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

                                    FORM 10-K

(Mark One)
(X)    Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
       Act of 1934 [FEE REQUIRED] 
       For the fiscal year ended December 31, 1997.    
       OR
(  )   Transition Report Pursuant to Section 13 or 15(d) of the Securities
       Exchange Act of 1934 [FEE REQUIRED]

For the transition period from __________________ to _________________

Commission File Number: 0-18280
                        -------

                           DIGITAL SOUND CORPORATION
                   -----------------------------------------
            (Exact name of Registrant as specified in its charter)

        California                                     95-3222624
-------------------------------                     ----------------
(State or other jurisdiction of                     (I.R.S. Employer)
incorporation or organization)                      Identification No.)

6307 Carpinteria Avenue, Carpinteria, California         93013
------------------------------------------------    ----------------     
   (Address of principal executive offices)            (Zip Code)


                                (805) 566-2000
             ---------------------------------------------------
             (Registrant's telephone number, including area code)


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

                                     None
                                     ----

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

                           Common Stock, no par value
                           --------------------------        
                                (Title of class)

Indicate by check mark whether 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 (229.405 of this chapter) 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 aggregate market value of Registrant's voting stock held by non-affiliates
of the Registrant as of January 22, 1998 was approximately $28,967,294

The number of shares outstanding of Registrant's common stock as of January 22,
1998: 20,561,593.


Documents Incorporated by Reference:
------------------------------------

Part of the following document is incorporated by reference to Part III of the
Form 10-K Report: Proxy Statement for Registrant's 1998 Annual Meeting of
Stockholders (the "1998 Proxy Statement").
<PAGE>
 
                            DIGITAL SOUND CORPORATION
                           Annual Report on Form 10-K
                                December 31, 1997

                                TABLE OF CONTENTS

                                     

<TABLE>
<CAPTION>
                                                    PART I                                               
                                                                                                             Page
                                                                                                             ----
<S>                                                                                                          <C>
Item 1.             Business..............................................................................    1
Item 2.             Properties............................................................................    7
Item 3.             Legal Proceedings.....................................................................    7
Item 4.             Submission of Matters to a Vote of Security Holders...................................    8
                    Executive Officers of the Registrant..................................................    9

                                                    PART II

Item 5.             Market for Registrant's Common Equity and Related Stockholder Matters.................   10
Item 6.             Selected Financial Data...............................................................   11
Item 7.             Management's Discussion and Analysis of Financial Condition and
                    Results of Operations.................................................................   12
Item 8.             Financial Statements and Supplementary Data...........................................   17
Item 9.             Changes in and Disagreements with Accountants on Accounting and
                    Financial Disclosure..................................................................   28

                                                    PART III

Item 10.            Directors and Executive Officers of the Registrant....................................   29
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............................   29

Signatures    ............................................................................................   31
</TABLE>
--------------------

Trademarks - Digital Sound(R), VoiceServer(R), VoiceForms(R), MessageNet(R),
UNIVOX(R), InfoMail(R) are registered trademarks of the Company. UNIX(R) is a
registered trademark of Novell Inc. Ethernet(TM) is a trademark of Xerox
Corporation. MediaCom(TM) is a trademark of Bellcore. Windows NT(R) is a
registered trademark of Microsoft Corporation. VoiceView(R) is a registered
trademark of Radish Communications Systems, Inc.
<PAGE>
 
                                    PART I

IN ADDITION TO HISTORICAL INFORMATION, THIS ANNUAL REPORT CONTAINS CERTAIN
FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S
ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS DISCUSSED IN THE
FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH
DIFFERENCE INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED IN THE SECTION
ENTITLED "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS -- FACTORS THAT MAY AFFECT FUTURE RESULTS." READERS SHOULD
CAREFULLY REVIEW THE RISK FACTORS DESCRIBED IN OTHER DOCUMENTS THE COMPANY FILES
FROM TIME TO TIME WITH THE SECURITIES AND EXCHANGE COMMISSION, INCLUDING THE
QUARTERLY REPORTS ON FORM 10-Q AND ANY CURRENT REPORTS ON FORM 8-K.

ITEM 1.   BUSINESS
          --------

Digital Sound Corporation, a California corporation, designs, manufactures and
markets high-capacity, network-based enhanced services solutions. The Company
has two product lines, the new product line and the existing product line. The
new product line is the PulsePoint(TM) Enhanced Application Platform and
Communication-Management Suite of Applications and is sold to telecommunications
network service providers, worldwide. The existing product line is the
VoiceServer(R) Family of Multimedia Messaging Products and is sold to
telecommunications network service providers and large corporations, worldwide.
Both the PulsePoint Enhanced Application Platform and Applications and
VoiceServer(R) products integrate voice, fax and e-mail messaging applications
on a single platform for implementation with telephony and data networks to
enable Unified Messaging. Unified Messaging enables senders to send and receive
messages using telephones, cellular phones, fax machines or screen-based
devices, such as desktop or portable personal computers. The PulsePoint Enhanced
Application Platform functions in a traditional voice/fax, data and
computer/telephony environment. The VoiceServer(R) platform functions in a
traditional voice/fax environment.

The Company sells its products primarily into the public service provider market
and secondarily into the customer premises equipment (CPE) market through a
variety of channels. These channels include direct and indirect sales.
Complementing a direct sales effort, the public enhanced services markets are
served by indirect channels, including original equipment manufacturers (OEMs)
and value added resellers (VARs). Indirect distributor channels serve the CPE
market.

The public service provider market includes a broad array of established and
emerging carriers that provide voice and data services to business and
residential customers. These providers offer enhanced application services to
increase adoption, to reduce churn of their customer base and to provide
strategic differentiation of their basic services.

These enhanced services are comprised of communication-management applications,
which include voice, fax and e-mail messaging, and are provided using enhanced
services solutions located at or connected to the telephone company's central
switching offices or voice/data access servers. The CPE market encompasses
communication-management applications, which include voice and fax messaging, in
which the voice messaging system is installed on the customer's premises and is
integrated with the customer's private branch exchange systems.

On December 19, 1997, the Company consummated a private placement of the
Company's convertible securities with certain investors (collectively, the
"Investors") for an aggregate of approximately $20 million pursuant to a
Preferred Stock Purchase Agreement (the "Purchase Agreement"). Pursuant to the
Purchase Agreement, the Company (i) sold for cash (A) 1,785,000 shares of the
Company's Series B Convertible Preferred Stock and (B) $6,612,502.50 aggregate
principal amount of the Company's Convertible Promissory Notes (the "Notes" and
together with the Series B Convertible Preferred Stock, the "Securities") and
(ii) exchanged the 2,631,579 shares of Series A Convertible Preferred Stock held
by affiliates of Oak Investment Partners ("Oak") for 666,667 shares of the
Series B Convertible Preferred Stock. Each share of Series B Convertible
Preferred Stock is convertible into 10 shares of Common Stock, subject to
certain antidilution adjustments. The Notes were issued because the Company did
not have an adequate number of shares of the underlying Common Stock authorized
to permit the conversion of the entire $20 million of Series B Convertible
Preferred Stock. The Company sold the Securities at a price of $0.75 per share
of Common Stock on an as-converted basis. The Notes automatically convert into
the Series B Convertible Preferred Stock if the Company's shareholders approve
an amendment to the Company's Ninth Amended and 
<PAGE>
 
Restated Articles of Incorporation authorizing a sufficient number of shares of
Common Stock to permit conversion of all of the Series B Convertible Preferred
Stock issuable upon conversion of the Notes ("Shareholder Approval"). Such
amendment is being submitted to the Company's shareholders for approval at the
Company's 1998 annual meeting. One of the Investors was Microsoft Corporation,
which purchased an aggregate of $5 million of the Securities. Affiliates of Oak
also purchased an aggregate of $5 million of the Securities.
<PAGE>
 
PRODUCTS

The Company's products use a common architecture, design and technology and
common hardware and software. The PulsePoint Enhanced Application Platform is
based on Microsoft(R)'s Windows NT(R) Server operating system, other Microsoft
technologies, products from Dialogic Corporation and a variety of other
technology providers. The platform is a highly-available, scalable, open-system
platform with an application development environment using state-of-the-art
computer industry solutions to enable rapid creation of integrated services.
Accompanying the platform is a Communication-Management Suite of Applications
that help end users communicate more effectively during real-time and
non-real-time communications.

The VoiceServer(R) is a single-unit, multimedia, and multiple-application
platform. Its single-system design allows multiple applications to share
resources, including ports, storage and digital signal processors. This fully
integrated design enables new applications to be added efficiently, while
reducing system costs. Since the VoiceServer(R) is completely self-contained,
downtime is reduced, reliability is increased, and ease of service is enhanced.

Hardware Products

The Company's PulsePoint Enhanced Application Platform is comprised of third
party, open-system hardware and software components, which are combined with the
company's proprietary middleware software. This platform is designed for the
messaging needs of small- to large-sized public service providers and resellers.
Its architecture supports a wide variety of port capacities from tens to
thousands of ports.

The Company's VoiceServer(R) family of products includes the following hardware
platforms:

VoiceServer(R) 2110 - Designed for the messaging needs of medium- to large-sized
organizations and the voice and fax messaging needs of small- to medium-sized
independent telephone companies ("telcos") and service bureaus. It supports up
to 25,000 mailboxes and provides from 8 to 120 voice ports.

VoiceServer(R) 3110 - Designed specifically for the unified messaging needs of
large-sized telco central offices, it supports up to 50,000 mailboxes and
provides up to 240 voice ports.

Software Products and Applications

The Company's new software products offer a spectrum of features, including
voice and fax messaging, call processing and call delivery. These applications
are written to run on Microsoft's Windows NT Server operating system using
Microsoft's Visual Studio integrated with Digital Sound's application creation
tools.

The Company currently has the following software applications available:

PulsePoint Messaging Application -- PulsePoint Messaging Application provides
messaging services for public enhanced services markets such as Competitive
Local Exchange Carriers and Internet Service Providers. A completely new
implementation, it includes flexible administration, a high-performance
object-oriented database for subscriber data and D/COM interfaces. It is a
highly flexible implementation that will allow the Company to meet the
requirements of service providers as they address the needs of their customers.

The Company's existing software products offer a spectrum of features, including
voice, fax and e-mail messaging, call processing, call delivery and audiotex
services. In addition, the Company offers enhanced speech technology products,
such as name-to-speech and speaker-independent recognition. These applications
are written for the UNIX System V operating system with proprietary extensions
(together called UNIVOX(R)) which provides voice, fax and e-mail processing,
multi-tasking capabilities and real-time processing extensions in a single
package.

InfoMail(R) 4.0 -- InfoMail is the Company's full-featured voice/fax messaging
product for CPE and public enhanced services markets. It includes advanced voice
mail features and offers flexible administration. InfoMail serves as a platform
for storing and retrieving voice and fax messages. InfoMail offers integrated
fax messaging, on-line tutorial, guest mailboxes, scheduled future delivery of
messages up to one year in advance, non-delivery notification, name delivery, a
personal reminder interface for users, user programming of calls to other
extensions and group distribution lists.
<PAGE>
 
Fax Mail -- Integrated with the InfoMail application, fax mail lets users access
a single mailbox for receiving and forwarding fax messages, allowing the user to
control when, where and how faxes are received. Voice comments can be "attached"
as a "voice cover sheet" and deposited as a single mixed-media message in the
subscriber's mailbox.
<PAGE>
 
Fax Overflow -- Integrated with the InfoMail application, this application
allows VoiceServer(R) to intercept incoming faxes when the receiving fax machine
is busy or out of service, storing them until the machine becomes available, and
then delivering to the fax machine.

Hands-Free Operation -- The Hands-free feature is provided as an InfoMail
software option. It allows users to save or delete new messages through the use
of spoken commands. It is especially convenient for cellular users.

Spoken Password -- Spoken password is an InfoMail feature that allows
subscribers to access their voice mailboxes by speaking passwords rather than
using touch-tone key presses.

InfoMail Express(TM) -- InfoMail Express integrates Internet e-mail with the
InfoMail multimedia platform to provide full unified messaging for the public
enhanced services market, and extends the unified messaging services of InfoMail
to personal computers. With InfoMail Express, users of personal computers
running Microsoft's Windows 95 and Internet Explorer can visually access
mailboxes on InfoMail Express to review voice, fax and e-mail messages.

MessageNet(R) -- The MessageNet option of InfoMail is the first high-speed
digital networking software for voice mail that is based on X.400, the industry
standard for message exchange. X.400 was selected because it supports the
transmission of voice, fax and e-mail. MessageNet provides the complete InfoMail
feature set, including real-time address confirmation of up to one million
users.

Inter-Vendor Networking -- These options provide the industry-standard protocols
for digital and analog transmission of messages among voice messaging systems
from different vendors. Audio Messaging Interchange Specification (AMIS)
networking allows for message exchange between remote VoiceServer(R)s and any
manufacturer's voice messaging system that utilizes the AMIS protocol.

CallController(TM) -- CallController provides call-processing capabilities,
which allow callers to route their calls to a specific destination by listening
to voice menus and entering responses on a telephone keypad. When integrated
with InfoMail, the caller can leave a voice message when encountering a busy
line or no answer when dialing an extension. As a flexible call processing and
audiotex application, CallController enables companies to program various
greetings.

VoiceForms(R) -- VoiceForms is an option to InfoMail that permits customers to
create and complete forms using the telephone. Like written forms, the
VoiceForms option asks specific questions and provides "electronic space" for
either voice or touch-tone key press responses. VoiceForms prompts callers to
leave necessary information, such as purchasing data and sales contact reports.
Completed VoiceForms are stored as voice messages for later transcription and
compilation.  VoiceForms can also be used to provide information to callers,
such as job openings on a "voice" bulletin board.

Audiotex/Bulletin Boards -- This application allows companies to combine
InfoMail, CallController and VoiceForms to create voice information lines that
provide information, such as hours of operation, job postings, and directions,
among others.

The following application enablers are available as a part of the Company's
VoiceServer(R):

Voice Development Server (VDS) -- VDS is a software tool-kit designed to aid
VARs and OEMs in the development of customized voice and fax applications. VDS
is well suited for developers because it allows them to take advantage of the
flexible UNIX operating environment to build voice and fax applications in a
high-level programming language.

Speaker-Dependent Speech Recognition -- This application enables developers to
create applications that use spoken input instead of touch-tone key press. Used
in applications that require security, it is used in InfoMail to allow users to
speak a password to access their voice/fax mailbox. It can be used for
voice-controlled transcription of VoiceForms in which users direct the system
with verbal commands rather than by touch-tone key presses, leaving hands free
for word processing. This capability simplifies the transcription task and
increases user productivity.

Speaker Verification -- Speaker Verification is a form of speaker-dependent
recognition that confirms the identity of a speaker. The spoken password of a
caller is analyzed using complex algorithms within the 
<PAGE>
 
system, which validate or reject the password, offering an additional level of
security in voice messaging and call processing applications.

Speaker-Independent Speech Recognition -- This enables developers to create
applications that allow users to respond to prompts with spoken "yes/no"
commands instead of touch-tone key presses. It is used with InfoMail's
Hands-Free interface for cellular phone users. It is used in Directory
Assistance (411) applications that offer "call completion" when they respond
"yes" or "no".

Continuous Speaker-Independent Recognition of Digits 0-9 -- This enables
developers to create applications that use spoken input instead of touch-tone
key presses. It is used for applications such as voice-activated dialing and
credit card and personal identification number collection. It does not require
speakers to pause between spoken numbers.

Name-to-Speech -- This converts text names into computer-synthesized speech.
Digital Sound has developed special algorithms to optimize the pronunciation of
proper names across a wide range of ethnic backgrounds. Name-to-speech
technology is used in InfoMail Express to speak the name of an e-mail sender
over the telephone. It can be used to provide spoken name confirmation to a
voice mail subscriber sending a message to a subscriber on a remote, networked
system.

MessageExpress(TM) -- This sophisticated protocol is designed to run over
various wireline and wireless protocols, such as TCP/IP, ISDN, VoiceView, and
X.25. Client software that resides on a personal computer, which communicates
with InfoMail Express server using the MessageExpress protocol.

SmartAnswer(TM) -- Digital Sound's patent-pending digital signal processing
(DSP) technology automatically determines whether an incoming call is from a
telephone, fax machine or computer and provides the appropriate response--voice
prompts, fax tone or remote log-in, respectively. This capability is used for
one-number deposit and retrieval of unified messages.

Datacom Interfaces

The Company provides the data communications interfaces listed below for the
PulsePoint Enhanced Application Platform and Communication-Management Suite of
Applications. These interfaces enable the PulsePoint Platform to work in
conjunction with a variety of data packet and circuit-switched networks.

      .  TCP/IP -- A communications protocol for internetwork routing and
         reliable message delivery.

      .  SNMP -- An open-network management surveillance protocol.

      .  Protocols supported by Dialogic's DM3(TM) Quad Voice Span products

The Company provides the data communications interfaces listed below for the
VoiceServer(R) product family. These interfaces enable the VoiceServer(R) to
work in conjunction with a variety of data processing and office automation
systems.

      .  RS232 -- An industry-standard mechanical and electrical interface for
         computers and communications line and devices.

      .  Ethernet -- A standard for high-speed data communications over a local
         area network.

      .  X.400 -- An industry standard for electronic message exchange, which
         the Company has adapted for voice mail networking.

      .  TCP/IP -- A communications protocol for internetwork routing and
         reliable message delivery.

      .  SMTP -- A standard protocol for transferring electronic mail messages
         from one computer or network to another. Simple Mail Transfer Protocol
         specifies how two mail systems interact and the control message format
         they use to transfer mail.


SWITCH INTEGRATIONS

The Company's existing systems have been integrated with most major telephone
switching systems, including systems offered by Lucent Technologies Inc.,
Ericsson Inc., GTE Corporation, NEC Corporation, 
<PAGE>
 
Northern Telecom Limited, Intecom, ROLM, a division of Siemens AG (ROLM), and
Siemens AG, Public Communication Networks Group. The Company's systems are also
compatible with most major central office switches, including those manufactured
by Lucent Technologies Inc., Ericsson, Inc., GTE Corporation, Motorola, Inc. and
Northern Telecom Limited.


1997 PRODUCT DEVELOPMENT

To further strengthen its product line, the Company continued to incorporate new
hardware and software technologies into the VoiceServer(R) product line.

During 1997 the Company continued development of an entirely new enhanced
application platform and applications for public enhanced services markets.

The Company continued to invest in upgrading the skills of the engineering
organization. The Company's engineering and development group included 54
employees at December 31, 1997. During the years ended December 31, 1995, 1996
and 1997 the Company spent approximately $7.2 million, $8.9 million and $12.2
million, respectively, on engineering and development. To date, all of the
Company's engineering and development expenses, including software development
costs, have been charged to operations as incurred.

1998 PRODUCT DEVELOPMENT OUTLOOK

In 1998, the Company will focus development activities on adding to its new
product offerings. Specific focus will be on leveraging the rapid application
tools to round out the applications in its Communication-Management Suite of
Applications.


QUALITY ASSURANCE AND MANUFACTURING

Digital Sound satisfies the requirements of one of the most rigorous
international quality standards, ISO 9001, as indicated by the 1995 registration
to ISO 9001 of its company-wide quality management system. The ISO 9000 series
of standards represents an international consensus on the essential features of
a quality system to ensure the effective operation of any business, and more
than 90 countries have adopted the ISO 9001 series as national standards. There
have also been two large regional adoptions, CEN (European Committee for
Standardization) and COPANT (the Pan-American Standards Commission). The Company
believes its certification to the most stringent level of the series (9001)
provides significant competitive advantage, and the quality management system
implemented in support of the certification effort ensures that procedures are
implemented and responsibilities defined to provide all employees with the
ability to pursue continuous quality improvement in meeting customer
requirements.

Quality First, the Company's Total Quality Management program, was initiated in
1991 and has continued to provide improved performance and enhancement of the
quality levels of the Company's products and services. The program has been
extended to include major customers through the Partnering for Quality Program.

The Company's manufacturing operations consist principally of final assembly and
testing of subassemblies and systems. The Company uses independent manufacturers
to perform printed circuit board assembly, building of cabinets and
subassemblies and sheet metal fabrication. These suppliers all satisfy the
strictest quality standards such as ISO or MIL-SPEC. Although the Company
generally uses standard parts and components in manufacturing its products,
certain components, primarily power supplies, disk drives, interface cards and
certain semiconductors are presently available only from a single source or from
limited sources. To date, the Company has been able to obtain adequate supplies
of these components in a timely manner from existing sources. However, delay or
lack of supply from existing sources or the inability to develop alternative
sources, if and as required in the future, could adversely affect the Company's
operating results.

At December 31, 1997, the Company's quality assurance and manufacturing group
included 19 employees.

CUSTOMER SUPPORT, SALES AND MARKETING
<PAGE>
 
The Company sells its products into the public enhanced services market and the
CPE market. The enhanced services market consists of local exchange carriers,
including the Regional Bell Operating Companies ("RBOCs"), Post Telephone and
Telegraphs ("PTT's", providers of telephone and telecommunications services in
most foreign countries), independent telephone companies, service bureaus,
inter-exchange carriers, cellular service providers and internet service
providers. The Company has distribution agreements with Siemens, AG of Germany,
GPT Limited of Coventry, England, and Consultronix Systems Corporation of the
Philippines, PT Galva of Indonesia, Intecom and Volt-Delta. The CPE market
consists of major corporations, such as Southern Pacific/Union Pacific Railroad,
Baxter Health Care, the Discovery Channel, Gordon Foods, The Boston Herald,
Polaroid and Motorola. It also consists of state and local governments, such as
the County of Los Angeles, County of Riverside and the State of Oregon and
universities such as the University of California campuses at Berkeley, San
Diego and Santa Barbara. To date, over 1,895 systems have been sold to customers
in the United States, Canada, the United Kingdom, France, the Dominican
Republic, Indonesia, Mexico, Malaysia, Russia, and the Philippines.

Customer service and support are of great importance to the Company. The Company
believes that customer satisfaction is achieved through continued high levels of
quality service and support. The Company's customer support group includes field
engineers, applications specialists, implementation specialists and third party
maintenance providers and is supported by a training staff and the Company's
entire technical staff when necessary. The Company maintains a 24-hour service
and support center at its Carpinteria facility. The Company has an extensive
field service organization with offices strategically located throughout the
United States to provide on-site emergency assistance should the need arise.
Most customers' problems are resolved over the telephone by remote diagnostic
and corrective actions.

The Company maintains a training center at its Carpinteria facility to support
the needs of its customers for instructional, administrative and technical
training. Additionally, the Company maintains a staff of highly qualified
trainers available to support customers' requests for on-site training at all
levels. Prior to equipment delivery, training and implementation, personnel are
made available to the customer to ensure a smooth installation, with follow-up
visits performed to reinforce previous training and answer new questions. The
training organization also offers technical software, system maintenance,
customer support and administrative courses. The Company's customer support,
sales and marketing group included 66 employees at December 31, 1997.

During the year ended December 31, 1995, GTE and Pacific Bell Information
Services Group accounted for 46.8% and 12.6%, respectively, of the net sales for
the Company. During the year ended December 31, 1996, GTE; PT Galva, Indonesia
and GPT, England accounted for 39.8%, 13.3% and 10.5%, respectively, of the net
sales for the Company. During the year ended December 31, 1997, GTE accounted
for 58.3% of the net sales for the Company.

Export sales, principally to Canada, Europe and Indonesia, during the years
ended December 31, 1995, 1996 and 1997 accounted for 1.6%, 26.0% and 5.3%,
respectively, of the Company's net sales. The percentage decrease in export
sales for 1997 was principally a result of the uncertainties surrounding the
Asian economies.

These sales depend on the Company's continued ability to meet agreed milestones,
specifications, requirements and conditions of sales contracts in a timely
manner. The Company's goal is to meet these requirements as agreed with each
customer, however, forward-planning involves risk; there can be no assurance
that it will do so or realize the corresponding revenue.

The Company currently maintains support and sales offices and/or has sales or
technical support representatives in the following locations: Phoenix, Arizona;
Irvine, California; Carpinteria, California; San Francisco, California; San
Diego, California; Roswell, Georgia; Chicago, Illinois; Tyngsboro,
Massachusetts; Irving, Texas; Coventry, England; Munich, Germany; and Kualu
Lumpur, Malaysia.

The Company provides a system product warranty for parts and labor for a
12-month period after commencement of operations or 13 months from date of
shipment, whichever occurs first. The Company offers several options for
maintenance and support services of its products on a contractual basis after
the limited product warranty has expired. Additionally, the Company offers a
performance guarantee for the VoiceServer(R), which guarantees the system
performance will not deteriorate under maximum load conditions. Otherwise, the
Company will re-configure the system or replace it at no cost to the customer.
<PAGE>
 
BACKLOG

The Company's backlog at December 31, 1997 was $1.5 million compared to $1.6
million at December 31, 1996. The Company includes in backlog orders for
products or services to be shipped or performed within 180 days. Quarterly
revenues and operating results will depend on the volume and timing of new
orders received during a quarter, which are difficult to forecast. Because of
the possibility of customer changes in delivery schedules or cancellation of
orders, the Company's backlog as of any particular date may not result in actual
sales for any future period.

COMPETITION

The messaging industry is highly competitive and the Company believes that
competition will intensify as the industry grows, matures and consolidates. The
Company competes with different companies in the different customer markets it
serves and the principal competitive factors vary depending on the customer
market.

Digital Sound focuses primarily on selling its products in the domestic and
international public enhanced services markets. Principal competitive factors
are reliability, scalability and the ability to offer a rich suite of integrated
multimedia applications on one platform. In the public enhanced services market,
the Company's principal competitors include Lucent Technologies Inc., Comverse
Technology Inc., Brite Voice Systems Inc., InterVoice, Inc., Glenayre
Technologies Inc, Unisys and Centigram Communications Corporation.

The Company continues to develop enhancements to its products and to develop new
products in order to address what the Company believes are the emerging
requirements of the telephone companies and other telecommunication service
providers. However, there can be no assurance that product requirements will not
change as this market develops or that other companies will not be faster or
more successful in bringing comparable products to market.

In the CPE market, the Company competes primarily with two types of companies:
PBX manufacturers, including Lucent, Nortel Limited and Siemens Rolm
Communications, Inc.; and independent voice processing manufacturers, such as
Centigram, Active Voice Corp. and Applied Voice Technology, Inc.

In the CPE market, the Company has indirect competition from a wide variety of
products, including stand alone voice mail systems, products offering call
processing services with voice mail features. In addition, the Company has
indirect competition from products integrated with other voice mail systems,
such as personal computer modems and software designed to furnish voice
processing and voice messaging features. Competitive factors include system
performance and reliability, service and support and the capability to integrate
systems with a variety of central office and cellular switches and other
communications systems.

The Company believes that its competitive strengths include carrier-class
reliability and scalability, a modular and integrated suite of
communication-management applications, a rapid application creation environment,
state-of-the-art digital networking, software-embedded signaling technology,
easy-to-use interfaces, and the ability to integrate with the switches of
multiple manufacturers.

In the public enhanced services and CPE markets, these competitors and other new
entrants may introduce and deliver new products with expanded capabilities that
could adversely affect the competitive position of the Company. The Company
believes competition for the sale of voice processing systems in its markets
will continue to evolve as customers' applications and technology become more
sophisticated. Some of the Company's competitors have substantially greater
development, marketing and capital resources than the Company.

PATENTS, COPYRIGHTS AND TECHNOLOGY LICENSES

The Company policy on intellectual property is to develop, utilize and protect
its patents, trademarks, copyrights and trade secrets in order to maximize the
value of the Company's technological expertise and innovation.

The Company holds four United States patents and has three patent applications
pending. The Company also has one foreign patent and ten foreign patent
applications pending. The Company has registered a number of trademarks in the
United States and has a number of trademark applications pending both in the
United States and in foreign countries. The Company's software is protected by
copyright and trade secrecy 
<PAGE>
 
laws. However, such protection does not ensure that the Company's competitors
will not develop similar technology. The Company periodically acquires
technology from third parties to supplement its development efforts. These
acquisitions may require prepaid license fees and/or the payment of royalties.
The Company holds a perpetual license from AT&T for the UNIX operating system.

EMPLOYEES

At December 31, 1997, the Company had 155 employees, including 66 in sales,
marketing and customer support, 54 in engineering and development, 19 in quality
assurance and manufacturing and 16 in corporate administration and finance. Many
of the Company's employees are highly skilled, and the Company's success will
depend in part on its ability to attract and retain such employees.

The Company has never had a work stoppage. No employees are represented by a
labor organization and the Company considers its employee relations to be good.


ITEM 2.   PROPERTIES
          ----------

The Company's corporate offices, engineering and development facilities and
manufacturing facilities are located in Carpinteria, California, in a total of
approximately 53,000 square feet. In December of 1996, the Company entered into
a new lease and consolidated into half of the facility that it currently
occupies. The move resulted in a savings of approximately 45.0% of the previous
annual lease payments. The facility is leased for a period of ten years
beginning in December 1996, with two five-year renewal options. Annual rental on
the facility was approximately $0.7 million in 1997, with the rent subject to
annual increases.

The Company currently maintains support and sales offices and/or has sales or
technical support representatives in the following locations: Phoenix, Arizona;
Irvine, California; Carpinteria, California; San Diego, California; San
Francisco, California; Roswell, Georgia; Chicago, Illinois; Tyngsboro,
Massachusetts; Irving, Texas; Coventry, England; Munich, Germany; and Kualu
Lumpur, Malaysia.

The Company believes that its current facilities are well maintained and
sufficient to satisfy its operations for the next several years.


ITEM 3.   LEGAL PROCEEDINGS
          ----------------- 

In 1992, Octel Communications Corporation (Octel, now Lucent Technologies, Inc),
a competitor of the Company, filed suit in the United States District Court for
the Northern District of California against Theis Research, Inc. (Theis) for a
declaratory judgment that Octel's products do not infringe certain patents held
by Theis and that those patents are invalid.

In 1993, the court consolidated several actions and Theis filed a counterclaim
for infringement, a judgment of patent validity and various claims for
injunctive and monetary relief against, among others, Pacific Telesis Group,
Pacific Bell and other Pacific Bell entities (Pacific Telesis). Pacific Telesis
tendered defense of this action to various of its vendors, including the
Company, which resulted in counterclaims by Theis against the Company, Octel,
Boston Technology (now Comverse Technology Inc), Northern Telecom and most other
manufacturers of voice mail products. In 1993, the court severed trial of the
counterclaims against all counter defendants except Octel, Comverse and Northern
Telecom.

In 1994, a jury concluded that the patents held by Theis Research, Inc. were
either invalid or not infringed upon by Octel, and the counterclaims against
Pacific Telesis in which Digital Sound has intervened are currently stayed.
Theis Research appealed the findings of invalidity and noninfringement to the
U.S. Court of Appeals and on November 6, 1997 the U.S. Court of Appeals affirmed
the District Court's decision in its entirety. Theis Research has until March
30, 1998 to seek to have the matter heard before the U.S. Supreme Court. If
Theis Research is granted a hearing before the U.S. Supreme Court and the U.S.
Supreme Court reverses the judgment, Theis Research may assert claims of
infringement against Pacific Telesis and Digital Sound on these patents.
However, if the U.S. Supreme Court refuses to hear the matter or affirms the
holding, the potential for any successful counterclaim against Pacific Telesis
and Digital Sound as a supplier to Pacific Telesis is significantly reduced.
<PAGE>
 
Management believes, based on information currently available, including
consultations with patent counsel, that the Company is not infringing upon any
valid patents of Theis. The Company will vigorously defend the patent
infringement claims and related claims for damages. While litigation is
inherently uncertain, Management believes in view of the jury verdict in the
Octel case that the ultimate resolution of these matters will not have a
material adverse effect on the financial condition or results of operations of
the Company. Should the outcome of this litigation be unfavorable to the
Company, however, the Company would be required to fulfill its indemnification
obligations to its customers, including Pacific Telesis, by either replacing or
modifying its products to avoid infringement or by procuring a license to use
the technology, either of which could have a materially adverse effect on the
financial condition or results of operations of the Company.

Additionally, the Company is subject to pending claims and litigation primarily
related to contractual, product and employee issues. Management, after review
and consultation with the Company's counsel, believes that the liability, if
any, from the disposition of such claims and litigation would not have a
materially adverse effect on the financial condition or results of operations of
the Company.


ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.
<PAGE>
 
     EXECUTIVE OFFICERS OF THE REGISTRANT                          
     ------------------------------------                          
               
     Pursuant to the Instructions to Paragraph (b) of Item 401 of Regulation S-
     K, the current executive officers of the Company, their ages and respective
     positions with the Company are set forth in the following table.
     Biographical information on each of the executive officers is set forth
     following the table. There are no family relationships between any director
     or executive officer and any other director or executive officer of the
     Company. Executive officers serve at the discretion of the Board of
     Directors.

<TABLE> 
<CAPTION> 
                                                                                            Served as Officer
Name                           Age     Position                                                   Since
-----------------------------------------------------------------------------------------------------------------
<S>                            <C>     <C>                                                  <C>  
Mark C. Ozur                    41     President                                                   1993
                                       Chief Executive Officer
Keith M. Beckwith               42     Vice President, Sales                                       1994
                                       Americas and Europe
James C. Eby                    51     Vice President, Chief Quality and Operations                1983
                                       Officer, Assistant Secretary
Stanford D. Milnes              49     Vice President, Sales                                       1997
                                       Asia/Pacific Rim
Benn Schreiber                  45     Vice President, Engineering                                 1997
B. Robert Suh                   38     Vice President, Finance,                                    1995
                                       Chief Financial Officer and
                                       Corporate Secretary
Pamela J. Thompson              39     Vice President, Marketing                                   1997
</TABLE> 

     Mr. Ozur has been President and Chief Executive Officer of the Company
     since December 1994. From April 1993 to November 1994 he served as Vice
     President -Chief Technical Officer. From 1990 to 1992 he was Vice President
     of Precision Visuals, a software development company, and from 1978 to 1982
     and 1986 to 1990 he was at Digital Equipment Corporation, a computer
     hardware and software company, developing software. During 1982, he founded
     Omtool Corporation, a compiler and software publishing company. 

     Mr. Beckwith has been Vice President, Sales since September 1994. From
     January 1991 to August 1994 he was Director, Voice Information Services.
     From August 1988 to December 1990 he was National Sales Manager. From
     August 1986 to July 1988 he was Regional Sales Manager.    

     Mr. Eby has been Vice President, Chief Quality and Opera tions Officer
     since September 1994. From January 1992 to August 1994 he was Vice
     President - Quality Assurance and Manufacturing of the Company. From
     October 1983 to December 1991 he was Vice President, Manufacturing.

     Mr. Milnes has been Vice President for Asia/Pacific Rim since January 1997.
     From January 1994 to January 1997 he was Vice President and Managing
     Director for Brite Voice Systems, Asia Pacific. From November 1988 to
     December 1993 he was Area Vice President for international marketing for
     Boston Technology.
     
     Mr. Schreiber was appointed Vice President, Engineering in August 1997.
     Previously, he worked at Digital Equipment Corporation (DEC) where he was
     the director of Windows NT Systems Software. Previously, Mr. Schreiber held
     several other engineering management positions at DEC.

     Mr. Suh has been Vice President and Chief Financial Officer since November
     1995. From September 1992 to October 1995 he was Chief Financial Officer
     for the Bank of Boston's European Division. From February 1988 to August
     1992 he was Director of Finance for the Bank of Boston's retail franchise
     throughout New England. From July 1985 to January 1988 he was a Manager in
     corporate development at MCI Communications Corporation.

     Ms. Thompson has been Vice President, Marketing since October 1997.
     Thompson comes to Digital Sound after eight years at Motorola, Inc. where
     she was most recently the Director of Strategic Businesses, responsible for
     developing and implementing wireless content solutions for paging carriers
     around the globe. Prior to this, Thompson was Managing Director for
     Motorola Air Communications, Ltd. Previously, Thompson held other senior
     management positions at Motorola, including Vice President and Director of
     Asia Pacific Wireless Data Network Operations and Manager of Corporate
     Strategy.
<PAGE>
 
                                     PART II

ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
          ---------------------------------------------------------------------

In 1997, the Company's common stock traded in the over-the-counter market under
the NASDAQ National Market System under the symbol DGSD. (Effective February 2,
1998, the symbol was changed to PLPT.) The following tables set forth the
following range of the high and low closing prices in each quarter during 1996
and 1997 as reported by the NASDAQ National Market System.


                                                           1996            
                                                 High               Low    
                    -----------------------------------------------------   
                    1st Quarter                $ 1.88              $ 1.13   
                    2nd Quarter                  2.63                1.19   
                    3rd Quarter                  2.25                1.38   
                    4th Quarter                  2.28                1.38   
                    -----------------------------------------------------   
                                                                           
                                                           1997            
                                                 High               Low    
                    -----------------------------------------------------   
                    1st Quarter                $ 1.72              $ 1.28   
                    2nd Quarter                  1.47                0.69   
                    3rd Quarter                  1.84                0.88   
                    4th Quarter                  1.63                0.94   
                    -----------------------------------------------------    

The Company has never paid any cash dividends on its stock and anticipates that,
for the foreseeable future, it will continue to retain any earnings for use in
the operation of its business. At January 23, 1998, there were approximately 750
holders of record of the Company's common stock.
<PAGE>
 
ITEM 6.   SELECTED FINANCIAL DATA
          -----------------------

Consolidated Selected Financial Data

Digital Sound Corporation
(In thousands, except per share data)


<TABLE> 
<CAPTION> 

                                                                                         Year Ended December 31,                    
------------------------------------------------------------------------------------------------------------------------------------
                                                            1993             1994             1995             1996          1997   
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                     <C>               <C>               <C>              <C>          <C>   
Statement of Operations Data:                           

Net sales                                                $ 23,264         $ 31,687          $ 23,201         $ 22,332     $  20,644
Cost of sales                                               8,917           13,295            10,858            8,312        10,523
                                                         --------------------------------------------------------------------------
Gross Margin                                               14,347           18,392            12,343           14,020        10,121
                                                         --------------------------------------------------------------------------

Selling, general and administrative                        11,572           10,165            11,781           12,846        17,122
Engineering and development                                 7,557            6,328             7,209            8,903        12,181
Reduction in workforce                                      1,250              -                 -                -             -
                                                         --------------------------------------------------------------------------
   Total operating expense                                 20,379           16,493            18,990           21,749        29,303
                                                         --------------------------------------------------------------------------

Income (loss) from operations                              (6,032)           1,899            (6,647)          (7,729)      (19,182)
Interest and other income, net                                313              669             1,473              950           273
                                                         --------------------------------------------------------------------------

Income (loss) before provision for income taxes            (5,719)           2,568            (5,174)          (6,779)      (18,909)
Provision for income taxes                                    -                (80)              (14)             (22)          (15)
                                                         --------------------------------------------------------------------------
Net income (loss)                                          (5,719)           2,488            (5,188)          (6,801)      (18,924)
                                                         --------------------------------------------------------------------------
Earnings (loss) per common share                         $   (.30)        $    .13          $   (.26)        $   (.34)    $    (.93)
Earnings (loss) per common share -
       assuming dilution                                 $   (.30)        $    .12          $   (.26)        $   (.34)    $    (.93)
Weighted average common and common
       equivalent shares outstanding                       18,830           21,183            19,881           20,086        20,363
------------------------------------------------------------------------------------------------------------------------------------
</TABLE> 

<TABLE> 
<CAPTION> 

                                                                                         Year Ended December 31,                    
------------------------------------------------------------------------------------------------------------------------------------
                                                            1993             1994             1995             1996          1997   
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                      <C>              <C>               <C>              <C>          <C> 
Balance Sheet Data:

Working capital                                          $ 23,370         $ 31,695          $ 25,085         $ 20,345     $ 12,131
Total assets                                               36,452           43,960            38,914           33,333       37,441
Long-term obligations, excluding current portion              615              127               -                -            -
Shareholders' equity                                       29,193           37,327            32,557           26,027       20,443
------------------------------------------------------------------------------------------------------------------------------------
</TABLE> 
<PAGE>
 
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
          -----------------------------------------------------------
          AND RESULTS OF OPERATIONS
          -------------------------
  
1997 Compared to 1996. Net sales decreased 7.6% from $22.3 million in 1996 to
$20.6 million in 1997, a decrease of $1.7 million. Sales to domestic U.S.
customers increased by $2.9 million, while sales to International customers
declined by $4.6 million. Due to uncertainties regarding the economic condition
in Asia, foreign sales fell sharply. In 1997, net sales from Europe and Asia
accounted for 5% of the Company's total revenue as compared to 26% coming from
outside the U.S. in 1996. Compared to the prior year, sales in the Voice
Information Services (VIS) market decreased $1.7 million while sales in the
Customer Premises Equipment (CPE) showed no change. New systems sales for the
VoiceServer(R) 1110, VoiceServer 2110 and VoiceServer 3110 family of products
decreased by $3.5 million in 1997 while sales of system upgrades and
enhancements increased by $1.8 million.

Gross margin as a percentage of net sales decreased from 62.8% in 1996 to 49.0%
in 1997, primarily as a result of the decrease in international sales and as a
result of a one-time charge to cost of sales of approximately $1.5 million in
connection with a review of the Company's operations, cost structure and balance
sheet. Excluding the one-time charge, the gross margin was 55% in 1997. Margins
on the sale of new systems decreased from 50.0% in 1996 to 46.2% in 1997. In
addition, the margin on the sale of system upgrades and enhancements and service
decreased from 70.5% in 1996 to 49.9% in 1997. This decrease in margins for
system upgrades, enhancements and service is reflective of a smaller percentage
of software upgrades, principally upgrades to the Company's latest version of
voice messaging software, InfoMail 4.0, performed in 1997.

Selling, general and administrative expenses increased from $12.8 million in
1996 to $17.1 million in 1997 as the Company invested in upgrading its personnel
and capabilities, primarily in Sales and Marketing. As a result of the increased
investment and decreased sales levels, selling, general and administrative
expenses were higher as a percentage of sales in 1997 (83.0%) as compared to
1996 (52.5%).

Engineering and development expenses increased from $8.9 million in 1996 to
$12.2 million in 1997. For 1997, engineering and development expenses reflect
the Company's strategy of continued investment in new product development and
product enhancements. As a result of the increase in spending for engineering
development in 1997 and decreased sales levels, engineering and development
expenses were higher as a percentage of sales in 1997 (59.0%) as compared to
1996 (39.9%).

Interest and other income decreased from $1.0 million in 1996 to $0.3 million
1997, principally as the result of a lower average cash balance.

The provision for income taxes in 1997 was $15,000. As a result of the above,
the Company incurred a net loss of $18.9 million as of December 31, 1997
compared to a net loss of $6.8 million in 1996.

The extent and timing of new orders for the Company's existing products from VIS
providers has a substantial effect on the company's net sales. Such orders are
usually significant in size and can materially affect sales in any quarter. The
Company's operations are not subject to a particular seasonality, however,
historically first quarter sales have been less than fourth quarter sales. It is
difficult to predict receipt of new orders reliably and quarterly revenues and
operating results will depend on volume and timing of new orders received during
a quarter.

1996 Compared to 1995. Net sales decreased 3.7% from $23.2 million in 1995 to
$22.3 million in 1996 as sales to domestic U.S. customers were below planned
levels. In 1996, net sales from Europe and Asia accounted for 26% of the
Company's total revenue as compared to less than 2% coming from outside the U.S.
in 1995. Compared to the prior year, sales in the Voice Information Services
(VIS) market were unchanged while sales in the Customer Premises Equipment (CPE)
market decreased by $0.8 million. New systems sales for the VoiceServer(R) 1110,
VoiceServer 2110 and VoiceServer 3110 family of products increased by $2.3
million in 1996 while sales of system upgrades and enhancements decreased by
$3.1 million.

Gross margin as a percentage of net sales increased from 53.2% in 1995 to 62.8%
in 1996, primarily as a result of the change in the product mix and the benefit
obtained from lower valued overall inventory carried over from the prior year.
The increase in sales outside the U.S. helped margins on the sale of new systems
rise from 49.4% in 1995 to 50.0% in 1996. In addition, the margin on the sale of
system upgrades and 
<PAGE>
 
enhancements and service increased from 54.6% in 1995 to 70.5% in 1996. This
increase in margins for system upgrades, enhancements and service is reflective
of a greater percentage of software upgrades, principally upgrades to the
Company's latest version of voice messaging software, InfoMail 4.0, performed in
1996.

Selling, general and administrative expenses increased from $11.8 million in
1995 to $12.8 million in 1996 as the Company invested in upgrading its personnel
and capabilities primarily in Sales and Marketing. As a result of the increased
investment, selling, general and administrative expenses were higher as a
percentage of sales (52.5%) in 1996 as compared to 1995 (50.8%).

Engineering and development expenses increased from $7.2 million in 1995 to $8.9
million in 1996. For 1996, engineering and development expenses reflected the
Company's strategy of continued investment in new product development and
product enhancements. As a result of the increase in spending for engineering
development in 1996, engineering and development expenses were higher as a
percentage of sales in 1996 (39.9%) as compared to 1995 (31.0%).

Interest and other income decreased from $1.5 million in 1995 to $1.0 million in
1996, principally the result of a lower average cash balance.

The provision for income taxes in 1996 was $22,000, which is adequate to cover
corporate tax liability. As a result of the above, the Company incurred a net
loss of $6.8 million as of December 31, 1996 compared to a net loss of $5.2
million in 1995.

FACTORS THAT MAY AFFECT FUTURE RESULTS

This Annual Report to Shareholders contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21S of the Securities Exchange Act of 1934, as amended. Actual results
could differ materially from those projected in such forward-looking statements
as a result of the factors set forth below and elsewhere in this document.

Digital Sound operates in a rapidly changing environment that involves a number
of risks, some of which are beyond the Company's control. The following
discussion highlights some of these risks.

As discussed in "Part I - Item 1. Business, "the Notes automatically convert
into the Series B Convertible Preferred Stock upon Shareholder Approval. Without
such Shareholder Approval, each holder of a Note may declare the principal and
all accrued interest immediately due and payable. The Company would be obligated
to repay immediately $6,612,502.50 in aggregate principal amount of the Notes
plus 7% interest from the date of issue. There can be no assurance that the
Company will have available cash resources to repay the Notes or that it would
be able to repay the Notes in compliance with applicable law. In addition, the
Company's obligations to repay the Notes will create a default under certain of
its other agreements. In the event Shareholder Approval is not obtained,
repayment of the Notes would have a material adverse effect on the Company's
financial condition and ability to implement its business strategy.

The Company has developed and introduced its new product line, the PulsePoint
Enhanced Application Platform and Communication-Management Suite of
Applications. The new platform and applications are designed to increase the
Company's market share and boost its position in the industry. See "Part I -
Item 1. Business." The successful introduction of these and other new products
is dependent on a number of factors, some of which are beyond the Company's
control, including product acceptance in the marketplace, introduction of
competitive products by existing or new competitors, changes in technology,
price competition and other factors. Any failure of such products to achieve
acceptance in the marketplace could significantly reduce future expected
revenues or result in the need for additional expenses to bring the product to
market. Furthermore, there can be no assurance that the Company will be
successful in introducing new products or that such products will generate
significant revenues or profits. The Company's inability to successfully
generate revenues from the introduction of these new products would have a
material adverse effect on the Company's financial condition and ability to
implement its business strategy.

The Company has not been operating profitably. The Company's strategy has been
to develop new technology and to expand its marketing capabilities, with the
goal of creating successful new products and marketing them effectively, thereby
returning the Company to profitability. The Company's on-going investments in
technology and marketing require funds, and although the Company presently has a
<PAGE>
 
significant positive cash balance as a result of the consummation of a private
placement in December 1997 (see "Part I - Item 1. Business."), the Company's
financial resources are not unlimited, and the Company's funds eventually will
be exhausted if the Company's strategy does not succeed in returning the Company
to profitability or otherwise enable it to raise additional working capital.

The Company is in the process of identifying operating and application software
challenges related to the "Year 2000" issue. The Year 2000 problem is the result
of computer programs being written using two digits (rather than four) to define
the applicable year. Software programs that have time-sensitive software may
recognize a date using "00" as the year 1900 rather than the Year 2000. This
could result in a major system failure or miscalculations. During 1997, the
Company completed the conversion of its primary in-house accounting, inventory,
and manufacturing control systems to a Year 2000 compliant system. The total
cost of the Year 2000 project is estimated to be $0.5 million. To date the
Company has incurred approximately $0.4 million related to the assessment of the
impact of Year 2000 on the Company and the purchase of new systems and system
modifications. The project is estimated to be completed not later than December
31, 1998, which is prior to any anticipated impact on its operating systems. The
Company believes that with conversion to new software and modifications to
existing software, the Year 2000 Issue will not pose significant operational
problems for its computer systems. The costs of the project and the date on
which the Company believes it will complete the Year 2000 modifications are
based on management's best estimates. However, there can be no guarantee that
these estimates will be achieved and actual results could differ materially from
those anticipated. If such modifications and conversions are not made, or not
completely timely, the Year 2000 issue could have a material impact on the
Company's business and consolidated results of operations.

The voice processing and messaging industry is highly competitive, with rapid
technological advances and constantly improving price/performance. As the
markets in which the Company operates continue to grow, the Company is
experiencing an increase in competition, and it expects this trend to continue.
The Company is not one of the largest providers of voice processing and
messaging equipment in the industry. Some of the Company's competitors have
substantially greater technical, marketing and financial resources and, in some
markets, a larger installed base of customers and a wider range of available
applications software.

The voice processing and messaging industry has experienced a continuing
evolution of product offerings and alternatives for delivery of services. These
trends have affected and may be expected to have a significant continuing
influence on conditions in the industry, although the impact on the industry
generally and on the Company's position in the industry cannot be predicted with
assurance. The Company and the industry are, in general, dependent on the U.S.
domestic telephone companies for a large percentage of revenue. The suppliers to
the telephone company market, which is primarily comprised of 7 regional Bell
operating companies and GTE, have largely been decided for first generation
voice processing requirements.

The market for voice processing and messaging systems is in a period of
transition. Budgetary constraints, uncertainties resulting from the introduction
of new technologies in the telecommunications environment and changes in the
government regulations have increased uncertainties in the market. Significant
changes in the domestic U.S. industry as a result of the 1996 Telecommunications
Act make planning decisions more difficult and increase the risk inherent in the
planning process.

The Company's operating results may fluctuate for a number of reasons. The
Company has short delivery cycles and as a result does not have a large order
backlog, which makes the forecasting of revenue inherently uncertain. This
uncertainty is compounded because each quarter's revenue results predominantly
from orders booked and shipped during the third month of the quarter. Because
the Company plans its operating expenses, many of which are relatively fixed in
the short term, on the basis of its anticipated revenues, even a relatively
small revenue shortfall may cause a period's results to be substantially below
expectations. Such a revenue shortfall could arise from any number of factors,
including lower than expected demand, supply constraints, delays in the
availability of new products, overall economic conditions or natural disasters.

The international portion of the Company's business, which represented 5.3% of
revenues for the year ending December 31, 1997, is subject to a number of
inherent risks, including difficulties in building and managing international
operations and international reseller networks and international service and
support of the Company's products, difficulties or delays in translating
products into foreign languages, fluctuations in the value of foreign
currencies, import/export duties and quotas, and unexpected regulatory, economic
or political changes in international markets. Disruption in the Asian economies
was the principal cause of a decrease in 
<PAGE>
 
the Company's foreign sales, from 26.0% of total sales in 1996 to 5.3% of total
sales in 1997. Although the majority of international transactions are performed
through confirmed letters of credit, due to the competitive environment in the
international marketplace, certain international customers may require longer
payment terms; and as a result, days sales outstanding may periodically extend
beyond ninety days on amounts due from these customers.

The development of new technologies and products is increasingly complex and
uncertain, which increases the risk of delays. The introduction of new systems
requires close collaboration and continued technological advancement involving
multiple hardware and software design, manufacturing, marketing and sales teams
within the Company as well as teams at outside suppliers of key components. The
failure of any one of these elements could cause the Company's new products to
fail to meet specifications or to miss the aggressive timetables that the
Company establishes. As the variety and complexity of the Company's product
families increase, the process of planning production and inventory levels also
becomes more difficult. The Company expects to continue investing heavily in
supporting the development effort required to bring new technologies and
products to the market. To support this, substantial financial resources will be
expended.

The Company believes that its production capacity should be sufficient to
support anticipated unit volumes for the foreseeable future. The Company is
primarily engaged in the final assembly and testing of the hardware equipment.
The Company currently buys the majority of its subassembly inventory from a
limited number of suppliers. The failure of these suppliers to provide such
subassemblies on a timely basis and within specifications could have a
materially adverse effect on the Company's business. If the Company is unable to
obtain certain key components, or to effectively forecast customer demand or
manage its inventory, increased inventory obsolescence or reduced utilization of
production capacity could adversely impact the Company's gross margins and
results of operations.

The Company has historically derived a significant portion of its revenue and
operating profit from a relatively small number of customers. In 1997, the
Company derived 58% of its revenue from a single customer (GTE). Should sales to
this customer be significantly reduced, the Company's operating results could be
materially adversely affected. International proposals for large system
installations typically involve a lengthy and complex bidding and selection
process, and the ability of the Company to obtain a particular proposal award is
inherently difficult to predict. The Company believes that the opportunities for
these installations will continue to grow and intends to continue to expand its
research and development, manufacturing, sales and marketing and product support
capabilities in anticipation of such growth. However, the timing and scope of
these opportunities and the pricing and margins associated with any eventual
proposal award are difficult to forecast, and may vary substantially from
transaction to transaction. The Company's future operating results may,
accordingly, exhibit a higher degree of volatility than the operating results of
other companies in its industry that have adopted different strategies. Although
the Company is actively pursuing a number of opportunities both in and out of
the United States, both the timing of any eventual opportunities and the
probability of the Company's receipts of significant purchase orders are
uncertain. The degree of dependence by the Company on large orders, and the
investment required to enable the Company to perform such orders, without
assurance of continuing order flow from the same customers and predictability of
gross margins on any future orders, increase the risk associated with its
business.

The Company's stock price, like that of other technology companies, is subject
to significant volatility. If revenues or earnings in any quarter fail to meet
the investment community's expectations, there could be an immediate impact on
the Company's stock price. The stock price may also be affected by broader
market trends unrelated to the Company's performance.

The Company routinely receives communications from third parties asserting
patent or other rights covering the Company's products and technologies. Based
upon the Company's evaluation, it may take no action or it may seek to obtain a
license. In any given case there is a risk that a license will not be available
with terms that the Company considers reasonable, or that litigation will ensue.
The Company expects that, as the number of hardware and software patents issued
continues to increase, and as the Company's business grows, the volume of these
third party communications will also increase.

The Company's corporate headquarters facility, at which the majority of its
research and development activities are conducted, is located near major
earthquake faults which have experienced earthquakes in the past. While the
Company does carry insurance at levels management believes to be prudent, in the
event of a major earthquake or other disaster affecting one or more of the
Company's facilities, it is likely that 
<PAGE>
 
insurance proceeds would not cover all of the costs incurred and, therefore, the
operations and operating results of the Company could be adversely affected.

Due to the factors noted above and elsewhere in management's discussion and
analysis of financial condition and results of operations, the Company's future
earnings and Common Stock price may be subject to significant volatility,
particularly on a quarterly basis. Past financial performance should not be
considered a reliable indicator of future performance and investors should not
use historical trends to anticipate results or trends in future periods. Any
shortfall in revenue or earnings from the levels anticipated by securities
analysts could have an immediate and significant adverse effect on the trading
price of the Company's Common Stock in any given period. Additionally, the
Company may not learn of such shortfalls until late in a fiscal quarter, which
could result in an even more immediate and adverse effect on the trading price
of the Company's Common Stock. Furthermore, the Company participates in a highly
dynamic industry which often results in volatility of the Company's Common Stock
price.

LIQUIDITY AND CAPITAL RESOURCES

For the year ended December 31, 1997, net working capital decreased by $8.2
million to $12.1 million compared to $20.3 million at December 31, 1996. In 1997
the decrease in working capital resulted principally from a reduction in
accounts receivable of $1.6 million, an increase in amounts borrowed under the
Company's credit line of $1.6 million, and an increase in shareholder notes
payable of $6.6 million. The increase in shareholder notes payable is the result
of the Company's December 1997 private placement of convertible securities; see
Notes 8 and 9 to the Consolidated Financial Statements.

At December 31, 1997, the Company had cash of $21.0 million and no long term
debt. During 1997, net cash used by operations was $13.6 million. The 1997
capital expenditures were $4.1 million, while budgeted expenditures for 1998 are
$1.6 million, principally hardware and software for test equipment. The Company
has never paid any cash dividends on its stock and anticipates that, for the
foreseeable future, it will continue to retain any earnings for use in the
operation of its business.

For the year ended December 31, 1996, net working capital decreased by $4.8
million to $20.3 million compared to $25.1 million at December 31, 1995. In 1996
the decrease in working capital resulted principally from a reduction in cash of
$5.3 million, an increase in accounts receivable of $2.3 million, a decrease in
inventory of $0.6 million, an increase in accounts payable of $0.9 million and
an increase in accrued payroll and other accrued liabilities of $0.3 million.
The decrease in cash reflects the Company's strategy of continued investment in
new product development, product enhancements and strengthening of its marketing
and sales capabilities.

At December 31, 1996, the Company had cash of $18.2 million and no long term
debt. During 1996, net cash used by operations was $4.6 million, which was
offset by $1.0 million of interest earned on cash balances. The 1996 capital
expenditures were $2.0 million.

For the year ended December 31, 1995, working capital decreased by $6.6 million
to $25.1 million compared to $31.7 million at December 31, 1994. In 1995 the
reduction in working capital resulted principally from a decrease in accounts
receivable of $3.7 million caused by substantially lower sales, a
reclassification of $1.4 million to other assets as a result of long term
investments which exceed the company's definition of cash and equivalents, a
settlement of $2.5 million as described in note 10 of Notes to Financial
Statements in the 1995 Annual Report, and a decrease in other accrued
liabilities related to sales tax payable and accrued license fees totaling $1.0
million.

At December 31, 1995, the Company had cash of $23.5 million and no long term
debt. During 1995, net cash used by operations was $4.3 million, which was
offset by $1.5 million of interest earned on cash balances.
<PAGE>
 
REPORT OF INDEPENDENT AUDITOR
-----------------------------

The Board of Directors and Shareholders
Digital Sound Corporation

We have audited the accompanying balance sheets of Digital Sound Corporation as
of December 31, 1997 and 1996, and the related statements of operations,
shareholders' equity, and cash flows for each of the three years in the period
ended December 31, 1997. 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 Digital Sound Corporation at
December 31, 1997 and 1996, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1997, in
conformity with generally accepted accounting principles.

/s/ Ernst & Young L.L.P.
    --------------------

ERNST & YOUNG LLP

Woodland Hills, CA
January 22, 1998
<PAGE>
 
ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
            -------------------------------------------

Consolidated Balance Sheets

Digital Sound Corporation
(In thousands, except share data)
<TABLE> 
<CAPTION> 
                                                                          Year Ended December 31, 
                                                                          -----------------------
                                                                            1996           1997
                                                                          -----------------------
<S>                                                                         <C>           <C> 
ASSETS
                                                                          -----------------------
Current assets:
     Cash, cash equivalents and pledged cash                                $18,187       $20,973
     Accounts receivable, less allowance for doubtful accounts of $600
       and $527 at December 31, 1996 and 1997, respectively                   5,695         4,111
     Inventories, net                                                         3,470         3,876
     Other current assets                                                       299           169
                                                                          -----------------------
       Total Current assets                                                  27,651        29,129     

Property and equipment, at cost:
     Computers and other equipment                                           11,077         9,504
     Furniture and fixtures                                                     982           999
     Leasehold improvements                                                   1,130         1,357
                                                                          -----------------------
                                                                             13,189        11,860
     Less accumulated depreciation and amortization                         (10,733)       (6,776)
                                                                          -----------------------
                                                                              2,456         5,084

Other assets:
     Investment securities                                                       --         1,030
     Other assets                                                             3,226         2,198
                                                                          -----------------------
     Total other assets                                                       3,226         3,228
                                                                          -----------------------
Total assets                                                                $33,333       $37,441
                                                                          =======================

LIABILITIES & SHAREHOLDERS' EQUITY
                                                                          -----------------------
Current liabilities:     
     Credit Line                                                            $    --       $ 1,581
     Shareholder notes payable                                                   --         6,613                         
     Accounts payable                                                         3,639         3,532
     Accrued payroll and related                                              1,986         3,102
     Other accrued liabilities                                                1,681         2,170
                                                                          -----------------------
       Total current liabilities                                              7,306        16,998
Commitments and contingencies
Shareholders' equity:
       Preferred stock 15,000,000 shares authorized
       Series A, no par value, 2,631,579 shares issued and
       outstanding at December 31, 1996                                       5,000   
       Series B, no par value, 2,451,667 shares issued and                              
       outstanding at December 31, 1997                                                    18,110        
     Common stock, no par value - 50,000,000 shares authorized,
         20,224,540 and 20,561,593 shares issued and outstanding
         at December 31, 1996 and 1997, respectively                         68,975        69,205
     Accumulated Deficit                                                    (47,948)      (66,872)
                                                                          -----------------------
         Total shareholders' equity                                          26,027        20,443
                                                                          -----------------------
Total liabilities & shareholders' equity                                     33,333        37,441
                                                                          -----------------------
</TABLE>
See accompanying notes.          
<PAGE>
 
Consolidated Statements of Operations


Digital Sound Corporation
(In thousands, except per share data)

<TABLE> 
<CAPTION> 
                                                         Year Ended December 31,
-----------------------------------------------------------------------------------------
                                                    1995           1996           1997
=========================================================================================
<S>                                              <C>            <C>            <C> 
Net sales                                         $23,201        $22,332        $ 20,644
Cost of sales                                      10,858          8,312          10,523
                                                  -------        -------        --------
Gross margin                                       12,343         14,020          10,121
                                                  -------        -------        --------

Selling, general and administrative                11,781         12,846          17,122
Engineering and development                         7,209          8,903          12,181
                                                  -------        -------        --------

   Total operating expense                         18,990         21,749          29,303
                                                  -------        -------        --------
Income (loss) from operations                      (6,647)        (7,729)        (19,182)
Interest and other income, net                      1,473            950             273
                                                  -------        -------        --------

Income (loss) before provision for income taxes    (5,174)        (6,779)        (18,909)
Provision for income taxes                            (14)           (22)            (15)
                                                  -------        -------        --------
Net income (loss)                                 $(5,188)       $(6,801)       $(18,924)
                                                  =======        =======        ========

Earnings (loss) per common share                  $  (.26)       $  (.34)       $   (.93)
                                                  =======        =======        ========
Weighted average common 
        shares outstanding                         19,881         20,086          20,363
                                                  =======        =======        ========
</TABLE> 

See accompanying notes.
<PAGE>
 
Consolidated Statements of Shareholders' Equity


Digital Sound Corporation
(In thousands, except share data)

<TABLE> 
<CAPTION> 
                                  Convertible              Convertible Preferred                                Total
                                  Preferred Stock             Stock Series B        Common Stock        Accumulated Shareholders'
------------------------------------------------------------------------------------------------------------------------------------
                                  Shares         Amount    Shares         Amount    Shares     Amount   Deficit        Equity
====================================================================================================================================
<S>                               <C>            <C>       <C>            <C>       <C>        <C>      <C>            <C> 
Balance, December 31, 1994          2,631,579    $ 5,000                            19,733,060  $68,286  $(35,959)      $ 37,327
Exercise of stock options                   -          -                               109,050      166                      166
Shares issued under employee
     stock purchase plan                                                               158,844      252                      252
Net loss                                    -          -                                     -        -    (5,188)        (5,188)
                                   ----------    -------    ---------      -------  ----------  -------  --------       --------
Balance, December 31, 1995          2,631,579    $ 5,000                            20,000,954  $68,704  $(41,147)      $ 32,557
Exercise of stock options                   -          -                                31,625       47                       47
Shares issued under employee
     stock purchase plan                                                               191,961      224                      224
Net loss                                                                                                   (6,801)        (6,801)
                                   ----------    -------    ---------      -------  ----------  -------  --------       --------
Balance, December 31, 1996          2,631,579    $ 5,000                            20,224,540  $68,975  $(47,948)      $ 26,027
Exercise of stock options                                                                4,375        7                        7
Shares issued under employee
     stock purchase plan                                                               332,678      223                      223
Conversion of Series A to
     Series B                      (2,631,579)    (5,000)     666,667        5,000                                             -
Shares issued under private
     placement of convertible
     securities                                             1,785,000       13,110                                        13,110
Net loss                                    -          -                                     -        -   (18,924)       (18,924)
                                   ----------    -------    ---------      -------  ----------  -------  --------       --------
Balance, December 31, 1997                  -          -    2,451,667      $18,110  20,561,593  $69,205  $(66,872)      $ 20,443
                                   ==========    =======    =========      =======  ==========  =======  ========       ========
</TABLE> 

See accompanying notes.
<PAGE>
<TABLE> 
<CAPTION> 
Consolidated Statements of Cash Flows


Digital Sound Corporation                                                              Year Ended December 31,
(In thousands)                                                        --------------------------------------------------------
                                                                           1995                   1996                 1997
==================================================                    =============           ============         ===========    
<S>                                                                   <C>                     <C>                  <C> 
Cash flows from operating activities:
Net income (loss)                                                     $      (5,188)          $     (6,801)        $   (18,924)
Adjustments to reconcile net income (loss)   
   to net cash provided (used) by operations:
      Depreciation and amortization                                           2,463                  2,349               2,979
      Provision for losses on accounts receivable                              (100)                    --                 (73)
      Gain on disposal of fixed assets                                          492                      3                  -- 
      Changes in operating assets and liabilities:
         Accounts receivable                                                  3,845                 (2,288)              1,657
         Inventories                                                           (137)                   628                (406)
         Other current assets                                                  (179)                   135                 130
         Other assets                                                        (3,732)                 1,412                (504)
         Accounts payable                                                       524                    927                (107)
         Accrued payroll and related                                            234                    373               1,116
         Other accrued liabilities                                           (1,034)                  (351)                489
--------------------------------------------------                    -------------           ------------         -----------    
            Net cash provided (used) by operations                           (2,812)                (3,613)            (13,643)
==================================================                    =============           ============         ===========    

Cash flows from investing activities:
   Increase in investment securities                                                                                    (1,030)
   Additions to property and equipment                                         (936)                (1,974)             (4,075)
--------------------------------------------------                    -------------           ------------         -----------    
         Net cash used in investing activities                                 (936)                (1,974)             (5,105)
==================================================                    =============           ============         =========== 

Cash flows from financing activities:
   Proceeds from issuance of preferred stock                                     --                     --              13,110
   Proceeds from issuance of notes payable                                       --                     --               6,613
   Proceeds from issuance of common stock                                       418                    271                 230
   Proceeds from line of credit                                                  --                     --               1,581
--------------------------------------------------                    -------------           ------------         -----------    
         Net cash provided by financing activities                              418                    271              21,534
==================================================                    =============           ============         =========== 

Net increase (decrease) in cash and equivalents                              (3,330)                (5,316)              2,786 
Cash and equivalents at beginning of period                                  26,833                 23,503              18,187
--------------------------------------------------                    -------------           ------------         -----------    
Cash and equivalents at end of period                                 $      23,503           $     18,187         $    20,973 
==================================================                    =============           ============         =========== 

Supplemental disclosures
   Cash paid for interest                                             $          --           $         --         $         6
   Cash paid for taxes                                                $          35           $         21         $        23
==================================================                    =============           ============         =========== 
</TABLE> 
See accompanying notes.
   


   

<PAGE>
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  Summary of Significant Accounting Policies

Nature of business.  Digital Sound Corporation (the Company) designs, 
manufactures and markets information processing systems which enable unified 
messaging.  

Principles of consolidation.  The consolidated financial statements include the 
accounts of Digital Sound Corporation (the Company) and its wholly owned 
subsidiaries Digital Sound International Corporation and DGSD Malaysia 
Corporation.  All significant intercompany transactions and balances have been 
eliminated.

Revenue recognition.  Generally sales are recognized when products are shipped 
or when services are performed.  Warranty costs are accrued at time of sale.  
Revenue from sales of extended warranties is accounted for as deferred revenues 
and recognized into income over the warranty or maintenance period.

Short term investments.  The Financial Accounting Standards Board issued 
Statement of Financial Accounting Standards No. 115, "Accounting for Certain 
Investments in Debt and Equity Securities" ("SFAS 115").  The Company adopted 
the provisions of SFAS 115 for investments held as of December 31, 1995.  The 
adoption had no effect on the financial statements.  Short term investments 
(principally commercial paper and discount notes with maturity dates generally 
within 90 days and considered cash equivalents) are classified as "held to 
maturity" based on the Company's positive intent and ability to hold the 
securities until maturity.  The securities are presented at amortized cost which
approximates fair value.  Amortization and interest on securities classified as
"held to maturity" is included in investment income.

Engineering and development.  Statement of Financial Accounting Standards No. 
86, "Accounting for the Cost of Computer Software to Be Sold, Leased or 
Otherwise Marketed," requires that development costs incurred in connection 
with research and development of software products and enhancements to existing 
software products be expensed and incurred until technological feasibility has
been established. Costs incurred subsequent to the establishment of
technological feasibility must be capitalized until the product is released for
sale. The Company considers technological feasibility to be demonstrated when a
fully functional working model has been produced. To date, all costs associated
with the development of new software products or enhancements to existing
software products have been expensed as incurred. The costs incurred beyond the
working model stage are not significant. Other engineering and development costs
are also expensed as incurred.

Inventories.  Inventories are stated at the lower of standard cost (which 
approximates the first-in first-out method) or market.

Property and equipment.  Property and equipment are depreciated using the 
straight-line method over the respective estimated useful lives, which range 
from two to five years.  Leasehold improvements are amortized over the period of
the lease or the estimated useful life, whichever is shorter.

Earnings (loss) per common share.  During 1997, the Company adopted Statement of
Financial Accounting Standards No. 128, "Earnings per Share" (SFAS No. 128).  
Pursuant to SFAS No. 128, earnings (loss) per common share are computed based 
upon the weighted average number of common shares outstanding for the period.  
Diluted earnings per common share reflects the potential dilution that could 
occur if securities were exercised or converted into common stock.  The adoption
of SFAS No. 128 did not result in a restatement of earnings (loss) per common 
share for the periods presented in the financial statements.  Antidilutive 
common stock equivalents were 28,728,380 in 1997, 2,651,526 in 1996, and 
2,309,526 in 1995 and were excluded from this calculation.

Stock-Based Compensation.  During 1996, the Company adopted Statement of 
Financial Accounting Standards No. 123, "Accounting for Stock-Based 
Compensation" (SFAS No. 123).  Pursuant to SFAS No. 123, a company may elect to 
continue expense recognition under Accounting Principles Board Opinion No. 25, 
"Accounting for Stock Issued to Employees" (APB No. 25) or to recognize 
compensation expense for grants of stock, stock options, and other equity 
instruments to employees based on the fair value methodology outlined in SFAS 
No. 123.  SFAS No. 123 further specifies that companies electing to continue 
expense recognition under APB No. 25 are required to disclose pro forma net 
income and pro forma earning per share as if fair value based accounting 
prescribed by SFAS No. 123 has been applied.  The Company has
<PAGE>
 
elected to continue expense recognition pursuant to APB No. 25. SFAS No. 123 is 
effective for fiscal years beginning after December 15, 1995.

CASH, CASH EQUIVALENTS AND PLEDGED CASH. The Company considers as cash 
equivalents only those investments that are short-term, highly liquid, readily 
convertible to cash, and so near their maturity that they present insignificant 
risk of changes in value because of changes in interest rates. The Company 
classifies as cash equivalents only those investments with maturities of three 
months or less. The Company pledged $1.0 million to facilitate a construction 
loan for the landlord to build new office space in its' existing building. These
funds became available to the Company in February 1998.

INCOME TAXES. The Company accounts for income taxes in accordance with 
Statement of Financial Accounting Standards 109, "Accounting for Income Taxes".
The standard prescribes a liability method for calculating the provision for 
income taxes, replacing the deferred method previously used by the Company.

DEFERRED LICENSE FEES. The company has entered into license agreements for which
the fees are amortized based on sales of product technology over the estimated
useful life of the technology, which is generally four years.

ESTIMATES AND ASSUMPTIONS. 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
December 31, 1997 and the reported amounts of revenues and expenses during the
year then ended. Actual results could differ from those estimates.

2.   INVENTORIES

Inventories at December 31, consist of the following:

<TABLE> 
<CAPTION> 
--------------------------------
(in thousands)                                                                1996         1997
================================                                            ========     ========
<S>                                                                         <C>            <C>  
Raw material and purchased parts                                            $1,528         $2,077
Work-in-progress                                                             1,815          1,521
Finished goods                                                                 127            278
--------------------------------                                            --------     -------- 
                                                                            $3,470         $3,876
                                                                            =========    ========
                                                                           
</TABLE> 

3.   CERTAIN ONE TIME CHARGES

In the fourth quarter of 1995, the Company recorded a one-time charge of 
approximately $2.1 million in connection with a comprehensive and systematic 
review of its operations, cost structure and balance sheet in light of expected 
new product introductions. The one time charge included $0.3 million in 
property and equipment write-offs, related to obsolescence of test fixtures and 
other equipment used in the production of the current product line, and $1.6 
million in inventory write-downs resulting from obsolescence of current 
inventory that is unable to be used in the new product line due to technological
changes and enhancements. An additional $0.2 million of miscellaneous 
operational charges were written-off.

Due to a longer than expected development period for the Company's new product 
line, the Company continued to market the old product line through 1997. In 
light of imminent new product introductions in early 1998, in the fourth quarter
of 1997 the Company recorded additional charges of approximately $1.5 million in
connection with a review of its operations, cost structure and balance sheet. 
The charges included $0.5 million in property and equipment write-offs related 
to obsolescence of test fixtures and other equipment used in the production of 
the current product line, and $1.0 million in inventory write-downs, resulting 
from obsolescence of current inventory and licenses that are unable to be used 
in the new product line due to technological changes and enhancements.

4.   OTHER ASSETS

Other assets at December 31 consist of the following:
<PAGE>


<TABLE> 
<CAPTION>  
--------------------------------------------------------------------------------
(In thousands)                                 1996                1997
================================================================================
<S>                                         <C>                 <C> 
Deferred license fees, net of accumulated
 amortization of $4,237 and $5,769 at
 December 31, 1996 and 1997, respectively    $2,938              $1,933
Other                                           288                 265
--------------------------------------------------------------------------------
                                             $3,226              $2,198
================================================================================
</TABLE> 
<PAGE>
 
5.   LEASES

In December 1996, the Company entered into a new ten year lease for the 
corporate headquarters in Carpinteria, California.  The lease is subject to an 
annual adjustment based on total sales.  In December of 1996 the company 
consolidated into half of the building that it currently occupies.  The new 
lease coupled with the consolidation of space resulted in a reduction in monthly
lease expenses of approximately 45%.  The Company also leases office equipment 
as well as regional office space under one to five year operating lease 
agreements.  

Effective January 1997, the Company entered into master lease 
agreements with BancBoston Leasing Inc. and Mellon US Leasing ("the Lease 
Agreements").  The BancBoston lease agreement is for a maximum of $3.0 million 
in equipment cost and the term of the lease is 48 months.  The BancBoston lease 
agreement requires cash collateral equal to the acquisition cost of the 
equipment leased.  The Company has utilized $1.25 million of the BancBoston 
lease agreement as of December 31, 1997.

The Mellon US Leasing lease agreement is for a maximum of $1.0 million in 
equipment cost and the term of the lease is for 30 months.  The Mellon lease 
agreement requires collateralization via a letter of credit equal to 50% of the 
acquisition cost of the equipment leased.  During 1997, a bank had provided the 
Company with this letter of credit, which was in turn collateralized by the  
Company's certificate of deposit.  Beginning in January 1998, the Company 
collateralized the letter of credit with available borrowing under its credit 
line.  The Company has fully utilized the Mellon US Leasing lease agreement as 
of December 31, 1997.

Minimum future lease payments as of December 31, 1997 are as follows:

<TABLE> 
<CAPTION> 
---------------------------------------------------
(In thousands)
===================================================
<S>                                        <C> 
1998                                        $ 1,446
1999                                          1,322
2000                                          1,287
2001                                          1,661
2002                                            996
2003 and beyond                               3,985
---------------------------------------------------
                                            $10,697
===================================================
</TABLE> 

Rent expense, including rent under noncancelable operating lease obligations, 
was approximately $1.7 million, $1.5 million, and $1.6 million for the years 
ended December 31, 1995, 1996 and 1997, respectively.

6.   OTHER ACCRUED LIABILITIES

Other accrued liabilities at December 31 consist of the following:

<TABLE> 
<CAPTION> 
----------------------------------------------------------------
(In thousands)                              1996           1997
================================================================
<S>                                        <C>            <C> 
Sales taxes payable                        $  180         $  202
Customer deposits                             322            262
Deferred revenue                               92            317
Accrued warranty reserve                      360            429
Other                                         727          1,222
----------------------------------------------------------------
                                           $1,681         $2,432
================================================================
</TABLE> 
<PAGE>
 
7.  Income Taxes

The provision for income taxes included in the Consolidated Statements of 
Operations consists of:

<TABLE> 
<CAPTION> 
--------------                            ----          ----          ----
(In thousands)                            1995          1996          1997
==============                            ====          ====          ====
<S>                                       <C>           <C>           <C> 
Current          
   Federal                                $ --          $ --          $ --
   State                                    14            22            15
--------------                            ----          ----          ----
                                          $ 14          $ 22          $ 15
==============                            ====          ====          ====
</TABLE> 

The provision for income taxes is at a rate different than the U.S. federal 
statutory tax rate for the following reasons:

<TABLE> 
<CAPTION> 
-----------------------------------    ---------     ---------    ---------
(In thousands)                            1995          1996         1997
===================================    =========     =========    ========= 
<S>                                    <C>           <C>          <C> 
Computed tax at statutory rate         $  (1,811)    $  (2,380)   $  (6,523)
State taxes, net of federal benefit            9            14           10
Loss not benefited                         1,854         2,336        6,519
Other                                        (38)           52            9
-----------------------------------    ---------     ---------    --------- 
                                       $      14     $      22    $      15
===================================    =========     =========    ========= 
</TABLE> 

Deferred income taxes reflect the tax impact of temporary differences between 
the amounts of assets and liabilities for financial reporting purposes and such 
amounts as measured by tax laws and regulations.

The components of deferred tax assets as of December 31, 1996 and 1997 are as 
follows:

<TABLE> 
<CAPTION> 
--------------------------------------------         ---------    --------- 
(In thousands)                                          1996         1997
============================================         =========    ========= 
<S>                                                  <C>          <C> 
Net operating loss carryforwards                     $  15,003    $  21,323
General business credit carryforwards                    1,468        3,140
Alternative minimum tax credit carryforwards               190          190
Inventory accounting methods                             1,813        1,833
Allowance for doubtful accounts                            252          220
Accrued vacation                                           147          278
Warranty service                                           152          179
Excess of book over tax depreciation                       415          296
Research expenditures accounting method                    865          821 
Other                                                       58          641
============================================         =========    ========= 
    Deferred tax assets, net                            20,363       28,921
Valuation allowance                                    (20,363)     (28,921)
--------------------------------------------         ---------    --------- 
    Net deferred tax asset                           $      --    $      --
============================================         =========    ========= 
</TABLE> 

Management determined that a valuation allowance of approximately $28.9 million,
primarily related to net operating loss and general business credit 
carryforwards, was required.  The valuation allowance increased approximately 
$8.6 million during 1997, primarily reflecting the current year net operating 
loss.

At December 31, 1997, the Company has net operating loss carryforward for 
federal income tax purposes of approximately $58.4 million which expire from 
2000 through 2012.  The Company has net operating loss carryforwards for 
California tax purposes of approximately $13.2 million at December 31, 1997 
which expire from 1998 through 2002.  The Company's ability to utilize the above
net operating loss carryforward may be limited due to the application of 
statutory provisions.

At December 31, 1997, the Company has general business credits of approximately 
$1.3 million for federal income tax purposes which expire from 1998 through 
2006.
<PAGE>
 
8.  Debt

Shareholder Notes Payable. The $6.6 million in shareholder notes payable arose 
in connection with the December 1997 $20 million private placement (see Note 9).

Credit Line. On July 28, 1997, the Company entered into a Security and Loan 
Agreement ("the Credit Line") with a bank for the purpose of obtaining a $5 
million credit line.  The credit line was secured by substantially all of the 
assets of the Company, and allowed for borrowings of up to the lesser of $2 
million or an amount equal to 50% of eligible domestic accounts receivable.  
Interest under the Credit Line was at the prime rate plus one-half percent.  The
Credit Line also allowed for borrowing up to the lesser of $3 million or an 
amount equal to 90% of eligible foreign accounts receivable and inventory.  
Borrowings under the Credit Line were subject to certain financial covenants and
restrictions on receivables, financial guarantees, and other related items.  On 
October 30, 1997, the Company was in violation of certain of the financial 
covenants of the Credit Line.  There were no borrowings under the Credit Line at
that time.  On October 31, 1997, the Company entered into an amendment to the 
Credit Line providing for a relaxation of certain financial covenants.  The 
amendments also allowed for borrowing up to $5 million or an amount equal to 65%
of eligible accounts receivable, foreign or domestic.  The interested charged 
under the Credit Line was increased to prime plus 2.0% (two percent).  In 
connection with the agreement, the Company issued a warrant to the bank (the 
"Warrant") for the purchase of 300,000 shares of the Company's Common Stock at 
an exercise price of $1.00 per share.  The terms of the warrant provide for 
"full ratchet" antidilution for 180 days after its issuance and for "weighted 
average" antidilution thereafter.  In December 1997, the Company completed a $20
million private placement of convertible securities.  The "full ratchet" 
antidilution provision of the Warrant effected an increase in the number of 
shares of common stock issuable under the Warrant from 300,000 to 400,000 and 
a decrease in the exercise price from $1.00 to $0.75.

In December 1997, due to the Company's achievement of certain milestone events, 
the interest rate applicable to the Credit Line was decreased from Prime plus 
two percent to Prime plus one-half percent (9% at December 31, 1997).  At 
December 31, 1997, the Credit Line was extended to June 30, 1998 and the amount 
borrowed was approximately $1.6 million.  Also at December 31, 1997, the Company
was in violation of one of the covenants of the Credit Line and received a 
one-time waiver of the covenant violation.

The Company maintains a lease agreement with Mellon US Leasing.  This lease 
agreement is collateralized by a $500,000 standby letter of credit issued under
the Company's Credit Line. (See Note 5).

9.  Shareholders' Equity and Related Items

The Company's amended Articles of Incorporation authorize 50,000,000 shares of 
common stock and 15,000,000 shares of preferred stock (of which 3,373,334 have 
been designated Series B), no par value, which may be issued by the Board of 
Directors without further approval by the shareholders.

In December 1997, the Company created the Series B preferred stock.  The holders
of the Series B convertible Preferred Stock are entitled to dividends at the 
applicable dividend rate for each share of the underlying Common Stock into 
which the Series B Convertible Preferred Stock is convertible.  Dividends on the
Series B Convertible Preferred Stock are not mandatory or cumulative.  Upon 
liquidation, the holders of the Series B Convertible Preferred Stock are 
entitled to $7.50 per share plus all accrued and unpaid dividends to the extent 
funds are available and subject to all amounts payable in respect of any other 
shares of preferred stock of the Company that rank pari passu with the Series B 
Convertible Preferred Stock.  Each share of Series B Convertible Preferred Stock
is entitled to a number of votes equal to the number of shares of Common Stock 
into which such share of Series B Convertible Preferred Stock could be 
converted.  The Series B Convertible Preferred Stock and the Common Stock vote 
together.  The Series B Convertible Preferred Stock is convertible at any time 
at the option of the holder into Common Stock, initially at a conversion price 
(the "Series B Preferred Conversion Price") of $0.75 per share of Common Stock. 
In addition to customary antidilution provisions, the Series B Preferred 
Conversion Price is subject to adjustment for certain issuances of the Company's
Common Stock if the consideration per share of such issuance is less than the 
Series B Preferred Conversion Price.  The Series B Convertible Preferred Stock 
is also subject to automatic conversion upon the earliest to occur of an event 
that would cause the Series B Convertible Preferred Stock to be required to be 
registered pursuant to the Securities Exchange Act of 1934, or upon the filing 
with the Secretary of the Company of the written approval of the holders of more
than 50% of the outstanding shares of the Series B Convertible Preferred Stock.

<PAGE>
 
In December 1997, the Company consummated a private placement of convertible 
securities for an aggregate of approximately $20 million (the "Transaction").  
The Company (i) exchanged the Series A convertible preferred stock initially 
issued for an aggregate consideration of $5 million into 666,667 shares of 
Series B convertible preferred stock at a price of $7.50 per share; (ii) issued 
1,785,000 shares of Series B convertible preferred stock at a price of $7.50 per
share for $13,387,500 of the funds raised in the Transaction; and (iii) issued 
Notes (the "Notes") for the balance of the $20 million raised in the 
Transaction, or $6,612,502.50.  At the time of the Transaction, the Company had 
adequate Common Stock authorized to allow for the ultimate conversion into 
common stock of the Series B convertible preferred stock issued under the terms 
of the Transaction and issued from the exchange of the Series A preferred stock.
The Notes will automatically convert to Series B Convertible Preferred Stock if 
the Company's shareholders approve an amendment to the Ninth Amended and 
Restated Articles of Incorporation authorizing a sufficient number of shares of 
common stock to permit conversion to common stock of all of the Series B 
Convertible preferred stock issuable upon conversion of the Notes.  If the 
Company's shareholders approve this amendment, the Notes will convert into an 
additional 881,667 shares of Series B convertible Preferred Stock, which would 
in turn be convertible into 8,881,670 shares of Common Stock.  If the Company's 
shareholders do not approve this amendment, the Notes will become immediately 
due and payable.  Pursuant to the terms of the Transaction, the Company must 
hold its annual meeting of shareholders no later than April 15, 1998, subject to
certain exceptions.

1983 Stock Option Plan.  The Company maintains a stock option plan which 
provides for the issuance of incentive stock options (ISOs) and nonqualified 
stock options (NSOs) to officers, employees, independent contractors, 
consultants and advisors of the Company.  In July of 1997 the Company filed a 
Form S-8 to register the issuance and sales of an additional 800,000 shares 
reserved under the plan.  The Company has reserved 6,500,000 shares of common 
stock for issuance thereunder.  The Plan terminates October 31, 2003.  At 
December 31, 1997, options to purchase 3,911,110 shares were outstanding of 
which 1,403,010 were exercisable at prices ranging from $1.25 to $3.31.

Directors' Stock Option Plan.  The Company maintains a stock option plan which 
provides for NSOs as equity incentives to assist the Company in recruiting and 
retaining outside directors.  In August of 1996 the Company filed a Form S-8 to 
register the issuance and sales of an additional 200,000 shares reserved under 
the plan.  The director's stock option plan allows for the Company to issue 
options covering up to 500,000 shares.

At December 31, 1997, options to purchase 270,600 shares were outstanding, of 
which 151,850 were exercisable at prices ranging from $1.25 to $3.31 and 185,000
were available for future grant of options under the plan.  The Company has 
reserved 500,000 shares of common stock for issuance thereunder.

A summary of option transactions under the two option plans is as follows:
<PAGE>
 
<TABLE> 
<CAPTION> 
                                                                           Number of Shares              Option Price
                                                                           ----------------        ---------------------   
<S>                                                                         <C>                   <C> 
Outstanding at
        December 31, 1994                                                      2,153,688           $    1.00 -      5.06
        Granted                                                                  454,972                1.62 -      3.31
        Exercised                                                               (109,050)               1.19 -      2.25
        Canceled or expired                                                     (148,242)               1.25 -      2.75
                                                                               ---------           ---------------------

Outstanding at
        December 31, 1995                                                      2,351,368                1.00 -      3.31
        Granted                                                                1,434,460                1.25 -      1.97
        Exercised                                                                (31,625)               1.19 -      1.63
        Canceled or expired                                                   (1,089,331)               1.00 -      5.06
                                                                               ---------           ---------------------

Outstanding at
        December 31, 1996                                                      2,664,872                1.25 -      3.31 
        Granted                                                                1,666,850                 .69 -      1.56
        Exercised                                                                 (4,375)               1.50
        Canceled or expired                                                     (415,637)                .93 -      3.13 
                                                                               ---------           ---------------------

Outstanding at
        December 31, 1997                                                      3,911,710                 .69 -      3.31
                                                                               =========           =====================
</TABLE> 
1990 EMPLOYEE STOCK PURCHASE PLAN.  The Company maintains a stock purchase plan 
to provide employees of the Company with a convenient means to acquire an equity
interest in the Company through payroll deductions, and to provide an incentive
for continued employment. The employee stock purchase plan reserves 2,000,000 
shares of common stock for issuance under the plan.

The plan qualifies as an "employee stock purchase plan" under Section 423 of the
Internal Revenue Code. All full-time employees are eligible to participate
through payroll deductions up to 10% of their compensation; participants may, at
their option, purchase shares from the Company at the lower of 85% of the fair
market value of the common stock at either the beginning or end of each six-
months option period. In the event the market price at the end of any option
period is less than 50% of the market price at the beginning of the period,
employee purchases are limited to twice the shares that could have been
purchased using the beginning market price.

During 1997, 332,678 shares were purchased at a price of $0.64. During 1996, 
191,961 shares were purchased at a price of $1.17. During 1995, 158,844 shares 
were purchased at prices ranging from $1.33 to $2.18. At December 31, 1997, 
324,411 shares were available for future issuance under the plan.

FAIR VALUE DISCLOSURES. Stock option grants are set at the closing price of the 
Company's common stock on the date of grant and the related number of shares 
granted are fixed at that point in time. Therefore under the principles of APB 
Opinion No. 25, the Company does not recognize compensation expense associated 
with the grant of stock options. SFAS No. 123, "Accounting for Stock-Based 
Compensation," requires the use of option valuation models to provide 
supplemental information regarding options granted after 1994. Pro forma 
information regarding net income and earnings per share shown below was 
determined as if the Company had accounted for its employee stock options and 
shares sold under its stock purchase plan under the fair value method of the 
Statement.

The fair value of the options was estimated at the date of grant using a Black-
Scholes option pricing model with the following weighted-average assumptions for
1997, 1996, and 1995, respectively: risk-free interest rates of 6.25%, 6.25% and
5.40%; dividend yields for the 3 periods of 0%; volatility factors of the
expected target price of the Company's common stock of 62.8% for the 3 periods;
and expected life of the options of 5.0 for the 3 periods. These assumptions
resulted in weighted-average fair values of $1.40, $1.47 and $2.32 per share for
stock options granted in 1997, 1996 and 1995, respectively.

The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options. The Company's employee stock options have 
characteristics significantly different from those of

<PAGE>
 
traded options such as vesting restrictions and extremely limited 
transferability.  In addition, the assumptions used in option valuation models 
(see above) are highly uncertain, particularly the expected stock price 
volatility of the underlying stock.  Because changes in these uncertain input 
assumptions can materially affect the fair value estimate, in management's 
opinion, the existing models do not provide a reliable single measure of the 
fair value of its employee stock options.

For purposes of pro forma disclosures, the estimated fair value of the options 
is amortized over the option vesting periods.  The pro forma effect on net 
income for 1997, 1996 and 1995 is not representative of the pro forma effect on 
net income in future years because it does not take into consideration pro forma
compensation expense related to grants made prior to 1995.  Pro forma 
information in future years will reflect the amortization of a larger number of 
stock options granted in several succeeding years.  The Company's pro forma 
information is as follows (in thousands, except per share information):

<TABLE> 
<CAPTION> 
                                                               Year ended December 31,                  
                                            ------------------------------------------------------------                        
(in thousands)                                  1997                    1996                    1995                            
                                            ------------            ------------            ------------                        
<S>                                         <C>                     <C>                     <C>                                 
Net loss - as reported                      $    (18,924)           $     (6,801)           $     (5,188)                       
Net loss - pro forma                             (19,428)                 (7,097)                 (5,232)                       
                                                                                                                                
Loss per share - as reported                $       (.93)           $       (.34)           $       (.26)                       
Loss per share - pro forma                  $       (.95)           $       (.35)           $       (.26)                       
                                            ============            ============            ============                        
</TABLE> 

Information regarding outstanding stock options and warrants as of December 31, 
1997 is as follows:

<TABLE> 
<CAPTION> 
                                         Options Outstanding                                            Options Exercisable
                   -----------------------------------------------------------------        --------------------------------------- 
                                                                   Weighted Average
                                        Weighted-Average              Remaining                                  Weighted-Average
Price Range            Shares            Exercise Price            Contractual Life            Shares             Exercise Price
------------       -------------     ---------------------      ---------------------       ------------      ----------------------
<S>                   <C>                    <C>                        <C>                    <C>                    <C> 
 $0.69-$1.53          2,471,485              $1.38                      4.84                   478,102                $1.13         
 $1.56-$2.00          1,406,000              $1.69                      2.65                   797,748                $1.72         
 $2.38-$3.31            334,225              $2.77                      1.78                   227,473                $2.80
============       =============     =====================      =====================       ============      ======================
</TABLE> 
<PAGE>
 
10.   Employee Benefit Plan

In 1994, the Company established a 401(k) plan the (the "Plan") covering 
substantially all of its employees.  The Plan allows eligible employees to 
contribute up to 15% of their compensation.  Company contributions are voluntary
and at the discretion of the Board of Directors.  Contributions made by the 
Company for the year ended December 31, 1997 and 1996 and 1995 totaled $23,224, 
$31,440, and $32,615, respectively.

11.   Contingencies

In 1992, Octel Communications Corporation (Octel, now Lucent Technologies Inc.)
a competitor of the Company, filed suit in the United States District Court for
the Northern District of California against Theis Research, Inc. (Theis) for a
declaratory judgment that Octel's products do not infringe certain patents held
by Theis and that those patents are invalid.

In 1993, the court consolidated several actions and Theis filed a counterclaim
for infringement, a judgment of patent validity and various claims for
injunctive and monetary relief against, among others, Pacific Telesis Group,
Pacific Bell and other Pacific Bell entities (Pacific Telesis). Pacific Telesis
tendered defense of this action to various of its vendors, including the
Company, which resulted in counterclaims by Theis against the Company, Octel,
Boston Technology (now Comverse Technology Inc), Northern Telecom and most other
manufacturers of voice mail products. In 1993, the court severed trial of the
counterclaims against all counter defendants except Octel, Boston Technology and
Northern Telecom.

In 1994, a jury concluded that the patents held by Theis Research, Inc. were
either invalid or not infringed upon by Octel, and the counterclaims against
Pacific Telesis in which Digital Sound has intervened are currently stayed.
Theis Research appealed the findings of invalidity and noninfringement to the
U.S. Court of Appeals and on November 6, 1997 the U.S. Court of Appeals affirmed
the District Court's decision in its entirety. Theis Research has until March
30, 1998 to seek to have the matter heard before the U.S. Supreme Court. If
Theis Research is granted a hearing before the U.S. Supreme Court and the U.S.
Supreme Court reverses the judgment, Theis Research may assert claims of
infringement against Pacific Telesis and Digital Sound on these patents.
However, if the U.S. Supreme Court refuses to hear the matter or affirms the
holding, the potential for any successful counterclaim against Pacific Telesis
and Digital Sound as a supplier to Pacific Telesis is significantly reduced.

Management believes, based on information currently available, including
consultations with patent counsel, that the Company is not infringing upon any
valid patents of Theis. The Company will vigorously defend the patent
infringement claims and related claims for damages. While litigation is
inherently uncertain, Management believes in view of the jury verdict in the
Octel case that the ultimate resolution of these matters will not have a
material adverse effect on the financial condition or results of operations of
the Company. Should the outcome of this litigation be unfavorable to the
Company, however, the Company would be required to fulfill its indemnification
obligations to its customers, including Pacific Telesis, by either replacing or
modifying its products to avoid infringement or by procuring a license to use
the technology, either of which could have a materially adverse effect on the
financial condition or results of operations of the Company.

Additionally, the Company is subject to pending claims and litigation primarily
related to contractual, product and employee issues. Management, after review
and consultation with the Company's counsel, believes that the liability, if
any, from the disposition of such claims and litigation would not have a
materially adverse effect on the financial condition or results of operations of
the Company.

12.   Significant Customers

During the year ended December 31, 1997, one customer accounted for 58% of the
Company's net sales. During the year ended December 31, 1996, three customers
accounted for 40%, 13% and 11% of the Company's net sales. During the year ended
December 31, 1995, two customers accounted for 47% and 13% of the Company's net
sales. No other customer accounted for sales of 10% or more. A majority of the
Company's sales are made to telecommunications companies. The Company performs
ongoing credit evaluations of its customers' financial condition and, generally,
requires no collateral from its customers. In 1997 export sales accounted for 5%
of the Company's net sales as compared to 26% in 1996.

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

None.
<PAGE>
 
                                   PART III

ITEM 10.     DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
             --------------------------------------------------

The information concerning Directors required by this item is incorporated by 
reference to Page 8-9 of the 1998 Proxy Statement.  Information concerning 
Executive Officers required by this item appears after Part I, Item 4 of this 
report.

ITEM 11.     EXECUTIVE COMPENSATION
             ----------------------

The information required by this item is incorporated by reference to Pages 
10-11 of the 1998 Proxy Statement.

ITEM 12.     SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
             --------------------------------------------------------------

The information required by this item is incorporated by reference to Page 5-7 
of the 1998 Proxy Statement.

ITEM 13.     CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
             ----------------------------------------------

None.


                                    PART IV

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

(a) Financial Statements, Financial Statement Schedules and Exhibits

      (1)    The following exhibits are filed herewith:

<TABLE> 
<CAPTION> 

      Exhibit
      Number               Title
      -------              -----
      <S>           <C> 
      10.40         Description of Registrant's Executive Bonus Plan for 1998.
      11.01         Computation of Earnings (Loss) per Common Share.
      23.00         Consent of Ernst & Young, LLP, independent auditors.
      10.57         Purchase Agreement between GTE Communication Systems
                    Corporation and Digital Sound Corporation (Contract Number
                    120900-92-01), dated January 13, 1993, and Amendments Nos. 1
                    through 9 thereto.
      27            Financial Data Schedule

</TABLE> 

The following exhibits to the Company's Registration Statement under the 
Securities Act of 1933, as amended (filed January 19, 1990, Registration No. 
33-33066), and the amendments thereto, are incorporated herein by reference:

<TABLE> 
<CAPTION> 

      Exhibit
      Number               Title
      -------              -----
      <S>           <C> 
       3.01         Registrant's Articles of Incorporation, as amended to date.
       3.02         Registrant's By-Laws, as amended to date.
      10.12         Form of Indemnity Agreement with Directors.

</TABLE> 

The following exhibits to the Company's Form 10-K for 1996 or subsequently filed
Form 10-Qs for 1997 are incorporated herein by reference:

      Exhibit
      Number               Title
      -------              -----
<PAGE>

<TABLE> 
     <S>    <C> 
     10.08  *The Amended and Restated Stock Option Plan for Independent
                Directors of Digital Sound Corporation, (The Directors' Plan).
               
     10.10  *Registrant's Preferred Stock Purchase Agreement 
     10.35  *Letter agreement between Registrant and Mark C. Ozur. 
     10.38  *Registrant's 1983 Stock Option Plan. 
     10.39  *Registrant's Employee Stock Purchase Plan 
     10.43  *Amendment dated March 26, 1993 to the Registrant's 1983 Stock 
               Option Plan. 
     10.44  Lease Agreement by and between the Registrant and Bluffs Group III
               dated October 1, 1996.


EXHIBIT 
NUMBER                  TITLE
-------                 -----

     10.45   Lease Agreement by and between the Registrant and BancBoston
               Leasing, Inc., dated January 8, 1997.
     10.46   Amendment dated April 4, 1997 to the Registrant's 1983 Stock Option
               Plan.
     10.47   Amendment dated March 26, 1993 to the Registrant's Employee Stock
               Purchase Plan.
     10.48   Amendment dated April 4, 1997 to the Registrant's Employee Stock
               Purchase Plan.
     10.49   Line of Credit Agreement between Registrant and Imperial Bank dated
               July 28, 1997.
     10.50   Security and Loan Agreement Domestic Facility by and between
               Registrant and Imperial Bank dated July 28, 1997.
     10.52   First Amendment and Waiver to Digital Sound Corporation Credit
               Terms and Conditions by and between Registrant and Imperial Bank
               dated October 30, 1997.
     10.53   First Amendment to Security and Loan Agreement, Domestic Credit by 
               and between Registrant and Imperial Bank dated October 30, 1997.
     10.54   Warrant Purchase Agreement by and between Registrant and Imperial Bank
               dated October 30, 1997
     10.55   Antidilution Agreement by and between Registrant and Imperial Bank dated
               October 30, 1997.
     10.56   Registration Rights Agreement by and between Registrant and Imperial
               Bank dated October 30, 1997

The following exhibits to the Company's Form 8-K dated December 23, 1997, are
incorporated by herein by reference:


     3.03    Certificate of Determination.
     10.1    Preferred Stock Purchase Agreement dated December 19, 1997.
     10.2    Form of Convertible Promissory Note.
     10.3    Registration Rights Agreement dated December 19, 1997

(b)  In December 1997, the Registrant filed the following report on a Form 8K:

        Preferred Stock Purchase Agreement dated December 19, 1997.
        Certificate of Determination.
        Form of Convertible Promissory Note.
        Registration Rights Agreement dated December 19, 1997.

------
*Management contract or compensatory plan or arrangement required to be filed as
        an Exhibit to the Form 10-K Report pursuant to Item 14(c).
</TABLE> 


<PAGE>
 
                                  SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange 
Act of 1934, the Registrant has duly caused this report to be signed on its 
behalf by the undersigned, thereunto duly authorized, on February 25, 1997.

               DIGITAL SOUND CORPORATION

               By: /s/ B. Robert Suh
                   ---------------------
                   B. Robert Suh
                   Vice President, Finance and 
                   Chief Financial Officer

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange 
Act of 1934, this report has been signed by the following persons in the 
capacities and on the dates indicated.

     Name                     Title                             Date
     ----                     -----                             ----

Chief Executive Officer:

                              President,
/s/ Mark C. Ozur              Chief Executive Officer,    February 25, 1998
------------------------      and Director
Mark C. Ozur              


Chief Financial Officer:
                              

/s/ B. Robert Suh             Vice President, Finance     February 25, 1998
-----------------------       Chief Financial Officer     
B. Robert Suh 


Directors:

/s/ John D. Beletic           Director                    February 25, 1998  
-----------------------
John D. Beletic

/s/ Bandel L. Carano          Director                    February 25, 1998  
-----------------------
Bandel L. Carano 

/s/ J. David Hann             Director                    February 25, 1998  
-----------------------
J. David Hann

/s/ Frederick J. Warren       Director                    February 25, 1998  
-----------------------
Frederick J. Warren

<PAGE>
 
                           DIGITAL SOUND CORPORATION

                                  SCHEDULE II

                       VALUATION AND QUALIFYING ACCOUNTS
             FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
                             (Amount in thousands)

<TABLE> 
<CAPTION>

                                      Balance at        Addition       Deductions        Balance
                                       beginning      charged to             from         at end
                                       of period        earnings        allowance      of period
================================================================================================
<S>                                     <C>             <C>              <C>            <C> 
December 31, 1995

Allowance for doubtful receivables         $ 700           $  34            $(134)         $ 600

Accrued warranty reserve                   $ 375           $ 232            $(232)         $ 375
------------------------------------------------------------------------------------------------
December 31, 1996

Allowance for doubtful receivables         $ 600           $  60            $ (60)         $ 600

Accrued warranty reserve                   $ 375           $ 217            $(232)         $ 360
------------------------------------------------------------------------------------------------
December 31, 1997

Allowance for doubtful receivables         $ 600           $ 393            $(466)         $ 527

Accrued warranty reserve                   $ 360           $ 589            $(520)         $ 429
================================================================================================
</TABLE>