<PAGE>
 
                       SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549
                                  FORM 10-KSB
                                        
(Mark One)
    X           ANNUAL REPORT UNDER SECTION 13 OR 15 (D) OF THE
--------               SECURITIES EXCHANGE ACT OF 1934                        

                        

                 For the fiscal year ended September 30, 1998
                                           ------------------


                                      or
________          TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

                     For the transition period from ______________ to __________

                       Commission file number    0-18603
                                               ---------

                            Integral Systems, Inc.
--------------------------------------------------------------------------------
                (Name of small business issuer in its charter)


            Maryland                                       52-1267968
---------------------------------               --------------------------------
 (State or other jurisdiction of                (I.R.S. Employer Identification 
 incorporation of organization)                  No.)

5000 Philadelphia Way, Suite A, Lanham, MD                    20706
------------------------------------------      --------------------------------
(Address of principal executive offices)                    (Zip Code)

Issuer's telephone number  (301) 731-4233
                           -----------------------------------------------------

        Securities registered under Section 12(b) of the Exchange Act:



        Title of each class            Name of each exchange on which registered

_________________________________      _________________________________________

_________________________________      _________________________________________

 
        Securities registered under Section 12(g) of the Exchange Act:



                                    Common
--------------------------------------------------------------------------------
                               (Title of class)

 
--------------------------------------------------------------------------------
                               (Title of class)


Check whether the issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 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  ________
                       --    

Check if there is no disclosure of delinquent fliers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will 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-KSB or any
amendment to this Form 10-KSB [X]

As of November 30, 1998, the aggregate market value of the Common Stock of the
Registrant (based upon the average bid and ask prices of the Common Stock as
reported by the market makers) held by non-affiliates of the Registrant was
$109,501,331.

As of November 30, 1998, 5,856,456 shares of the Common Stock of the Registrant
were outstanding.

For the year ended September 30, 1998, the Registrant's revenues were
$28,035,506.

TRANSITIONAL SMALL BUSINESS DISCLOSURE FORMAT (CHECK ONE):  Yes[ ]  No [X]

                                       1
<PAGE>
 
                                    PART 1

  The Business section, Management's Discussion and Analysis of Financial
Condition and Results of Operations and other parts of this Form 10-KSB contain
certain statements that are not historical facts which are "forward-looking
statements," and can be identified by the use of forward-looking terminology
such as "believes,"  "expects," "may," "will," "should," or "anticipates," the
negatives thereof or other variations thereon or comparable terminology, and
include statements as to the intent, belief or current expectations of Integral
Systems, Inc. (the "Company") and its directors, officers and management with
respect to future operations, performance or position of the Company.   These
forward-looking statements are predictions.  No assurances can be given that the
future results indicated, whether expressed or implied, will be achieved.  The
Company's actual results may differ significantly from the results discussed in
the forward-looking statements.  While sometimes presented with numerical
specificity, these forward-looking statements are based upon a variety of
assumptions relating to the business of the Company, which although considered
reasonable by the Company, may not be realized.  Because of the number and range
of the assumptions underlying the Company's forward-looking statements, many of
which are subject to significant uncertainties and contingencies beyond the
reasonable control of the Company, some of the assumptions inevitably will not
materialize and unanticipated events and circumstances may occur subsequent to
the date of this document.  These forward-looking statements are based on
current information and expectation, and the Company assumes no obligation to
update.  Therefore, the actual experience of the Company and results achieved
during the period covered by any particular forward-looking statement may differ
substantially from those anticipated.  Consequently, the inclusion of forward-
looking statements should not be regarded as a representation by the Company or
any other person that these estimates will be realized, and actual results may
vary materially.  There can be no assurance that any  of these expectations will
be realized or that any of the forward-looking statements contained herein will
prove to be accurate.


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

COMPANY OVERVIEW


  The Company builds satellite ground systems for command and control,
integration and test, data processing, and simulation. Since its inception in
1982, the Company has provided ground systems for over 100 different satellite
missions for communications, science, meteorology and earth resource
applications. The Company has an established domestic and international customer
base that includes government and commercial satellite operators, spacecraft and
payload manufacturers and aerospace systems integrators.

  The Company has developed innovative software products that reduce the cost
and minimize the development risk associated with traditional, custom-built
systems. The Company believes that it was the first to offer a comprehensive
commercial-off-the-shelf (COTS) software product line for command and control.
As a systems integrator, the Company leverages these products to provide turnkey
satellite control facilities that can operate multiple satellites from any
manufacturer. These systems offer significant cost savings for customers that
have traditionally purchased a separate custom control center for each of their
satellites.

  For over 15 years, the Company has provided flexible, reliable and affordable
ground system solutions. This has allowed the Company to stay ahead of the
competition and perform well in an industry that has traditionally been
dominated by much larger aerospace firms. The Company believes that it has a
unique combination of competitive advantages, including the following:


  .  Experience.   More experience with different types of satellites and
     operational scenarios than any competitor.

  .  Technology.   Internationally recognized and proven COTS products that were
     first to market and that continue to lead the competition in functionality.

  .  Capabilities.   Turnkey systems for customers who need a comprehensive
     range of products and services.

                                       2
<PAGE>
 
  .  Delivery schedule and price.   Ability to deliver systems faster and at a
     lower cost than the competition.


  Through its wholly owned subsidiary Integral Marketing, Inc., ("IMI") the
Company acts as a manufacturers' representative, selling electronic test
instrumentation and equipment to customers primarily in Maryland, Virginia and
the District of Columbia. For a discussion of the Company's business segments,
see Note 12 to the Consolidated Financial Statements.

  Integral Systems Inc. is a Maryland corporation incorporated in 1982.


INDUSTRY BACKGROUND


  The space industry can be broken down into several industry sectors: (i)
infrastructure, (ii) communications, (iii) emerging applications, and (iv)
support services. Each of these sectors is funded by both government and
commercial investments. Space infrastructure encompasses the development,
manufacture and procurement of hardware and related systems for both space
assets (i.e., satellites and payloads) and ground assets (i.e., satellite ground
systems). The Company's business is focused in the ground system component of
the infrastructure sector. The communications sector of the space industry
includes revenue generated by satellite systems for commercial
telecommunications services and government and military communications.
Satellite technology has become critical to supporting many aspects of
telecommunications infrastructure, including long-distance telephony, personal
communications systems and private networks. The emerging applications market
includes space technologies utilized for new applications such as global
positioning systems and remote sensing. Support services for the space industry
include technical support, engineering, finance and consulting which facilitate
growth in space-related markets.

  According to a recent study by SpaceVest, space industry revenues will exceed
$95 billion in 1998 and will grow at a rate of approximately 10% per year.
Industry growth is supported by a study recently cited in Space News predicting
that nearly 1,700 satellites will be launched over the next 10 years. The 1998
space infrastructure revenues are expected to be approximately $53 billion,
comprising over half of the total space market. The ground sector, which
includes ground equipment, installations and operations, currently accounts for
approximately $25 billion of total space infrastructure revenues. The ground
sector is almost as large as all other sectors of the space infrastructure
market combined.

  The Company estimates that the current worldwide command and control market
represents approximately $4 billion. However, the Company also believes that the
increasing acceptance of COTS products will lead to substantial price reductions
and a subsequent decrease in market volume. The Company believes that its COTS
software products leave it well positioned to capitalize on this market trend,
resulting in an increase in both its revenues and market share.

  The space industry exhibits certain general characteristics. First, the space
industry is by nature global. There is a trend towards privatization and
deregulation in the communications and space industries which has engendered
numerous opportunities for private concerns to become players in these
traditionally government dominated markets. Opportunities in the space industry
have also been generated by the rapid growth in the information technology
industry.

  Second, there is an increasing demand for satellite-based applications.
Improvements in space and communications technologies have resulted in modern
communications satellites with power, capacity, switching capabilities and
longevity significantly greater than those of their predecessors. These
improvements in performance, together with satellites' inherent geographic
coverage and technical advantages, have made satellite-based communications
increasingly competitive with other communications technologies, broadening the
market for satellite support services.

  Third, government and business organizations also are increasingly demanding
that satellite ground systems be designed for interoperability with computer
hardware and software products and that such products be usable with existing
legacy systems. In addition, concerns over excessive development costs and the
rapid pace of technological change have led both government and business
organizations to demand flexible systems created by adapting COTS software and
hardware, rather than systems that have been built to customized specifications.
This emphasis on 

                                       3
<PAGE>
 
system flexibility using readily available commercial products creates extensive
opportunities for flexible COTS products and for systems integration.


THE COMPANY SOLUTION


  The Company offers satellite ground systems that provide low-cost, efficient
and flexible operations. The principal characteristics of the Company's approach
are as follows:

  Open Systems and Ease of Integration.  The Company's family of products
addresses the dynamic environment of satellite operation through a commitment to
open systems architecture. The Company's products are implemented as open
systems with full adherence to industry hardware and software standards. The
Company's software can be rehosted to virtually any UNIX platform. A Windows NT
version is currently slated for release in 1999. The open architecture of the
Company's products allows interoperability with existing systems. Although the
Company's software components are typically sold as bundled products, they may
be purchased and operated separately or integrated with existing command and
control software.

  Advanced Architecture.   Unlike the traditional host-based approach, the
Company's ground systems are fully distributed, consisting of a set of
workstations all communicating via a local area network ("LAN") backbone. Any
software function can be performed on any workstation, eliminating the host
computer bottleneck and allowing the processing and network loading to be fine-
tuned by reallocation of logical processes to physical hardware. This approach
also provides more reliable operations by eliminating single points of failure.

  Depth of Functionality.   The Company's command and control software supports
all aspects of satellite operation through a bundle of four inter-operable
software products: (i) a real-time package; (ii) an off-line package; (iii) an
orbit analysis package; and (iv) a database package. The Company's real-time
package performs daily and routine satellite operations, including commanding,
telemetry processing and fault detection and correction. The off-line package
supports sustaining engineering functions, including trending and statistical
analysis of data archived by the real-time system. The orbit analysis package
performs orbit determination and prediction functions to monitor and control the
position of the satellite in space. The database package tailors the performance
of the other three packages, which are general in scope, to the specific
requirements of each satellite mission. That is, the database defines the
telemetry and command characteristics and the desired orbital elements and
tolerances.

  Flexibility/Adaptability.   A critical element to achieving initial operator
acceptance of a new system and facilitating rapid implementation is the ability
of the Company's software to serve the needs of particular satellite systems.
All of the Company's software is database driven, allowing it to support
satellite design changes or different series of satellites, without modifying
the underlying software. Similarly, the software also supports a wide range of
COTS hardware, including antenna, RF and baseband equipment, allowing the total
system to be delivered in the most efficient configuration for each mission.
Finally, the software is platform independent and can run on any UNIX computer,
with a Windows NT capability slated for release in 1999. This platform
independence makes it possible for the Company and its customers to take full
advantage of rapidly declining computer costs.

  Superior Price/Performance.  The Company seeks to achieve superior
price/performance by providing comprehensive solutions within the budgetary
needs of its customers. The Company believes that its COTS software products
provide advanced yet cost-effective solutions for satellite operators. These
COTS software products eliminate the need for expensive development services,
thereby substantially reducing the overall cost of a ground system. The
Company's database driven software allows satellites to be added over time which
permits the initial system acquisition costs to be amortized over years of
operations. The Company believes its software products exceed industry
expectations in functionality, technical sophistication and ease of use.

COMPANY STRATEGY


  The Company is currently a leading provider of satellite command and control
systems, providing systems for a wide variety of satellites. The Company intends
to extend its leadership and to expand its market share in world command and
control solutions for users of all satellite types. Primary elements of the
Company's strategy include:

  Technological Leadership.   The Company intends to continue to commit
substantial resources to further develop the next generation of its EPOCH and
OASYS off-the-shelf products. For example, the products are currently being re-
engineered to operate under the Windows NT operating system to take advantage of
the tremendous third-party product base available on NT platforms, and to
eliminate the risk of UNIX becoming 

                                       4
<PAGE>
 
obsolete. The Company anticipates that it will have migrated most of its
software solutions to the Windows NT platform in 1999. In addition, because the
satellite infrastructure industry is increasingly requiring standards
compliance, the Company intends to adhere to existing and future industry
standards and participate in the further development of such standards.

  Strategic Alliances and Partnerships.   In addition to its own development and
marketing organization, the Company has and will continue to establish
partnerships with select third parties, primarily satellite and hardware
manufacturers, to assist the Company in successfully integrating its software
products, implementing total solution command and control systems and developing
customer relationships.

  Integration with Complementary Products.   The Company believes that its
ability to offer command and control software products that can integrate
seamlessly with all satellite types and ground system components is a key
competitive advantage. The Company also intends to integrate its software
products with complementary products, including visualization tools, scheduling
engines and decision support aids in order to maintain its competitive advantage
and provide maximum flexibility for its customers.

  Sales, Support, Service and Marketing Organizations.   The Company currently
sells and supports its command and control software through direct sales to
satellite operators and systems integrators in North America, Europe and Asia.
The Company plans to invest significantly in expanding its sales, support and
service capabilities in these geographic regions while simultaneously gaining
entry into emerging markets in South America and Africa. The Company also
intends to augment its direct marketing efforts with U.S. Government
organizations to capitalize on the growing acceptance of COTS solutions in the
government sphere.

  In addition to expanding its market share in its core business, the Company
intends to draw on its capabilities and reputation in the command and control
area to develop opportunities in related areas. The key aspects of this growth
strategy are as follows:

  New Suite of Off-the-Shelf Applications.   The Company intends to broaden its
COTS line beyond command and control to include other applications currently
utilizing customized solutions. These applications, which include payload data
processing, payload integration and test ("I&T") and ground equipment monitoring
and control, have overlapping functionality with the Company's command and
control applications and provide significant market growth opportunities. To
date, the Company is building or has delivered twelve payload data processing
systems, six satellite payload I&T systems and several monitoring and control
systems.

  Professional Services Capabilities.   The Company believes that providing
comprehensive services and a high level of customer support is critical to its
ability to maintain its leading position in command and control systems and to
expand into new markets. Therefore, the Company intends to expand its
professional services organization in areas including hardware testing, pre- and
post-sale software support, quality assurance, project installation management
and training. For example, the Company is implementing an ISO 9000 compliance
program and anticipates certification by late 1999.

  Strategic Acquisitions.   Management may, at some time, determine to
selectively pursue acquisitions of businesses, products or technologies that
enhance its competitive position more efficiently than through in-house
development. The Company has not acquired any businesses to date and has no
agreements or understandings to do so at this time.


PRODUCTS


  Most of the Company's sales involve a combination of COTS software and
hardware products together with development services for mission specific
requirements and system integration as summarized below.


 Command and Control Software.


  EPOCH 2000, the Company's COTS software solution for satellite command and
control, is designed to operate a variety of satellites with a minimum of
personnel. EPOCH 2000's success has placed the Company at the forefront of
replacing antiquated satellite control centers with smaller systems that can fly
multiple satellites produced by any manufacturer.  EPOCH 2000's open
architecture, in combination with a graphical user interface and automated
monitoring and control features, allow operators to monitor and control both
their satellites and 

                                       5
<PAGE>
 
ground systems.

  EPOCH features a modern, distributed architecture consisting of a series of
user workstations interconnected via an Ethernet LAN. This approach provides
better performance than traditional mini-computer based ground systems at a
lower cost.  EPOCH provides end-to-end satellite command and control
capabilities, including telemetry processing and display, commanding and command
verification ("CV"), ground station automation, alarm/event processing and
data archive and retrieval..  These functions are driven by the EPOCH database,
allowing the system to support multiple satellites solely through database
updates, without modifying the run-time software. This results in lower
maintenance and operations costs throughout the lifecycle.

  The typical EPOCH installation consists of a front-end processor which
provides the interface to the front-end hardware (e.g., bit syncs, command
encoders) and a series of user analysis workstations, all interconnected via the
LAN.  The front end processor executes a real-time version of UNIX and services
all the time-critical requirements. The analyst stations provide the mechanism
for users to control and monitor the satellite and the ground equipment. With
this approach, the processing burden is distributed across the network. The
system can be expanded indefinitely (up to the capacity of the network) by
adding new workstation nodes. Even the network capacity limitations can be
overcome by dividing the system into subnets inter-connected by bridges and
routers. Thus, additional users can be accommodated during peak loads with no
degradation in system response times.

  Functionally, the software addresses all of the requirements for real-time
satellite control, including:

  Telemetry Processing.   The EPOCH software provides end-to-end telemetry
processing support, including frame decommutation, engineering unit ("EU")
conversion and limits checking.

  Commanding.   EPOCH provides full support for satellite commanding and CV. The
commanding software is mnemonic-based; the user can transmit a command to the
satellite by typing in the mnemonic from a pull-down list arranged
alphabetically or by spacecraft subsystem.

  Automation.   Routine satellite and ground system control procedures can be
fully automated via the EPOCH Satellite Test and Operations Language ("STOL").
STOL allows frequently used command and configuration sequences to be stored in
ASCII procedure files for automatic execution.

  Alarms/Events.   EPOCH provides a centralized alarm/events processor for
detecting and optionally correcting the following conditions: command or
telemetry verification failure, telemetry out-of-limits condition, front-end
processor failure or network communication problems.

  Data Archive and Retrieval.   A built-in archive capability provides a
permanent record of all significant ground system activity for long-term
trending and analysis.


  OASYS, the Company's mission-planning software, provides full spectrum support
for spacecraft orbit determination and control, including measurement set
reductions, orbit determination, ephemeris propagation, maneuver planning and
orbit events/reports.  OASYS allows the user to manage a single spacecraft or a
fleet in any Earth orbit, including low Earth, geosynchronous and Molniya-type
orbits.


  ABE, the Company's offline analysis package, provides trending and statistical
analysis of the information recorded in the real-time EPOCH archives. ABE
supports automatic data extraction of key data, along with summary-level
statistics (i.e., daily and seasonal minimums and maximums), advanced
statistical processing techniques (i.e., covariance, convolution and regression)
and graphical data visualization.

  All of these applications are tailored to specific customer requirements
through a fourth package, the database. The database application is based on a
commercial package for Relational Data Base Management System (''RDBMS''), with
a top-level user interface and functional extensions developed by the Company.
The database provides ''fill-in-the-blank'' menu edit forms allowing the
operator to specify every relevant operational characteristic and threshold for
the satellite, its orbit and the associated ground equipment.

                                       6
<PAGE>
 
  LEO-T, the Low Earth Orbiting Terminal, is a new product developed by the
Company as an extension of its existing command and control products. The LEO-T
software provides fully automated, un-manned, remote operations of satellite
ground stations, also known as telemetry, tracking, and control ("TT&C")
sites, for Low Earth Orbit ("LEO") satellites. The chief difference between LEO-
T and the other COTS software products is that LEO-T involves the monitoring and
control of the ground equipment, rather than satellites themselves. The software
controls antenna positioning and tracking, RF and baseband setup, communications
path switching and management of redundant equipment. The software also provides
a mechanism for transferring data between the tracking sites and the central
satellite control facility.


 Development Services and Systems Integration.


  The Company provides services to support mission-specific requirements for
both government and commercial customers. Most of the Company's ground system
contracts have a service component. Depending on the application, the services
may include tailoring of COTS software products, integration of third-party
hardware and software and/or custom software development. The Company also
provides post-delivery warranty and maintenance service for most of its systems.
The Company believes that its expertise and experience in satellite systems and
operations, computer software and hardware, engineering/mathematical analysis
and end-user applications allow it to provide ground systems that exceed
traditional expectations on system performance, cost and implementation
schedule. The Company's experience, together with its innovative COTS software
products and software tools, reduce the risks and lead time associated with
ground system development.


 Applications.


  The Company believes that it has strengthened its position in the marketplace
by developing a business base in certain critical application areas that offer
continued growth potential. The Company provides products and services in
different combinations in order to deliver systems for the following
applications:

  Command and Control.   The Company's EPOCH 2000 product line provides the
complete spectrum of capabilities for operating satellites from any
manufacturer. The Company sells the EPOCH 2000 software as a stand-alone product
or bundled as a turnkey system with third-party hardware (e.g. antenna, RF,
baseband and computer equipment).

  Integration and Test.   The Company provides I&T systems for the spacecraft
bus and payload. The I&T systems are based on the EPOCH 2000 product line and
software tools developed by the Company for data visualization and analysis for
payload I&T.

  Station Automation.   The Company has recently extended the EPOCH 2000 product
line to include a new product, called the LEO-T. The LEO-T software provides
fully automated un-manned operations of remote tracking stations for LEO
satellites.


  Data Processing.   The Company offers software tools and custom development
services for satellite payload data acquisition and processing. The Company's
principal work in this area has been for meteorological satellites.

  Simulation.   The Company builds satellite simulators which are used for
ground system checkout, training, spacecraft anomaly resolution and flight
software validation.



CUSTOMERS


  In general, there are three major applications for satellites: communications,
remote sensing and science. The Company has customers in each of these areas.
The Company believes that the combination of its proven COTS software products
and its strength as a systems integrator has positioned it to serve as an end-
to-end provider of total solutions for all of these applications.


 Communications.

                                       7
<PAGE>
 
  The Company provides satellite command and control products for a variety of
communications satellites. One of the principal advantages that the Company's
products offer in the commercial sector is the ability to operate fleets of
satellites from multiple vendors. This capability allows operators to reduce
costs by consolidating their control centers and using a single software package
to operate their satellites.

  The Company's products are currently flying communications satellites from
most of the major satellite manufacturers, including Hughes Space and
Communications Company, Lockheed Martin Corporation, Loral Space &
Communications Ltd. and Aerospatiale. The Company's customers include GE
Americom, Loral Skynet, Shinawatra Satellite Public Company Ltd. and China
Telecommunications Broadcast Satellite Corporation. All of these operators have
purchased the Company's products to operate their fleets of geosynchronous Earth
orbit ("GEO") communications satellites.

  Remote Sensing and Meteorology.

  The Company builds command and control systems as well as payload and image
data processing systems for meteorological satellites. Since its inception, the
Company has provided ground systems for the U.S. National Oceanic and
Atmospheric Administration ("NOAA"), including both their Geostationary
Operational Environmental Satellite Program ("GOES") and the Television
Infrared Observational Satellite ("TIROS") programs. The Company's systems
support mission operations, instrument data processing, simulation and flight
software validation. The Company also built the complete command and control
system for the U.S. Air Force Defense Meteorological Satellite Program
("DMSP'), whose operations were recently transitioned to civilian control
under NOAA's aegis. Since 1982, the Company has also been under contract to
provide the DMSP program with satellite simulators used for training, ground
system checkout and flight software analysis.

  High-performance ground systems are required to support Earth resource
satellites that provide military and civilian customers with accurate image
data. The Company has provided such command and control subsystems to Space
Imaging/EOSAT and other operators.

  The Company's DOMSAT receive station ("DRS") is a PC-based product that
receives real-time environmental information via satellite from ground-based
data collection platforms and provides integrated capability for data management
and analysis. The Company has sold over 70 DRS systems in the U.S. for a variety
of government and commercial applications. Customers include the U.S. Geological
Survey, the U.S. Army Corps of Engineers, the State of Louisiana and the City of
Colorado Springs, Colorado.


 Scientific Research.


  The Company has supported a variety of diverse and complex science missions.
The Company has supported more than a dozen missions for the National
Aeronautics and Space Administration ("NASA"), including the Small Explorer
("SMEX") missions, International Solar-Terrestrial Physics ("ISTP")
missions, X-ray Timing Explorer ("XTE") and Tropical Rainfall Measuring
Mission ("TRMM"). Projects range from the development of distributed command
and control systems to validation of complex embedded flight software.

  The Company was selected by the Johns Hopkins University Applied Physics
Laboratory to support the first NASA Discovery Mission, the Near Earth Asteroid
Rendezvous Program ("NEAR").  NEAR is the first in a series of low-cost,
small-planet exploratory missions designed to gather data about asteroids in the
solar system. The Company's EPOCH 2000 product forms the core of the mission's
command and control ground system and also supports the spacecraft I&T.

  The National Space Program Office ("NSPO") for the Republic of China
selected the Company to provide the complete command and control system for
their ROCSAT-1 satellite. As a subcontractor to AlliedSignal, the Company
provided the control center software, baseband hardware and system engineering
and integration support. The Company also supports small satellite missions in
America such as Orbital Sciences Corporation's SeaStar and Microlab programs.


MARKETING

                                       8
<PAGE>
 
  The Company relies upon senior corporate management, project managers and
senior technical staff to carry out its marketing program, including the
development and execution of marketing plans, proposal presentations and the
performance of related tasks. These individuals collect information concerning
requirements of current and potential customers in the course of contract
performance and formal and informal briefings, from published literature and
through participation in professional and industry organizations. Senior
management evaluates this information, identifies potential business
opportunities and coordinates proposal efforts. The primary source of business
in the Company's existing markets is by referral from existing customers.
Additionally, the Company advertises extensively in Space News Magazine and
other industry publications.

  The Company seeks business believed to be of long-term benefit based on
considerations such as technical sophistication, favorable market positioning
and potential product spin-offs. One of the Company's primary marketing
strategies is to anticipate and understand the changing needs of its customers
and then to be prepared to meet those needs as they arise in new programs or in
new program functions. This approach to marketing is mirrored in the Company's
products that are highly adaptable to growth and change in the requirements of
each user.


CONTRACT REVENUE


  The Company earns revenues from sales of its products and services through
contracts that are funded by the U.S. Government as well as commercial and
international organizations. The Company may be either a prime contractor
directly to the end-user of its products and services or it may act as a
subcontractor under a contract with another company.


   The percentages of revenues received by the Company from prime contracts and
subcontracts for fiscal years 1998 and 1997 are as follows:


                                                     FISCAL YEAR
           CONTRACT SOURCE                     1998               1997
           ---------------                     ----               ----
           Prime Contract                       68%                79%
             Subcontract                        32%                21%
                                                          
  For a given contract, the revenue mix may include the Company's COTS software
products, pass-through of third-party hardware and software, and services
provided by the Company or its subcontractors. The Company, through its wholly
owned subsidiary IMI, earns commission revenue by representing a number of
electronic product manufacturers in Maryland, Virginia and the District of
Columbia, principally in space-related markets.

  The Company generates revenue under three types of contracts: cost plus, fixed
price and time and material ("T&M") contracts. Under a cost plus contract, the
Company is reimbursed for allowable costs within the contractual terms and
conditions and is paid a negotiated fee. The fee may be fixed or based on
performance incentives. Revenue recognition under a cost plus contract is based
upon actual costs incurred and a pro rata amount of the negotiated fee.  Under a
fixed price contract, the Company is paid a stipulated price for services or
products and bears the risk of increased or unexpected costs. Revenue under a
fixed price contract is recognized using the percentage of completion method of
accounting based on costs incurred in relation to total estimated costs. Under a
T&M contract, the Company receives fixed hourly rates intended to cover salary
costs attributable to work performed on the contract and related overhead
expenses, reimbursement for other direct costs and a profit. Revenue is
recognized under a T&M contract at the contractual rates as labor hours and
direct expenses are incurred. A significant amount of the Company's revenue is
earned under cost plus contracts. To date, the vast majority of contracts for
the purchase of the Company's COTS software products have been fixed priced in
nature, either firm fixed price contracts or T&M fixed labor rate contracts.

  The following table summarizes the percentage of revenues attributable to each
contact type for the period indicated:


                                        FISCAL YEAR           FISCAL YEAR
             CONTRACT TYPE                  1998                  1997
             -------------                  -----                 ----

                                       9
<PAGE>
 
              Cost Plus                     41%                    51%
             Fixed Price                    56%                    46%
          Time and Materials                 3%                     3%
                                                                          
  Based on recent trends, the Company believes that the relative percentage of
cost plus contracts will decline in future fiscal periods.


U.S. GOVERNMENT CONTRACTS


  Company revenues from U.S. Government contracts are derived from a combination
of contracts with the U.S. Government and subcontracts with other companies that
have prime contracts with the U.S. Government. For fiscal years 1998 and 1997,
approximately 65% and 67%, respectively, of the Company's revenues were derived
from contracts or subcontracts funded by the U.S. Government.

  NOAA, one agency, represented 43% and 41% of revenues, respectively, for
fiscal years 1998 and 1997.  The Company expects that at least 43% of its
revenue for fiscal year 1999 will be derived from NOAA contracts. The loss of
any one of these NOAA contracts could significantly affect the Company's
performance. Similarly, the expiration, or termination for convenience, of any
major contract could significantly affect the Company's performance if not
renewed or replaced by contracts of similar value. It is estimated that the
single largest NOAA contract will represent approximately 18% of the Company's
fiscal year 1999 revenue. This contract is to develop the ground system used to
operate the next generation of geosynchronous weather satellites at NOAA.

  U.S. Government contracts are awarded by formal advertising or procurement by
negotiation. Negotiated procurements may, but do not necessarily, involve the
solicitation of competitive proposals. If competitive proposals are solicited,
the U.S. Government selects the proposal most advantageous to it and then
conducts negotiations with the selected bidder.

  Many of the U.S. Government programs in which the Company participates as a
contractor or subcontractor extend for several years but are funded only on an
annual basis. Accordingly, the Company's contracts and subcontracts are subject
to termination, reduction or modification in the event of changes in the
government's requirements or budgetary constraints. Additionally, when the
Company participates in a project as a subcontractor, it is subject to the risk
that the prime contractor may fail or be unable to perform the prime contract.

  All of the Company's U.S. Government contracts and subcontracts are also
subject to termination for ''convenience.'' Should a contract be so terminated,
the Company would be reimbursed for allowable costs to the date of termination
and would be paid a proportionate amount of the stipulated profits or fees
attributable to the work actually performed.

  The Company's books and records are subject to audit by the Defense Contract
Audit Agency (DCAA). Such audits can result in adjustments to contract costs and
fees. Although the Company thus far has not been required to make any material
audit adjustments, the possibility that such adjustments will be required always
exists. Management is of the opinion that any such audit adjustments would not
have a material adverse effect on the financial position or results of
operations of the Company.

  The Company's contracts and subcontracts with federal government agencies are
subject to competition and awarded on the basis of technical merit, personnel
qualifications, experience and price. The Company's business, financial
condition and results of operations could be materially affected by changes in
procurement policies, a reduction in funds available for the services provided
by it and other risks generally associated with federal government contracts.
New government contract awards also are subject to protest by competitors at the
time of award that can result in the re-opening of the competition or evaluation
process, or the award of a contract to a competitor. The Company considers such
bid protests to be a customary element in the process of procuring government
contracts.

  In addition to the right to terminate, U.S. Government contracts are
conditioned upon the continuing availability of congressional appropriations.
Congress usually appropriates funds on a fiscal year basis even though 

                                       10
<PAGE>
 
contract performance may take several years. Consequently, at the outset of a
major program, the contract is usually incrementally funded, and additional
funds are normally committed to the contract by the procuring agency as
appropriations are made by Congress for future fiscal years. In addition,
contractors often experience revenue uncertainties during the first quarter of
the government's fiscal year (beginning October 1) until differences between
budget requests and appropriations are resolved. To date, Congress has funded
all years of the multi-year major program contracts for which the Company has
served as prime contractor or a subcontractor, although there can be no
assurance that this will be the case in the future.


NON-U.S. GOVERNMENT CONTRACTS


  In addition to having contracts with the U.S. Government, the Company also has
contracts with commercial and international organizations. For fiscal years 1998
and 1997, approximately 35% and 33%, respectively, of the Company's revenues
were derived from non-U.S. Government contracts. These contracts are typically
with commercial satellite operators, satellite manufacturers, aerospace systems
integrators and foreign governments.

  Most of the Company's non-U.S. Government contracts are awarded competitively
and are performed on a fixed price basis. Typically, these contracts are for
turnkey systems that are delivered by the Company in six to eighteen months.
Payment is most often based on delivery milestones established in the Company's
contract. In addition, the contracts may include a system warranty period that
lasts one to two years. The Company also offers extended support for the system
on a fixed price or T&M basis.

  For certain of the Company's non-U.S. Government contracts, the Company often
has terms in its contracts under which the customer can enforce performance of
the Company or seek damages in case the Company does not perform as agreed to in
the contract. Contracts may require the Company to post a performance bond,
establish an irrevocable letter of credit or agree to pay liquidated damages in
the event of late delivery.


BACKLOG


  The Company's estimated backlog is as follows:

<TABLE> 
<CAPTION> 
                                         SEPTEMBER 30, 1998            SEPTEMBER 30, 1997
                                         ------------------            ------------------
<S>                                      <C>                           <C> 
  Outstanding Commitments (1)......           $ 17,389,358                  $ 14,010,47
  General Commitments (2)..........             25,212,281                   12,490,050
                                                ----------                   ----------
     Total........................            $ 42,601,639                  $26,500,527
                                                ===========                 ===========
</TABLE>
                                                                                
_______________
  (1) Represents orders that are firm and funded.
  (2) Represents orders that are firm but not yet funded and contracts awarded
      but not yet signed.

  Under outstanding commitments, the Company agrees to provide specific
services, frequently over an extended period of time, with continued performance
of those services contingent upon the customer's year-to-year decision to fund
the contract.

  General commitments consist of contract options and sole source business that
management believes likely to be exercised or awarded in connection with
existing contracts. Contract options are the Company's contractual agreement to
perform specifically defined services only in the event the customer thereafter
requests the Company to do so. Sole source business refers to contract work
which the Company reasonably expects to be awarded based on its unique expertise
in a specific area or because it has previously done all such work in that area
for the customer or prime contractor who will award the contract. The Company
estimates that 55% of backlog as of September 30, 1998 will be completed during
fiscal year 1999. Estimated backlog includes contract options through September
30, 2002, including general commitments.

  Many of the Company's contracts are multi-year contracts and contracts with
option years, and portions of these contracts are carried forward from one year
to the next as part of the Company's contract backlog. The Company's total
contract backlog represents management's estimate of the aggregate unearned
revenues expected to be earned by the Company over the life of all of its
contracts, including option periods. Because many factors affect the scheduling
of projects, there can be no assurance as to when revenues will be realized on
projects included in the 

                                       11
<PAGE>
 
Company's backlog. In addition, although contract backlog represents only
business which is considered to be firm, there can be no assurance that
cancellations or scope adjustments will not occur. The majority of backlog
represents contracts under the terms of which cancellation by the customer would
entitle the Company to all or a portion of its costs incurred and potential fees
to the date of cancellation.

  However, the Company also believes that backlog is not necessarily indicative
of future revenues. The Company's backlog typically is subject to large
variations from quarter to quarter as existing contracts are renewed or new
contracts are awarded. Additionally, all U.S. Government contracts included in
backlog may be terminated at the convenience of the government.

COMPETITION

  The Company experiences significant competition in all of the areas in which
it does business. The Company believes it is one of four companies in the United
States which derive the major portion of their revenue from the development of
satellite ground systems. The Company competes with numerous companies having
similar capabilities, some of which are larger and have considerably greater
financial resources, including Lockheed Martin Corporation, Loral Space &
Communications Ltd., Orbital Sciences Corporation, AlliedSignal, Computer
Sciences Corporation, Alcatel Espace, Matra Marconi Space and Aerospatiale. Many
of these competitors are significantly larger and have greater financial
resources than the Company, and some of these competitors are divisions or
subsidiaries of large, diversified companies that have access to the financial
resources of their parent companies. In addition, several smaller companies have
specialized capabilities in similar areas. In general, the markets in which the
Company competes are not dominated by a single company; instead, a large number
of companies offer services that overlap and are competitive with those offered
by the Company. There can be no assurance that the Company will be able to
compete successfully.

  Because its command and control business is specialized and the Company is a
leader in COTS software products, the market for this business is somewhat less
competitive. In the command and control software market, the Company competes
against other companies in the space industry. The Company's products also face
competition from certain Government off the Shelf (GOTS) products for satellite
command and control. In its other business areas, ground equipment and systems
integration, the Company competes against systems integrators and product
manufacturers.

  The Company believes that the principal competitive factors in the businesses
in which it operates are technical understanding, management capability, past
contract performance, personnel qualifications and price.

  The Company principally obtains contracts and subcontracts through competitive
procurements offered by the U.S. Government or commercial enterprises. Because
of its size, the Company often joins with a larger company in pursuing major
procurements. It is not unusual for the Company to compete with a company for a
contract while simultaneously joining with the same company in pursuit of
another contract.

  It is not possible to predict how the Company's competitive position may be
affected by changing economic or competitive conditions, customer requirements
or technological developments.

PROPRIETARY RIGHTS

  The Company regards its products as proprietary trade secrets and confidential
information. The Company relies on a combination of common law copyright and
trade secret laws, third-party nondisclosure agreements and other industry
standard methods for protecting ownership of its proprietary software. There can
be no assurance, however, that in spite of these precautions, an unauthorized
third party will not obtain and use information that the Company considers
proprietary. To date, the Company has not registered any of its copyrights or
trademarks. In addition, the laws of some foreign countries do not protect the
Company's proprietary rights to the same extent as the laws of the United
States. There can be no assurance that the mechanisms used by the Company to
protect its software will be adequate or that the Company's competitors will not
independently develop software products that are substantially equivalent or
superior to the Company's products. None of the Company's software is patented.
The Company believes that it has all necessary rights to market its products,
although there can be no assurance third parties will not assert infringement
claims in the future.

  The Company believes that, due to the nature of its products, the skill of
personnel, knowledge and experience 

                                       12
<PAGE>
 
of management, and familiarity with the operation of the Company's products are
more important in maintaining a leadership position in the industry than the
protection of intellectual property rights.

EMPLOYEES

  The Company believes that its employees and their knowledge and capabilities
are a major asset. The Company has been successful in attracting and retaining
employees skilled in its core business competencies. The Company intends to
continue to employ highly skilled personnel, as well as personnel knowledgeable
concerning the needs and operations of its major customers.

  As of December 8, 1998, the Company employed approximately 184 employees of
whom 180 are full-time employees and 148 of whom are considered professionals in
engineering related disciplines.  Of the engineering professionals, 94% have
undergraduate degrees in a scientific discipline and 45% of those have advanced
degrees in a scientific discipline. Approximately 86% of the engineering staff
have at least seven years experience.

  The Company believes that its relations with its employees are good. None of
the Company's employees are covered by collective bargaining agreements.

  There is significant competition for employees with the computer, engineering
and information technology skills required to perform the services the Company
offers. The Company's success will depend in part upon the Company's ability to
attract, retain, train and motivate highly skilled employees.

RESEARCH AND DEVELOPMENT

  The Company is continually engaged in research and development activities both
to improve its existing software products as well as probe additional product
areas for the future growth and development of the Company. Currently, the
Company is focusing its research and development efforts primarily on developing
and improving the user interface systems for its COTS software products. In
fiscal years 1998 and 1997, total capitalized software development expenditures
were $693,309 and $816,730 respectively.

ENVIRONMENT

  No material effects on the Company's expenditures, earnings, or competitive
position are anticipated as a result of compliance with federal, state, and
local provisions which have been enacted or adopted regulating the discharge of
material into the environment, or otherwise related to the protection of the
environment.

FINANCING

  The Company has access to a general line of credit facility through which it
can borrow up to $3.0 million. Borrowings under the line of credit bear interest
at the Eurodollar Rate plus 1.9% per annum. Any accrued interest is payable
monthly. The line of credit is secured by the Company's billed and unbilled
accounts receivable. The line also has certain financial covenants, including
minimum net worth and liquidity ratios. The line expires February 28, 1999. At
September 30, 1998 and 1997, the Company had outstanding balances of zero
dollars and $500,000, respectively, under such line of credit.

  The Company also has access to a $2.0 million equipment lease line of credit
under which it had $1,150,000 and zero dollars outstanding as of September 30,
1998 and 1997 respectively.  The balance is payable over 36 months and bears
interest at a rate of 8.8% per annum. The unused portion of the line of credit
will be used to finance future equipment purchases under substantially similar
terms.

   See Footnote Numbers 5 and 7 of the notes to the Financial Statements for
further information regarding these matters.

FINANCIAL INFORMATION IN INDUSTRY SEGMENTS

   During the year ended September 30, 1998, the Company's operations included
two reportable segments: 

                                       13
<PAGE>
 
Satellite ground systems and electronic test instrumentation and equipment
marketing.

   The Company provides satellite ground systems - computer systems for
satellite command and control, data processing, simulation, and flight software
validation.  Customers for these systems include US Government organizations
such as National Aeronautics and Space Administration (NASA), the National
Oceanic and Atmospheric Administration (NOAA), and the US Air Force, as well as
commercial satellite operators, both domestic and foreign.

  Through its wholly-owned subsidiary, Integral Marketing, Inc. (IMI), the
Company acts as a manufacturer's representative, selling electronic test
instrumentation and equipment to customers primarily in Maryland, Virginia and
the District of Columbia. (The Company's other wholly-owned subsidiary,
InterSys, Inc. provides consulting services for satellite design and
procurement, but is presently inactive.)

   See Footnote Number 12 of the notes to the Financial Statements for financial
information regarding these segments.

                                       14
<PAGE>
 
ITEM 2. PROPERTIES
        -----------

   The Company's headquarters occupies approximately 25,600 square feet at 5000
Philadelphia Way, Lanham, Maryland 20706. The lease expires March 15, 1999, and
the annual lease cost for this lease is approximately $226,000, excluding
operating expenses of approximately $43,520. During fiscal year 1997 the Company
contracted for an additional 17,638 square feet of space at 4200 Forbes Blvd.
Lanham, Maryland 20706. This second lease expires April 15, 1999 and has an
annual lease cost, excluding operating expenses, of approximately $148,000. The
Company believes that adequate additional suitable space will be available as
required.

   The Company is currently renegotiating its lease with its headquarters
landlord to both expand its space and extend the term of its lease.

   The Company believes that it has adequate insurance coverage to protect its
properties and assets.

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

   The Company is from time to time involved in litigation incidental to the
conduct of its business. The Company is not currently a party to any lawsuit or
proceeding which, in the opinion of management, would be likely to have a
material adverse effect on the Company's business, financial condition or
results of operations.

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

   The Annual Meeting of Shareholders was held on July 22, 1998. The following
matters were voted on by shareholders, and received the votes indicated.

     1.    The shareholders elected the following individuals to the Board of
           Directors:

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
DIRECTOR                    FOR        AGAINST      ABSTAIN    BROKER NON-VOTES
<S>                      <C>           <C>          <C>        <C> 
--------------------------------------------------------------------------------
Dominic A. Laiti         5,616,474        0         196,902           0
--------------------------------------------------------------------------------
Robert P. Sadler         5,616,474        0         196,902           0
--------------------------------------------------------------------------------
Thomas L. Gough          5,616,474        0         196,902           0
--------------------------------------------------------------------------------
McComas                  5,616,474        0         196,902           0
--------------------------------------------------------------------------------
Steven R. Chamberlain    5,616,474        0         196,902           0
--------------------------------------------------------------------------------
Bonnie K. Wachtel        5,616,474        0         196,902           0
--------------------------------------------------------------------------------
</TABLE>

   
     2.   The shareholders ratified the appointment of Rubino & McGeehin,
          Chartered as independent accountants to the Company for the fiscal
          year ending September 30, 1998, as follows:

<TABLE> 
<CAPTION> 
          ----------------------------------------------------------------------
                           FOR                AGAINST                ABSTAIN
          ----------------------------------------------------------------------
          <S>           <C>                   <C>                    <C> 
                        5,620,784              9,300                 183,292
           Total                                                   
          ----------------------------------------------------------------------
</TABLE>


     3.   The shareholders did not approve a proposed amendment to the Articles
          of Amendment and Restatement of the Articles of Incorporation that
          would have provided for a staggered Board of Directors and that would
          have provided that directors be removed only for cause and then only
          by the affirmative vote of at least sixty-seven percent of the holders
          of the aggregate combined voting power of all classes of capital stock
          entitled to vote. The vote was as follows:

<TABLE>
<CAPTION>
          ----------------------------------------------------------------------
                           FOR                AGAINST                ABSTAIN
          ----------------------------------------------------------------------
          <S>           <C>                   <C>                   <C> 
                        3,588,532             536,920               1,687,924
           Total                                                   
          ----------------------------------------------------------------------
</TABLE> 


     4.   The shareholders did not approve a proposed amendment to the Articles
          of Amendment and Restatement of the Articles of Incorporation which
          would have provided for the authorization

                                       15
<PAGE>
 
          of 1,000,000 shares of series preferred stock, par value $0.01, and
          would have vested in the Board of Directors the power to classify or
          reclassify such stock in one or more series. The vote was as follows:
            
<TABLE>
<CAPTION>
          ----------------------------------------------------------------------
                           FOR                AGAINST                ABSTAIN
          ----------------------------------------------------------------------
          <S>           <C>                   <C>                   <C> 
                        3,487,782             601,720               1,723,874
           Total                                                   
          ----------------------------------------------------------------------
</TABLE> 


     5.   The shareholders approved a proposed amendment to the Company's 1988
          Stock Option Plan, as amended and restated January 1, 1994, which
          authorized an increase in the number of shares of the Company's common
          stock, par value $0.01, available for issuance thereunder by 600,000
          shares and which allows for a "cashless" exercise of stock options
          issued after such amendment:

<TABLE>
<CAPTION>
          ----------------------------------------------------------------------
                           FOR                AGAINST                ABSTAIN
          ----------------------------------------------------------------------
          <S>           <C>                   <C>                   <C> 
                        3,646,182             450,020               1,717,174
           Total                                                   
          ----------------------------------------------------------------------
</TABLE> 
            

                                       16
<PAGE>
 
                                    PART II

                                        
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER'S MATTERS
        -----------------------------------------------------------------------
     
   The following table sets forth the high and low prices of the Common Stock as
reported by The Nasdaq National Market, where the Common Stock trades under the
Symbol "ISYS." The prices reported have been adjusted to give retroactive
effect to changes resulting from stock dividends and stock splits.

 <TABLE>
<CAPTION>
               1998 FISCAL YEAR                   HIGH         LOW    
               ----------------                   ----         ---   
               <S>                               <C>          <C>    
               First Quarter                      7.06         4.88  
               Second Quarter                    16.00         6.59  
               Third Quarter                     17.00        11.69  
               Fourth Quarter                    18.50        10.63  
</TABLE> 
                                                            
<TABLE> 
<CAPTION>                                                    
               1997 FISCAL YEAR                  HIGH          LOW   
               ----------------                  ----          ---   
               <S>                               <C>           <C> 
               First Quarter                      5.17         3.25  
               Second Quarter                     5.08         3.66  
               Third Quarter                      5.58         3.58  
               Fourth Quarter                     6.00         4.50   
</TABLE> 

   As of September 30, 1998, there were approximately 1,306 holders of record of
the Company's Common Stock.

   Historically, the Company has not paid any cash dividends, nor does the
Company anticipate declaring or paying cash dividends in the foreseeable future.
Instead, the Company intends to invest earnings in the operations, development
and growth of its business. The payment of future dividends on the Common Stock
and the rate of such dividends, if any, will be determined in light of any
applicable contractual restrictions limiting the Company's ability to pay
dividends, the Company's earnings, financial condition, capital requirements and
other factors deemed relevant by the Board of Directors. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Liquidity and Capital Resources."

   On October 1, 1998, the Company indefinitely postponed its secondary offering
and withdrew its registration statement on Form S-1 filed with the Securities
and Exchange Commission on July 2, 1998, as amended on July 13, 1998, due to
adverse market conditions.

                                       17
<PAGE>
 
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        -----------------------------------------------------------------------
        OF OPERATIONS
        -------------

                        COMPARISON OF FISCAL YEAR 1998
                        -------------------------------
                              TO FISCAL YEAR 1997
                              -------------------

Overview

   Integral Systems, Inc. builds satellite ground systems for command and
control, integration and test, data processing, and simulation. Since its
inception in 1982, the Company has provided ground systems for over 100
different satellite missions for communications, science, meteorology, and earth
resource applications. The Company has an established domestic and international
customer base that includes government and commercial satellite operators,
spacecraft and payload manufacturers, and aerospace systems integrators.

   The Company has developed innovative software products that reduce the cost
and minimize the development risk associated with traditional custom-built
systems. The Company believes that it was the first to offer a comprehensive
COTS (Commercial-Off-The-Shelf) software product line for command and control.
As a systems integrator, the Company leverages these products to provide turnkey
satellite control facilities that can operate multiple satellites from any
manufacturer. These systems offer significant cost savings for customers that
have traditionally purchased a separate custom control center for each of their
satellites.

RESULTS OF OPERATIONS

     The components of the Company's income statement as a percentage of revenue
are depicted in the following table for the fiscal years ended September 30,
1998 and September 30, 1997:

<TABLE> 
<CAPTION>                                                       
                                            % of                        % of 
                              1998        REVENUE         1997        REVENUE 
                              ----        -------         ----        -------
                         (IN THOUSANDS)             (IN THOUSANDS)    
<S>                      <C>              <C>       <C>               <C>   
Revenue                      $28,036       100.0       $20,059         100.0  
Cost of revenue               20,677        73.8        16,020          79.9  
                             -------       -----       -------         -----  

Gross margin                   7,359        26.2         4,039          20.1  
SG&A                           3,047        10.9         2,303          11.5  
Offering Expenses                378         1.4             0           0.0  
Prod. amortization               660         2.4           660           3.3  
                             -------       -----       -------         -----  
                                                                              
Income from operations         3,274        11.7         1,076           5.3  
Other income (exp.) net         -167         -.6           -64           -.3  
                             -------       -----       -------         -----  
                                                                              
Income before taxes            3,107        11.1         1,012           5.0  
Income taxes                   1,198         4.3           383           1.9  
                             -------       -----       -------         -----  
                                                                              
Net income                     1,909         6.8           629           3.1  
                             =======       =====       =======         =====  
</TABLE>
                                                                                

                                       18
<PAGE>
 
Revenue

   The Company earns revenue from sales of its products and services through
contracts that are funded by the U.S. Government, both as a prime contractor or
a subcontractor, as well as commercial and international organizations. The
Company, through its wholly-owned subsidiary IMI, earns commission revenue by
representing a number of electronic product manufacturers in Maryland, Virginia
and the District of Columbia, principally in space related markets.

   Internally, the Company classifies revenues in two separate categories on the
basis of the contracts' procurement and development requirements: (i) contracts
which require compliance with Government procurement and development standards
("Government Services") are classified as government revenue, and (ii) contracts
conducted according to commercial practices ("Commercial Products and Services")
are classified as commercial revenue, regardless of whether the end customer is
a commercial or government entity. Sales of the Company's COTS products are
classified as Commercial Products and Services revenue. IMI sales of third-party
hardware and software are also classified as Commercial Products and Services
revenue.

   For the fiscal years ended September 30, 1998 and 1997 the Company's revenues
were generated from the following sources:


<TABLE>
<CAPTION>
   REVENUE TYPE                          1998      1997
   ------------                         ------    ------
   <S>                                  <C>       <C> 
   COMMERCIAL PRODUCTS & SERVICES
   Commercial Users                       35%       33%
   U.S. Government Users                   8        10
                                        -----     -----
     Subtotal                             43        43
                                        -----     -----
   GOVERNMENT SERVICES
   NOAA                                   43        41
   NASA                                    5         9
   Other U.S. Government Users             9         7
                                        -----     ----- 
     Subtotal                             57        57
                                        -----     -----

        Total                            100%      100%
                                        =====     =====
</TABLE>

   Based on the Company's revenue categorization system, the Company classified
43% of its revenue as Commercial Products and Services revenue with the
remaining 57% classified as Government Services revenue for both the fiscal
years ended September 30, 1998 and 1997. By way of comparison, if the revenues
were classified strictly according to end-user (independent of the Company's
internal revenue categorization system), the U.S. Government would account for
65% and 67% of the total revenues for fiscal years 1998 and 1997, respectively.

   On a consolidated basis, revenue increased 39.8%, or $7.9 million, to $28.0
million for fiscal year 1998, from $20.1 million for fiscal year 1997.  The
increase was principally due to increases in both the Company's Government
Services revenues and the Company's Commercial Products and Services revenues,
the latter reflecting an expanding market acceptance for and sales of the
Company's EPOCH product line and related services.

COST OF REVENUE/GROSS MARGIN

   The Company computes gross margin by subtracting cost of revenue from
revenue.  Included in cost of revenue are direct labor expenses, overhead
charges associated with the Company's direct labor base and other costs that can
be directly related to specific contract cost objectives, such as travel,
consultants, equipment, subcontracts and other direct costs.

   Gross margins on contract revenues vary depending on the type of product or
service provided.  Generally, license revenues (related to the sale of the
Company's COTS products) have the greatest gross margins because of the minimal
associated marginal costs to produce.  By contrast, gross margins rates for
equipment and subcontract pass-throughs seldom exceed 15%.  Engineering service
gross margins typically range between 20% and 30%, while gross margins for IMI
vary considerably depending on sales volume achieved.

                                       19
<PAGE>
 
   During fiscal year 1998, cost of revenue increased to $20.7 million from
$16.0 million in fiscal year 1997 due primarily to increases in direct labor and
related overhead costs necessary to staff the Company's new contracts and
revenue growth. Cost of revenue expressed as a percentage of revenues, declined
to 73.8% for fiscal year 1998 from 79.9% for fiscal year 1997 primarily due to a
lower percentage of equipment and subcontract costs in the fiscal year 1998 cost
of revenue mix.

   The Company's gross margin increased 82.2%, or $3.4 million, to $7.4 million
for fiscal year 1998 from $4.0 million for fiscal year 1997.  The increase was
principally due to margin percentage improvements in all of the Company's
revenue components (i.e. licenses, engineering services, pass-throughs and IMI)
coupled with revenue growth.  Most notably, engineering services margins
increased considerably due to the virtual elimination of project overruns that
adversely affected margins during fiscal year 1997.  As a result of the
foregoing factors, gross margin as a percentage of revenue was 26.2% during
fiscal year 1998 compared to 20.1% for fiscal year 1997.

OPERATING EXPENSES/ INCOME FROM OPERATIONS

   Selling, General & Administrative expenses (SG&A) increased to approximately
$3.0 million in fiscal year 1998 from $2.3 in fiscal year 1997.  The change was
primarily due to increases in the Company's selling and marketing infrastructure
costs combined with increased bid and proposal expenses.  As a percentage of
revenue, however, SG&A accounted for only 10.9% of revenue in fiscal year 1998
compared to 11.5% in the preceding fiscal year.  Product amortization was
$660,000 for both fiscal years 1998 and 1997.

   During fiscal year 1998, the Company charged approximately $380,000 to
operating expense in connection with its decision to indefinitely postpone a
secondary public offering that was registered with the Securities and Exchange
Commission (SEC) in July 1998 on Form S-1 and subsequently withdrawn in
September 1998.

   Income from operations increased 204.3% to $3.3 million for fiscal year 1998
from $1.1million for fiscal year 1997 primarily due to increases in gross margin
dollars described above.  As a percentage of revenue, income from operations
increased to 11.7% for fiscal year 1998 from 5.3% for the prior year.  This
increase was principally the result of improved gross margin rates combined with
lower percentages of SG&A and product amortization as a function of revenue.

   The Company's effective tax rate was 38.6% and 37.8% for fiscal years 1998
and 1997 respectively.

OUTLOOK

   The Company's strong fiscal year results represent a continued trend from
prior fiscal years of increased sales and profitability on those sales. At this
time the Company has a significant backlog of work to be performed, as well as
potential contract awards it believes are probable based on proposals in the
pipeline. Management believes that operating results for future periods will
continue to improve based on the following assumptions:

     .    Demand for satellite technology and related products and services will
          continue to expand
     .    Sales of its software products and engineering services will continue
          to increase
     .    Sales from its IMI subsidiary will continue to grow

                                       20
<PAGE>
 
                        LIQUIDITY AND CAPITAL RESOURCES
                        -------------------------------
                                        
   Since the Company's inception in 1982, it has been profitable on an annual
basis and has generally financed its working capital needs through internally
generated funds, supplemented by borrowings under the Company's general line of
credit facility with a commercial bank and the proceeds from the Company's
initial public offering in 1988.

   For fiscal year 1998, the Company generated approximately $2.6 million of
cash from operating activities and used approximately $800,000 for investing
activities, including approximately $690,000 for newly capitalized software
development costs.  During fiscal year 1998, the Company also purchased
approximately $110,000 of fixed assets (principally new computers and equipment)
and procured an additional $800,000 of electronic equipment under capital lease.

   The Company has access to a general line of credit facility through which it
can borrow up to $3.0 million.  Borrowings under the line of credit bear
interest at the Eurodollar Rate plus 1.9% per annum.  Any accrued interest is
payable monthly.  The line of credit is secured by the Company's billed and
unbilled accounts receivable.  The line also has certain financial covenants,
including minimum net worth and liquidity ratios.  The line expires February 28,
1999.  At September 30, 1998, the Company had no amounts outstanding under the
line of credit.

   The Company also has access to a $2.0 million equipment lease line of credit
under which it had $1,150,000 outstanding as of September 30, 1998.  The balance
is payable over 36 months and bears interest at a rate of 8.8% per annum. The
unused portion of the line of credit will be used to finance future equipment
purchases under substantially similar terms.

   The Company currently anticipates that its current cash balances, amounts
available under its credit facilities and net cash provided by operating
activities will be sufficient to meet its working capital and capital
expenditure requirements for at least the next twelve months.  The Company
believes that inflation did not have a material impact on the Company's revenues
or income from operations in fiscal years 1998 and 1997 to date.

YEAR 2000 COMPLIANCE

   Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field.  To distinguish 21st
century dates from 20th century dates, these date code fields must be able to
accept four digit entries. The Company has evaluated its information technology
infrastructure and its software products for Year 2000 compliance. The Company
does not expect that the cost to modify its information technology
infrastructure or its software products to be Year 2000 compliant will be
material to its business, financial condition or results of operations. The
Company does not anticipate any material disruption in its operations as a
result of any failure by the Company to be in compliance. No assurance can be
given, however, that unanticipated or undiscovered Year 2000 compliance problems
would not have a material adverse effect on the Company's business, financial
condition or results of operations.
 
   In addition, the Company has limited information concerning the compliance
status of its suppliers.  Although the Company is not dependent on any one
supplier or any group of suppliers, in the event that any of the Company's
significant suppliers do not successfully and timely achieve Year 2000
compliance, the Company's business, financial condition or results of operations
could be materially adversely affected.

FORWARD LOOKING STATEMENTS

   Certain of the statements contained in this section, including those under
the headings "Outlook" and "Liquidity and Capital Resources" are forward-
looking. In addition, from time to time, the Company may publish forward-looking
statements relating to such matters as anticipated financial performance,
business prospects, technological developments, new products, research and
development activities and similar matters. While the Company believes that
these statements are and will be accurate, a variety of factors could cause the
Company's actual results and experience to differ materially from the
anticipated results or other expectations expressed in the Company's statements.
The Company's business is dependent upon general economic conditions and upon
various conditions specific to its industry, and future trends cannot be
predicted with certainty. Particular risks and uncertainties that may effect the
Company's business including the following:

                                       21
<PAGE>
 
     .    The presence of competitors with greater financial resources and their
          strategic response to the Company's new services.
     .    The potential obsolescence of the Company's services due to the
          introduction of new technologies.
     .    The response of customers to the Company's marketing strategies and
          services.
     .    Changes in activity levels in the Company's core markets.

                                       22
<PAGE>
 
ITEM 7.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
          -------------------------------------------



                            INTEGRAL SYSTEMS, INC.
                               AND SUBSIDIARIES

                                   ______

                       CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                      AND
                         INDEPENDENT AUDITORS' REPORT
<PAGE>
 
                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
DESCRIPTION                                                            PAGES
<S>                                                                    <C>
Independent Auditors' Report                                             1
 
Consolidated Balance Sheet as of September 30, 1998                      2
 
Consolidated Statements of Operations for the Years Ended
 September 30, 1998 and 1997                                             3
 
Consolidated Statements of Stockholders' Equity for the Years Ended
  September 30, 1998 and 1997                                            4
 
Consolidated Statements of Cash Flows for the Years Ended
 September 30, 1998 and 1997                                             5
 
Notes to Consolidated Financial Statements                              6-17
</TABLE>
<PAGE>
 
                         Rubino & McGeehin, Chartered
                         Certified Public Accountants
                        6905 Rockledge Drive, Suite 700
                           Bethesda, MD  20817-1818


 

 

                         INDEPENDENT AUDITORS' REPORT



To the Board of Directors and Stockholders
Integral Systems, Inc.


     We have audited the accompanying consolidated balance sheet of Integral
Systems, Inc. and its subsidiaries as of September 30, 1998, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
the years ended September 30, 1998 and 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 consolidated financial position of Integral
Systems, Inc. and its subsidiaries as of September 30, 1998, and their
consolidated results of operations and consolidated cash flows for the years
ended September 30, 1998 and 1997, in conformity with generally accepted
accounting principles.



November 20, 1998
Bethesda, Maryland

                                       1
<PAGE>
 
                   INTERGRAL SYSTEMS, INC. AND SUBSIDIARIES
                          CONSOLIDATES BALANCE SHEET
                              SEPTEMBER 30, 1998

                                    ASSETS

<TABLE>
<CAPTION>
                                Current assets
                                --------------
<S>                                                           <C>
   Cash and cash equivalents                                        $ 3,055,144
   Accounts receivable                                               10,912,373
   Employee receivables and other receivables                             2,686
   Prepaid expenses                                                      52,472
   Deferred income taxes                                                182,691
                                                                    -----------
                                                              
   Total current assets                                              14,205,366
                                                              
Property and equipment, at cost, net of accumulated           
  depreciation and amortization                                       1,180,425
                                  Deposits                               11,671
                                  --------
Software development costs, net of accumulated amortization           1,485,551
                                                                    -----------
                                                                        
   Total assets                                                     $16,883,013
                                                                    ===========

                   LIABILITIES AND STOCKHOLDERS' EQUITY

                            Current liabilities
                            -------------------

   Accounts payable - trade                                         $ 3,083,964
   Accrued expenses                                                   2,263,688
   Capital lease payable - current portion                              401,386
   Billings in excess of revenue for contracts in progress              518,720
   Income tax payable                                                   747,777
                                                                    -----------
                                                                        
   Total current liabilities                                          7,015,535
                                                                        
Capital lease payable - long term portion                               748,446
                                                                    -----------
                                                                        
   Total liabilities                                                  7,763,981
                                                                    -----------
 
                          Commitments and contingencies
                          -----------------------------
 
Common stock, $.01 par value, 10,000,000 shares authorized,
  5,839,984 shares issued and outstanding                                58,399
                          Additional paid-in capital                  1,398,982
                          --------------------------
Retained earnings                                                     7,661,651
                                                                    ----------- 
                                                                
   Total stockholders' equity                                         9,119,032
                                                                    -----------
                                                                
   Total liabilities and stockholders' equity                       $16,883,013
                                                                    ===========
</TABLE> 

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


                                       2
<PAGE>

                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                 ____________ 
 
<TABLE> 
<CAPTION>         
                                                                       1998                  1997              
                                                                       ----                  ----
<S>                                                                 <C>                 <C> 
Revenue                                                              $ 28,035,506         $  20,058,984
                                                                     ------------         -------------        
Cost of revenue
  Direct labor                                                          6,679,422             4,514,765
  Direct equipment and subcontracts                                     7,985,289             7,614,788
  Travel and other direct costs                                           951,895               628,598
  Overhead costs                                                        5,059,996             3,261,652
                                                                     ------------         -------------
 
    Total cost of revenue                                              20,676,602            16,019,803
                                                                     ------------         -------------
 
Gross margin                                                            7,358,904             4,039,181
 
Selling, general and administrative                                     3,047,042             2,303,294
Product amortization                                                      660,000               660,000
Offering expenses                                                         378,110                     -
                                                                     ------------         -------------
 
Income from operations                                                  3,273,752             1,075,887
 
Other income (expense)
  Interest income                                                          60,447                45,169
  Interest expense                                                        (86,556)              (10,509)
  Miscellaneous, net                                                     (140,816)              (98,375)
                                                                     ------------         -------------
 
Income before income taxes                                              3,106,827             1,012,172
 
Provision for income taxes                                              1,197,801               383,343
                                                                     ------------         -------------
 
  Net income                                                         $  1,909,026         $     628,829
                                                                     ============         =============
 
Weighted average number of common shares:
  Basic                                                                 5,793,433             5,718,060
 
  Diluted                                                               6,232,933             5,907,613
 
Earnings per share:
  Basic                                                              $        .33         $         .11
                                                                     ============         =============
 
  Diluted                                                            $        .31         $         .11
                                                                     ============         =============
</TABLE>

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

                                       3
<PAGE>

                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                   YEARS ENDED SEPTEMBER 30, 1998 AND 1997 
                                _____________  
<TABLE>
<CAPTION>
                                                                     Common                                   
                                                                     Stock at     Additional                     
                                                   Number of           Par          Paid-in       Retained           
                                                    Shares            Value         Capital       Earnings          Total   
                                                    ------            -----         -------       --------          -----
<S>                                                <C>            <C>            <C>              <C>           <C> 
Balance, September 30, 1996                        5,715,198      $  57,152      $   777,684      $ 5,123,796   $  5,958,632
  Stock options exercised                              9,706             97           24,868                -         24,965
  Tax benefit of stock options exercised                   -              -            9,607                -          9,607
  Net income                                               -              -                -          628,829        628,829
                                                   ---------      ---------      -----------      -----------   ----------- 
                                                 
Balance, September 30, 1997                        5,724,904         57,249          812,159        5,752,625      6,622,033
  Stock options exercised                            115,080          1,150          361,201                -        362,351
  Tax benefit of stock options exercised                   -              -          225,622                -        225,622
  Net income                                               -              -                -        1,909,026      1,909,026
                                                   ---------      ---------      -----------      -----------   ----------- 
                                                 
Balance, September 30, 1998                        5,839,984      $  58,399      $ 1,398,982      $ 7,661,651   $ 9,119,032
                                                   =========      =========      ===========      ===========   ===========
</TABLE>

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

                                       4
<PAGE>

                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                   YEARS ENDED SEPTEMBER 30, 1998 AND 1997 
                                ____________  

<TABLE>
<CAPTION>
                                                                            1998                      1997
                                                                            ----                      ----
<S>                                                                       <C>                     <C> 
Cash flows from operating activities:                          
 Net income                                                               $ 1,909,026             $   628,829
                                                                          -----------             -----------
 Reconciling adjustments:                                      
  Depreciation and amortization                                             1,188,994                 977,536
  Change in deferred taxes                                                   (138,367)                 29,589
  Tax benefit of stock options exercised                                      225,622                   9,607
  (Increase) decrease in:                                      
    Accounts receivable                                                    (1,843,966)             (4,218,521)
    Prepaid expenses and deposits                                              52,229                 (49,234)
    Employee receivables                                                       (1,486)                 23,000
  (Decrease) increase in:                                      
    Accounts payable - trade                                                  196,545               2,100,718
    Accrued expenses                                                          760,367                 345,965
    Billings in excess of revenue for contracts in progress                  (284,461)                674,256
    Income tax payable                                                        572,767                 126,950
                                                                          -----------             -----------
                                                               
      Total adjustments                                                       728,244                  19,866
                                                                          -----------             -----------
                                                               
 Net cash provided by operating activities                                  2,637,270                 648,695
                                                                          -----------             -----------
                                                               
Cash flows from investing activities:                          
 Acquisition of property and equipment                                       (108,648)               (720,233)
 Software development costs                                                  (693,309)               (816,728)
                                                                          -----------             -----------
                                                               
 Net cash used in investing activities                                       (801,957)             (1,536,961)
                                                                          -----------             -----------
                                                               
Cash flows from financing activities:                          
 Proceeds from sale/lease back                                                500,000                       -
 Payments on capital lease obligations                                       (149,134)                      -
 (Payments on) proceeds from line of credit                                  (500,000)                500,000
 Proceeds from exercise of stock options                                      362,351                  24,965
                                                                          -----------             -----------
                                                               
 Net cash provided by financing activities                                    213,217                 524,965
                                                                          -----------             -----------
                                                               
Net increase (decrease) in cash                                             2,048,530                (363,301)
                                                               
Cash and cash equivalents, beginning of year                                1,006,614               1,369,915
                                                                          -----------             -----------
                                                               
Cash and cash equivalents, end of year                                    $ 3,055,144             $ 1,006,614
                                                                          ===========             ===========
</TABLE>

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

                                       5
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997


1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


     PRINCIPLES OF CONSOLIDATION

     The accompanying consolidated financial statements include the accounts of
     Integral Systems, Inc. (the Company) and its wholly owned subsidiaries,
     Integral Marketing, Inc. (IMI) and InterSys, Inc. (InterSys). All
     significant intercompany transactions have been eliminated in
     consolidation.

     
     USE OF ESTIMATES

     The preparation of financial statements in conformity with generally
     accepted accounting principles requires management to make estimates and
     assumptions that affect certain reported amounts and disclosures.
     Accordingly, actual results could differ from those estimates.


     CONTRACT REVENUE

     Revenue under cost-plus-fixed-fee contracts is recorded on the basis of
     direct costs plus indirect costs incurred and an allocable portion of the
     fixed fee. Revenue from fixed-price contracts is recognized on the
     percentage-of-completion method, measured by the cost-to-cost method for
     each contract. Revenue from time and materials contracts is recognized
     based on fixed hourly rates for direct labor expended. The fixed rate
     includes direct labor, indirect expenses and profits. Material or other
     specified direct costs are recorded at actual cost.


     Contract costs include all direct material and labor costs and those
     indirect costs related to contract performance. General and administrative
     costs are charged to expense as incurred. Provisions for estimated losses
     on contracts in progress are made in the period in which such losses are
     determined. Changes in job performance, job conditions, and estimated
     profitability, including final contract settlements, may result in
     revisions to costs and income and are recognized in the period in which the
     revisions are determined. The Company's contracts vary in length from one
     to four years.


     The fees under certain government contracts may be increased or decreased
     in accordance with cost or performance incentive provisions which measure
     actual performance against established targets or other criteria. Such
     incentive fee awards or penalties are included in revenue at the time the
     amounts can be reasonably determined.


     Unbilled accounts receivable represents revenue recognized in excess of
     amounts billed. The liability, billings in excess of revenue for contracts
     in progress, represents billings in excess of revenue recognized.

                                       6
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                _______________


1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


     CHANGE IN ACCOUNTING FOR COMMISSION REVENUES


     During the fiscal year ended September 30, 1997, the Company elected to
     record commission revenues earned by IMI at the time orders are shipped.
     Previously, the Company recorded commission revenues at the time orders
     were received. The effect of this change was not material to the financial
     statements.


     DEPRECIATION AND AMORTIZATION

     Property and equipment are stated at cost. The Company follows the policy
     of providing depreciation and amortization by charges, on the straight-line
     method, to operating expenses at rates based on estimated useful lives as
     follows:


          CLASSIFICATION                  ESTIMATED USEFUL LIVES


          Electronic equipment                    3 Years
          Furniture and fixtures                  5 Years
          Leasehold improvements                  Life of lease
          Software                                3 Years


     Maintenance and repair costs are charged to expense as incurred.
     Replacements and betterments are capitalized. At the time properties are
     retired or otherwise disposed of, the property and related accumulated
     depreciation or amortization accounts are relieved of the applicable
     amounts and any gain or loss is credited or charged to income.


     SOFTWARE DEVELOPMENT COSTS

     The Company has capitalized costs related to the development of certain
     software products. In accordance with Statement of Financial Accounting
     Standards No. 86, capitalization of costs begins when technological
     feasibility has been established and ends when the product is available for
     general release to customers. Amortization is computed on an individual
     product basis and has been recognized for those products available for
     market based on the products' estimated economic lives which average four
     years. Due to inherent technological changes in software development,
     however, the period over which such capitalized costs is being amortized
     may have to be modified.

                                       7
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                ______________


1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


     EARNINGS PER SHARE

     Effective October 1, 1997, the Company adopted Statement of Financial
     Accounting Standards (SFAS) No. 128, Earnings Per Share. This statement
     replaces the previously reported primary and fully diluted earnings per
     share with basic and diluted earnings per share. Unlike primary earnings
     per share, basic earnings per share excludes any dilutive effects of stock
     options. Diluted earnings per share is similar to the previously used fully
     diluted earnings per share. All earnings per share amounts have been
     restated to conform to SFAS No. 128. No reconciling items existed between
     the net income used for basic and diluted earnings per share. The only
     reconciling item between the shares used for basic and diluted earnings per
     share related to outstanding stock options. The earnings per share
     computations have been adjusted retroactively where appropriate for the
     stock splits discussed in Note 11.


     CASH CONCENTRATIONS AND CASH EQUIVALENTS

     The Company considers all highly-liquid debt instruments purchased with a
     maturity of three months or less to be cash equivalents. Cash accounts are
     maintained primarily with one federally insured financial institution.
     Balances usually exceed insured limits, but management does not consider
     this to be a significant concentration of credit risk.


2.   ACCOUNTS RECEIVABLE AND REVENUE

     Accounts receivable at September 30, 1998, consist of the following:

<TABLE>
<CAPTION>
                                    BILLED
     <S>                                                  <C>
     Government Services                                              
       Prime contracts                                    $ 3,414,165
       Subcontracts                                         1,725,807
     Commercial Products and Services                       1,788,922
                                                          -----------
                                                                     
        Total billed                                        6,928,894
                                                          -----------
                                                                     
                                   UNBILLED      
     Government Services                                             
       Prime contracts                                        868,020
       Subcontracts                                         1,812,102
     Commercial Products and Services                       1,303,357
                                                          -----------
                                                                     
        Total unbilled                                      3,983,479
                                                          -----------
                                                                     
       Total accounts receivable                          $10,912,373
                                                          =========== 
</TABLE>

                                       8
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                ______________


2.   ACCOUNTS RECEIVABLE AND REVENUE (CONTINUED)


     Unbilled accounts receivable include amounts arising primarily from the use
     of the percentage-of-completion or other methods of recognizing revenue
     that differ from contractual billing terms. Substantially all unbilled
     receivables are expected to be billed and collected in one year.

     The Company earns revenue, both as a prime contractor and a subcontractor,
     from sales of its products and services through contracts funded by the
     U.S. government, as well as commercial and international organizations. The
     Company's subsidiary, IMI, earns commission revenue by representing
     electronic product manufacturers.

     The Company classifies contract revenues in two separate categories on the
     basis of the contract's procurement and development requirements: (i)
     contracts which require compliance with government procurement and
     development standards are classified as government revenue (Government
     Services) and (ii) contracts conducted according to commercial practices
     are classified as commercial revenue (Commercial Products and Services),
     regardless of whether the end customer is a commercial or government
     entity. Sales of the Company's commercial-off-the-shelf software products
     are classified as Commercial Products and Services revenue. IMI sales of
     third party hardware and software are also classified as Commercial
     Products and Services revenue.

     During the years ended September 30, 1998 and 1997, approximately 57% of
     the Company's revenue was from Government Services, primarily the National
     Oceanic and Atmospheric Administration (NOAA) and the National Aeronautics
     and Space Administration (NASA). The remaining revenue is from Commercial
     Products and Services as defined above.

     By the way of comparison, if revenues were reclassified according to end
     customer, the Company's revenue from U.S. government customers, both as a
     prime contractor and a subcontractor, for the years ended September 30,
     1998 and 1997, was 65% and 67%, respectively. Revenue from non-U.S.
     government customers for the years ended September 30, 1998 and 1997, was
     35% and 33%, respectively.

     For the year ended September 30, 1997, non-U.S. government revenue included
     one customer which provided revenue in excess of 10% of total annual
     revenue.

                                       9
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                ______________


3.   PROPERTY AND EQUIPMENT


     Property and equipment as of September 30, 1998, are as follows:

<TABLE>
     <S>                                                                  <C>       
                                                                                    
     Electronic Equipment                                                 $  593,509
     Furniture and fixtures                                                   43,743
     Leasehold improvements                                                    7,863
     Software                                                                 55,040
     Equipment under capital lease                                         1,298,968
                                                                          ----------
                                                                                    
      Total property and equipment                                         1,999,123
     Less:  accumulated depreciation and amortization                       (818,698)
                                                                          ---------- 
                                                                     
     Property and equipment, net                                          $1,180,425
                                                                          ==========
</TABLE>

     As discussed in Note 7, the Company entered into a sale-leaseback
     arrangement for certain electronic equipment during the year ended
     September 30, 1998.


4.   SOFTWARE DEVELOPMENT

     Software development costs as of September 30, 1998, consist of the
     following:

     <TABLE>    
     <S>                                                                  <C>        
     Costs Incurred                                                       $3,974,994
     Less:  accumulated amortization                                      (2,489,443)
                                                                          -----------
                                                                                     
     Software development costs, net                                      $1,485,551
                                                                          =========== 
</TABLE>

Amortization expense for the years ended September 30, 1998 and 1997, was
$660,000.


5.   LINE OF CREDIT


     The Company has a line of credit agreement with a bank at September 30,
     1998, for $3,000,000. Borrowings under the line are due on demand and bear
     interest at the Eurodollar Rate, plus 1.9% per annum. The line of credit is
     secured by the Company's billed and unbilled accounts receivable and has
     certain financial covenants, including minimum net worth and liquidity
     ratios. The line expires February 28, 1999. At September 30, 1998, the
     Company had no outstanding balance under the line of credit.

                                      10
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                ______________


6.   ACCRUED EXPENSES

     Accrued expenses at September 30, 1998, consist of the following:

     Accrued Payroll                                                 $1,154,476
     Accrued vacation                                                   515,990
     Payroll taxes                                                      261,887
     Retirement plan payable                                            327,798
     Other                                                                3,537
                                                                     ----------
                                                                     
      Total accrued expenses                                         $2,263,688
                                                                     ========== 

7.   COMMITMENTS AND CONTINGENCIES

     Capital Leases

     During the year ended September 30, 1998, the Company secured a $2,000,000
     equipment lease line of credit and entered into a sale-leaseback
     arrangement. Under the arrangement, the Company sold certain electronic
     equipment and leased it back for a period of three years. The leaseback has
     been accounted for as a capital lease. There was no significant difference
     between the book value and fair value of the equipment sold, and
     accordingly, no gain or loss from the sale was recorded.

     The Company also incurred additional capital lease obligations when it
     entered into new leases for equipment. The total capital lease additions
     were $1,298,966 for the year ended September 30, 1998. Future payments
     under the capital lease obligations at September 30, 1998, are as follows:


     Years ending September 30,  1999                             $  476,114
                                 2000                                488,394
                                 2001                                301,570
                                 2002                                 12,279
                                                                  ----------
                                                                            
     Total payments                                                1,278,357
     Less amount representing interest at 8.8% per annum            (128,525)
                                                                  ----------
                                                                            
     Present value of future lease payments                       $1,149,832
                                                                  ========== 

                                      11
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                ______________


7.   COMMITMENTS AND CONTINGENCIES (CONTINUED)


     Operating Leases

     The Company leases office space under two leases which expire in 1999.
     Future minimum lease payments under these operating leases are as follows:


        Year ending September 30,  1999                             $  190,000
                                                                     =========

     Lease payments do not include operating expenses or utilities, which are
     adjusted annually. Rent expense was $468,280 and $306,111, for the years
     ended September 30, 1998 and 1997, respectively.


     Government Contracts

     A significant portion of the Company's revenues represent payments made by
     the U.S. Government and by contractors that have prime contracts with the
     U.S. Government. These revenues are subject to adjustment upon audit by the
     Defense Contract Audit Agency (DCAA). Audits by the DCAA have been
     completed on the Company's contracts and subcontracts through the year
     ended September 30, 1996. Management is of the opinion that any
     disallowances of costs for subsequent fiscal years by the government
     auditors, other than amounts already provided, will not materially affect
     the Company's financial statements.


8.   INCOME TAXES

     For the years ended September 30, 1998 and 1997, the provision for income
     taxes consists of the following:

                                                    1998                1997
                                                    ----                ----
     Current tax expense                               
      Federal                                    $1,096,247           $289,616
      State                                         239,921             64,138
                                                  ----------          --------
                                                  1,336,168            353,754
     Deferred tax (benefit) expense                (138,367)            29,589
                                                  ----------          --------
                                                                      
      Total provision                            $1,197,801           $383,343
                                                  ==========          ======== 

                                      12
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                ______________


8.   INCOME TAXES (CONTINUED)

     At September 30, 1998, the tax effect of significant temporary differences
     representing deferred tax assets and liabilities are as follows:

<TABLE>
<CAPTION>
                                                                       Asset (Liability)
     <S>                                                               <C>              
     Depreciation and Amortization                                              $(22,445)
     Vacation accrual                                                            201,236
     Revenue reserve                                                               3,900
                                                                                --------
                                                                                        
      Net deferred tax asset                                                    $182,691
                                                                                ======== 
</TABLE>

     The effective income tax rates differ from the statutory United States
     income tax rate due principally to the following:

<TABLE>
<CAPTION>
                                                     1998            1997 
                                                     ----            ---- 
     <S>                                             <C>             <C>  
     Federal statutory rate                          34.0%           34.0%
     State tax, net of federal                                            
      income tax benefit                              4.6             4.6 
     Other                                              -            (0.7)
                                                     ----            ---- 
                                                                          
     Effective rate                                  38.6%           37.9%
                                                     ====            ====  
</TABLE>


9.   PROFIT SHARING AND EMPLOYEE BENEFITS PLANS

     The Company has a profit sharing and 401(k) plan for the benefit of
     substantially all employees. Profit sharing contributions consist of
     discretionary amounts determined each year by the Board of Directors of the
     Company based upon net profits for the year and total compensation paid.
     The 401(k) feature allows employees to make elective deferrals not to
     exceed 10% of compensation. The Company also has a money purchase plan
     which obligates the Company to contribute 5% of eligible salaries under the
     plan. For the years ended September 30, 1998 and 1997, contributions to the
     plans totalled $797,470 and $570,829, respectively.

                                      13
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                ______________


10.  STOCK OPTION PLAN


     Effective May 25, 1988, as amended on January 1, 1994, the Company
     established a stock option plan to create additional incentives for the
     Company's employees, consultants and directors to promote the financial
     success of the Company. The Board of Directors has sole authority to select
     full-time employees, directors or consultants to receive awards of options
     for the purchase of stock under this plan. At September 30, 1998, the
     maximum number of shares of common stock which may be issued pursuant to
     the stock option plan is 1,800,000. The price of each option is set at the
     stock's bid price on the date of the Board of Directors meeting at which
     the option is granted. Options expire no later than ten years from the date
     of grant (five years for greater-than-10% owners) or when employment
     ceases, whichever comes first, and vest from one to five years.


     The stock option plan is accounted for under Accounting Principles Board
     (APB) Opinion No. 25. Accordingly, no compensation has been recognized for
     the plan. Had compensation cost for the plans been determined based on the
     estimated fair value of the options at the grant dates consistent with the
     method of Statement of Financial Accounting Standards (SFAS) No. 123, the
     Company's net income and earnings per share for the years ended September
     30, 1998 and 1997, would have been:

<TABLE>
<CAPTION>
                                                              1998                1997 
                                                              ----                ----
     <S>                                                  <C>                 <C>                  
     Net income:                                                                                
      As reported                                          $ 1,909,026        $  628,829     
      Pro forma                                            $ 1,511,608        $  358,991   
                                                                                                
     Earnings per share:                                                                        
      As reported  -   basic                                  $   0.33           $  0.11   
                   -   dilutive                               $   0.31           $  0.11   
      Pro forma    -   basic                                  $   0.26           $  0.06   
                   -   dilutive                               $   0.24           $  0.06    
</TABLE>

     The fair value of the options granted is estimated on the date of the grant
     using the Black-Scholes options pricing model assuming the following: no
     dividend yield, risk-free interest rate of 6%, expected volatility of 40%,
     and an expected term of the options of four years. Stock option balances
     and activity discussed herein have been adjusted for the stock splits
     discussed in Note 11.

                                      14
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                  ___________

10. STOCK OPTION PLAN (CONTINUED)


    At September 30, 1998, options to purchase stock under this plan were
    outstanding to employees as follows:


                               Number of    Exercise Price
                                Shares       Per Share

                                67,872      $  1.00 - 1.99           
                                96,522      $  2.00 - 2.99           
                               367,600      $  3.00 - 3.99           
                               115,800      $  4.00 - 4.99           
                                14,200      $  5.00 - 5.99           
                                 4,000      $  6.00 - 6.99           
                                 4,000      $  9.00 - 9.99           
                                17,000      $12.00 - 12.99           
                                 9,000      $13.00 - 13.99           
                                 5,000      $14.00 - 14.99           
                                11,500      $15.00 - 15.99           
                               -------                               
                               712,494                               
                               =======                                

    Of the options outstanding at September 30, 1998, 418,228 options are
    exercisable immediately, and 294,266 options are exercisable over the next
    four years. Transactions involving the plan for the years ended September
    30, 1998 and 1997, were as follows:


                                                             Weighted Average
                                                    Shares    Exercise Prices

     Options outstanding, September 30, 1996        707,922      $3.33
         Granted                                     39,024      $4.38
         Exercised                                   (9,706)     $2.57
         Cancelled                                        -        N/A
                                                    -------
 
     Options outstanding, September 30, 1997        737,240      $3.40
         Granted                                     98,308      $9.17
         Exercised                                 (115,080)     $5.09
         Cancelled                                   (7,974)     $3.26
                                                   --------
 
     Options outstanding, September 30, 1998        712,494      $4.23
                                                   ========

     The weighted average fair values of options granted during the years ended
     September 30, 1998 and 1997 were $3.72 and $1.72, respectively.

                                      15
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                  ___________


11. STOCK SPLITS AND AUTHORIZED SHARES


    On June 4, 1997, the Company's shareholders approved an increase to the
    Company's authorized shares from 2.0 million to 10.0 million and also
    authorized a three-for-one stock split which became effective in July 1997.
    On May 29, 1998, the Company's board of directors declared a two-for-one
    stock split in the form of a 100% stock dividend for stockholders of record
    as of June 9, 1998.


    Stockholders' equity has been restated to give retroactive recognition to
    the stock splits for all periods presented by reclassifying from additional
    paid-in capital to common stock the par value of the additional shares
    arising from the splits. In addition, all references to number of shares,
    per share amounts, stock option data, and market prices of common stock have
    been restated.


12. BUSINESS SEGMENT INFORMATION

    During the years ended September 30, 1998 and 1997, the Company's operations
    included two reportable segments:  Satellite ground systems and electronic
    test instrumentation and equipment marketing.


    The Company provides satellite ground systems - computer systems for
    satellite command and control, data processing, simulation, and flight
    software validation. Customers for these systems include U.S. Government
    organizations such as National Aeronautics and Space Administration (NASA),
    the National Oceanic and Atmospheric Administration (NOAA), and the U.S. Air
    Force, as well as commercial satellite operators, both domestic and foreign.


    Through its wholly-owned subsidiary, IMI, the Company acts as a
    manufacturer's representative, selling electronic test instrumentation and
    equipment to customers primarily in Maryland, Virginia and the District of
    Columbia. (The Company's other wholly-owned subsidiary, InterSys, provides
    consulting services for satellite design and procurement, but is presently
    inactive.) Summarized financial information is as follows:


                                        1998             1997         
                                        ----             ----
    Net sales
      Satellite ground systems      $26,621,259            $19,521,353
      Equipment marketing           $ 1,414,246            $   537,631
 
    Income before taxes
      Satellite ground systems      $ 2,623,586            $   882,483
      Equipment marketing           $   483,241            $   129,689
 
    Identifiable assets
      Satellite ground systems      $13,208,837            $11,130,040
      Equipment marketing           $   369,512            $   192,414

                                      16
<PAGE>
 
                    INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    YEARS ENDED SEPTEMBER 30, 1998 AND 1997
                                  ___________


12. BUSINESS SEGMENT INFORMATION (CONTINUED)


                                              1998             1997
                                              ----             ----
 
    Capital expenditures
      Satellite ground systems              $106,855          $705,146
      Equipment marketing                   $  1,793          $ 15,087
 
    Depreciation and amortization
      Satellite ground systems              $522,929          $312,706
      Equipment marketing                   $  6,065          $  4,830


    Identifiable assets of the respective segments include accounts receivable,
    property and equipment, and software development costs. Cash and cash
    equivalents and the remaining assets are considered corporate assets. There
    were no significant intercompany sales. Satellite ground systems capital
    expenditures for the year ended September 30, 1998, excludes the addition of
    equipment under capital leases totalling $1,298,966.


13. SUPPLEMENTAL CASH FLOW INFORMATION

    For the years ended September 30, 1998 and 1997, income taxes paid, net of
    refunds, were $537,733 and $214,360, respectively, and interest expense
    incurred and paid was $86,556 and $10,509, respectively.

    Capital lease obligations of $1,298,966 were incurred during the year ended
    September 30, 1998, when the Company entered into new leases for equipment.

                                      17
<PAGE>
 
ITEM 8.   DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
          ----------------------------------------------------


  None

                                      18
<PAGE>
 
                                    PART III


ITEM 9.   DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
          ------------------------------------------------------------- 
          COMPLIANCE WITH  SECTION 16(A) OF THE EXCHANGE ACT.
          ---------------------------------------------------

   Name                     Position with the Company
   ----                     -------------------------

   Steven R. Chamberlain    Chairman of the Board, Chief Executive Officer and
                            Director    
     
   Thomas L. Gough          President, Chief Operating Officer, and Director

   Robert P. Sadler         Vice President, Quality Control, Secretary,
                            Treasurer, and Director

   Steven K. Kowal          Vice President, Commercial Products

   Steven A. Carchedi       Vice President, Commercial Programs

   Donald F. Mack, Jr.      Vice President, Integration & Test Programs

   William I. Tittley       Vice President, Asia Pacific Operations

   Elaine M. Parfitt        Vice President and Chief Financial Officer

   Patrick R. Woods         Vice President, Government Programs

   B. Clark Austin          Vice President, Marketing and Sales, Commercial
                            Programs

   Bonnie K. Wachtel        Outside Director
 
   Dominic A. Laiti         Outside Director

   R. Doss McComas          Outside Director

   Directors serve until the next annual meeting of stockholders or until
successors have been duly elected and qualified.  Officers of the Company serve
at the discretion of the Board of Directors.

STEVEN R. CHAMBERLAIN, 43, a Company founder, has been Chairman of the Board
since June 1992, President since May 1988, and a Director since 1982.  He served
as Vice President from 1982 until he became President.  From 1978 to 1982, OAO
Corporation employed Mr. Chamberlain where he progressed from Systems Analyst to
Manager of the Offutt Air Force Base field support office.  Mr. Chamberlain
holds a B.S. degree in Physics from Memphis State University and has done
graduate work in Physics and Mathematics at Memphis State and the University of
Maryland.  Mr. Chamberlain is married to Kimberly A. Chamberlain, who was the
Company's Vice President and Chief Financial Officer until her resignation in
February 1997.

THOMAS L. GOUGH, 50, became a member of the Company's staff in January, 1984.
In March 1996, he was elected to the Board of Directors of the Company.  He has
served as President and Chief Operating Officer of the Company since June, 1992.
For three years before being named President, he served as Vice President and
Chief Financial Officer.  Prior to joining the Company, he was employed by
Business and Technological Systems, Inc., serving initially as a Project Leader
and later as the Software Systems Division Manager.  From 1972 to 1977, he was
employed by Computer Sciences Corporation, where he progressed from Programmer
Analyst to Section Manager.  Mr. Gough earned a B.S. degree from the University
of Maryland where he majored in Information Systems Management in the School of
Business and Public Administration.

ROBERT P. SADLER, 48, a Company founder, has been a Director, Secretary, and
Treasurer since 1982.  In May 1988, he was appointed Vice President of
Administration; in June 1992, he was appointed Vice President, Quality Control.
From 1976 to 1982, OAO Corporation ("OAO") employed Mr. Sadler where he
progressed from Computer Analyst to Project Manager.  Mr. Sadler obtained a B.S.
in Mathematics and a B.S. in Computer Sciences from Pennsylvania State
University, and a M.S. in Management of Information Systems Technology from
George Washington University.

STEVEN K. KOWAL, 45, a Company founder, has been with the Company since 1982.
In May 1998, he was appointed Vice President, Commercial Products while in May
1988, he was appointed Vice President of Engineering Manufacturing.  Mr. Kowal
is the Chairman of the Board of IMI.  From 1979 to 1982, OAO employed Mr. Kowal,
where he was a Manager of Hardware Development on several of OAO's major
systems.  Mr. Kowal holds a B.S. degree in Electrical Engineering from the
University of Delaware.

STEVEN A. CARCHEDI, 46, joined the Company in 1991, and has been Vice President
of Commercial Programs since 1994.  Before joining the Company as a full-time
employee in 1991, Mr. Carchedi worked with the Company for 

                                      19
<PAGE>
 
two years as an independent business development consultant. Previously, he
worked for Computational Engineering, Inc., where he held positions as a
Mathematician, Program Manager, Corporate Director, and Vice President of
Business Development. Mr. Carchedi holds a B.S. degree in Mathematics from Wake
Forest University and a M.A. degree in Mathematics from the University of
Maryland.

DONALD F. MACK, JR., 45, joined the Company in 1986 and has been Vice President,
Integration and Test Programs since May 1998.  In July 1989, he was appointed
Vice President of Engineering.  He is currently developing new business areas
for the Company.  From 1979 to 1986, General Electric Corporation's Space
Systems Division employed Mr. Mack where he progressed from Design Engineer to
Senior Project Supervisor for systems development.  Mr. Mack holds a B.S. degree
in Electrical Engineering from Northeastern University and a M.S. degree in
Electrical Engineering from Johns Hopkins University.

WILLIAM I. TITTLEY, 55, joined the Company in 1992, performing as Project
Manager on the first EPOCH 2000 sale to the Chinese Government.  In March 1995,
Mr. Tittley was appointed Vice President, Asia Pacific Operations, to oversee
the Company's operations and business development in that region.  Formerly, Mr.
Tittley was with OAO (from 1977 through 1992), where he performed duties as
Director of Space Systems Programs in charge of the technical and financial
direction of aerospace programs.  Mr. Tittley holds a B.S. equivalent in
Aerospace Vehicle Design from the Academy of Aeronautics (State University of
New York), and has pursued graduate studies in Astronomy at the University of
Maryland and in Engineering at the California Coast University.

ELAINE M. PARFITT, 35, joined the Company in 1983.  She served as Staff
Accountant/Personnel Administrator until January 1995, when she was promoted to
Controller/Director of Accounting.  In March 1997, Ms. Parfitt was appointed
Vice President and Chief Financial Officer.  She holds a B.S. degree in
Accounting from the University of Maryland.

B. CLARK AUSTIN, 44, joined the Company in 1998 and is Vice President, Marketing
and Sales, Commercial Programs.   Before joining the Company, Mr. Austin was a
founder of TSI Telsys Corp., where as a corporate officer he held positions as
Director of Sales and Vice President, Sales and Marketing.  Mr. Austin holds an
A.A. Degree in Aviation Administration from Mesa College and has studied
Business Administration at the University of San Diego.

PATRICK R. WOODS, 43, joined the Company in 1995, and has been Vice President,
Government Programs since May 1998 and has been Vice President, NOAA Programs
since 1996.  From 1994 to 1995, he worked for Space Systems/Loral (SS/L), and
from 1985 to 1994, he worked for the Lockheed Martin Corporation (formerly Loral
Aerospace).  Mr. Woods served as the Director of Mission Operations for both
SS/L and the AeroSys Division of Loral Aerospace. While at Loral Aerospace, Mr.
Woods received the NASA Public Service Group Achievement Award from NASA
Administrator Admiral Richard Truly for his management of the Hubble Space
Telescope control center development and launch support.  Mr. Woods holds a B.S.
in Public Administration and a M.P.A. in Public Management from Indiana
University.

BONNIE K. WACHTEL, 43, has served as an outside director since May 1988.  Since
1984, she has been Vice President, General Counsel, and a Director of Wachtel &
Co., Inc., an investment-banking firm in Washington, DC.  Ms. Wachtel serves as
a Director of several corporations, including VSE Corporation and Information
Analysis, Inc.  She holds a B.A. and M.B.A. from the University of Chicago, and
a J.D. from the University of Virginia, and is a Certified Financial Analyst.

DOMINIC A. LAITI, 67, was elected as an outside director of the Company in July
1995.  Mr. Laiti is presently employed as an independent consultant and was
President and Director of Globalink, Inc. from, January 1990 to December 1994.
He has over 26 years of experience in starting, building, and managing high-
technology private and public companies with annual revenues from $2 million to
over $120 million.  Mr. Laiti was President of Hadron, Inc. from 1979 to 1989;
Vice President of Xonics, Inc. from 1972 to 1979; and Vice President of KMS
Industries from 1968 to 1972.  He is a former Director of United Press
International, Saturn Chemicals Company, Hadron, Inc., Telecommunications
Industries, Inc., MAXXAM Technology, Inc., and Jupiter Technology, Inc.

R. DOSS MCCOMAS, 44, joined the Board as an outside director in July 1995. He is
President of Integrated Wireless Systems, Inc. a manufacturer and integrator of
cellular and wireless local loop systems. Previously, he held

                                      20
<PAGE>
 
positions with COMSAT RSI, including Chairman of its divisions, Equity
Investments and Plexsys International, Vice President of Acquisitions, Strategic
Planning and International Marketing as well as General Counsel. He holds a B.A.
degree from Virginia Polytechnic Institute; an M.B.A. from Mt. Saint Mary's; and
a J.D. from Gonzaga University.

                                      21
<PAGE>
 
ITEM 10.  EXECUTIVE COMPENSATION



a.   Summary Compensation Table
     --------------------------


The following table sets forth compensation received by the Company's CEO and
four highest paid executive officers that earned over $100,000 during the fiscal
year ended September 30, 1998:

<TABLE>
<CAPTION>
                                        ANNUAL COMPENSATION                      LONG-TERM COMPENSATION
                                        -------------------                      ----------------------
                                                                                 AWARDS                PAYOUTS
                                                                                 ------                -------
      NAME AND PRINCIPAL                                                         SHARES                 OTHER
          POSITION                  YEAR        SALARY        BONUS        UNDERLYING OPTIONS   COMPENSATION ($)/(1)/
          --------                  ----        ------        -----       ------------------   -------------------
<S>                                 <C>         <C>           <C>         <C>                  <C> 
CHIEF EXECUTIVE OFFICER
 Steven. R. Chamberlain             1998         $140,120    $30,000                   0                $13,847             
                                    1997         $117,088    $13,000                   0                $11,639             
                                    1996         $114,179    $14,000              90,000                $11,486             
                                                                                                                            
CHIEF OPERATING OFFICER/PRES.                                                                                          
  Thomas L. Gough                   1998         $125,251    $20,000                   0                $12,357             
                                    1997         $106,242    $11,000                   0                $10,508             
                                    1996         $101,581    $ 8,000              60,000                $10,061             
                                                                                                                            
VICE PRES. COMMERCIAL PROGS.                                                                                           
  Steven A. Carchedi                1998         $122,432    $20,000                   0                $11,092             
                                    1997         $103,701    $11,000                   0                $10,136             
                                    1996         $ 97,771    $12,000              60,000                $ 9,572             
                                                                                                                            
VICE PRES. COMMERCIAL PRODS.                                                                                                
  Steven K. Kowal                   1998         $119,672    $12,000                   0                $11,711             
                                    1997         $102,257    $10,000                   0                $10,001             
                                    1996         $ 97,771    $ 9,000              24,000                $ 9,572             
                                                                                                                            
VICE PRES. GOVERNMENT PROGS.
  Patrick R. Woods /(2)/            1998         $117,284    $15,000                   0                $12,382             
                                    1997         $104,857    $ 8,000                   0                $ 9,674             
                                    1996         $ 68,950    $ 5,000                   0                $ 4,824              
</TABLE> 

(1)  All other Compensation represents employer pension contributions. It does
     not include the value of insurance premiums paid by or on behalf of the
     Company with respect to term life insurance for the benefit of each
     identified individual at $528, $472 and $463 in 1998, 1997 and 1996,
     respectively.
(2)  Partial Year at the Company in 1996


  There were no options or SAR's granted to named officers during the fiscal
                        year ended September 30, 1998.

                                      22
<PAGE>
 
b. Compensation Pursuant to Plans
   ------------------------------

    The Company's Board of Directors awards annual bonuses to officers and
employees on a discretionary basis. Currently no formal plan exists for
determining bonus amounts.

    Effective October 1, 1987, the Company established a 401K pension and profit
sharing plan ("the Plan") under Section 401 of the Internal Revenue Code ("the
Code").  Under the Plan the Company contributes annually an amount equal to 5%
of an eligible employee's salary, and may make additional contributions of up to
7.0% of an eligible employee's salary.  The employee may contribute up to an
additional 10% as salary deferral.  In fiscal years 1998 and 1997, the Company
contributed a total of 11% of eligible employees' salaries to the plans.

c. Stock Option Plan
   -----------------

    Effective May 25, 1988, the Company established a stock option plan, as
amended and restated in 1994 and 1998 (the ''Stock Option Plan''), to create
additional incentives for the Company's employees, consultants and directors to
promote the financial success of the Company. The Stock Option Committee has the
authority to select full-time employees, directors or consultants to receive
awards of options for the purchase of stock of the Company under this plan. The
maximum number of shares of Common Stock which may be issued pursuant to the
Stock Option Plan was increased from 300,000 to 1,200,000 during fiscal year
1994. At the Annual Meeting of stockholders of the Company held on July 22, 1998
(the ''1998 Annual Meeting''), the stockholders approved an amendment and
restatement of the Stock Option Plan which, among other changes, increased the
number of shares subject to options under the Stock Option Plan from 1,200,000
to 1,800,000 shares.  Options to purchase a total of 98,308 shares of Common
Stock were issued and options to purchase 115,080 shares of Common Stock were
exercised during fiscal year 1998. The Company has reserved for issuance an
aggregate of 1,494,236 shares of Common Stock of which options to purchase
712,494 shares are outstanding. Pursuant to the Stock Option Plan, options may
be incentive stock options within the meaning of Section 422 of the Code or
nonstatutory stock options, although incentive stock options may be granted only
to employees.

AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES

    No named executive officer exercised any option shares during the fiscal
year ended September 30, 1998.

<TABLE>
<CAPTION>
      NAME             NUMBER OF SECURITIES UNDERLYING UNEXERCISED          VALUE OF UNEXERCISED "IN-THE-MONEY" OPTIONS
     -----                  OPTIONS AT SEPT. 30, 1998                               AT SEPT. 30, 1998 (1)
--------------------------------------------------------------------------------------------------------------------
                            EXERCISABLE        UNEXERCISABLE           EXERCISABLE           UNEXERCISABLE
--------------------------------------------------------------------------------------------------------------------
<S>                    <C>                    <C>                    <C>                    <C>
Steven R. Chamberlain           83,478              51,522             $1,012,236               $606,774              
---------------------------------------------------------------------------------------------------------------------
Thomas L. Gough                 22,000              36,000             $  254,870               $417,060             
---------------------------------------------------------------------------------------------------------------------
Steven A. Carchedi             104,628              27,372             $1,361,691               $324,189             
---------------------------------------------------------------------------------------------------------------------
Steven K. Kowal                 15,000               9,000             $  178,800               $107,280             
---------------------------------------------------------------------------------------------------------------------
Patrick R. Woods                     0                   0             $        0               $      0              
--------------------------------------------------------------------------------------------------------------------
</TABLE>

   (1) Value for "In the Money" options represents the difference between the
       exercise prices of outstanding options and the fair market value of the
       Company's common stock of $15.50 per share at September 30, 1998.

d. Compensation of Directors
   -------------------------

   Presently, outside directors who are not employees of the Company receive
$5,000 per year for their services.  Bonnie K. Wachtel, Dominic A. Laiti and R.
Doss McComas are outside directors who are not employees of the Company.

e. Termination of Employment and Change of Control Termination
   -----------------------------------------------------------

                                      23
<PAGE>
 
The Company has no compensatory plan or arrangement with respect to any
individual named in the Summary Compensation Table (Item 11(a)) which results or
will result from the resignation, retirement or any other termination of such
individual's employment with the Company or its subsidiaries or from a change in
control of the Company or a change in the individual's responsibilities
following a change in control.

                                      24
<PAGE>
 
ITEM 11.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT


a.  Security Ownership of Certain Beneficial Owners (as of 9/30/98)
    ---------------------------------------------------------------

None.

b.  Security Ownership of Management (as of 9/30/98)
    ------------------------------------------------

The following table sets forth certain information regarding the beneficial
ownership of the Company's common stock, par value $.01, as of September 30,
1998, by (i) each director and officer of the Company and (ii) all directors and
executive officers as a group.  Except as indicated in the table, the address of
each below-named director and executive officer is that of the Company's
principal executive offices.

<TABLE>
<CAPTION>
NAME AND ADDRESS OF BENEFICIAL OWNER       AMOUNT AND NATURE OF          PERCENT OF
------------------------------------       --------------------          ----------
                                             BENEFICIAL OWNER              CLASS
                                             ----------------              -----
<S>                                        <C>                            <C>
EXECUTIVE OFFICERS, DIRECTORS              
Steven R. Chamberlain                             436,718 (1)               7.4%         
Thomas L. Gough                                   183,100 (2)               3.1%                       
Robert P. Sadler                                  263,818 (3)               4.5%                       
Elaine M. Parfitt                                  14,400 (4)                *                             
Donald F. Mack, Jr                                 46,100 (5)                *                             
Steven K. Kowal                                   225,076 (6)               3.8%                       
Steven A. Carchedi                                131,628 (7)               2.2%                       
William I. Tittley                                 16,800 (8)                *                             
Patrick Woods                                         --                     *                             
B. Clark Austin                                       --                     *                             
                                                                                                         
Bonnie K. Wachtel                                  38,400 (9)                *                             
  1101 Fourteenth Street, N.W.                                                                                         
  Suite 800                                                                                              
  Washington, D.C. 20036                                                                                 
                                                                                                         
Dominic A. Laiti                                   24,000(10)                *                             
  12525 Knoll Brook Drive                                                                                
  Clifton, Va. 22024                                                                                     
                                                                                                         
R. Doss McComas                                    24,000(11)                *                             
  409 Biggs Drive                                                                                        
  Front Royal, Va. 22630                                                                                 
                                                                                                         
All Directors and Executive Officers as a group                  
  (13 persons).                                    1,404,040               22.8%                        
</TABLE>

 *   Less than one percent of the Common Stock outstanding.
(1)  Includes outstanding options to purchase 83,478 shares of Common Stock
     which are exercisable within 60 days.
(2)  Includes outstanding options to purchase 22,000 shares of Common Stock
     which are exercisable within 60 days.
(3)  Includes 239,760 shares, which Mr. Sadler holds with his wife, and 3,900 as
     trustee for his children. Also includes outstanding options to purchase
     1,878 shares of Common Stock which are exercisable within 60 days.
(4)  Includes outstanding options to purchase 1,500 shares of Common Stock which
     are exercisable within 60 days.
(5)  Includes outstanding options to purchase 6,000 shares of Common Stock which
     are exercisable within 60 days.
(6)  Includes outstanding options to purchase 15,000 shares of Common Stock
     which are exercisable within 60 days.
(7)  Includes outstanding options to purchase 104,628 shares of Common Stock
     which are exercisable within 60 days.
(8)  Includes outstanding options to purchase 15,000 shares of Common Stock
     which are exercisable within 60 days.
(9)  Includes outstanding options to purchase 12,000 shares of Common Stock
     which are exercisable within 60 days.
(10) Includes outstanding options to purchase 24,000 shares of Common Stock
     which are exercisable within 60 days.
(11) Includes outstanding options to purchase 24,000 shares of Common Stock
     which are exercisable within 60 days.

ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
          ----------------------------------------------

                                      25
<PAGE>
 
   None.


ITEM 13. EXHIBITS, LISTS, AND REPORTS ON FORM 8K
         ---------------------------------------

       (a)    Exhibits


       3.1   Amended and Restated Articles of Incorporation of the Company

       3.2   Amended and Restated By-Laws of the Company

       4.1   Specimen Common Stock Certificate (Incorporated by reference to the
             Registration Statement on Form S-1 (File No. 333-58453) filed by
             the Company with the Commission on July 2, 1998)

       10.1  1988 Stock Plan (Incorporated by reference to the Registration
             Statement on Form S-8 (File No. 333- 61559) filed by the Company
             with the Commission on August 14, 1998)

       10.2  Contract effective May 17, 1996 between Integral Systems Inc. and
             the U.S. National Oceanic and Atmospheric Administration
             (Incorporated by reference to the Company's Annual Report on Form
             10-KSBA filed by the Company with the Commission on July 10, 1997).
             (Portions of this exhibit have been omitted pursuant to an order
             for confidential treatment granted by the Commission)

       10.3  Lease dated April 1, 1987, as amended, between Integral Systems
             Inc. and Washington Business Park Associates

       10.4  Master Equipment Lease Agreement dated December 3, 1997 between
             Integral Systems Inc. and NationsBanc Leasing Corporation
             Certificate (Incorporated by reference to the Registration
             Statement on Form S-1 (File No. 333-58453) filed by the Company
             with the Commission on July 2, 1998)

       10.5  Loan Agreement dated November 14, 1997 between Integral Systems
             Inc. and NationsBank N.A. and Promissory Note dated November 14,
             1997 by Integral Systems Inc. in favor of NationsBank N.A.
             (Incorporated by reference to the Registration Statement on Form S-
             1 (File No. 333-58453) filed by the Company with the Commission on
             July 2, 1998)

       11.1  Computation of Per Share Earnings

       21.1  List of Subsidiaries of the Registrant

       23.1  Consent of Rubino & McGeehin, Chartered

       27.1  Financial Data Schedule


       (b)    Reports on Form 8-K


         The Company did not file any reports on Form 8-K for the fiscal year
                           ended September 30, 1998.

                                      26
<PAGE>
 
In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.


SIGNATURE                             TITLES                            DATE


/s/ Steven R. Chamberlain    Chairman of the Board, Director,          12/23/98
--------------------------                                             --------
     Steven R. Chamberlain   Chief Executive Officer



/s/ Thomas L. Gough          President, Chief Operating Officer,       12/23/98 
--------------------------                                             --------
     Thomas L. Gough         Director



/s/ Robert P. Sadler         Vice President of Quality Control,        12/23/98
--------------------------                                             --------
     Robert P. Sadler        Secretary & Treasurer; Director



/s/ Bonnie K. Wachtel        Director                                  12/23/98
--------------------------                                             --------
     Bonnie K. Wachtel



/s/ Dominic A. Laiti         Director                                  12/23/98
--------------------------                                             --------
     Dominic A. Laiti



/s/ R. Doss McComas          Director                                  12/23/98
--------------------------                                             --------
     R. Doss McComas

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



                                         INTEGRAL SYSTEMS, INC.



DATE:   12/23/98                  BY:   /s/ Steven R. Chamberlain
                                       ----------------------------
                                       Steven R. Chamberlain
                                       Chairman of the Board and
                                       Chief Executive Officer
 


DATE:  12/23/98                   BY:   /s/ Thomas L. Gough
                                       ----------------------------
                                       Thomas L. Gough
                                       President, Chief Operating Officer
                                       Director



DATE: 12/23/98                    BY:   /s/ Elaine M. Parfitt
                                       -----------------------------
                                       Elaine M. Parfitt
                                       Chief Financial Officer, Principal
                                       Accounting Officer
<PAGE>
 
                            INTEGRAL SYSTEMS, INC.


                               INDEX TO EXHIBITS


(a)  Exhibits
 

     3.1   Amended and Restated Articles of Incorporation of the Company
     3.2   Amended and Restated By-Laws of the Company
     4.1   Specimen Common Stock Certificate (Incorporated by reference to the
           Registration Statement on Form S-1 (File No. 333-58453) filed by the
           Company with the Commission on July 2, 1998).
     10.1  1988 Stock Plan (Incorporated by reference to the Registration
           Statement on Form S-8
           (File No. 333-61559) filed by the Company with the Commission on
           August 14, 1998).
     10.2  Contract effective May 17, 1996 between Integral Systems Inc. and the
           U.S. National Oceanic and Atmospheric Administration (Incorporated by
           reference to the Company's Annual Report on Form 10-KSBA filed by the
           Company with the Commission on July 10, 1997). (Portions of this
           exhibit have been omitted pursuant to an order for confidential
           treatment granted by the Commission).
     10.3  Lease dated April 1, 1987, as amended, between Integral Systems Inc.
           and Washington Business Park Associates.
     10.4  Master Equipment Lease Agreement dated December 3, 1997 between
           Integral Systems Inc. and NationsBanc Leasing Corporation Certificate
           (Incorporated by reference to the Registration Statement on Form S-1
           (File No. 333-58453) filed by the Company with the Commission on July
           2, 1998).
     10.5  Loan Agreement dated November 14, 1997 between Integral Systems Inc.
           and NationsBank N.A. and Promissory Note dated November 14, 1997 by
           Integral Systems Inc. in favor of NationsBank N.A. (Incorporated by
           reference to the Registration Statement on Form S-1 (File No. 333-
           58453) filed by the Company with the Commission on July 2, 1998).
     11.1  Computation of Per Share Earnings
     21.1  List of Subsidiaries of the Registrant
     23.1  Consent of Rubino & McGeehin, Chartered
     27.1  Financial Data Schedule