SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-QSB


(Mark One)

[ X ]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED AUGUST 31, 1998


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


                         Commission file number: 0-24426


                               C-PHONE CORPORATION
                            -------------------------
        (Exact name of small business issuer as specified in its charter)


         New York                                                06-1170506
-------------------------------                                 -------------
(State or other jurisdiction of                                 (IRS Employer
incorporation or organization)                               Identification No.)


                             6714 NETHERLANDS DRIVE
                        WILMINGTON, NORTH CAROLINA 28405
                    ----------------------------------------
                    (Address of principal executive offices)


                                 (910) 395-6100
                ------------------------------------------------
                (Issuer's telephone number, including area code)


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


State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date.

            7,871,734 shares of common stock as of October 14, 1998.


Transitional Small Business Disclosure Form      Yes [ ]    No [X]

<PAGE>

                               C-PHONE CORPORATION

                                   FORM 10-QSB

                                      INDEX



                                                                     PAGE NUMBER
                                                                     -----------
PART I.   FINANCIAL INFORMATION

ITEM 1.   FINANCIAL STATEMENTS

          Balance Sheets as of February 28, 1998
            and August 31, 1998 (unaudited) ...............................  3

          Statements of Operations for the three and six
            months ended August 31, 1997 and 1998 (unaudited) .............  4

          Statements of Cash Flows for the six months
            ended August 31, 1997 and 1998 (unaudited) ....................  5

          Notes to Unaudited Financial Statements .........................  6

ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION .......  9


PART II.  OTHER INFORMATION

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ............. 17

ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K ................................ 17

SIGNATURES ................................................................ 18

<PAGE>

PART I.  FINANCIAL INFORMATION
ITEM 1.  FINANCIAL STATEMENTS

                                                  C-PHONE CORPORATION
                                                    BALANCE SHEETS
<TABLE>
<CAPTION>

                                                                                       February 28, 1998 August 31, 1998
                                                                                       ----------------- ---------------
                                    ASSETS                                                                 (unaudited)
Current assets:
<S>                                                                                      <C>             <C>         
         Cash and cash equivalents                                                       $  4,200,231    $  6,568,021
         Accounts receivable, net of allowance for doubtful accounts
                  of $173,227 at February 28, 1998 and  $174,215 at
                  August 31, 1998 (unaudited)                                                 346,684         264,735
         Inventories                                                                        1,641,528       1,687,588
         Prepaid expenses and other current assets                                             73,728         141,867
                                                                                         ------------    ------------
                           Total current assets                                             6,262,171       8,662,211
Property and equipment, net                                                                   164,174         108,884
Other assets                                                                                   42,686          45,262
                                                                                         ------------    ------------
                           Total assets                                                  $  6,469,031    $  8,816,357
                                                                                         ============    ============

                                    LIABILITIES, PREFERRED STOCK AND
                                    SHAREHOLDERS' EQUITY

Current liabilities:
         Accounts payable, trade                                                         $    796,019    $    458,979
         Accrued expenses                                                                     295,647         263,074
                                                                                         ------------    ------------
                           Total current liabilities                                        1,091,666         722,053

Series A convertible preferred stock, $1,000 stated amount;                
         5,000 shares designated; 4,500 and 724 shares issued and
         outstanding  at February 28, 1998 and August 31, 1998 (unaudited),
         respectively (Note 3(b))                                                           4,543,767         749,290

Shareholders' equity:
         Common stock, $.01 par value; 20,000,000 shares authorized              
                  at February 28, 1998 and August 31, 1998 (unaudited);
                  5,348,234 and 7,595,666 shares issued and outstanding at
                  February 28, 1998 and August 31, 1998 (unaudited), respectively              53,482          75,957
         Paid-in capital - common stock                                                    18,038,006      27,640,609
         Paid-in capital - preferred stock                                                  1,318,350         212,108
         Accumulated deficit                                                              (18,576,240)    (20,583,660)
                                                                                         ------------    ------------
                           Total shareholders' equity                                         833,598       7,345,014
                                                                                         ------------    ------------
                           Total liabilities, preferred stock and shareholders' equity   $  6,469,031    $  8,816,357
                                                                                         ============    ============

                       The accompanying notes are an integral part of the financial statements.

                                                          3
</TABLE>
<PAGE>


                                              C-PHONE CORPORATION
                                           STATEMENTS OF OPERATIONS
                                                  (unaudited)
<TABLE>
<CAPTION>

                                                    Three Months Ended August 31,  Six Months Ended August 31,
                                                    -----------------------------  ---------------------------
                                                         1997           1998           1997           1998
                                                     -----------    -----------    -----------    -----------

<S>                                                  <C>            <C>            <C>            <C>        
Net sales                                            $   319,789    $   540,765    $   752,910    $   879,915
Other revenue                                              4,360          9,124          8,039         25,512
                                                     -----------    -----------    -----------    -----------
              Total revenue                              324,149        549,889        760,949        905,427
                                                     -----------    -----------    -----------    -----------

Cost of goods sold                                       418,406        631,548      1,319,422      1,139,621
Cost of other revenue                                      1,012          1,241          1,012          9,443
                                                     -----------    -----------    -----------    -----------
              Total cost of revenue                      419,418        632,789      1,320,434      1,149,064
                                                     -----------    -----------    -----------    -----------

              Gross profit (loss)                        (95,269)       (82,900)      (559,485)      (243,637)
                                                     -----------    -----------    -----------    -----------

Operating expenses:
         Selling, general and administrative           1,003,111        703,284      2,165,323      1,428,868
         Research, development and engineering           240,247        197,733        520,986        406,800
                                                     -----------    -----------    -----------    -----------
              Total operating expenses                 1,243,358        901,017      2,686,309      1,835,668
                                                     -----------    -----------    -----------    -----------

              Operating loss                          (1,338,627)      (983,917)    (3,245,794)    (2,079,305)

Interest expense                                            (135)            --           (447)            --
Interest income                                           41,862         87,518         84,273        140,261
                                                     -----------    -----------    -----------    -----------

              Net loss                               $(1,296,900)   $  (896,399)   $(3,161,968)   $(1,939,044)
                                                     ===========    ===========    ===========    ===========

Per-share data:
Basic and diluted net loss per common share          $     (0.25)   $     (0.13)   $     (0.62)   $     (0.31)
                                                     ===========    ===========    ===========    ===========
Shares used in computing net loss per common share     5,203,356      7,114,095      5,061,132      6,460,859
                                                     ===========    ===========    ===========    ===========

                   The accompanying notes are an integral part of the financial statements.
</TABLE>

                                                       4
<PAGE>

                                            C-PHONE CORPORATION
                                          STATEMENTS OF CASH FLOWS
                                                (unaudited)
<TABLE>
<CAPTION>

                                                                                Six Months Ended August 31,
                                                                                ---------------------------
                                                                                    1997           1998
                                                                                ------------   ------------
<S>                                                                             <C>            <C>         
Cash flows from operating activities:
         Net loss                                                               $(3,161,968)   $(1,939,044)
         Adjustments to reconcile net loss to net cash
                  used in operating activities:
                  Depreciation and amortization                                      53,527         66,817
                  Bad debt expense                                                   96,258        103,991
                  Compensation expense of stock options                              19,200         12,800
                  Compensation expense of stock issued                               14,220             --
                  Changes in operating assets and liabilities:
                           Accounts receivable                                      (73,854)       (22,042)
                           Inventories                                               62,729        (46,060)
                           Prepaid expenses and other current assets                (34,926)       (68,139)
                           Other assets                                              93,154         (2,576)
                           Accounts payable                                        (220,106)      (337,040)
                           Accrued expenses                                        (160,000)       (32,573)
                                                                                -----------    -----------
                                    Net cash used in operating activities        (3,311,766)    (2,263,866)
                                                                                -----------    -----------

Cash flows from investing activities:
         Equipment purchases                                                        (37,215)       (11,527)
                                                                                -----------    -----------
                                    Net cash used in investing activities           (37,215)       (11,527)
                                                                                -----------    -----------

Cash flows from financing activities:
         Proceeds from exercise of stock options                                     34,750        304,937
         Proceeds from private placement of common stock, net                     4,369,518             --
         Proceeds from exercise of warrants, net                                         --      4,338,246
         Payment of capital lease obligations                                       (11,507)            --
                                                                                -----------    -----------
                                    Net cash provided by financing activities     4,392,761      4,643,183
                                                                                -----------    -----------

                                    Net increase in cash and cash equivalents     1,043,780      2,367,790
                                                                                -----------    -----------

Cash and cash equivalents, beginning of period                                    1,398,049      4,200,231
                                                                                -----------    -----------

Cash and cash equivalents, end of period                                        $ 2,441,829    $ 6,568,021
                                                                                ===========    ===========

Supplemental disclosure of cash flow information:

         Interest paid                                                          $       447    $         0
                                                                                ===========    ===========

                  The accompanying notes are an integral part of the financial statements.
</TABLE>

                                                     5
<PAGE>

                               C-PHONE CORPORATION
                     NOTES TO UNAUDITED FINANCIAL STATEMENTS

                                 AUGUST 31, 1998

1.   BASIS OF PRESENTATION

     The accompanying unaudited financial statements of C-Phone Corporation (the
     "Company")  have  been  prepared  in  accordance  with  generally  accepted
     accounting  principles  for  interim  financial  information  and  with the
     instructions to Form 10-QSB and Item 310(b) of Regulation SB.  Accordingly,
     they do not  include  all of the  information  and  footnotes  required  by
     generally accepted accounting principles for complete financial statements.
     In the  opinion  of  management,  such  financial  statements  include  all
     adjustments  necessary to present  fairly,  in all material  respects,  the
     information  set forth  therein.  Operating  results  for the three and six
     month periods ended August 31, 1998 are not  necessarily  indicative of the
     results that may be expected for the fiscal year ending  February 28, 1999.
     The unaudited  financial  statements should be read in conjunction with the
     audited  financial   statements  and  footnotes  thereto  included  in  the
     Company's  Annual Report on Form 10-KSB for the fiscal year ended  February
     28, 1998.

2.   STOCK OPTIONS

     As of August 31, 1998,  options for 261,892 shares of the Company's  common
     stock, par value $.01 per share (the "Common Stock") were outstanding under
     the  Company's  1994 Stock  Option Plan (the  "Plan")  (51,750 of which are
     non-qualified options exercisable at prices ranging from $3.00 to $7.00 per
     share, depending upon the date of grant, and 210,142 of which are incentive
     stock  options  exercisable  at prices  ranging  from $3.125 to $10.375 per
     share,  depending  upon the date of the  grant),  and  options  for 154,688
     shares of Common Stock were  available  for future  grants.  Due to vesting
     provisions  included in the  options,  only  options  representing  179,964
     shares of Common Stock were  exercisable as of August 31, 1998.  During the
     six month period ended August 31, 1998,  options to purchase  57,749 shares
     of Common Stock were  exercised at an average  exercise  price of $5.28 per
     share. The following table summarizes  certain  information with respect to
     exercisable options:

                                                          Number of
                    Range of                               Options
                 Exercise Price                          Exercisable
          ------------------------------             --------------------
                  $3.00 - $3.38                             61,391
                  $5.95 - $6.75                             25,517
                  $7.00 - $7.50                             90,724
                     $10.375                                 2,332

3.   PREFERRED STOCK, WARRANTS AND CONTINGENT VALUE RIGHTS

     (a) During the week of March 31,  1997,  the  Company  completed  a private
         placement (the "March Placement"),  through a placement agent, pursuant
         to which the  Company  issued  an  aggregate  of  833,667  shares  (the
         "Original   Shares")  of  Common   Stock  to  the   participants   (the
         "Investors")  in the March  Placement  and  received  net  proceeds  of
         approximately  $4,370,000  (after  payment,  or  accrual,  of fees  and
         expenses of approximately $632,000).  Accompanying each of the Original
         Shares  was  the  right,  under  certain   circumstances,   to  receive
         additional  shares of Common  Stock in  accordance  with the terms of a
         "contingent value right" (the "Rights"). The Rights, which expired June
         25, 1998,  were  automatically  exercised at the time, and from time to
         time,  as the  Original  Shares  were  first  publicly  sold  through a
         broker-dealer.  The terms of the Rights  provided that,  upon the first
         such sale of any  Original  Shares  at a price of less  than  $8.00 per
         share, the seller of the Original Shares would  automatically  receive,
         for each such  Original  Share  sold,  and  without  the payment of any
         additional  consideration,  such additional  number of shares of Common
         Stock as equaled (i) $8.00  divided by the Adjusted  Price,  minus (ii)
         one;  where the  Adjusted  Price  equals the greater of (x) the average
         closing  bid price per share of  Common  Stock on The  Nasdaq  National
         Market for the ten trading days immediately  preceding the date of sale
         of the Original  Shares,  and (y) $2.00.  All the Original  Shares have
         been publicly resold and, pursuant to the terms of the Rights,  136,863
         additional shares were issued as a result thereof.

                                       6
<PAGE>

                               C-PHONE CORPORATION
                     NOTES TO UNAUDITED FINANCIAL STATEMENTS

                                 AUGUST 31, 1998

         In  connection  with the  March  Placement,  the  Company  issued to an
         affiliate of the  placement  agent  warrants to acquire an aggregate of
         150,000 shares of Common Stock at an exercise price of $9.60 per share,
         which warrants expired without being exercised.

     (b) On December 19, 1997,  the Company  completed a private  placement (the
         "December  Placement")  pursuant  to which  the  Company  issued to the
         several  participants  an aggregate of (i) 4,500 shares (the "Preferred
         Shares" ) of the Company's  Series A Convertible  Preferred  Stock (the
         "Preferred  Stock"),  par value $.01 per share,  with an initial stated
         value of $1,000 per share (which increases at the rate of 5% per annum)
         (such amount, as increased from time to time, the "Stated Value"), (ii)
         warrants (the  "One-Year  Warrants") to acquire up to 315,000 shares of
         Common Stock, and (iii) warrants (the "Three-Year Warrants") to acquire
         up to 135,000 shares of Common Stock. The Company received net proceeds
         of  approximately  $4,110,000  (after  payment,  or  accrual,  of  fees
         (including   finders  fees)  and  related   expenses  of  approximately
         $390,000).  Each Preferred Share is convertible,  from time to time, at
         the option of the holder, into such number of shares of Common Stock as
         is  determined  by  dividing  the  Stated  Value by the  lesser  of (x)
         $7.3575,  and (y) 85% of the average of the  closing  bid price  during
         such three  consecutive  trading  day period as may be  selected by the
         holder  during  the  25-day  trading  period   preceding  the  date  of
         conversion.  Any  outstanding  Preferred  Shares on  December  19, 1999
         automatically  will be converted  into Common  Stock at the  conversion
         price then in effect. The Preferred Shares are subject to redemption at
         the option of the holder if, among other things,  (i) the Company fails
         to maintain an  effective  registration  statement  with respect to the
         shares of Common Stock  issuable upon exercise of the Preferred  Shares
         for more than 30 consecutive  days or more than 60 days in any 12-month
         period, or (ii) the Company fails to maintain the listing of the Common
         Stock on the Nasdaq  National  Market or another  principal  securities
         exchange or automated  quotation system. If any of the foregoing events
         occur and the holders of the Preferred  Shares elect to exercise  their
         redemption rights, the Company will be required to redeem the remaining
         outstanding  Preferred  Shares at an amount equal to the greater of (x)
         118% of the  Stated  Value of the  Preferred  Shares and (y) the market
         value of the Common  Stock into which the  Preferred  Shares would have
         been converted on the date of redemption.  The One-Year Warrants expire
         on December 19, 1998, have an exercise price of $8.05 per share and are
         redeemable  at the option of the Company at a price of $.01 per warrant
         if the closing  price of the Common  Stock is greater  than 130% of the
         exercise  price of the  One-Year  Warrants for 10  consecutive  trading
         days.  The  Three-Year  Warrants  expire on December 19, 2000,  have an
         exercise price of $9.10 per share and are not redeemable. In connection
         with  the  December  Placement,  the  Company  paid a  finder's  fee of
         $295,000 and issued to an affiliate  of the finder  warrants  (upon the
         same terms as the One-Year Warrants) to acquire an aggregate of 185,000
         shares of Common Stock.

         Regulations  promulgated  by the  Securities  and  Exchange  Commission
         require  that all issues of  mandatorily  redeemable  stock be excluded
         from the  shareholders'  equity  section  of the  balance  sheet and be
         presented  separately.  One of  the  characteristics  of a  mandatorily
         redeemable stock is that it contains conditions for redemption, even if
         remote,  which are not solely within the control of the issuer.  As set
         forth above,  the  Preferred  Shares are subject to  redemption  at the
         option of the holder under  certain  circumstances.  Since there is the
         possibility  that the occurrence of an event outside the control of the
         Company could cause redemption, the Preferred Stock has been classified
         separately from shareholders' equity on the balance sheet.

     (c) On May 13, 1998, the Company reduced the exercise price of the warrants
         to purchase  200,000  shares of Common Stock issued in its 1994 initial
         public offering (the "1994  Warrants") from $8.40 to $6.00 per share in
         consideration  for (i) requiring  payment of the exercise price for the
         1994  Warrants to be made in cash (rather  than upon  surrender of 1994
         Warrants) and (ii) changing the expiration date thereof from August 18,
         1999 to May 21, 1998.  On May 13, 1998,  the closing sales price of the
         Common Stock was $9.75. The holders of the 1994 Warrants  exercised all
         of the 1994  Warrants by May 15, 1998.  In  addition,  as of August 31,
         1998,  One-Year Warrants  (including the warrants issued to the finder)
         to  purchase  325,000  shares  of  Common  Stock at $8.05 per share and
         Three-Year  Warrants to purchase 60,000 shares of Common Stock at $9.10
         per  share  also  had  been  exercised.  As a  result  of such  warrant
         exercises, during the six months,

                                       7
<PAGE>
                               C-PHONE CORPORATION
                     NOTES TO UNAUDITED FINANCIAL STATEMENTS

                                 AUGUST 31, 1998


         ended August 31, 1998, the Company received net proceeds of $4,350,945.
         As of August 31, 1998,  3,776 Preferred  Shares had been converted into
         an aggregate of 1,604,683 shares of Common Stock.

4.   NET LOSS PER SHARE

     In February 1997, the Financial Accounting Standards Board issued Statement
     of Financial Accounting  Standards No. 128 ("SFAS No. 128"),  "Earnings Per
     Share," which  established  new standards for  computation  of earnings per
     share.  SFAS No. 128  requires the  presentation  on the face of the income
     statement of "basic"  earnings per share and "diluted"  earnings per share.
     Basic  earnings  per share is computed by  dividing  the net income  (loss)
     available  to  common  shareholders  by  the  weighted  average  number  of
     outstanding common shares. The calculation of diluted earnings per share is
     similar to the  calculation  of basic  earnings per share,  except that the
     denominator  includes  dilutive  common  stock  equivalents  such as  stock
     options and  warrants.  Common stock  options and warrants are not included
     for the three and six months ended August 31, 1997 or 1998 as they would be
     anti-dilutive.  The accretion of the 5% annual  increase in stated value of
     the Preferred  Stock in the amount of $22,499 and $68,377 for the three and
     six months ended August 31, 1998  increased  the net loss  attributable  to
     common  shareholders  to $918,898  and  $2,007,421,  respectively,  for the
     purposes  of the  calculation  of net loss per  share for the three and six
     months ended August 31, 1998.


                                       8
<PAGE>


ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

         THIS  QUARTERLY  REPORT  ON  FORM  10-QSB  CONTAINS,   IN  ADDITION  TO
         HISTORICAL INFORMATION, CERTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE
         SIGNIFICANT RISKS AND UNCERTAINTIES.  SUCH  FORWARD-LOOKING  STATEMENTS
         ARE BASED ON  MANAGEMENT'S  BELIEF AS WELL AS ASSUMPTIONS  MADE BY, AND
         INFORMATION  CURRENTLY  AVAILABLE TO, MANAGEMENT  PURSUANT TO THE "SAFE
         HARBOR" PROVISIONS OF THE PRIVATE  SECURITIES  LITIGATION REFORM ACT OF
         1995.  FORWARD-LOOKING  STATEMENTS  CAN GENERALLY BE IDENTIFIED AS SUCH
         BECAUSE THE CONTEXT OF THE STATEMENT USUALLY WILL INCLUDE WORDS SUCH AS
         THE  COMPANY  "BELIEVES"  OR  "EXPECTS"  OR  WORDS OF  SIMILAR  IMPORT.
         SIMILARLY,   STATEMENTS  THAT  DESCRIBE  THE  COMPANY'S  FUTURE  PLANS,
         OBJECTIVES,  ESTIMATES  OR GOALS ARE ALSO  FORWARD-LOOKING  STATEMENTS.
         SUCH STATEMENTS ADDRESS FUTURE EVENTS AND CONDITIONS CONCERNING CAPITAL
         EXPENDITURES,  EARNINGS,  SALES,  LIQUIDITY AND CAPITAL RESOURCES,  AND
         ACCOUNTING   MATTERS.   THE  COMPANY'S   ACTUAL  RESULTS  COULD  DIFFER
         MATERIALLY FROM THOSE EXPRESSED IN, OR IMPLIED BY, THE  FORWARD-LOOKING
         STATEMENTS CONTAINED HEREIN.  FACTORS THAT COULD CAUSE OR CONTRIBUTE TO
         SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED BELOW
         AND  IN  ITEM  1 -  "DESCRIPTION  OF  BUSINESS"  AND  ELSEWHERE  IN THE
         COMPANY'S  ANNUAL REPORT ON FORM 10-KSB FOR THE YEAR ENDED FEBRUARY 28,
         1998, AS WELL AS FACTORS SUCH AS FUTURE ECONOMIC CONDITIONS, ACCEPTANCE
         BY CUSTOMERS OF THE  COMPANY'S  PRODUCTS,  CHANGES IN CUSTOMER  DEMAND,
         LEGISLATIVE,  REGULATORY  AND  COMPETITIVE  DEVELOPMENTS  IN MARKETS IN
         WHICH  THE  COMPANY   OPERATES   AND  OTHER   CIRCUMSTANCES   AFFECTING
         ANTICIPATED REVENUES AND COSTS. THE COMPANY UNDERTAKES NO OBLIGATION TO
         RELEASE  PUBLICLY THE RESULT OF ANY REVISIONS TO THESE  FORWARD-LOOKING
         STATEMENTS  THAT MAY BE MADE TO REFLECT EVENTS OR  CIRCUMSTANCES  AFTER
         THE DATE OF THIS  QUARTERLY  REPORT ON FORM  10-QSB OR TO  REFLECT  THE
         OCCURRENCE OF OTHER UNANTICIPATED EVENTS.

OVERVIEW

         The Company is primarily engaged in the engineering,  manufacturing and
marketing  of video  conferencing  systems.  In  1993,  the  Company  introduced
C-Phone(R),  its first  PC-based video  conferencing  system which operates over
digital networks.  In 1997, the Company introduced C-Phone Home(TM),  a TV-based
set-top  "video  phone"  which  operates  over  analog  telephone  lines using a
standard television set. In early 1998, the Company introduced the DS-324(TM), a
TV-based video conferencing  system which operates over either analog or digital
telephone lines. In May 1998, the Company introduced C-Phone ITV(TM), a TV-based
set-top device that provides Internet access using a standard television set and
an analog telephone line.

         The Company  presently  markets  several  TV-based  video  conferencing
products, including the DS-324 for business and personal use, the DS-324/Pro(TM)
for business use and special  applications,  the  DS-324/AV(TM) for security and
surveillance  applications,  the  DS-324/TTY(TM)  for the hearing disabled,  the
DS-324/Multipoint  System(TM)  for distance  learning and training,  and C-Phone
Home for  individual  home use. The Company  believes  that its  TV-based  video
conferencing  products currently have greater market potential than its PC-based
products  and the  Company has decided to shift its  resources  to its  TV-based
products. The Company will continue to support its PC-based products and provide
equipment to its existing  customer base and to new customers in connection with
specialized  applications,  if any. The  Company's  C-Phone ITV internet  access
device is  currently  being  marketed to its  existing  customers  for  specific
applications such as healthcare and to selected foreign markets.  The Company is
continuing to explore other market opportunities for C-Phone ITV.

         The  Company's  products  are  marketed  through a variety of  channels
depending  upon the product.  The Company's  TV-based video phone is marketed to
end users, distributors, resellers and original equipment manufacturers ("OEMs")
which  integrate  the  product  with  other  equipment  for  resale to  specific
industries  such as health  care and  security  services.  During the year ended
February 28, 1998 ("Fiscal 1998"), many retail

                                       9
<PAGE>


distributors  offered  the end user the  option to  purchase  C-Phone  Home on a
stand-alone  basis or,  similar to the method by which most cellular  telephones
are sold,  at a lower  price when  purchased  with  telecommunications  services
offered by the  Company.  The  proceeds to the Company from units sold under the
latter  option were less than the  Company's  cost of the product and, as 36% of
C-Phone Home sales were made under such  purchase  option in Fiscal  1998,  such
sales and the required  markdown of related inventory to reflect such sale price
contributed  significantly  to the gross loss for that  period.  The Company has
discontinued this purchase option due to the lack of market acceptance.

         As a result of the foregoing  and the low volume of sales,  the Company
has incurred significant losses during the three fiscal years ended February 28,
1998 and the six months ended August 31, 1998.  Until market  acceptance  of the
Company's  products  is  established,  of which there can be no  assurance,  the
Company expects to continue to incur significant  losses due to its expenditures
for product development and the commercialization of its products.

RECENT EQUITY OFFERINGS

         MARCH 1997 PRIVATE  PLACEMENT.  During the week of March 31, 1997,  the
Company completed a private placement (the "March Placement")  pursuant to which
the Company issued an aggregate of 833,667 shares of the Company's common stock,
par value $.01 per share (the "Common Stock"),  to the participants in the March
Placement and received net proceeds of approximately  $4,370,000  (after payment
of fees and  expenses  of  approximately  $632,000).  Accompanying  each of such
shares was the right, under certain circumstances,  to receive additional shares
of Common Stock in  accordance  with the terms of a  "contingent  value  right."
Pursuant to the terms of such rights,  136,863 additional shares of Common Stock
subsequently  were issued.  In connection with the March Placement,  the Company
issued to an affiliate of the placement  agent  warrants to acquire an aggregate
of 150,000 shares of Common Stock at an exercise price of $9.60 per share, which
warrants expired without being exercised.

         DECEMBER  1997  PRIVATE  PLACEMENT.   In  December  1997,  the  Company
completed a private placement (the "December  Placement")  pursuant to which the
Company issued an aggregate of (i) 4,500 shares (the "Preferred  Shares") of the
Company's  Series A Convertible  Preferred  Stock, par value $.01 per share (the
"Preferred  Stock")  with an initial  stated  value of $1,000  per share  (which
increases at the rate of 5% per annum) (such amount,  as increased  from time to
time, the "Stated Value"), (ii) warrants (the "One-Year Warrants") to acquire up
to 315,000 shares of Common Stock, and (iii) warrants (the "Three-Year Warrants"
and with the One-Year Warrants, collectively, the "1997 Warrants") to acquire up
to 135,000 shares of Common Stock, to the participants in the December Placement
and received  aggregate  proceeds of approximately  $4,110,000 (after payment of
fees and expenses of  approximately  $390,000).  In connection with the December
Placement,  the  Company  paid a  finder's  fee of  $295,000  and  issued  to an
affiliate of the finder warrants (upon the same terms as the One-Year  Warrants)
to acquire an aggregate of 185,000  shares of Common Stock,  which warrants have
been exercised.

         Each Preferred Share is  convertible,  from time to time, at the option
of the holder,  into such number of shares of Common Stock as is  determined  by
dividing  the  Stated  Value by the lesser of (i)  $7.3575,  and (ii) 85% of the
average of the  closing  bid price  during  such three  consecutive  trading day
period as may be  selected  by the  holder  during  the 25  trading  day  period
preceding the date of conversion.  Any outstanding  Preferred Shares on December
19, 1999  automatically  will be converted  into Common Stock at the  conversion
price then in effect.  As of October 14, 1998, 4,317 of the Preferred Shares had
been converted into 1,880,751 shares of Common Stock.

         The One-Year  Warrants expire on December 19, 1998 and have an exercise
price of $8.05 per share (115% of the closing  price of the Common  Stock on the
Nasdaq  National  Market  ("NNM") on the trading day  immediately  preceding the
closing date of the December  Placement),  subject to  adjustment  under certain
circumstances,  including  upon the  issuance  of  shares  of  Common  Stock (or
securities convertible or exchangeable into shares of Common Stock) at less than
80% of the then  market  price on the NNM for the  Common  Stock.  The  One-Year
Warrants  are  redeemable  at the  option of the  Company at a price of $.01 per
warrant if the closing price of the Common Stock on the NNM is greater than 130%
of the exercise price of

                                       10
<PAGE>


the  One-Year  Warrants  then in effect for 10  consecutive  trading  days.  The
Three-Year  Warrants  expire on December 19, 2000 and have an exercise  price of
$9.10 per share (130% of the closing price of the Common Stock on the NNM on the
trading day immediately  preceding the closing date of the December  Placement),
subject to adjustment under certain  circumstances,  including upon the issuance
of shares of Common Stock (or securities convertible or exchangeable into shares
of Common  Stock) at less than 80% of the then  market  price on the NNM for the
Common Stock.  The  Three-Year  Warrants are not  redeemable.  As of October 14,
1998,  325,000  shares of Common Stock had been issued upon exercise of One-Year
Warrants at $8.05 per share  (including the warrants issued to the finder in the
December  Placement),  60,000 shares had been issued upon exercise of Three-Year
Warrants  at $9.10 per share and the  Company  received  aggregate  proceeds  of
$3,162,250 from the exercise thereof.

         The  Preferred  Shares  are  subject to  redemption  at the option of a
holder if, among other things, (i) the effectiveness of a Registration Statement
for the shares of Common Stock issuable upon conversion of the Preferred  Shares
lapses for more than 30  consecutive  days or more than 60 days in any  12-month
period, or (ii) the Company fails to maintain the listing of the Common Stock on
the NNM or another principal  securities  exchange or automated quotation system
and such failure continues for more than 30 days. If any of the foregoing events
occur and the holders of the Preferred Shares elect to exercise their redemption
rights,  the  Company  will be  required  to redeem  the  remaining  outstanding
Preferred  Shares at an amount  equal to the  greater  of (a) 118% of the Stated
Value of the Preferred Shares on the date of redemption and (b) the market value
of the Common Stock into which the Preferred Shares would have been converted on
the date of redemption. There can be no assurance that the Company will have the
financial  ability to redeem the  Preferred  Shares,  if required  (although the
Company currently has such financial ability), and, even if the Company has such
ability,  such payment may materially  adversely affect the Company's  financial
condition and deplete its cash resources.

         1994 WARRANT  EXERCISES.  In connection with the Company's 1994 initial
public  offering,   the  Company  had  issued  to  the   representative  of  the
underwriters,  warrants  expiring August 19, 1999 to purchase  200,000 shares of
Common  Stock at an  exercise  price of $8.40 per share.  On May 13,  1998,  the
Company  reduced the  exercise  price of such  warrants  to $6.00 per share,  in
consideration  for (i) requiring payment of the exercise price for such warrants
to be made in cash (rather than upon  surrender of warrants)  and (ii)  changing
the expiration  date thereof to May 21, 1998. On May 13, 1998, the closing sales
price of the Common Stock was $9.75.  All of such warrants were exercised by May
15, 1998 and the Company received aggregate proceeds of $1,200,000.

         EQUITY LINE. On September 18, 1998, the Company  entered into a Private
Equity Credit Agreement (the "Equity Line") with Sovereign  Partners,  L.P. (the
"Investor").  Pursuant  to  the  terms  of  the  Equity  Line,  subject  to  the
satisfaction  of certain  conditions,  the Company  may require the  Investor to
purchase  shares of Common  Stock over a period of 18 months from the  effective
date of the Registration Statement (as defined below), for an aggregate purchase
price of up to $5 million (but in no event more than 1,543,765  shares of Common
Stock (which  represented  19.99% of the then outstanding shares of Common Stock
). Under the terms of the Equity Line,  during any 30-day  period  following the
effective  date of the  Registration  Statement,  the  Company,  subject  to the
satisfaction of certain conditions,  can require the Investor to purchase shares
of Common  Stock for an  aggregate  purchase  price of between  $500,000  and $1
million.  The purchase price per share to be paid by the Investor for the shares
of Common  Stock  acquired  under the Equity  Line will equal 85% of the average
closing bid price of the Common Stock  during the five trading days  immediately
preceding the notice of purchase (the "Put Notice")  given by the Company to the
Investor.

         The Investor's  obligation to purchase shares of Common Stock under the
Equity Line is subject to various conditions, including, among other things: (i)
effectiveness of the Registration Statement;  (ii) the average closing bid price
of the  Common  Stock  being at least  $1.00 per share for the 20  trading  days
preceding  the date of the Put  Notice;  (iii)  continued  trading of the Common
Stock on The Nasdaq Stock  Market;  and (iv) the  percentage of the Common Stock
beneficially  owned  by the  Investor  being  not  more  than  9.9% of the  then
outstanding  Common  Stock.  The Company may  terminate  the Equity Line without
further obligation to the Investor at any time after it has sold to the Investor
at least $1 million of Common Stock.

                                       11
<PAGE>

         Under a related  Registration Rights Agreement,  the Company has agreed
to  file,  and  maintain   effectiveness   (subject  to  certain  penalties  for
noncompliance) of, a registration statement (the "Registration Statement") under
the  Securities  Act of 1933 for the  resale by the  Investor  of the  shares of
Common Stock purchased by it under the Equity Line.

         In connection with entering into the Equity Line, the Company issued to
Cardinal  Capital  Management,  Inc.,  as finder,  a two-year  warrant (the "CCM
Warrant") to purchase  100,000 shares of Common Stock at an exercise price equal
to $8.00 per share.  The CCM Warrant is redeemable  for $0.01 per warrant at the
option of the Company if the closing  sales  price of the Common  Stock  exceeds
$10.00 for five  consecutive  trading  days.  The Company also paid the finder a
cash fee of $30,000  upon  signing of the Equity  Line and has agreed to pay the
finder  an  additional  cash fee  equal to 6% of the  amount of any sales by the
Company  pursuant to the Equity  Line;  with the $30,000  payment to be credited
against the first sale under the Equity Line.

         Further  information  with  respect  to the  March  Placement  and  the
December  Placement  is set  forth  in  Item 6 -  "Management's  Discussion  and
Analysis or Plan of Operation - Recent Equity Offerings" of the Company's Annual
Report on Form  10-KSB for the fiscal  year ended  February  28,  1998.  Further
information  with  respect  to the  Equity  Line is set forth in Item 5 - "Other
Events" of the Company's Current Report on Form 8-K, dated September 24, 1998.

RESULTS OF OPERATIONS

THREE  MONTHS  ENDED  AUGUST 31,  1998 ("2ND  QUARTER  99") AS COMPARED TO THREE
MONTHS ENDED AUGUST 31, 1997 ("2ND QUARTER 98")

         REVENUES.  Net sales  increased  69% to $540,765 in 2nd Quarter 99 from
$319,789 in 2nd  Quarter 98,  reflecting  the  Company's  change of focus to its
TV-based  products  from its PC-based  products as a result of an  industry-wide
slowdown in the  continued  acceptance of PC-based  desktop video  conferencing.
Sales of TV-based products represented 92% of net sales during 2nd Quarter 99 as
compared  to 26% of net sales  during  2nd  Quarter 98 while  PC-based  products
represented  8% of nets sales for 2nd Quarter 99 as compared to 74% of net sales
for 2nd  Quarter 98.  During 2nd  Quarter  99, the Company had other  revenue of
$9,124  compared to $4,360 during 2nd Quarter 98. As a result of the  foregoing,
revenues  increased  70% to  $549,889  in 2nd  Quarter 99 from  $324,149  in 2nd
Quarter 98.

         COST OF  REVENUE.  Cost of revenue  consists  of cost of goods sold and
cost of other revenue.  Cost of goods sold includes  labor,  materials and other
manufacturing  costs (such as salaries,  supplies,  leasing costs,  depreciation
related  to  production  operations  and  the  write-down  of  inventory  to net
realizable value). Cost of other revenue consists primarily of the allocation of
salaries  and benefits of personnel  and the cost of outside  services  directly
related to such revenue.  Cost of goods sold  increased 51% to $631,548 (117% of
net sales) in 2nd  Quarter 99 from  $418,406  (131% of net sales) in 2nd Quarter
98. The increase in cost of goods sold was the result of increased sales volume.
The decrease in the  percentage of cost of goods sold to net sales was primarily
the result of the increased sales volume and the decrease in the number of units
sold at less than cost when purchased in conjunction  with a  telecommunications
agreement with the Company.  The Company discontinued selling units at less than
cost when purchased in conjunction  with a  telecommunications  agreement during
2nd Quarter 99 due to lack of acceptance  by consumers.  Cost of goods sold as a
percentage of net sales during 2nd Quarter 99 remained  elevated due to the high
cost of manufacture of the Company's TV-based products in its initial production
stage and the  inability to cover fixed  manufacturing  costs at low  production
volumes.  Cost of other revenues was $1,241 in 2nd Quarter 99 (or 14% of related
revenue) as compared to cost of revenue of $1,012 (or 23% of related revenue) in
2nd Quarter 98.

         GROSS PROFIT  (LOSS).  The gross loss was $82,900 in 2nd Quarter 99, as
compared  to a gross loss of $95,269  in 2nd  Quarter  98. The gross loss in 2nd
Quarter 99 was primarily the result of the low sales volume and the related high
cost of goods sold discussed above.

                                       12
<PAGE>

         SELLING,    GENERAL   AND   ADMINISTRATIVE.    Selling,   general   and
administrative  expenses  decreased  30% to $703,284  (128% of  revenues) in 2nd
Quarter 99 from  $1,003,111  (309% of  revenues)  in 2nd Quarter 98. The primary
reason for the decrease was a 57% decrease in selling and marketing  expenses to
approximately  $205,000  in 2nd  Quarter 99 from  approximately  $475,000 in 2nd
Quarter 98,  substantially  all of which  decrease was  directly  related to the
marketing  launch of C-Phone Home in 2nd Quarter 98. The Company expects that it
will continue to incur substantial selling,  general and administrative expenses
during  Fiscal  1999  as a  result  of the  continued  commercialization  of the
Company's TV-based products.

         RESEARCH,  DEVELOPMENT  AND  ENGINEERING.   Research,  development  and
engineering  expenses decreased 18% to $197,733 (36% of revenues) in 2nd Quarter
99 from $240,247 (74% of revenues) in 2nd Quarter 98. The decrease was primarily
the  result  of the  completion  of the  initial  development  of the  Company's
TV-based  products  during  Fiscal  1998.  All of these  costs  were  charged to
operations  as incurred  and were funded by the  Company's  cash  reserves.  The
Company  expects  to  continue  to  invest  significant   resources  during  the
foreseeable future in new product development and engineering.

         OPERATING  LOSS.  As a  result  of the  factors  discussed  above,  the
Company's  operating  loss  decreased  26% to  $983,917  in 2nd  Quarter 99 from
$1,338,627 in 2nd Quarter 98.

         INTEREST.  Interest income  increased 109% to $87,518 in 2nd Quarter 99
from  $41,862  in 2nd  Quarter 98 as a result of  interest  earned on the higher
average  cash and cash  equivalents  due to the  receipt  of  proceeds  from the
December  Placement  and from the  exercise of  previously  issued  warrants and
options in May 1998, partially offset by the continued use of the Company's cash
and cash equivalents to fund operations.

         INCOME TAXES.  The Company's  losses for 2nd Quarter 99 and 2nd Quarter
98 may be utilized as an offset  against future  earnings,  although there is no
assurance that future operations will produce taxable earnings.

SIX MONTHS  ENDED  AUGUST 31,  1998 ("SIX  MONTHS 99") AS COMPARED TO SIX MONTHS
ENDED AUGUST 31, 1997 ("SIX MONTHS 98")

         REVENUES.  Net sales  increased  17% to  $879,915 in Six Months 99 from
$752,910  in Six  Months 98,  reflecting  the  Company's  change of focus to its
TV-based  products  from its PC-based  products as a result of an  industry-wide
slowdown in the  continued  acceptance of PC-based  desktop video  conferencing.
Sales of TV-based products represented 88% of net sales during for Six Months 99
as  compared  to 25% of net sales  during Six Months 98 while  sales of PC-based
products  represented 12% of sales for Six Months 99 as compared to 75% of sales
for Six Months 98.  During Six  Months  99,  the  Company  had other  revenue of
$25,512  compared to $8,039 during Six Months 98. As a result of the  foregoing,
revenues  increased 19% to $905,427 in Six Months 99 from $760,949 in Six Months
98.

         COST OF  REVENUE.  Cost of revenue  consists  of cost of goods sold and
cost of other revenue.  Cost of goods sold includes  labor,  materials and other
manufacturing  costs (such as salaries,  supplies,  leasing costs,  depreciation
related  to  production  operations  and  the  write-down  of  inventory  to net
realizable value). Cost of other revenue consists primarily of the allocation of
salaries  and benefits of personnel  and the cost of outside  services  directly
related to such revenue. Cost of goods sold decreased 14% to $1,139,621 (130% of
net  sales) in Six Months 99 from  $1,319,422  (175% of net sales) in Six Months
98. The  decrease in cost of goods sold and the  decrease in the  percentage  of
cost of goods sold to net sales was  primarily the result of the decrease in the
number of units  sold at less than cost when  purchased  in  conjunction  with a
telecommunications  agreement with the Company and a decrease in unit costs. The
Company  discontinued  selling  units  at  less  than  cost  when  purchased  in
conjunction  with a  telecommunications  agreement  during 2nd Quarter 99 due to
lack of acceptance by consumers. Cost of goods sold as a percentage of net sales
during Six Months 99 remained  elevated due to the high cost of  manufacture  of
the  Company's  TV-based  products  in its  initial  production  stage  and  the
inability to cover fixed manufacturing costs at low production volumes.  Cost of
other  revenues  was  $9,443 in Six  Months 99 (or 37% of  related  revenue)  as
compared to cost of revenue of $1,012 (or 13% of related  revenue) in Six Months
98.

                                       13
<PAGE>

         GROSS PROFIT  (LOSS).  The gross loss was $243,637 in Six Months 99, as
compared  to a gross  loss of  $559,485  in Six Months 98. The gross loss in Six
Months 99 was  primarily the result of the low sales volume and the related high
cost of goods sold discussed above.

         SELLING,    GENERAL   AND   ADMINISTRATIVE.    Selling,   general   and
administrative  expenses  decreased 34% to $1,428,868  (158% of revenues) in Six
Months 99 from  $2,165,323  (285% of  revenues)  in Six Months  98. The  primary
reason for the decrease was a 65% decrease in selling and marketing  expenses to
approximately  $420,000 in Six Months 99 from  approximately  $1,194,000  in Six
Months 98,  substantially  all of which  decrease  was  directly  related to the
marketing  launch of C-Phone  Home in Six Months 98. The decrease in selling and
marketing  expenses was  partially  offset by increased  investor  relations and
other shareholder  expenses resulting from a significant  increase in the number
of holders of the Common  Stock.  The Company  expects that it will  continue to
incur substantial  selling,  general and  administrative  expenses during Fiscal
1999 as a result of the continued  commercialization  of the Company's  TV-based
products.

         RESEARCH,  DEVELOPMENT  AND  ENGINEERING.   Research,  development  and
engineering  expenses  decreased 22% to $406,800 (45% of revenues) in Six Months
99 from  $520,986 (68% of revenues) in Six Months 98. The decrease was primarily
the  result  of the  completion  of the  initial  development  of the  Company's
TV-based  products  during  Fiscal  1998.  All of these  costs  were  charged to
operations  as incurred  and were funded by the  Company's  cash  reserves.  The
Company  expects  to  continue  to  invest  significant   resources  during  the
foreseeable future in new product development and engineering.

         OPERATING  LOSS.  As a  result  of the  factors  discussed  above,  the
Company's  operating  loss  decreased  36% to  $2,079,305  in Six Months 99 from
$3,245,794 in Six Months 98.

         INTEREST.  Interest  income  increased 66% to $140,261 in Six Months 99
from  $84,273  in Six  Months 98 as a result of  interest  earned on the  higher
average  cash and cash  equivalents  due to the  receipt  of  proceeds  from the
December  Placement  and from the  exercise of  previously  issued  warrants and
options in May 1998, partially offset by the continued use of the Company's cash
and cash equivalents to fund operations.

         INCOME TAXES.  The Company's losses for Six Months 99 and Six Months 98
may be utilized  as an offset  against  future  earnings,  although  there is no
assurance that future operations will produce taxable earnings.

LIQUIDITY AND CAPITAL RESOURCES

         The Company  has  financed  its recent  operations  primarily  from the
proceeds of the March  Placement,  which  raised net  proceeds of  approximately
$4,370,000,   and  the  December   Placement,   which  raised  net  proceeds  of
approximately  $4,110,000.  In addition,  during May 1998, the Company  received
approximately  $4,650,000  from the exercise of previously  issued  warrants and
options. See "Recent Equity Offerings."

         At August 31, 1998,  the Company had working  capital of $7,940,158 (an
increase of $2,769,353  from  $5,170,505 at February 28, 1998) and cash and cash
equivalents of $6,568,021 (as compared to $4,200,231 at February 28, 1998).  The
Company's invested funds consisted primarily of overnight repurchase  agreements
for  discount  notes  issued by the  United  States  Treasury  or United  States
government agencies.  During Six Months 99, operating activities used $2,263,866
of net cash, primarily to fund operating  activities,  investing activities used
$11,527 of net cash for equipment  purchases,  and financing activities provided
$4,643,183  of net cash from the  exercise of  previously  issued  warrants  and
options.  Due  to the  technical  nature  of  the  Company's  business  and  the
anticipated   expansion   of  its  video   conferencing   technology   into  new
applications, management expects to continue to expend significant resources for
continued development and engineering as well as selling and marketing expenses.

         The Company  believes that its current working  capital,  together with
anticipated  funds from  operations and proceeds from the Equity Line (discussed
above), will be sufficient to meet the Company's

                                       14
<PAGE>

projected  operating  needs and capital  expenditures,  including  the continued
development and commercialization of its TV-based products, at least through the
second quarter of fiscal year 2000.  However,  if any of the Company's  TV-based
products gain significant market acceptance, of which there can be no assurance,
the very substantial  investment which would then be required by the Company for
manufacturing,  inventory  and marketing  expenditures  and carrying of accounts
receivable related to the commercialization of such products,  would require the
Company to obtain even more working capital.  The Company  anticipates that such
additional  funds  should be  available  through one or more  possible  sources,
including through (i) the sale of common stock pursuant to the Equity Line, (ii)
a  private  placement  of (a) its debt  securities,  including  debt  securities
convertible  into Common Stock,  and/or (b) its Common Stock or preferred stock,
(iii) the exercise of the Company's outstanding warrants, if the market price of
the Common Stock were to exceed the exercise  price of such  warrants,  of which
there can be no assurance, and/or (iv) a public offering of Common Stock. Unless
adequate income relating to sales of TV-based  products is attained,  the timing
or receipt of which cannot be predicted, the Company may require additional cash
resources for the development of alternative products. There can be no assurance
that additional funds needed by the Company will be available when needed or, if
available,  that the terms of such  fundings  will be favorable or acceptable to
the Company.

         The  development  and recent  introduction  of TV-based  products  have
placed a significant strain on the Company's limited  personnel,  management and
other resources.  The Company's ability to manage any future growth  effectively
will require it to continue to attract, train, motivate and manage its employees
successfully  and  to  continue  to  improve  its  operational,   financial  and
management systems. The Company's failure to effectively manage its growth could
have a material adverse effect on the Company's business and operating results.

         The Company  leases its facility and owns its  manufacturing  equipment
free from  encumbrances.  As of August 31,  1998,  the  Company  had no material
commitments for capital expenditures.

         At February 28, 1998,  the Company  estimates that it had available net
operating loss  carryforwards of approximately  $15,125,000 for Federal purposes
and net economic  loss  carryforwards  of  approximately  $15,337,000  for state
purposes, which may be used to reduce future taxable income, if any. The Federal
carryforwards  will  expire  starting in 2009 and the state  carryforwards  will
expire starting in 1999.

         The Company believes that,  during the past three years,  inflation has
not had a  significant  impact  on the  Company's  sales or  operating  results.
Certain of the Company's products,  and components and subassemblies used by the
Company in its  products,  are  manufactured  outside  of the United  States and
represent a material  portion of the unit cost of the Company's  basic products.
Although the Company has not experienced any significant price increases to date
as a result of changes  in foreign  currency  rates,  there can be no  assurance
that, in the future,  changes in foreign currency rates will not affect the cost
of its foreign  purchased  components and  subassemblies.  The Company's foreign
sales are denominated in U.S. dollars and the Company does not incur any foreign
currency risks; however, fluctuations in currency exchange rates could cause the
Company's  products to become  relatively  more expensive to foreign  customers,
which would result in a reduction in foreign sales or the  profitability  of any
of such sales.

IMPACT OF YEAR 2000 ISSUE

         Computer systems may experience problems handling dates beyond the year
1999 because many computer  programs use only two digits to identify a year in a
date  field.  The  Company  has  addressed  this  issue in  several  parts - the
Company's  products,   the  Company's  application  software  for  its  internal
operations and third-party suppliers.

         PRODUCTS  -  As  the  Company's   products  do  not  include  date/time
mechanisms in their  operating  software,  the Company's  products are Year 2000
compliant.  However, some of the Company's earlier PC-based products use Windows
for  Workgroups as their  operating  system and there may exist Year 2000 issues
with the specific user installed LAN interface  employed by any certain customer
which issues are beyond the scope of the Company's involvement.

                                       15
<PAGE>

         APPLICATION  SOFTWARE - During Fiscal 1998, for  operational  purposes,
the Company made the decision to upgrade its internal  financial and operational
software  system.  This upgrade was completed in June 1998 and the system is now
Year 2000 compliant.  The Company has substantially completed the identification
of other internal  computer-based systems it uses which may require upgrading to
insure  operational  continuity  beyond  December 31, 1999. The Company plans to
complete such  identification,  the upgrading of necessary  applications and the
testing of all  application  software for Year 2000  compliance  by December 31,
1998.

         THIRD-PARTY  SUPPLIERS - The Company is assessing the possible  effects
on the Company's operations of Year 2000 compliance related to key suppliers and
subcontractors.  The Company's  reliance on suppliers and  subcontractors  means
that the failure to address Year 2000  compliance  issues by these parties could
have a material  impact on the Company's  business.  The Company has  identified
critical third-party  suppliers and has requested  information as to their plans
and  progress  in  addressing  the Year 2000  problem.  The  Company  expects to
complete its evaluation of its third-party suppliers by December 31, 1998. Based
upon its  evaluations,  the Company will develop  alternative  sourcing or other
contingency plans by mid-1999.

         COSTS - The  total  cost  associated  with the Year  2000  issue is not
expected to be material  to the  Company's  financial  position.  The  Company's
current estimated out-of-pocket cost is not expected to exceed $50,000, of which
only an  immaterial  amount has been  expended  to date..  As the upgrade of the
Company's  application software was done for operational  purposes,  the cost of
such upgrade has not been included in the Company's estimates.

         RISKS  -  Due  to  the  uncertainty  of  the  Year  2000  readiness  of
third-party  suppliers,  the Company is unable to determine at this time whether
the  consequences  of Year  2000  failures  will have a  material  impact on the
Company's results of operations,  liquidity or financial condition. In addition,
although the  Company's  business is not dependent on any single or small number
of  customers,  Year 2000  problems  which  significantly  interrupt  the normal
business  operations of a significant  number of the Company's  customers  could
have material adverse impact on the Company. The Company has not yet developed a
contingency  plan in the event of unsuccessful  implementation  of its Year 2000
project  or as a  result  of the  noncompliance  by any  of  the  Company's  key
suppliers or customers.  However,  the Company  believes that its Year 2000 plan
will significantly  reduce the Company's  exposure from the problems  associated
with the Year 2000 issues.

                                       16

<PAGE>

PART II. OTHER INFORMATION

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

         On  July  31,  1998  the  Company   held  an  Annual   Meeting  of  its
shareholders,  at which time each of the six incumbent  directors of the Company
who had been  nominated by the Board of Directors for  re-election as a director
of the Company was re-elected as a director. The votes cast were as follows:

                                            For            Withheld
                                         ---------         --------
         Daniel P. Flohr                 6,544,153          56,532
         Seymour L. Gartenberg           6,543,628          57,057
         Tina L. Jacobs                  6,544,153          56,532
         Donald S. McCoy                 6,544,228          56,457
         E. Henry Mize                   6,543,428          57,257
         Stuart E. Ross                  6,543,228          57,457

         At the  Annual  Meeting  two  additional  proposals  were voted upon as
follows:

         (1)  Proposal to approve the  issuance of any shares of Common Stock in
              excess  of  1,068,513   shares  of  Common  Stock   issuable  upon
              conversion of the Series A Preferred Shares:

                     For                    Against            Abstaining
                     ---                    -------            ----------

                  1,957,764                 167,930             32,991


         (2)  Proposal to ratify  PricewaterhouseCoopers  LLP (formerly Cooper &
              Lybrand  L.L.P.) as the  independent  auditors for the Company for
              the fiscal year ending February 28, 1999:

                     For                    Against            Abstaining
                     ---                    -------            ----------

                  6,554,353                 24,394              21,938


ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

         (a)  EXHIBITS

              27.  Financial Data Schedule

         (b)  REPORTS ON FORM 8-K

              The Company  did not file a Current  Report on Form 8-K during the
              quarter  ended  August 31, 1997;  however,  the Company did file a
              Current Report on Form 8-K (responding to Item 5 - "Other Events")
              on September 25, 1998.

                                       17

<PAGE>


                                   SIGNATURES

In accordance with the  requirements of the Exchange Act, the registrant  caused
this  report to be  signed on its  behalf  by the  undersigned,  thereunto  duly
authorized.

                           C-PHONE CORPORATION


Date: October 14, 1998     By:  /s/ Daniel P. Flohr
                               -------------------------------------------------
                                    Daniel P. Flohr
                                    President and Chief Executive Officer
                                    (Principal Executive Officer)


Date: October 14, 1998     By:  /s/ Paul H. Albritton
                               -------------------------------------------------
                                    Paul H. Albritton
                                    Vice President and Chief Financial Officer
                                    (Principal Accounting and Financial Officer)


                                       18