                     ---------                     ---------
Options outstanding at year-end                       444        $1.43            683          $1.41            810          $1.36
                                             =============                     =========                     =========
Options exercisable at year-end                       393        $1.39            340          $1.33            301          $1.16
                                             =============                     =========                     =========
Options available for future grant                      -                           -                             -
                                             =============                     =========                     =========
Weighted average remaining contractual
      life in years                                   5.5
                                             =============
Range of per share exercise prices for
      options outstanding at year-end        $0.53 - $1.65
                                             =============
</TABLE>

                                      F-17
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)

 
  In May 1996, the Board adopted the Company's 1996 Stock Option Plan. The
Company's 1996 Equity Incentive Plan (the "Incentive Plan") was adopted by the
Board of Directors in July 1996 as an amendment and restatement of the Company's
1996 Plan. At that time, the Board had authorized and reserved an aggregate of
1,267 shares of common stock for issuance under the Incentive Plan. In June
1998, 1,200 additional shares of common stock were authorized and reserved for
issuance under the Incentive Plan.

  The Incentive Plan provides for the grant of incentive stock options to
employees and nonstatutory stock options, restricted stock purchase awards and
stock bonuses to employees, directors and consultants. The terms of stock
options granted under the Incentive Plan generally may not exceed 10 years. The
exercise price of options granted under the Incentive Plan is determined by the
Board of Directors, provided that the exercise price for an incentive stock
option cannot be less than 100% of the fair market value of the common stock on
the date of the option grant and the exercise price for a nonstatutory stock
option cannot be less than 85% of the fair market value of the common stock on
the date of the option grant. Options granted under the Incentive Plan vest at
the rate specified in each optionee's option agreement.

  The following represents option activity under the Incentive Plan for the
years ended January 31,:

<TABLE> 
<CAPTION> 
                                                           1999                       1998                      1997
                                                 ------------------------    ----------------------    -----------------------
                                                                Weighted                  Weighted                   Weighted
                                                                 Average                   Average                    Average
                                                                Per Share                 Per Share                  Per Share
                                                 Number of       Exercise    Number of     Exercise    Number of      Exercise
                                                  Options         Price       Options       Price       Options        Price
                                                 ---------      ---------    ---------    ---------    ---------     ---------
<S>                                              <C>            <C>          <C>          <C>          <C>           <C> 
Options outstanding at beginning of year             799          $8.61         638        $ 5.09           -          $    -
Options granted with exercise prices below                                                          
  market on the date of grant                          -          $   -           -        $    -         525          $ 3.49
Options granted with exercise prices equal                                                          
  to market on the date of grant                     973          $9.97         245        $14.83         141          $10.74
Options exercised                                    (88)         $6.07         (46)       $ 3.47          (8)         $ 3.30
Options forfeited                                   (221)         $7.58         (38)       $ 9.01         (20)         $ 3.48
                                                   -----                        ---                       ---
Options outstanding at year-end                    1,463          $9.68         799        $ 8.61         638          $ 5.09
                                                   =====                        ===                       ===
Options exercisable at year-end                      218          $6.87         114        $ 5.74          16          $ 3.30
                                                   =====                        ===                       ===
Options available for future grant                   862                        414                       621
                                                   =====                        ===                       ===
</TABLE> 

                                      F-18
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)

 
  For various price ranges, weighted average characteristics of outstanding
stock options under the Incentive Plan at January 31, 1999 were as follows:

<TABLE> 
<CAPTION> 
                                       Outstanding Options                       Exercisable Options
                             ----------------------------------------          ------------------------
                                                            Weighted                          Weighted
                                                             Average                           Average
                             Shares         Remaining       Per Share          Shares         Per Share
                              Under           Life           Exercise           Under          Exercise
Range of Exercise Prices     Option          (Years)          Price            Option           Price
------------------------     ------         ---------       ---------          ------         ---------
<S>                          <C>            <C>             <C>                <C>            <C> 
$3.30 to $4.63                 237             5.7           $ 3.30              137           $ 3.30
$4.64 to $6.94                 448             9.1           $ 5.17                -           $    -
$6.95 to $9.25                  63             8.4           $ 8.41               17           $ 8.61
$9.26 to $11.56                 78             7.9           $10.97               20           $11.01
$11.57 to $13.88                64             8.5           $13.21               11           $13.35
$13.89 to $16.19               417             8.2           $14.16               16           $14.81
$16.20 to $18.50               110             7.5           $17.37               17           $17.34
$18.51 to $20.81                17             7.5           $19.56                -           $    -
$20.82 to $23.13                29             9.4           $22.28                -           $    -
                             -----                                               ---
     Total                   1,463                                               218
                             =====                                               ===
</TABLE> 

  During the year ended January 31, 1999, the Company granted 5 shares of common
stock as stock bonuses to certain employees.  The Company recorded $78 of
compensation expense related to these stock bonuses during the year ended
January 31, 1999.

  During the year ended January 31, 1997, the Company recorded deferred
compensation costs of $452 for the difference between the exercise price and the
deemed fair value of the Company's common stock at the date of grant for options
issued under the Incentive Plan. Of the total deferred expense, the Company
recognized $87, $63 and $106 as compensation expense during the years ended
January 31, 1999, 1998 and 1997, respectively. The remaining deferred
compensation expense will be amortized over the remaining vesting periods of the
options, which range from 3 to 51 months.

  The Company applies APB Opinion 25, "Accounting for Stock Issued to
Employees," and related interpretations to account for its stock option plans.
Under SFAS No. 123, compensation cost would be recognized for the fair value of
the employee's option rights.  In determining the fair value, the Company used
the Black-Scholes model, assumed no dividend per year, used expected lives
ranging from 2 to 10 years, expected volatility of 100.0%, 72.55%, and 65.2% for
the years ended January 31, 1999, 1998 and 1997, and risk free interest rates
ranging from 4.0% to 5.75% for the year ended January 31, 1999, 5.75% to 7.25%
for the year ended January 31, 1998 and 7.0% for the years ended January 31,
1997. The weighted average per share fair value of options granted during the
year with exercise prices equal to market price on the date of grant was $8.66,
$10.83 and $3.94 for the years ended January 31, 1999, 1998 and 1997,
respectively.  The weighted average per share fair value of the options granted
during the year ended January 31, 1997 with exercise prices below market price
on the date of grant was $3.58.  There were no options granted with exercise
prices below market price on the date of grant during the years ended January
31, 1999 or 1998.  Had compensation cost for the Company's grants for stock-
based compensation plans been determined consistent with SFAS 123, the Company's
net income and earnings per share would have been reduced to the pro-forma
amounts indicated below.

                                      F-19
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


<TABLE>
<CAPTION>
                                                            Year Ended January 31,
                                                -----------------------------------------------
                                                 1999               1998                  1997
                                                ------             ------                ------
<S>                                             <C>                <C>                   <C> 
Net income as reported                          $4,564             $4,944                $4,447
                                                ======             ======                ======
Proforma net income                             $1,193             $3,794                $3,710
                                                ======             ======                ======
Net income per share as reported:                                           
         Basic                                  $ 0.42             $ 0.47                $ 0.90
                                                ======             ======                ======
         Diluted                                $ 0.39             $ 0.42                $ 0.46
                                                ======             ======                ======
Proforma net income per share:                                              
         Basic                                  $ 0.11             $ 0.36                $ 0.78
                                                ======             ======                ======
         Diluted                                $ 0.10             $ 0.33                $ 0.39
                                                ======             ======                ======
</TABLE>

  Employee Stock Purchase Plan.   In July 1996, the Company's Board of Directors
approved the Employee Stock Purchase Plan (the "Purchase Plan") covering an
aggregate of 300 shares of the Company's common stock. Under the Purchase Plan,
the Board of Directors may authorize participation by eligible employees,
including officers, in periodic offerings following the adoption of the Purchase
Plan. The offering period for any offering will be no more than 27 months.  Plan
offering periods have been six months since the inception of the plan.
Employees are eligible to participate if they are employed by the Company or an
affiliate of the Company designated by the Board of Directors and meet
eligibility standards established by the Board of Directors. Employees who
participate in an offering can have up to 15% of their earnings withheld
pursuant to the Purchase Plan and applied, on specified dates determined by the
Board of Directors, to the purchase of shares of common stock. The price of
common stock purchased under the Purchase Plan will be equal to 85% of the lower
of the fair market value of the common stock on the commencement date or the
purchase date of each offering period. Employees may end their participation in
the offering at any time during the offering period, and participation ends
automatically on termination of employment with the Company and its affiliates.
The Purchase Plan will terminate at the Board of Directors' discretion.

  During the year ended January 31, 1999 and 1998, employees purchased 87 and 26
shares of common stock at weighted average per share prices of $6.04 and $10.88,
respectively.  The Company applies APB Opinion 25, "Accounting for Stock Issued
to Employees," and related interpretations to account for the Purchase Plan.

  Had compensation cost been determined based on the fair value at the grant
dates for awards under the Purchase Plan using the Black-Scholes model, the 
Company's net income would have been reduced by $229 for the year ended January 
31, 1999 and would not have differed from reported amounts for the years ended 
January 31, 1998 and 1997.


10. Shareholder Rights Plan:

  In October 1998, the Board of Directors of the Company adopted a stockholder
rights plan, as set forth in the Rights Agreement, dated as of October 7, 1998
by and between the Company and Norwest Bank Minnesota, N.A., as rights agent.
Pursuant to the Rights Agreement, one Right was issued for each share of the
Company's common stock outstanding as of October 15, 1998.  Each of the Rights
entitles the registered holder to purchase, from the Company, one one-thousandth
of a share of Series A Junior Participating Preferred Stock at a price of $35.50
per one one-thousandth of a share.  The Rights generally will not become
exercisable unless and until, among other things, any person or group not
approved by the Board of Directors acquires beneficial ownership of 15% or more

                                      F-20
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                   (in thousands, except per share amounts)


of the Company's outstanding common stock or commences a tender offer or
exchange offer which would result in a person or group beneficially owning 15%
or more of the Company's outstanding common stock.  Upon the occurrence of
certain events, each holder of a Right, other than such person or group, would
thereafter have the right to purchase, for the then exercise price of the Right,
shares of common stock of the Company, or a corporation or other entity
acquiring the Company, having a value equal to two times the exercise price of
the Right.  The Rights are redeemable by the Company under certain circumstances
at $0.01 per Right and will expire, unless earlier redeemed or extended, on
October 15, 2008.


11. Employee Benefit Plan:

  The Company maintains an employee savings plan that qualifies under Section
401(k) of the Internal Revenue Code (the "Code") for all of its full-time
employees.  The plan allows employees to make specified percentage pretax
contributions up to the maximum dollar limitation prescribed by the Code.  The
Company has the option to contribute to the plan up to a maximum of $2,000 per
employee per year.  Company contributions to the plan during the years ended
January 31, 1999, 1998 and 1997 were $253, $192 and $0, respectively.


12. Related Parties:

  During the years ended January 31, 1997 the Company recognized revenues of
$2,244 from transactions with a shareholder.  As of January 31, 1998, this
former related party was no longer a shareholder of the Company.


13. International Operations:

  The Company's long-lived assets are located principally in the United States.
The Company's revenues for the years ended January 31, which are transacted in
U.S. dollars, are derived based on sales to customers in the following
geographic regions:

<TABLE>
<CAPTION>
                                       1999                1998                1997
                                       ----                ----                ----
<S>                                  <C>                 <C>                 <C>
United States                        $12,735             $13,620             $ 9,890
Japan                                 19,256              11,726               5,978
Other                                    592                  17                 153
                                     -------             -------             -------
                                     $32,583             $25,363             $16,021
                                     =======             =======             =======
</TABLE>


14. Subsequent Event:

  On April 6, 1999, the Company entered into an Agreement and Plan of
Reorganization and Merger with Auco, Inc. ("Auco), a privately held developer of
embedded networking technology based in Redwood City, California.  The
transaction is structured as a merger in which the Company will exchange 2.5
million shares of its common stock for all currently outstanding shares of Auco
capital stock, on a fully-diluted basis, and its convertible note payable. It is
expected that the merger will be accounted for as a pooling of interests.  As a
result of the merger, Auco will become a subsidiary of the Company.

  Consummation of the merger is subject to terms and conditions customary for a
transaction of this type, including approval of certain matters by the
shareholders of the Company and Auco.

                                      F-21
<PAGE>
 
                      REPORT OF INDEPENDENT ACCOUNTANTS 
                       ON FINANCIAL STATEMENT SCHEDULES


To the Board of Directors and Stockholders
Peerless Systems Corporation

Our audits of the financial statements referred to in our report dated March 5,
1999, except for the subsequent event described in Note 14, as to which the date
is April 6, 1999, appearing on page F-2 of this 1999 Annual Report on Form 10-K,
also included an audit of the financial statement schedule listed in Item
14(a)(2) of the Form 10-K.  In our opinion, the financial statement schedule
presents fairly, in all material respects, the information set forth therein
when read in conjunction with the related financial statements.


PRICEWATERHOUSECOOPERS LLP


Woodland Hills, California
March 5, 1999

                                      S-1
<PAGE>
 
                SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
                                (In thousands)

                                        
<TABLE>
<CAPTION>
 
                                                                                Additions
                                                                                 Charged
                                                                 Balance at      to Costs                        Balance at
                                                                 Beginning         and         Deductions           End
                 Description                                     of Period       Expenses          (a)           of Period
-------------------------------------------------------          ---------       --------      ----------        ----------
<S>                                                              <C>            <C>            <C>               <C>
Year Ended January 31, 1997
Reserves deducted from assets to which they apply:
       Allowance for uncollectible accounts receivable           $       -       $    100      $        -        $      100
       
Year Ended January 31, 1998
Reserves deducted from assets to which they apply:
       Allowance for uncollectible accounts receivable           $     100       $      -      $        -        $      100
 
Year Ended January 31, 1999
Reserves deducted from assets to which they apply:
       Allowance for uncollectible accounts receivable           $     100       $     75      $        -        $      175
</TABLE> 
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(a)    Accounts written off, net of recoveries
 
  
                                      S-2
<PAGE>
 
                               INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit
Number
------
<C>             <S>
3.1(1)          Certificate of Incorporation of the Company.
3.2(4)          Amended and Restated Bylaws of the Company.
4.1             Instruments defining the rights of security holders. Reference is made to Exhibits 3.1 and 3.2.
4.2(4)          Rights Agreement, dated October 7, 1998, between the Company and Norwest Bank Minnesota, N.A., as Rights Agent.
10.1(1)         Form of Indemnity Agreement.
10.2(1)(2)      1992 Stock Option Plan (the "Option Plan"), as amended.
10.3(1)(2)      1996 Equity Incentive Plan.
10.4(1)(2)      Form of Incentive Stock Option.
10.5(1)(2)      Form of Nonstatutory Stock Option.
10.6(1)(2)      1996 Employee Stock Purchase Plan.
10.7(1)         Third Party Development Agreement (the "Adobe Third Party License"), dated and September 18, 1992, between the
                        Registrant and Adobe Systems Incorporated ("Adobe").
10.8(1)(3)      Reference Post Appendix #2 to the Adobe Third Party License, dated February 11, 1993.
10.9(1)         Amendment No. 1 to the Adobe Third Party License, dated November 29, 1993.
10.10(1)(3)     PCL Development and License Agreement (the "PCL License"), dated June 14, 1993, between the Registrant and Adobe.
10.11(1)(3)     Amendment No. 1 to the PCL License, dated October 31, 1993.
10.12(1)(3)     Letter Modification to the PCL License, dated August 5, 1994.
10.13(1)(3)     Addendum No. 1 to the PCL License, dated March 31, 1995.
10.14(1)(3)     Letter Modification to the PCL License, dated August 30, 1995.
10.15(1)        Lease Agreement between the Company and Continental Development Corporation, dated February 6, 1992, and Addendum,
                        dated February 6, 1992.
10.16(1)        First Amendment to Office Lease, dated December 1, 1995, between the Company and Continental Development
                        Corporation.
10.18(1)(2)     Employment Agreement with Lauren Shaw.
10.19(1)(2)     Employment Agreement with Edward Gavaldon.
10.20(5)        Second Amendment to Office Lease, dated April 8, 1997, between the Company and Continental Development Corporation.
10.21(5)        Third Amendment to Office Lease dated, December 16, 1997, between the Company and Continental Development
                        Corporation.
10.22           Fourth Amendment to Office Lease, dated April 22, 1998, between the Company and Continental Development Corporation.
23.1            Consent of PricewaterhouseCoopers LLP.
24.1            Power of Attorney. Reference is made to page 30.
27.1            Financial Data Schedule.
</TABLE>
_____________
(1)   Previously filed in the Company's Registration Statement on Form S-1 (File
      No. 333-09357), as amended and incorporated herein by reference.
(2)   Management contract or compensatory plan or arrangement.
(3)   Subject to Confidential Treatment Order.
(4)   Previously filed in the Company's Current Report on Form 8-K, filed
      October 8, 1998, and incorporated herein by reference.
(5)   Previously filed in the Company's 1998 Annual Report filed on Form 10-K,
      filed April 24, 1998, and incorporated herein by reference.