<PAGE>
 
================================================================================
                                 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, 1998                                 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 20, 1998 was approximately
$162,750,072.

   The number of shares of Common Stock outstanding as of April 20, 1998 was
                                  10,769,844.

                      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 18, 1998 (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; 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" (which includes "Risk Factors"), "Properties", "Market for
Registrant's Common Equity and Related Stockholder Matters" and "Management
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 risk factors on pages 12
through 18, among other things, should be considered in evaluating the Company's
prospects and future financial performance.

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<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION

                          1998 FORM 10-K ANNUAL REPORT

                               TABLE OF CONTENTS

                                                                  PAGE
                                                                  ----
                                     PART I
<TABLE>
<CAPTION>
 
<S>          <C>                                                   <C>
Item 1.      BUSINESS...........................................    4
Item 2.      PROPERTIES.........................................   18
Item 3.      LEGAL PROCEEDINGS..................................   18
Item 4.      SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS   18

                                    PART II
Item 5.      MARKET FOR THE REGISTRANT'S COMMON EQUITY RELATED
             STOCKHOLDER MATTERS................................   19
Item 6.      SELECTED FINANCIAL DATA............................   20
Item 7.      MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL 
             CONDITION AND RESULTS OF OPERATIONS................   21
Item 8.      FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA........   27
Item 9.      CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON 
             ACCOUNTING AND FINANCIAL DISCLOSURE................   27

                                    PART III

Item 10.      DIRECTORS AND EXECUTIVE OFFICERS..................   28
Item 11.      EXECUTIVE COMPENSATION............................   29
Item 12.      SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS 
              AND MANAGEMENT....................................   29
Item 13.      CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....   29

                                    PART IV

Item 14.      EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
              ON FORM 8-K.......................................   30
</TABLE> 
                                        
                                  TRADEMARKS

Memory Reduction Technology (MRT)(R) is a registered trademark of Peerless 
Systems Corporation. WINEXPRESS(TM), PeerlessPrint(TM) and QuickPrint(TM) are 
trademarks of Peerless Systems Corporation and are subjects of applications 
pending for registration with United States Patent and Trademark Office.  
Peerless Systems(TM) (in English and Japanese Katakana), PEERLESS(TM) (in logo) 
and P(TM) (in logo) are trademarks and service marks 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 all cases, these 
designations are claimed as trademarks or registered trademarks by their 
respective companies.

--------------------------------------------------------------------------------

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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 market for embedded imaging
systems represents a small portion of the worldwide market for digital document
products. The Company estimates the digital document market, based in part upon
data and projections provided by International Data Corporation ("IDC"), was
approximately $26 billion in 1996.

  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 600 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 applications 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 

                                       4
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power of the digital document product. In response, embedded imaging systems
have evolved from 8-bit to 32-bit platforms that 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 this
trend towards 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 "Risk Factors--Technological Change;
Dependence on the Digital Document Product Market" 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, 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 

                                       5
<PAGE>
 
introduced MFPs, which have required each of them to broaden their imaging
expertise. At the same time, the need for 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, 70% 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 87% by 2001. See "Risk Factors--Developing Markets"
for a discussion of this forward-looking statement. 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:

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<PAGE>
 
  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, 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 XL.  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 5M and high-end inkjet products. PeerlessPrintXL
provides monochrome and color compatibility with HP's latest PCL XL 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.

  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 planned as a 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 and the QP 1800 ASICs.
Additionally, the Company has introduced the QP+401 which is expected to be
available in fiscal 1999.

  In addition, the Company, in partnership with Rockwell Semiconductor Systems,
Inc. ("Rockwell"), is developing an integrated processor solution for the
multifunction SOHO 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. 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 utilized by open industry-standard network management systems.

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  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
inkjet products (currently under development), fax or laser-based workgroup MFP
products and high-speed copier-based MFP products. The lower-cost inkjet
solution, currently under joint development with Rockwell, will combine Peerless
imaging technology and Rockwell fax technology. The higher-end solutions combine
the Company's networkable imaging products with MFP-specific extensions to
facilitate printing, copying, faxing and scanning by 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
1998, the Company announced its first object-based embedded imaging system for a
color MFP, a fax-based MFP and a high-speed MFP capable of print speeds of up to
40 pages per minute.

  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 image system reduces memory requirements for printing  color pages while
simultaneously accelerating the document imaging process and increasing print
quality. During fiscal 1998, the Company released its first embedded object-
based imaging system for a desktop color laser printer to an OEM customer.


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

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  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 three patents in the United States covering 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. Furthermore, the Company has established relationships with Emulex and
Osicom that allow the Company to support network printing under a wide range of
networking technologies. The Company also has an agreement with HDE, Inc. for an
internet printing solution and has licensed MFP host software from Jetfax. 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 coprocessor solutions.  The integrated processors
combine the Company's basic digital document product functionality with an
industry-standard microprocessor.

  In October 1996, the Company entered into an agreement with Rockwell
Semiconductor Systems, Inc. ("Rockwell"), 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 Rockwell and Peerless to
specify, design and produce an integrated semiconductor solution for
multifunction products that combines Rockwell's fax technology and Peerless'
embedded imaging technology. See "Risk Factors - Potential Fluctuations in
Quarterly Results; Seasonality; Revenue Reporting" for further discussion of
this agreement.

  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 Rockwell, the Company has
derived substantially all of its revenues in recent years from direct sales to
digital document product OEMs, including Canon, IBM and Minolta.

  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, 1998 included Adobe, Canon, IBM and Minolta.

  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 Rockwell 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 Rockwell, which has the rights to manufacture and sell this
chipset directly to digital document product manufacturers. Rockwell is
presently the Company's sole customer in the SOHO market. See "Risk Factors--
Dependence on Sole Source Providers."

  Asian Markets.  Peerless' Asian 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 recent downturn in the Asian economy, the Company has not experienced
a decrease in its sales to Asian customers.  See "Risk Factors - International
Activities" for further discussion on Asian markets.

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 products 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 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 at building the Company's brand awareness. These
programs consist of public relations and Peerless product branding on its
silicon and software products.

                                       10
<PAGE>
 
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 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 three 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 three applications pending in Japan, three applications pending
in the European Patent Office and five application 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 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 subject 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 

                                       11
<PAGE>
 
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 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, 1998, the Company had a total of approximately 160 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.



RISK FACTORS

  Investors in the Company should be aware of the following risks and
uncertainties that could materially affect the Company's results of operations
and the market for the Company's securities.

                                       12
<PAGE>
 
  History of Operating Losses; Accumulated Deficit.  The Company has been
profitable only since the quarter ended December 31, 1995. The Company
recognized net losses of approximately $639,000 and $1.2 million for the fiscal
years ended December 31, 1995 and 1994, respectively. The Company's historical
losses have resulted in an accumulated deficit of approximately $3.9 million as
of January 31, 1998. Although the Company reported net income of $4.9 million
and $4.4 million for the fiscal years ended January 31, 1998 and 1997,
respectively, there can be no assurance that the Company will maintain
profitability on a quarterly or annual basis in the future.

  Potential Fluctuations in Quarterly Results; Seasonality; Revenue Reporting.
The Company in the past has experienced, and in the future may experience,
significant fluctuations in quarterly operating results that have been and may
be caused by many factors including: initiation or termination of arrangements
between the Company and its existing and potential OEM customers; the timing of
introductions of new products or product enhancements by the Company, its OEMs
and their competitors; the phase-out or early termination of OEM products
incorporating the Company's technology; the size and timing of engineering
services contracts, one-time software licensing transactions and recurring
licensing fees; the size and timing of and fluctuations in end-user demand for
the OEM products incorporating the Company's technology; inventories of digital
document products carried by the OEMs' distributors that exceed current or
projected end-user demand; performance by the Company and its OEM customers
pursuant to their plans and agreements; seasonal trends; the mix of services
provided or products sold and the gross margins attributable to such services or
products; competition and pricing; customer order deferrals in anticipation of
new products or product enhancements; industry and technology developments;
changes in the Company's operating expenses: software bugs, product delays or
other product quality problems; currency fluctuations; and general economic
conditions. For example, in recent quarters the Company's quarterly revenues
have been significantly affected by the timing of one-time licensing
transactions, by decreases in recurring product licensing revenues resulting
from the phase-out by the Company's OEMs of products incorporating the Company's
technology and by variations in end-user demand. The Company expects that its
operating results will continue to fluctuate significantly in the future as a
result of these and other factors.

  A substantial portion of the Company's costs and expenses is related to costs
of engineering services and maintenance, other personnel costs, product
development, facilities and marketing programs. 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, in any
event, if revenues are below expectations, the Company's quarterly and annual
operating results will be adversely affected, which could have a material
adverse effect on the price of the Company's Common Stock. The Company in the
past has experienced, and in the future may experience, significant fluctuations
in quarterly engineering services results that have been and may be caused by
many factors including: an increase in the estimated hours to completion
associated with a particular engineering services project; 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. For example, if the estimated hours to
completion associated with a particular engineering services project increases
during the course of the project, the estimated percentage that has been
completed will subsequently decrease, and the portion of the total fixed
engineering services project revenue that the Company will be able to recognize
at that point in time will decrease as a result. For these and other reasons, it
is likely that in future quarters the Company's operating results from time to
time may be below the expectations of public market analysts and investors,
which also could have a material adverse effect on the price of the Company's
Common Stock.

  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. As a result, the Company's
product licensing revenues associated with unit shipments by its OEMs may be
subject to similar fluctuations, although no assurance can be given that the
Company's OEMs will experience such fluctuations or as to the effect of such
fluctuations, if any, on the Company's revenues. In addition, because one or
more key OEM transactions, milestones or OEM product 

                                       13
<PAGE>
 
shipments that are scheduled to be realized by the Company or its OEMs at the
end of a quarter may be delayed until the beginning of the next quarter,
quarterly revenues are subject to significant fluctuations.

  The recurring product licensing revenues reported by the Company are dependent
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 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. As a result, the Company may be unable to estimate such
revenues accurately prior to public announcement of the Company's quarterly
results. In such event, the Company subsequently may be required to restate its
recognized revenues or adjust revenues for subsequent periods, which could have
a material adverse effect on the Company's operating results.

  In October 1996, the Company entered into an agreement with Rockwell
Semiconductor Systems, Inc., a major developer and manufacturer of fax and modem
chips, relating to the licensing of Peerless technologies and engagement of
Peerless technical personnel for engineering development services. Pursuant to
the agreement, the Company is entitled to engineering service payments,
development license fees and prepayment of royalty guarantees. The agreement
provides that Rockwell may terminate the relationship for any reason upon 60
days notice and with notice in the event of a material breach. If the agreement
is terminated for a material breach by Peerless prior to the shipment of the
licensed product developed under this agreement, Peerless is obligated to a
return a portion of the licensing fees previously paid. No assurance can be
given as to the ability of the Company to perform in accordance with the terms
of the agreement or as to the ability or willingness of Rockwell to continue
developing, marketing and selling proposed products covered by the agreement.
Thus, the achievement of, or failure to achieve, certain milestones under this
agreement, the development and sale of, or failure to develop and sell, products
under this agreement, or the termination, with or without a material breach, of
this agreement, may cause the Company's revenues to fluctuate significantly from
quarter to quarter.

  Dependence on Market Success of Third Parties. With the exception of Adobe and
Rockwell, 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. The ability and willingness of these OEMs to do so is based upon a
number of factors, such as: the timely development by the Company and the OEMs
of new products with new functionality, increased speed and enhanced performance
at acceptable prices to end users; development costs of the OEMs; licensing and
engineering fees of the Company; compatibility with emerging industry standards;
technological advances; patent and other intellectual property issues;
competition generally; and overall economic conditions. Many of these factors
are beyond the control of the Company and, to a lesser extent, also may be
beyond the control of any of the OEMs. 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. Since the Company's
business is entirely dependent on its relationships with its OEMs, the inability
or unwillingness of any of the Company's significant OEMs to continue its
relationship with the Company and to develop and promote products incorporating
the Company's technology would have a material adverse effect on the Company's
operating results.

  Concentration of Revenues. The Company's customers that individually comprised
more than 10% of the Company's total revenues for the year ended January 31,
1998 were Adobe, Canon, IBM, Minolta and Rockwell.  Revenues from the Company's
top four customers accounted for approximately 60%, 61% and 74% of the Company's
total revenues for the fiscal years ended January 31, 1998 and 1997 and December
31, 1995, respectively, and the Company anticipates that its revenues in the
future 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

                                       14
<PAGE>
 
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. 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. In addition, 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. The Company also is subject to a credit risk associated
with the concentration of its accounts receivable from these customers. No
assurance can be given as to the ability or willingness of any of the Company's
customers to continue utilizing the Company's services and technology consistent
with past practice or at all, or as to the ability of the Company in the future
to sell its services and technology consistent with past practice or at all to
its existing or new customers. Any significant decrease in sales of products by,
or a reduction in licensing or engineering services to, the Company's larger
customers, any failure of the Company to replace its existing customers or to
enter into relationships with new customers in accordance with the Company's
expectations, or any delay in or failure to make the payments due to the Company
from such customers could have a material adverse effect on the Company's
operating results.

  Technological Change; Dependence on the Digital Document Product Market. 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 currently derives substantially all of its
revenues from the licensing of technology and the sale of related engineering
services that enable the printing and imaging of digital documents, and the
Company anticipates that these sources of revenue will continue to account for
substantially all of the Company's revenues for the foreseeable future. The
Company and its OEMs are required to develop and release in a regular and timely
manner new digital document products with increased speed, enhanced resolution,
reduced memory requirements, multifunction capability, network compatibility and
color imaging. The acceptable amount of time to develop these products is
continuing to decrease, which increases the complexity for and costs to the
Company and its OEMs. In addition, the Company, its OEMs and their competitors
from time to time may announce new products, capabilities or technologies that
may replace or shorten the life cycles of the OEM products incorporating the
Company's technology. 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.

  Product Development; Product Delays. The Company in the past has experienced
delays in product development, and the Company may experience similar delays in
the future. 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 

                                       15
<PAGE>
 
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 errors will not be found, that the Company will not experience
development challenges resulting in unanticipated problems or delays in the
acceptance of products by the Company's OEMs or shipment of the OEMs' products,
or 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.

  Developing Markets. A substantial portion of the Company's recent development
efforts has been directed at the development of new embedded imaging
technologies, particularly for laser and inkjet MFPs, color products and digital
photography. The markets for these products are new and rapidly evolving. The
Company's OEMs currently are selling laser monochrome and color network printers
and MFPs incorporating the Company's technology. Although certain of the
Company's technology currently is available to OEM customers, once an agreement
with an OEM is entered into, the technology must undergo further development, or
customization, before it can be incorporated into an OEM's specific digital
document product. The Company's OEMs have not yet shipped any inkjet products
incorporating the Company's technology, and the Company has limited experience
in the SOHO market to date. Further, the Company's digital photography effort
remains in the early start-up phase and the Company has signed no OEM contracts
for this technology to date. The Company's future success will be dependent to a
significant degree upon broad market acceptance of its technologies under
development. This success will be dependent in part on the ability of the
Company's OEMs to develop new products that provide the functionality,
performance, speed and network connectivity demanded by the market at acceptable
prices, and to convince end users to adopt new generation products for office
and desktop use. There can be no assurance that: the market for MFP, color
printing and other products proposed by the Company will develop or continue to
expand; the Company will be able to offer in a timely manner, if at all, its new
technologies; the Company's OEM customers will choose the Company's technology
for use in their MFPs, color printers, digital cameras or other products; the
Company's OEM customers will be successful in developing such MFPs, color
printers, digital cameras and other products; or such products will gain market
acceptance. The failure of any of these events to occur would 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.
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, and is currently seeking to license color matching
technology from Adobe. 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.

  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 

                                       16
<PAGE>
 
the inability to hire or retain qualified personnel could have a material
adverse effect on the Company's operating results.

  International Activities. Revenues from sales to the Company's customers
outside the United States accounted for 46%, 38% and 41% of the Company's total
revenues for the fiscal years ended January 31, 1998 and 1997 and December 31,
1995, respectively. Therefore, the Company is substantially dependent on its
international business activities. Further, 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 year, the Asian economy has experienced a downturn.  As a
result, some members of the imaging industry have recently 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. These market fluctuations may adversely affect the market price of
the Common Stock.

   Effect of Anti-Takeover Provisions. Certain provisions of the Company's
Certificate of Incorporation (the "Charter") and Bylaws (the "Bylaws") and
certain provisions of Delaware law could have the effect of making it more
difficult for a third party to acquire, or of discouraging a third party from
attempting to acquire, control of the Company. Such provisions could limit the
price that investors might be willing to pay in the future for the Company's
Common Stock. These provisions permit the issuance of "blank check" preferred
stock by the Board of Directors without stockholder approval, require super-
majority approval to amend certain provisions in the Charter and Bylaws, require
that all stockholder actions be taken at duly called annual or special meetings
and not by written consent, and impose various procedural and other requirements
that could make it more difficult for stockholders to effect certain corporate
action. Furthermore, the Company is subject to the anti-takeover provisions of
Section 203 of the Delaware General Corporation Law, which prohibits the Company
from engaging in a "business combination" with an "interested stockholder"
for a period of three years after the date of the transaction in which the
person first becomes an "interested stockholder," unless the business
combination is approved in a prescribed manner. The application of Section 203
could also have the effect of delaying or preventing a change of control of the
Company.

   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-

                                       17
<PAGE>
 
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.

   Based on a recent assessment, the Company will be required to modify certain
support software so that its computer systems will properly utilize dates beyond
December 31, 1999. Management believes that the Company's engineering and
development tools will not be impacted by the Year 2000 Issue as they are not
date sensitive. The Company believes that the exposure, if any, to contingencies
related to the Year 2000 Issue for products developed for OEMs is not material.
The Company is currently developing a plan that would include initiating formal
communications with all of its significant vendors, large customers and
development partners to determine the extent to which the Company is vulnerable
to those third parties' failure to remediate their own Year 2000 Issues.

   The estimated cost to complete the project is not expected to have a material
effect on the financial position or results of operations of the Company. The
Company will utilize both internal and external resources for Year 2000 software
modifications.  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.


ITEM 2 -- PROPERTIES.

  The Company leases its principal facilities in El Segundo, California. The
Company expanded its facilities during the year ended January 31, 1998 from
30,000 square feet to 47,000 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 1998.

                                       18
<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, 1998           January 31, 1997
           --------------------     -----------------------
Quarter     High         Low           High          Low
--------   -------     --------     ----------    ---------
<S>        <C>          <C>         <C>           <C> 
First      $20.750       $8.500     Not Yet Publicly Traded
Second     $17.000      $10.250     Not Yet Publicly Traded
Third      $17.250      $12.500       $13.000       $10.250
Fourth     $16.375       $9.000       $23.000       $10.500
</TABLE> 

   As of April 20, 1998, there were approximately 128 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.  Under the terms of the Company's revolving line of credit,
the Company currently is prohibited from paying dividends on its Common Stock.
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 future even after the
prohibition on paying dividends under the revolving line of credit is no longer
effective.

                                       19
<PAGE>
 
ITEM 6 - SELECTED FINANCIAL DATA

   The statement of operations data for the years ended January 31, 1998 and
1997 and December 31, 1995 and the balance sheet data at January 31, 1998 and
1997, 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, 1994 and 1993 and
the balance sheet data at January 31, 1996 and at December 31, 1995, 1994, and
1993 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
                                                              JANUARY 31, (1)              YEARS ENDED DECEMBER 31,
                                                         -----------------------   ------------------------------------
                                                            1998          1997        1995        1994         1993       
                                                         ----------   ----------   ----------   ----------   ----------   
STATEMENT OF OPERATIONS DATA:
<S>                                                       <C>          <C>          <C>          <C>          <C> 
    Revenues:
       Product licensing                                   $15,806      $ 8,322      $ 4,774     $  4,394     $  1,586
       Engineering services and maintenance                  9,557        7,699        5,639        4,942        3,655
                                                           --------     ---------    --------    ---------    --------- 
          Total revenues                                    25,363       16,021       10,413        9,336        5,241
                                                           --------     ---------    --------    ---------    ---------
    Cost of revenues:                                    
       Product licensing                                       141          144          143          218          341
       Engineering services and maintenance                  7,974        6,123        5,111        5,457        5,095
                                                           --------     --------     --------    ---------    ---------
          Total cost of revenues                             8,115        6,267        5,254        5,675        5,436
                                                           --------     --------     --------    ---------    ---------
              Gross margin                                  17,248        9,754        5,159        3,661         (195)
                                                           --------     --------     --------    ---------    ---------
    Operating expenses:
       Research and development                              4,604        2,701        2,088        1,767        1,766
       Sales and marketing                                   3,732        2,746        2,142        1,878        1,656
       General and administrative                            2,915        2,546        1,293        1,000        1,048
                                                           --------     --------     --------    ---------    ---------
          Total operating expenses                          11,251        7,993        5,523        4,645        4,470
                                                           --------     --------     --------    ---------    ---------
    Income (loss) from operations                            5,997        1,761         (364)        (984)      (4,665)
    Interest income (expense), net                           1,391          186         (176)        (118)         (96)
                                                           --------     --------     --------    ---------    ---------
       Income (loss) before income taxes                     7,388        1,947         (540)      (1,102)      (4,761)
    Provision (benefit) for income taxes                     2,444       (2,500)          99          124           63
                                                           --------     --------     --------    ---------    ---------
    Net income (loss)                                      $ 4,944      $ 4,447      $  (639)    $ (1,226)    $ (4,824)
                                                           ========     ========     ========    =========    =========
    Net income (loss) per share - assuming dilution (2)    $  0.42      $  0.46      $ (0.24)    $  (0.47)    $  (1.89)
                                                           ========     ========     ========    =========    =========
    Shares used in per share calculation (2)                11,652        9,893        2,664        2,599        2,556
                                                           ========     ========     ========    =========    =========
<CAPTION> 
                                                                    JANUARY 31, (1)                         DECEMBER 31,
                                                         ------------------------------------   ------------------------------------
                                                            1998          1997        1996        1995         1994          1993
                                                         ----------   ----------   ----------   ----------   ----------   ----------
<S>                                                       <C>          <C>          <C>          <C>         <C>          <C> 
BALANCE SHEET DATA:
    Cash and cash equivalents                              $ 3,199      $24,162      $   722     $ 1,184      $   393      $    771
    Working capital (deficit)                               23,713       25,056       (2,608)     (2,307)      (3,192)       (2,477)
    Total assets                                            40,095       35,109        4,041       4,185        3,541         3,221
    Long-term obligations                                      421          317        4,286       4,299        2,594         2,296
    Redeemable Preferred Stock                                   -            -        5,932       5,931        6,645         6,422
    Total stockholders' equity (deficit)                    33,807       28,064      (11,867)    (11,596)     (11,941)      (10,528)
</TABLE> 
_________
(1) The Company changed its fiscal year end to January 31, beginning February 1,
    1996.

(2) See Note 8 of Notes to Financial Statements for a description of the
    computation of the net income (loss) per share and the number of shares used
    in the per share calculation for the years ended January 31, 1998 and 1997
    and December 31, 1995.

                                       20
<PAGE>
 
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 information 
available to the Company on the date hereof, and the Company assumes no 
obligation to update any such forward-looking statements as a result of certain 
factors, including those set forth below, under "Risk Factors" and elsewhere in 
this report.

OVERVIEW

  The Company provides software-based embedded imaging systems to OEMs of
digital document products. The Peerless family of products and engineering
services provides advanced embedded imaging technologies that enable the
Company's customers to develop digital printers, copiers and MFPs quickly and
cost effectively. The Company's revenues are comprised of both recurring and
one-time development licensing fees, as well as engineering services and
maintenance fees related to the Company's embedded imaging software and
supporting technologies. The Company changed its fiscal year end from December
31 to January 31, commencing February 1, 1996, in order to better align the
timing of the Company's financial reporting with the timing of receipt of
royalty information by the Company from its OEMs. Accordingly, information for
the year ended January 31, 1997 is compared with the information for the year
ended December 31, 1995. No analysis is provided for the month ended January 31,
1996.

  The Company's product licensing revenues are comprised of both recurring
licensing fees and one-time development licensing fees for source code.
Recurring licensing revenues are derived from per unit fees paid quarterly by
the Company's OEMs upon shipment or manufacture of products incorporating the
Company's technology. Recurring licensing revenues are derived to a lesser
extent from arrangements in which the Company enables its products to be used
with third-party technology, such as certain arrangements with Adobe. The
Company's one-time development licensing fees for source code are paid by OEMs
for access to the Company's software, which in turn generates recurring
licensing revenues if the software is incorporated into OEM products that are
subsequently developed and shipped.

  The Company's engineering services revenues are derived primarily from
adapting the Company's software and supporting electronics to specific OEM
requirements. The Company provides its engineering services to OEMs seeking an
embedded imaging solution for their digital document products. The Company's
maintenance revenues are derived from software maintenance agreements.
Maintenance revenues constitute a small portion of engineering services and
maintenance revenues.

  The Company recognizes its recurring product licensing revenues on a royalty
basis generally when the Company's OEM customers ship or manufacture products
that incorporate the Company's technology. Generally, the Company recognizes its
one-time development licensing revenues for source code upon shipment to and
acceptance by the Company's OEMs. The Company recognizes engineering services
revenues over the course of the development work on a percentage-of-completion
basis. Maintenance revenues are recognized ratably over the term of the
maintenance contract, which generally is 12 months. Licensing revenues are
recognized in accordance with Statement of Position 91-1 "Software Revenue
Recognition."  (See the "Future Developments" section of Management's Discussion
and Analysis of Financial Condition and Results of Operations). The recurring
product licensing revenues reported by the Company are dependent on the timing
and accuracy of royalty 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 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. As
a result, 
                                       21
<PAGE>
 
the Company may be unable to estimate such revenues accurately prior to public
announcement of the Company's quarterly results. In such event, the Company
subsequently may be required to restate its recognized revenues or adjust
revenues for subsequent periods, which could have a material adverse effect on
the Company's operating results.

  The Company frequently receives payments from its OEMs in advance of
recognition of the associated revenues and, in some cases, the Company receives
guaranteed minimum payments in advance of per unit licensing royalties. These
amounts are recorded as deferred revenue.  Deferred revenue consists of prepaid
licensing fees as well as payments received in advance for engineering services
and maintenance to be performed.

  In October 1996, the Company entered into an agreement with Rockwell
Semiconductor Systems, Inc., 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.  Pursuant to
the agreement, the Company is entitled to engineering service payments,
development license fees and prepayment of royalty guarantees.  The Company's
operating results for fiscal 1998 and 1997 were favorably impacted by revenues
received pursuant to this agreement and the Company anticipates that revenues
from this agreement will continue to favorably impact the Company in fiscal
1999.  No assurance can be given as to the ability of the Company to perform in
accordance with the terms of the agreement or as to the ability or willingness
of Rockwell to continue developing, marketing and selling proposed products
covered by the agreement, which is subject to termination by Rockwell upon
notice. The failure to achieve certain milestones under this agreement, the
failure to develop or sell products under this agreement or the termination of
this agreement could have a material adverse effect on the Company's operating
results.

  The Company's customers currently include, among others, Adobe and Rockwell
and OEM customers Canon, IBM and Minolta. A significant portion of the Company's
revenues in recent years has been concentrated with a limited number of
customers, and the Company anticipates that its revenues in the future will be
similarly concentrated. In the fiscal years ended January 31, 1998 and 1997 and
December 31, 1995, the Company's top four customers accounted for an aggregate
of 60%, 61% and 74% of total revenues, respectively.  Revenues from sales to the
Company's customers outside the United States accounted for 46%, 38% and 41% of
the Company's total revenues for the fiscal years ended January 31, 1998 and
1997 and December 31, 1995, respectively. Therefore, the Company is
substantially dependent on its international business activities. 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 customers 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.

  The Company has a history of operating losses which have contributed to an
accumulated deficit of approximately $3.9 million at January 31, 1998. Although
the Company has reported net income for the fiscal years ended January 31, 1998
and 1997, there can be no assurance that the Company will continue to achieve
taxable income in the future.  Further, the Company's operating results for
fiscal years 1998 and 1997 were favorably affected by a non-recurring benefit
for income taxes of $369,000 and $2.5 million, in the fourth quarters of each
fiscal year, respectively.

  The Company's cost of revenues includes product licensing costs as well as
engineering services and maintenance costs. Cost of engineering services and
maintenance is comprised primarily of salaries and benefits for engineering
personnel, materials and an allocation of corporate facilities overhead costs.
Maintenance costs constitute a small portion of engineering services and
maintenance costs. Research and development expenses are comprised primarily of
employee salaries and benefits, an allocation of engineering management and
administrative staff expenses and an allocation of the corporate facilities
overhead. Sales and marketing expenses are comprised primarily of employee
salaries and benefits, commissions and bonuses, advertising and promotional
expenses, the cost of operating the Japan sales office and an allocation of the
corporate facilities overhead. 

                                      22


<PAGE>
 
General and administrative expenses are comprised primarily of salaries and
benefits, fees paid to the Company's external auditors, counsel and other
corporate consultants, an allocation of the corporate facilities overhead and
expenses required of a public company.

   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. See "Risk Factors - Year 2000
Compliance" for further discussion of this issue.

                                       23
<PAGE>
 
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.

<TABLE> 
<CAPTION> 
                                                  PERCENTAGE OF TOTAL REVENUES
                                                --------------------------------
                                                    YEARS ENDED     YEAR ENDED
                                                    JANUARY 31,     DECEMBER 31,
                                                ------------------  ------------
                                                  1998      1997       1995
                                                --------  --------  ------------
<S>                                             <C>       <C>        <C> 
STATEMENT OF OPERATIONS DATA:
     Revenues:
         Product licensing                        62.3 %    51.9 %     45.8  %
         Engineering services and maintenance     37.7      48.1       54.2
                                                -------   -------    -------
             Total revenues                      100.0     100.0      100.0
                                                -------   -------    -------  
     Cost of revenues:
         Product licensing                         0.6       0.9        1.4
         Engineering services and maintenance     31.4      38.2       49.1
                                                -------   -------    -------
             Total cost of revenues               32.0      39.1       50.5
                                                -------   -------    -------
                  Gross margin                    68.0      60.9       49.5
                                                -------   -------    -------
     Operating expenses:
         Research and development                 18.2      16.9       20.0
         Sales and marketing                      14.7      17.1       20.5
         General and administrative               11.5      15.9       12.4
                                                -------   -------    -------
             Total operating expenses             44.4      49.9       52.9
                                                -------   -------    -------
     Income (loss) from operations                23.6      11.0       (3.4)
     Interest income (expense), net                5.5       1.2       (1.7)
                                                -------   -------    -------
         Income (loss) before income taxes        29.1      12.2       (5.1)
     Provision (benefit) for income taxes          9.6     (15.6)       1.0
                                                -------   -------    -------
     Net income (loss)                            19.5 %    27.8 %     (6.1) %
                                                =======   =======    =======
</TABLE> 
     Years Ended January 31, 1998 and 1997

   Revenues for the year ended January 31, 1998 increased 58% to $25.4 million
from the $16.0 million for the year ended January 31, 1997.  The increase in
revenues was driven by an increase in product licensing revenues of 90% to $15.8
million in the current year from $8.3 million in the prior year.  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 current
fiscal year 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% to $9.6 million from $7.7 million reported
for 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 to 25
in fiscal 1998 from 19 in fiscal 1997.

                                       24
<PAGE>
 
   The Company's gross margin as a percentage of total revenues increased to 68%
for the year ended January 31, 1998 from 61% for the year ended January 31,
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%
for the year ended January 31, 1998 from 52% for the year ended January 31,
1997.

   Peerless continues to invest heavily in the future by funding the research
and development of new technology solutions.  Research and development expenses
increased 71% between the years ending January 31, 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 application specific integrated circuit ("ASIC") designs.
Additionally, the Company invested in digital photography technology during the
year ended January 31, 1998.  Management anticipates that research and
development costs will continue to increase.  Research and development costs as
a percentage of total revenues were 18% and 17% in fiscal years 1998 and 1997,
respectively.

   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 solutions.  Sales and marketing expenses
decreased to 15% of total revenues for the year ended January 31, 1998 from 17%
for the year ended January 31, 1997.  This decrease in expenses as a percentage
of total revenues indicates that the Company's revenues are growing at a faster
rate than its discretionary expenses.

   General and administrative expense for the year ended January 31, 1998
increased 15% from the year ended January 31, 1997.  The expense growth related
primarily to an increase in personnel and expenses, including staff and costs,
necessary to support the growth in the Company's operations.  General and
administrative expenses decreased to 12% of total revenue for the year ended
January 31, 1998 as compared to 16% of total revenues for the years ended 1997.
This decrease over the prior year is the result of an increased revenue base in
the current year.

   The Company earned interest income of $1.4 million for the year ended January
31, 1998. Interest income earned in fiscal 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. Interest income of
$329,000 earned for the year ended January 31, 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.

   Due to a reduction in the valuation allowance during the year ended January
31, 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%.  As of January 31, 1998, the Company had research and
experimentation credits for federal and state tax purposes of approximately
$215,000 and $213,000, respectively.  The Company also had approximately
$789,000 of foreign tax credits available to offset future federal taxes
otherwise payable.  Once the available research and experimentation and foreign
tax credits are fully utilized, the Company will be subject to an estimated
annual tax rate in the range of 35% to 40%.

   Years Ended January 31, 1997 and December 31, 1995

  Revenues for the year ended January 31, 1997 increased 54% to $16.0 million
from $10.4 million for the year ended December 31, 1995. Product licensing
revenues increased 73% to $8.3 million in the year ended January 31, 1997 from
$4.8 million in the year ended December 31, 1995, due to increased shipments of
products that 

                                       25
<PAGE>
 
incorporate the Company's technology. Engineering services and maintenance
revenues increased 37% to $7.7 million from $5.6 million due to an increase in
design wins.

  The Company's gross margin as a percentage of total revenues increased to 61%
for the year ended January 31, 1997 from 50% for the year ended December 31,
1995.  This increase was primarily due to a shift in the Company's revenue mix
toward higher-margin product license fees.

  Research and development expenses increased 29% to $2.7 million for the year
ended January 31, 1997 from $2.1 million for the year ended December 31, 1995
Research and development expenses increased primarily due to an increase in
research and development personnel, principally associated with the Company's
color development efforts.

  Sales and marketing expenses for the year ended January 31, 1997 increased 29%
to $2.7 million from $2.1 million for the year ended December 31, 1995.  The
increase was primarily due to hiring of additional sales and marketing personnel
and added promotional activities.

  General and administrative expenses for the year ended January 31, 1997
increased 92% to $2.5 million from $1.3 million for the year ended December 31,
1995, and increased as a percentage of total revenues to 15.9% from 12.4%. The
increase was primarily due to the hiring of additional management and
administrative personnel and the enhancement of information systems support.


LIQUIDITY AND CAPITAL RESOURCES
 
   Compared to January 31, 1997, total assets at January 31, 1998 grew 14% to
$40.1 million and stockholders' equity grew 20% to $33.8 million.  The Company's
cash and short-term investment portfolio was $20.2 million at January 31, 1998
and the current ratio was 5.0:1.  Cash generated by operations during the year
ended January 31, 1998 was $1.8 million as compared to the $1.0 million
generated in the previous fiscal year.

   Net cash used for investing activities during the year ended January 31, 1998
was $23.5 million and was comprised primarily of purchases and sales of
investments.  During fiscal 1998, the Company expanded its operating facilities
57% from 30,000 square feet to 47,000 square feet in order to accommodate the
current and expected growth in operations.  Additions to property and equipment
during the year ended January 31, 1998 totaled $3.2 million and related
primarily to leasehold improvements made to the operating facilities and
furniture, computer and equipment purchases associated with the growth in
headcount.

   Net cash provided by financing activities during fiscal 1998 was $736,000 and
related to the issuance of common stock under the Company's employee stock
purchase plan and the exercise of common stock options.  Cash provided by
financing activities of $25.8 million during fiscal 1997 was generated primarily
by net proceeds from the Company's initial public offering in September 1996.

   At present, the Company has available a $2.0 million revolving line of credit
with a bank, which is collateralized by substantially all assets of the Company.
The cash available under the line may be used for term loans, letters of credit,
or spot and future exchange rate contracts (subject to limitations).  The line
of credit, which terminates in May 1998, unless extended, requires the Company
to maintain compliance with certain financial covenants.  As of January 31,
1998, the Company had no outstanding obligations under the line of credit.


FUTURE DEVELOPMENTS

  In October 1997, the American Institute of Certified Public Accountants issued
Statement of Position 97-2, "Software Revenue Recognition" ("SOP 97-2"), which
supersedes Statement of Position 91-1, "Software Revenue 

                                       26
<PAGE>
 
Recognition". SOP 97-2, and amendments thereto, provide guidance on applying
generally accepted accounting principles in recognizing revenue on software
transactions and is effective for transactions entered into in fiscal years
beginning after December 15, 1997. Retroactive application of the provisions of
SOP 97-2 is prohibited. Management is currently evaluating the requirements of
SOP 97-2 and the impact that adoption of SOP 97-2 will have on the financial
statements of the Company. Such adoption, however, may delay the timing of
revenue recognition on certain of the Company's contracts.

  In June 1997, the Financial Accounting Standards Board ("FASB") issued
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130").  SFAS 130 establishes standards for reporting and display of
comprehensive income and its components in a full set of general-purpose
financial statements.  An enterprise that has no items of other comprehensive
income in any period presented is not required to report comprehensive income.
SFAS 130 is effective for fiscal years beginning after December 15, 1997 and may
require additional disclosures for all periods presented, however, it will not
impact the Company's reported amounts of net income (loss).

  In June 1997, the FASB issued Statement of Financial Accounting Standards No.
131, "Disclosures about Segments of an Enterprise and Related Information"
("SFAS 131").  SFAS 131 establishes standards for the way that public business
enterprises report information about operating segments in annual financial
statements and requires that those enterprises report selected information about
operating segments in interim financial reports issued to shareholders.  It also
establishes standards for related disclosures about products and services,
geographic areas, and major customers.  SFAS 131 is effective for fiscal years
beginning after December 15, 1997.  Management is currently evaluating the
requirements of SFAS 131 and the impact that adoption of SFAS 131 will have on
the financial statements of the Company.


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.

                                       27
<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, 1998 is contained in the
following table
<TABLE>
<CAPTION>
 
Name                       Age   Position
----                       ---   --------
<S>                        <C>   <C>
 
Edward A. Gavaldon          52   President, Chief Executive Officer and Chairman of the 
                                 Board
Hoshi Printer               55   Vice President, Finance and Administration, Chief Financial 
                                 Officer and Secretary
Reginald Cardin             50   Vice President, Engineering
David R. Fournier           44   Vice President, Sales, Field Operations and Marketing
Thomas B. Ruffolo           44   Vice President, Corporate Development
</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.

  Hoshi Printer has served the Company as Vice President, Finance and
Administration, Chief Financial Officer and Secretary since June 1996. Prior to
joining the Company, Mr. Printer was Chief Financial Officer of Neuron Data, a
software tools company, from July 1995 to May 1996; Soane Technologies, a
polymer technology company, from July 1994 to June 1995; and Catalytica, an
environmental technology company, from January 1990 to June 1994. Mr. Printer
also worked at Xerox Corporation for over 17 years in various positions
including 6 years as Vice President of Finance. Mr. Printer received an M.B.A.
degree from Stanford University.

  Reginald Cardin has served the Company as Vice President, Engineering since
February 1997 and served as Vice President and Chief Technology Officer from
August 1995 to February 1997. Prior to joining the Company, Mr. Cardin worked at
IBM for over 20 years in various positions including Manager, Presentation
Integration and Programming Center Manager, Printing Systems. Mr. Cardin
received a B.A. degree in biology and English from Tufts University.

  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.

  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 a B.S. degree in computer science from Colorado State University and an
M.B.A. degree from Pepperdine University.

                                       28
<PAGE>
 
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.

                                       29
<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 Coopers & Lybrand L.L.P., Independent Accountants
Balance Sheets
Statements of Operations
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, 1998.

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

<TABLE>
<CAPTION>
EXHIBIT
Exhibit
Number
-------
<C>           <S>
3.1(1)       Certificate of Incorporation of the Company.
3.2(1)       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(1)       Amended and Restated Investor Rights Agreement dated October 6, 1995.
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"), 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
</TABLE> 

                                       30
<PAGE>
 
<TABLE> 
<C>           <S> 
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
10.17(1)      Amended and Restated Investor Rights Agreement, dated October 6, 1995
10.18(1)(2)   Employment Agreement with Lauren Shaw
10.19(1)(2)   Employment Agreement with Edward Gavaldon 
10.20         Second Amendment to Office Lease dated April 8, 1997 between the Company and
                  Continental Development Corporation
10.21         Third Amendment to Office Lease dated December 16, 1997 between the Company and
                  Continental Development Corporation
23.1          Consent of Coopers & Lybrand L.L.P.
24.1          Power of Attorney. Reference is made to page 32.
27.1          Financial Data Schedule.
27.2          Financial Data Schedule.
27.3          Financial Data Schedule.
27.4          Financial Data Schedule.
27.5          Financial Data Schedule.
27.6          Financial Data Schedule.
</TABLE> 
_____________
(1)  Incorporated by reference from the indicated exhibit in the Company's
     Registration Statement on Form S-1 (File No. 333-09357), as amended.
(2)  Management contract or compensatory plan or arrangement.
(3)  Subject to Confidential Treatment Order.

                                       31
<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 24th day of April,
1998.


                             PEERLESS SYSTEMS CORPORATION


                             By:    /s/ Hoshi Printer
                                ------------------------------
                                        Hoshi Printer
                              Chief Financial Officer and Secretary
                                 (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.

<TABLE> 
<CAPTION>
      SIGNATURE                                   TITLE                  DATE
      ---------                                   -----                  ----
<S>                                <C>                                   <C> 

    /s/ EDWARD A. GAVALDON         President, Chief Executive Officer    April 24, 1998  
 -----------------------------     and Chairman of the Board                                               
    Edward A. Gavaldon             (Principal Executive Officer) 
                                   


    /s/ HOSHI PRINTER              Chief Financial Officer and           April 24, 1998 
------------------------------     Secretary (Principal Financial and                                              
    Hoshi Printer                  Accounting Officer)        
                                   


   /s/ ROBERT V. ADAMS             Director                              April 24, 1998
------------------------------                                              
      Robert V. Adams



   /s/ ROBERT G. BARRETT           Director                              April 24, 1998
------------------------------                                           
      Robert G. Barrett



   /s/ ROBERT L. NORTH             Director                              April 24, 1998
------------------------------     
       Robert L. North
</TABLE> 

                                       32
<PAGE>
 
                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
 
 
                                                                 Page
                                                                 ----
<S>                                                              <C>
 
Report of Coopers & Lybrand L.L.P., Independent Accountants      F-2
 
Balance Sheets                                                   F-3
 
Statements of Operations                                         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
Peerless Systems Corporation

We have audited the accompanying balance sheets of Peerless Systems Corporation
as of January 31, 1998 and 1997 and the related statements of operations,
stockholders' equity, and cash flows for the years ended January 31, 1998 and
1997, the one month period ended January 31, 1996 and for the year ended
December 31, 1995. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Peerless Systems Corporation at
January 31, 1998 and 1997, and the results of its operations and its cash flows
for the years ended January 31, 1998 and 1997, the one month period ended
January 31, 1996 and for the year ended December 31, 1995, in conformity with
generally accepted accounting principles.



Coopers & Lybrand L.L.P.


Newport Beach, California
March 12, 1998

                                      F-2
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                                 BALANCE SHEETS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>

                                                                                                       JANUARY 31,
                                                                                           ------------------------------------
                                                                                               1998                   1997
                                                                                           -------------       ----------------
                                              ASSETS                                       
<S>                                                                                        <C>                  <C>  
Current assets:                                                                            
      Cash and cash equivalents                                                                  $ 3,199               $24,162
      Short term investments                                                                      16,982                 2,000
      Trade accounts receivable, less allowance for doubtful accounts of $100                    
         at January 31, 1998 and 1997                                                              5,577                 3,314
      Unbilled receivables                                                                         1,386                   363
      Deferred tax asset                                                                           1,544                 1,692
      Prepaid expenses and other current assets                                                      892                   253
                                                                                                 -------               -------
             Total current assets                                                                 29,580                31,784
                                                                                   
                                                                                    
Investments                                                                                        5,501                     -
Property and equipment, net                                                                        4,426                 1,665
Deferred tax asset                                                                                   249                 1,207
Other assets                                                                                         339                   453
                                                                                                 -------               -------
      Total assets                                                                               $40,095               $35,109
                                                                                                 =======               =======
                                                                                           
                         LIABILITIES AND STOCKHOLDERS' EQUITY                                                       
Current liabilities:                                                                       
      Accounts payable                                                                           $ 1,149               $   568
      Accrued wages                                                                                1,065                   711
      Accrued compensated absences                                                                   501                   345
      Other current liabilities                                                                      392                   337
      Income taxes payable                                                                           406                   100
      Deferred rent, current portio                                                                   76                    76
      Deferred revenue, current portion                                                            2,278                 4,591
                                                                                                 -------               -------
             Total current liabilities                                                             5,867                 6,728
Deferred rent                                                                                        421                   217
Deferred revenue                                                                                       -                   100
                                                                                                 -------               -------
      Total liabilities                                                                            6,288                 7,045
                                                                                                 -------               -------
                                                                                                 
Commitments and contingencies (Note 6)                                                           
                                                                                                 
Stockholders' equity:                                                                            
      Common stock, $.001 par value, 30,000 shares authorized, 10,696 and 10,484                       
        shares issued and outstanding at January 31, 1998 and 1997, respectively                      11                    10
Additional paid-in capital                                                                        37,952                37,225
Deferred compensation                                                                               (275)                 (346)
Accumulated deficit                                                                               (3,881)               (8,825)
                                                                                                 -------               -------
      Total stockholders' equity                                                                  33,807                28,064
                                                                                                 -------               -------
      Total liabilities and stockholders' equity                                                 $40,095               $35,109
                                                                                                 =======               =======
 
</TABLE> 

    The following notes are an integral part of these financial statements.

                                      F-3
<PAGE>
 
                         PEERLESS SYSTEMS CORPORATION
                           STATEMENTS OF OPERATIONS
                   (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


<TABLE>
<CAPTION>
                                                               YEARS ENDED                                          
                                                               JANUARY 31,                   MONTH ENDED            YEAR ENDED
                                                         ------------------------            JANUARY 31,            DECEMBER 31, 
                                                          1998             1997                 1996                   1995
                                                         -------          -------               -----                -------
<S>                                                      <C>              <C>                   <C>                  <C> 
Revenues:                                                                                                            
   Product licensing                                     $15,806          $ 8,322               $ 329                $ 4,774
   Engineering services and maintenance                    9,557            7,699                 396                  5,639
                                                         -------          -------               -----                -------
      Total revenues                                      25,363           16,021                 725                 10,413
                                                         -------          -------               -----                -------
Cost of revenues:                                                                                                    
   Product licensing                                         141              144                   5                    143
   Engineering services and maintenance                    7,974            6,123                 564                  5,111
                                                         -------          -------               -----                -------
      Total cost of revenues                               8,115            6,267                 569                  5,254
                                                         -------          -------               -----                -------
      Gross margin                                        17,248            9,754                 156                  5,159
                                                         -------          -------               -----                -------
Operating expenses:                                                                                                  
  Research and development                                 4,604            2,701                 127                  2,088
  Sales and marketing                                      3,732            2,746                 156                  2,142
  General and administrative                               2,915            2,546                 119                  1,293
                                                         -------          -------               -----                -------
      Total operating expenses                            11,251            7,993                 402                  5,523
                                                         -------          -------               -----                -------
Income (loss) from operations                              5,997            1,761                (246)                  (364)
Interest income (expense), net                             1,391              186                 (17)                  (176)
                                                         -------          -------               -----                -------
Income (loss) before income taxes                          7,388            1,947                (263)                  (540) 
Provision (benefit) for income taxes                       2,444           (2,500)                  7                     99 
                                                         -------          -------               -----                --------
      Net income (loss)                                  $ 4,944          $ 4,447               $(270)                $ (639) 
                                                         =======          =======               =====                ========
                                                                                                                             
Net income (loss) per common share                       $  0.47          $  0.90                                     $(0.24)
                                                         =======          =======                                    ========
Net income (loss) per common share -                                                                                         
  assuming dilution                                      $  0.42          $  0.46                                     $(0.24) 
                                                         =======          =======                                    ========
Weighted average common shares                                                                                               
  outstanding                                             10,608            4,964                                      2,664 
                                                         =======          =======                                    ========
Weighted average common shares                                                                                               
  outstanding and dilutive shares                         11,652            9,893                                      2,664 
                                                         =======          =======                                    ======= 
</TABLE>



    The following 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                                    TOTAL 
                                                   NUMBER OF                PAID-IN       DEFERRED      ACCUMULATED   STOCKHOLDERS'
                                                    SHARES       AMOUNT     CAPITAL     COMPENSATION      DEFICIT    EQUITY(DEFICIT)
                                                   ---------     ------     --------    ------------    -----------  ---------------
<S>                                                <C>            <C>       <C>         <C>             <C>          <C> 
Balances, December 31, 1994                        2,635          $ 3       $   235                        $(12,179)   $(11,941)
     Issuance of common stock for cash               202                        270                                         270
     Increase in redemption value of Series                                                                                  
       A and Series B Preferred Stock                                                                          (175)       (175)
     Decrease in redemption value of Series                                                                                     
       A Preferred Stock                                                        889                                         889
     Net loss                                                                                                  (639)       (639)
                                                  ------          ---       -------           -----        --------    --------
Balances, December 31, 1995                        2,837            3         1,394                         (12,993)    (11,596)
     Increase in redemption value of Series                                                                                    
       A and Series B Preferred Stock                                                                            (1)         (1)
     Net loss                                                                                                  (270)       (270)
                                                  ------          ---       -------           -----        --------    --------
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 shares 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
                                                  ======          ===       =======           =====        ========    ========
</TABLE> 

    The following 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,        MONTH ENDED     YEAR ENDED
                                                                              ----------------------    JANUARY 31,    DECEMBER 31,
                                                                                1998           1997        1996            1995
                                                                              --------       -------      ------          -------
<S>                                                                           <C>            <C>           <C>          <C> 
Cash flows from operating activities:
  Net income (loss)                                                           $  4,944       $ 4,447       $(270)         $  (639)
  Adjustments to reconcile net income (loss) to net cash provided (used)
    by operating activities
      Depreciation and amortization                                                832           488          15              203
      Amortization of securities                                                  (247)           -            -                -
      Amortization of deferred compensation                                         63           106           -                -
      Changes in operating assets and liabilities:
          Trade accounts receivable                                             (2,263)       (1,301)       (267)             735
          Unbilled receivables                                                  (1,023)         (118)        (34)            (200)
          Prepaid expenses and other current assets                               (639)         (151)          1               63
          Deferred income taxes                                                  1,106        (2,899)          -                -
          Other assets                                                             (27)            -           5             (241)  
          Accounts payable                                                         581           137          36             (117)
          Accrued wages                                                            354            88          29               24
          Accrued compensated absences                                             156            35         (42)              37
          Other current liabilities                                                 55           128         135             (231)
          Income taxes payable                                                     306           100           -                -
          Deferred rent                                                             (9)          (74)         (8)            (203)
          Deferred revenue                                                      (2,413)           20         (24)            (767)
                                                                              --------       -------      ------          -------
            Net cash provided (used) by operating activities                     1,776         1,006        (424)          (1,336)
                                                                              --------       -------      ------          -------
 
Cash flows from investing activities:
      Purchases of property and equipment                                       (3,239)       (1,105)        (38)             (47)
      Purchases of held-to-maturity securities                                 (24,244)            -           -                -
      Purchases of available-for-sale securities                                (2,992)       (2,000)          -                -
      Proceeds from held-to-maturity securities                                  7,000             -           -                -
      Purchase of software license                                                   -          (250)          -                -
                                                                              --------       -------      ------          -------
            Net cash used by investing activities                              (23,475)       (3,355)        (38)             (47)
                                                                              --------       -------      ------          -------
                                                                                                                                    
Cash flows from financing activities:
      Proceeds from issuance of common stock                                       407        26,295           -              270
      Proceeds from exercise of common stock options                               329           149           -                -
      Proceeds from issuance of convertible notes payable                            -             -           -            3,070
      Net payments on line of credit                                                 -             -           -           (1,095)
      Payments on obligations under capital leases                                   -          (655)          -              (71)
                                                                              --------       -------      ------          -------
            Net cash provided by financing activities                              736        25,789           -            2,174
                                                                              --------       -------      ------          -------
            Net (decrease) increase in cash and cash equivalents               (20,963)       23,440        (462)             791
Cash and cash equivalents, beginning of period                                  24,162           722       1,184              393
                                                                              --------       -------      ------          -------
Cash and cash equivalents, end of period                                      $  3,199       $24,162      $  722          $ 1,184
                                                                              ========       =======      ======          =======
</TABLE> 

    The following 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,          YEAR ENDED  
                                                                                --------------------      DECEMBER 31, 
                                                                                 1998          1997           1995
                                                                                ------       -------         ------    
<S>                                                                             <C>          <C>             <C> 
Supplemental disclosure of cash flow information:                                                          
  Cash paid during the year for:                                                                           
     Income taxes                                                                $ 151        $  321          $ 111
                                                                                ======       =======         ======
     Interest                                                                    $   -        $  250          $ 175
                                                                                ======       =======         ======
                                                                                                             
Supplemental schedule of noncash investing and finance activities:                                           
  Tenant improvements paid by the Company's landlord                             $ 213        $    -          $   -
                                                                                ======       =======         ======
  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          $ 175
                                                                                ======       =======         ======
  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          $ 366
                                                                                ======       =======         ======
  Deferred compensation related to stock option grants                           $   -        $  452          $   -
                                                                                ======       =======         ======
  Decrease in redemption value of Series A Preferred Stock                       $   -        $    -          $ 889
                                                                                ======       =======         ======     
</TABLE>

    The following 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. 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, as well as multifunction products which combine
printer, fax, copier and scanner capabilities.  The Company changed its fiscal
year end from December 31 to January 31, commencing February 1, 1996.  Upon the
closing of the Company's initial public offering in September 1996, the Company
reincorporated in the state of Delaware and changed the par value of its common
stock to $0.001 per share.

  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.

  Short Term Investments:

  The Company's investments at January 31, 1998 consisted of held-to-maturity
and available-for-sale U.S. government debt, corporate debt, and other debt
securities.  Investments at January 31, 1997 consisted entirely of other debt
securities and were classified as available-for-sale.

  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 interest income.

  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 over
estimated useful lives of 5-10 years, and over the lesser of the term of the
lease or the estimated useful life of leasehold improvements and assets under
capital leases. 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
operations.

                                      F-8
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



  Capitalization of Software Development Costs:

  The Company follows the working model approach to determine technological
feasibility of its products. Costs that are incurred subsequent to establishing
technological feasibility are immaterial and, therefore, the Company expenses
all costs associated with the development of its products as such costs are
incurred.

  Revenue Recognition:

  Development license revenue from the licensing of source code for the
Company's standard products to customers is recognized upon shipment and
customer acceptance. Recurring licensing revenue is recognized on a royalty
basis, generally when the Company's OEM customers ship or manufacture products
that incorporate Peerless' technology to their end-user customers.

  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.

  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 billing 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, "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.

                                      F-9
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



  Net Income (Loss) Per Common Share:

  Net income (loss) per common share ("basic EPS") is computed by dividing net
income available to common shareholders (the numerator) by the weighted average
number of common shares outstanding (the denominator) during the period.  The
computation of net income (loss) 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 8 to the Company's financial statements.


  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 10
to the Company's financial statements.

  Statements of Cash Flows:

  For purposes of the statements of cash flows, the Company considers all highly
liquid investments with a maturity of three months or less when purchased to be
cash equivalents.

  Reclassifications:

  Certain previously reported financial information has been reclassified to
conform to the current year's presentation.

  Future Developments:

  In October 1997, the American Institute of Certified Public Accountants issued
Statement of Position 97-2, "Software Revenue Recognition" ("SOP 97-2"), which
supersedes Statement of Position 91-1, "Software Revenue Recognition". SOP 97-2,
and amendments thereto, provide guidance on applying generally accepted
accounting principles in recognizing revenue on software transactions and is
effective for transactions entered into in fiscal years beginning after December
15, 1997. Retroactive application of the provisions of SOP 97-2 is prohibited.
Management is currently evaluating the requirements of SOP 97-2 and the impact
that adoption of SOP 97-2 will have on the financial statements of the Company.
Such adoption, however, may delay the timing of revenue recognition on certain
of the Company's contracts.

                                      F-10
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                        

  In June 1997, the Financial Accounting Standards Board ("FASB") issued
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130").  SFAS 130 establishes standards for reporting and display of
comprehensive income and its components in a full set of general-purpose
financial statements.  An enterprise that has no items of other comprehensive
income in any period presented is not required to report comprehensive income.
SFAS 130 is effective for fiscal years beginning after December 15, 1997 and may
require additional disclosures for all periods presented, however, it will not
impact the Company's reported amounts of net income (loss).

  In June 1997, the FASB issued Statement of Financial Accounting Standards No.
131, "Disclosures about Segments of an Enterprise and Related Information"
("SFAS 131").  SFAS 131 establishes standards for the way that public business
enterprises report information about operating segments in annual financial
statements and requires that those enterprises report selected information about
operating segments in interim financial reports issued to shareholders.  It also
establishes standards for related disclosures about products and services,
geographic areas, and major customers.  SFAS 131 is effective for fiscal years
beginning after December 15, 1997.  Management is currently evaluating the
requirements of SFAS 131 and the impact that adoption of SFAS 131 will have on
the financial statements of the Company.


2. INVESTMENTS:

<TABLE>
<CAPTION>
     Investments at January 31 consisted of the following:

                                                                        1998             1997
                                                                       -------          ------
<S>                                                                    <C>              <C> 
          HELD-TO-MATURITY SECURITIES:                                                  
               Maturities within one year:                                              
                   U.S. government debt securities                     $ 6,007          $    -
                   Corporate debt securities                             3,979               -
                   Certificates of deposit                               2,000               -
                                                                       -------          ------
                                                                        11,986               -
               Maturities after one year through five years:                            
                   U.S. government debt securities                       5,501               -
                                                                       -------          ------
                                                                        17,487               -
                                                                       -------          ------
          AVAILABLE-FOR-SALE SECURITIES:                                                
               Maturities within one year:                                              
                   Corporate debt securities                             2,996               -
               Maturities after ten years:                                              
                   Other debt securities                                 2,000           2,000
                                                                       -------          ------
                                                                         4,996           2,000
                                                                       -------          ------
                    Total investments                                  $22,483          $2,000
                                                                       =======          ======
</TABLE>


  The fair value of held-to-maturity securities at January 31, 1998 and 1997
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:

<TABLE>
<CAPTION>
  Property and equipment at January 31 consisted of the following:

                                                              1998                   1997
                                                       --------------         --------------
 
<S>                                                       <C>                    <C>
Computers and other equipment                                 $ 3,671                $ 2,682
Furniture                                                         182                    130
Leasehold improvements                                              3                     88
Construction-in-progress                                        1,795                      -
                                                       --------------         --------------
                                                                5,651                  2,900 
Less, accumulated depreciation                                                               
 and amortization                                              (1,225)                (1,235)
                                                       --------------         --------------
                                                              $ 4,426                $ 1,665
                                                       ==============         ==============
</TABLE>



  Depreciation for the years ended January 31, 1998 and 1997 and December 31,
1995 was $691, $426, and $203, respectively.


4. LINE OF CREDIT:

  The Company has a revolving bank line of credit which is collateralized by
substantially all of the assets of the Company.  The maximum amount available
under the line of credit is $2 million, of which up to $1 million can be used
for either term loans, letters of credit, or spot and future foreign exchange
contracts.  The interest rate on this line of credit is the bank's prime
interest rate plus 0.25% (an effective rate of 8.75% at January 31, 1998). Under
the terms of this agreement, which expires in May 1998, the Company is required
to maintain compliance with certain financial ratios (as defined in the
agreement), the most restrictive of which are a quick asset ratio of not less
than 3:1 and a debt to tangible net worth ratio of 0.5:1. The Company is also
required to report net income for each fiscal quarter. As of January 31, 1998,
the Company had no outstanding obligations under the line of credit.

                                        
5. 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.

                                      F-12
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



6. COMMITMENTS AND CONTINGENCIES:

  Operating Leases:

  The Company leases its offices and certain operating equipment under operating
leases that expire through 2007.

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

<TABLE>
<CAPTION>
              FOR THE YEARS          
            ENDING JANUARY 31,       
            ------------------       
            <S>                                        <C>
                   1999                                $  964
                   2000                                   960
                   2001                                   987
                   2002                                 1,006
                   2003                                 1,041
                Thereafter                              4,467
                                                       ------
                                                       $9,425
                                                       ======
</TABLE>


  Total rental expense was $881, $906, and $1,059 for the years ended January
31, 1998 and 1997 and December 31, 1995, respectively.

  Concentration of Credit Risk:

  At January 31, 1998 and 1997, the Company had cash and certificates of deposit
on deposit at banks that were in excess of federally-insured limits. The
aggregate excess amounts were $2,132 and $23,981, respectively.

  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 accounting loss, should a customer be
unable to meet its obligation to the Company, would be equal to the recorded
accounts receivable. At January 31, 1998 and 1997, three customers represented
64% and four customers represented 66% of total accounts receivable,
respectively.  For the years ended January 31, 1998 and 1997 and December 31,
1995, five customers represented 71% and  three customers represented 53% and
62% of total revenues, respectively.

  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 or
results of operations of the Company.

                                      F-13
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

7. INCOME TAXES:

  The income tax provision (benefit) consists of:


<TABLE>
<CAPTION>
 
                                                                                                           
                                                YEAR  ENDED JANUARY 31,                         YEAR ENDED    
                                         --------------------------------------                 DECEMBER 31,  
                                             1998                     1997                         1995       
                                         -------------           --------------               ----------------
<S>                                      <C>                     <C>                           <C>             
Current:
       Federal                                 $  786                 $     64                         $   -
       State                                      461                       15                             -
       Foreign                                     92                      320                            99
                                              --------               ----------                      -------- 
                                                1,339                      399                            99
                                              --------               ----------                      --------  
Deferred:
       Federal                                    887                   (2,151)                            -
       State                                      218                     (748)                            -
                                              --------               ----------                      -------- 
                                                1,105                   (2,899)                            -
                                              --------               ----------                      -------- 
                                               $2,444                  $(2,500)                        $  99
                                              ========               ==========                      ======== 
</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)
consist of:

<TABLE>
<CAPTION>
                                                               YEAR  ENDED JANUARY 31,                        YEAR ENDED    
                                                        --------------------------------------                DECEMBER 31,  
                                                            1998                    1997                        1995       
                                                       -------------           -------------                --------------- 
<S>                                                    <C>                      <C>                          <C>
Property and equipment                                      $ 125                   $  19                        $  (19)
Accrued liabilities                                           (58)                     13                           (42)
Allowance for doubtful accounts                                 -                     (43)                            -
Deferred revenue                                              698                     149                           332
Deferred expenses                                             (86)                     32                           (43)
State taxes                                                   (69)                    249                             -
Tax credit carryforwards                                      823                    (497)                         (253)
Net operating loss carryforwards                            1,315                     908                          (317)
Other                                                          (2)                    (20)                            3
                                                         ---------                --------                      --------
                                                            2,746                     810                          (339)
Change in valuation allowance                              (1,641)                 (3,709)                          339
                                                         ---------                --------                      --------
   Net deferred income tax provision (benefit)            $ 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>
                                                                      1998                       1997
                                                                  -------------              ------------- 
<S>                                                               <C>                         <C>
Deferred tax assets:
       Accrued liabilities                                            $  206                     $  147
       Allowance for doubtful accounts                                    43                         43
       Deferred revenue                                                1,175                      1,874
       Deferred expenses                                                 213                        127
       Tax credit carryforwards                                        1,274                      2,097
       Net operating loss carryforwards                                    -                      1,316
       Other                                                              22                         20
                                                                  -------------              ------------- 
              Total deferred tax assets                                2,933                      5,624
                                                                  -------------              ------------- 
Deferred tax liabilities:
       Property and equipment                                           (171)                       (46)
       State taxes                                                      (180)                      (249)
                                                                  -------------              ------------- 
               Total deferred tax liabilities                           (351)                      (295)
                                                                  -------------              ------------- 
       Subtotal                                                        2,582                      5,329
Valuation allowance                                                     (789)                    (2,430)
                                                                  -------------              ------------- 
               Net deferred income tax asset                          $1,793                    $ 2,899
                                                                  =============              =============
</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 differs from the amount that would
result from applying the federal statutory rate as follows:

<TABLE>
<CAPTION>
                                                                                                       
                                                              YEAR ENDED JANUARY 31,                  YEAR ENDED   
                                                            ----------------------------             DECEMBER 31,   
                                                              1998                1997                  1995        
                                                            ---------          ---------             ------------
<S>                                                         <C>                <C>                   <C>    
Statutory regular federal income tax rate                      34.0 %               34.0 %                (34.0)%
Foreign provision                                               1.2                 16.4                   18.3
Nondeductible expenses                                          0.4                  1.2                    3.2
State tax                                                       8.2                    -                      -
Foreign tax and research and experimentation credits             -                 (13.3)                 (23.4)
Change in valuation allowance                                 (12.3)              (168.2)                  55.7
Other                                                           1.6                  1.5                   (1.5)
                                                             --------            ---------               --------
       Provision (benefit) for income taxes                    33.1 %             (128.4)%                 18.3 %
                                                             ========            =========               ========
</TABLE>

                                      F-15
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



  As of January 31, 1998, the Company has research and experimentation credit
carryforwards for federal and state purposes of approximately $215 and $213,
respectively. The research and experimentation credits begin to expire in 2000
for federal purposes. The Company also has foreign tax credits of approximately
$789 for federal purposes, which begin to expire in 1998, and alternative 
minimum tax credit carryforwards for federal and state purposes of approximately
$42 and $15, respectively.


8.  NET INCOME (LOSS) PER COMMON SHARE:
     Net income (loss) per common share is calculated as follows:

<TABLE>
<CAPTION>
                                                              YEAR ENDED JANUARY 31,  
                                           -----------------------------------------------------------    YEAR ENDED DECEMBER 31, 
                                                      1998                           1997                          1995
                                           ----------------------------   ----------------------------   --------------------------
                                              NET             PER-SHARE    NET               PER-SHARE   NET              PER-SHARE 
                                            INCOME   SHARES    AMOUNT     INCOME    SHARES     AMOUNT    LOSS    SHARES     AMOUNT
                                            ------   ------    ------     ------    ------     ------    ----    ------     ------
<S>                                          <C>     <C>       <C>         <C>      <C>        <C>       <C>     <C>        <C>
BASIC EPS
Net income (loss) available to the common
    stockholders                            $4,944   10,608     $0.47     $4,447    4,964      $0.90     $(639)  2,664     $ (0.24)
                                                                =====                          =====                       =======
EFFECT OF DILUTIVE SECURITIES
Options                                        -      1,044                  -      1,729                  -       -
Warrants                                       -        -                    -        655                  -       -      
Convertible preferred stock                    -        -                    -      1,765                  -       -
7% convertible notes payable                   -        -                    143      780                  -       -
                                            ------   ------               ------    -----                -----    ----- 
DILUTED EPS
Net income (loss) available to common
    stockholders with assumed conversions   $4,944   11,652     $0.42     $4,590    9,893      $0.46     $(639)   2,664    $ (0.24)
                                            ======   ======     =====     ======    =====      =====     =====    =====    ======= 
</TABLE>

  Options to purchase 157 shares of common stock at $14.63 to $18.50 per share
were outstanding during the year ended January 31, 1998 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.  These options, which expire
in December 2006 and December 2007, were still outstanding at January 31, 1998.
All potentially dilutive securities were included in the calculation of diluted
EPS for the year ended January 31, 1997.  All potentially dilutive securities
were excluded from the computation of diluted EPS for the year ended December
31, 1995 because they would have an antidilutive effect on net loss per share.


9. 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.

                                      F-16
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



  Shares of Series A Preferred Stock were convertible into the Company's common
stock at a rate of $2.22 per share of common stock, subject to anti-dilution
adjustments. Conversion into the Company's common stock could occur at any time
at the holder's option, but would automatically occur upon the effective date of
a registration statement relating to a public offering of at least $10,000 of
the Company's common stock under the Securities Act of 1933.

  Holders of Series A Preferred Stock were entitled to a noncumulative annual
dividend of $0.18 per share, payable only when and as declared by the Board of
Directors out of legally available funds.

  Until October 1995, the Company was required to redeem all shares of Series A
Preferred Stock in three equal installments on June 1, 1997, 1998 and 1999 upon
the request of a majority of the holders of the outstanding Series A Preferred
Stock received prior to May 1, 1997. The redemption amount was based on $2.25
per share of Common Stock plus a redemption premium equal to $0.045 per share
times the number of calendar quarters that elapsed between March 31, 1991 and
the date of redemption. As a result of this provision for a redemption premium,
the Company recorded the incremental increases in Series A Preferred Stock and
charged the like amount to Accumulated Deficit.

  As a result of an amendment of the Company's Articles of Incorporation in
1995, the Series A Preferred Stock redemption dates were changed to June 1,
1999, 2000 and 2001, redeemable upon the request of a majority of the holders of
the outstanding Series A Preferred Stock received prior to April 1, 1999 and
consent of the holders of a majority of the then outstanding principal amount of
the Debentures (Note 5). All redemption premiums relating to Series A Preferred
Stock were retroactively eliminated. As a result of this amendment, $889 of
accumulated incremental increases to Series A Preferred Stock relating to
redemption premiums, including $150 and $200 recognized in 1995 and 1994,
respectively, was added to Additional Paid-In Capital and charged to Series A
Preferred Stock in 1995. The Company continued to accrete for the difference
between the carrying values and the redemption values of its Series A and B
Preferred Stock until September 1996.

  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.

  The Company's Series B Preferred Stock had substantially the same rights,
privileges and restrictions as those of Series A Preferred Stock. Shares of
Series B Preferred Stock were convertible into the Company's common stock at a
rate of $2.30 per share of common stock, subject to anti-dilution adjustments,
and would also automatically convert into common stock upon the effective date
of a registration statement relating to a public offering of at least $10,000 of
the Company's common stock under the Securities Act of 1933.

  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 of the Company's common stock, respectively.

                                      F-17
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                        


10. 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.

  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 under the nonstatutory option plan:


<TABLE>
<CAPTION>

                                                               YEAR ENDED JANUARY 31,                   
                                                -----------------------------------------------            YEAR ENDED 
                                                          1998                    1997                  DECEMBER 31, 1995
                                                ----------------------     --------------------       -----------------------    
                                                              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              22        $0.50            65      $0.52              88          $0.43
Options exercised                                    (20)       $0.53           (42)     $0.53             (13)         $0.20
Options forfeited                                      -                         (1)     $0.53             (10)         $0.42
                                                   ------                   --------                   -------- 
Options outstanding at end of year                     2        $0.20            22      $0.50              65          $0.52
                                                   ------                   --------                   -------- 
Options exercisable at year-end                        2        $0.20            22      $0.50              46          $0.52
                                                   ======                   ========                   ======== 
Options available for future grant                     -                          -                                         -
                                                   ======                   ========                   ======== 
Weighted average remaining contractual
  life in years                                        2
                                                   ======   
Per share exercise prices for options
   outstanding at year-end                          $0.20
                                                   ======     
</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.

                                      F-18
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                        


  The following represents option activity under the 1992 Stock Option Plan:


<TABLE>
<CAPTION>
                                                              YEARS ENDED JANUARY 31,                                    
                                              ------------------------------------------------------          YEAR ENDED 
                                                         1998                           1997              DECEMBER 31, 1995
                                              -------------------------      -----------------------    ---------------------
                                                              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             810        $1.36           774          $1.26         309        $0.92
Options granted                                        -                        188          $1.65         503        $1.43
Options exercised                                   (120)       $1.07          (100)         $1.19          (3)       $0.66
Options forfeited                                     (7)       $1.02           (52)         $1.22         (35)       $0.73
                                             -----------                       ----                     ------
Options outstanding at end of year                   683        $1.41           810          $1.36         774        $1.26
                                             ===========                       ====                     ======    
Options exercisable at year-end                      340        $1.33           301          $1.16         162        $0.88
                                             ===========                       ====                     ======
Options available for future grant                     -                          -                        277
                                             ===========                       ====                     ======
Weighted average remaining contractual       
life in years                                          8
                                             ===========
Range of per share exercise prices for       
      options outstanding at year-end        $0.53-$1.65
                                             ===========
</TABLE>


  In May 1996, the Board adopted the Company's 1996 Stock Option Plan (the
"1996 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. The Board has authorized and reserved an
aggregate of 1,267 shares of common stock 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.

                                      F-19
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                        


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

<TABLE>
<CAPTION>
                                                                                1998                       1997
                                                                         ---------------------    ----------------------
<S>                                                                      <C>         <C>          <C>          <C>
                                                                                     WEIGHTED                  WEIGHTED
                                                                                      AVERAGE                   AVERAGE
                                                                                     PER SHARE                 PER SHARE
                                                                         NUMBER OF    EXERCISE    NUMBER OF     EXERCISE
                                                                          OPTIONS      PRICE       OPTIONS        PRICE
                                                                         --------    ---------    ----------    ---------
Options outstanding at beginning of year                                      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     245       $14.83           141       $10.74
Options exercised                                                             (46)      $ 3.47            (8)      $ 3.30
Options forfeited                                                             (38)      $ 9.01           (20)      $ 3.48
                                                                             ----                       ----
Options outstanding at end of year                                            799       $ 8.61           638       $ 5.09
                                                                             ====                       ====               
Options available for future grant                                            415                        621
                                                                             ====                       ====
</TABLE>

  For various price ranges, weighted average characteristics of outstanding
stock options at January 31, 1998 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 $ 4.95                                  414                  9               $ 3.30                     80       $ 3.30
$8.25 to $12.38                                  144                  9               $10.22                     26       $ 9.99
$2.39 to $18.50                                  241                  9               $15.26                      8       $16.36
 
</TABLE>


  During the year ended January 31, 1997, the Company recognized deferred
compensation expense 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 $63 and $106 as compensation expense during the twelve months
ended January 31, 1998 and 1997, respectively. The remaining deferred
compensation expense will be amortized over the remaining vesting periods of the
options, which range from 15 to 63 months.

                                      F-20
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


  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 72.55% for the year ended
January 31, 1998 and 65.2% for the years ended January 31, 1997 and December 31,
1995 and risk free interest rates ranging from 5.75% to 7.25% for the year ended
January 31, 1998 and 7.0% for the years ended January 31, 1997 and December 31,
1995, respectively. 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 $10.83, $3.94, and $0.99 for the years ended January 31, 1998 and 1997 and
December 31, 1995, 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, 1998 and December 31, 1995. 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.

<TABLE>
<CAPTION>
                                                       YEAR ENDED JANUARY 31,               YEAR ENDED              
                                              -----------------------------------          DECEMBER 31,  
                                                   1998                 1997                  1995       
                                              -------------         -------------         -------------   
<S>                                           <C>                    <C>                   <C>
Net income (loss) as reported                   $  4,944              $  4,447               $   (639)
                                               ===========           ===========           ============
Proforma net income (loss)                      $  3,794              $  3,710               $   (776)
                                               ===========           ===========           ============          
Net income (loss) per share as reported:
      Basic                                     $   0.47              $   0.90               $  (0.24)
                                               ===========           ===========           ============
      Diluted                                   $   0.42              $   0.46               $  (0.24)
                                               ===========           ===========           ============
Proforma net income (loss) per share:
      Basic                                     $   0.36              $   0.78               $  (0.29)
                                               ===========           ===========           ============
      Diluted                                   $   0.33              $   0.39               $  (0.29)
                                               ===========           ===========           ============
</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.

                                      F-21
<PAGE>
 
                          PEERLESS SYSTEMS CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (Continued)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


                                        
  During the year ended January 31, 1998, employees purchased 26 shares of
common stock at a weighted average per share price of $10.88.  The Company
applies APB Opinion 25, "Accounting for Stock Issued to Employees," and related
interpretations to account for the Purchase Plan.  Accordingly, $105 and $73 in
compensation expense related to this plan was charged to income for the years
ended January 31, 1998 and 1997, respectively.  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, pro forma net income (loss) per
share would not differ from the reported amounts for all periods presented.


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, 1998 and 1997 and December 31, 1995 were $192, $0 and $0,
respectively.


12. RELATED PARTIES:

  During the years ended January 31, 1997 and December 31, 1995, the Company
recognized revenues of $2,244 and $707 respectively, from transactions with a
shareholder. At January 31, 1997, the Company had $894 of deferred revenue
relating to license fees prepaid by this related party. Included in accounts
receivable at January 31, 1997 is $288, due from this related party. As of
January 31, 1998, this former related party was no longer a shareholder of the
Company.


13. INTERNATIONAL OPERATIONS:

  The Company's revenues, which are transacted in U.S. dollars, are derived from
the following geographic regions:

<TABLE>
<CAPTION>
                                          YEAR ENDED JANUARY 31,           YEAR ENDED      
                                    ------------------------------         DECEMBER 31,    
                                         1998              1997               1995        
                                    ------------      ------------        -------------   
<S>                                  <C>                 <C>                <C>            
United States                        $ 13,620            $  9,890            $  6,139           
Japan                                  11,726               5,978               4,221          
Other                                      17                 153                  53          
                                    ----------          ----------          ----------    
                                     $ 25,363            $ 16,021            $ 10,413           
                                    ==========          ==========          ==========    
</TABLE>                                                                 
                                                                         
                                     F-22
                                                                         
                                                                         
<PAGE>
 
                       REPORT OF INDEPENDENT ACCOUNTANTS


To the Board of Directors and Stockholders
Peerless Systems Corporation

Our report on the financial statements of Peerless Systems Corporation is
included on page F-2 of this 1998 Annual Report filed on Form 10-K. In
connection with our audits of such financial statements, we have also audited
the related financial statement schedule listed in the index on page 30 of this
Form 10-K.

In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information required to be
included therein.


Coopers & Lybrand L.L.P.

Newport Beach, California
March 12, 1998

                                      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 December 31, 1995
Reserves deducted from assets to which they apply:
  Allowance for uncollectible accounts receivable       $      -          $       -           $   -              $       -
 
Month Ended January 31, 1996
Reserves deducted from assets to which they apply:
  Allowance for uncollectible accounts receivable       $      -          $       -           $   -              $       -
 
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
</TABLE> 
-----

(a)   Accounts written off, net of recoveries

                                      S-2
<PAGE>
 
                               INDEX TO EXHIBITS
<TABLE> 
<CAPTION>                                         
Exhibit
Number
------
<S>           <C> 
3.1(1)        Certificate of Incorporation of the Company.
3.2(1)        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(1)        Amended and Restated Investor Rights Agreement dated October 6,
              1995.
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"), 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
10.17(1)      Amended and Restated Investor Rights Agreement, dated October 6,
              1995
10.18(1)(2)   Employment Agreement with Lauren Shaw
10.19(1)(2)   Employment Agreement with Edward Gavaldon
10.20         Second Amendment to Office Lease dated April 8, 1997 between the
              Company and Continental Development Corporation
10.21         Third Amendment to Office Lease dated December 16, 1997 between
              the Company and Continental Development Corporation
23.1          Consent of Coopers & Lybrand L.L.P.
24.1          Power of Attorney. Reference is made to page 32.
27.1          Financial Data Schedule.
27.2          Financial Data Schedule.
27.3          Financial Data Schedule.
27.4          Financial Data Schedule.
27.5          Financial Data Schedule.
27.6          Financial Data Schedule.
</TABLE> 
__________
(1) Incorporated by reference from the indicated exhibit in the Company's
    Registration Statement on Form S-1 (File No. 333-09357), as amended.
(2) Management contract or compensatory plan or arrangement.
(3) Subject to Confidential Treatment Order.