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

                                   FORM 10-K
(Mark One)
[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934 [NO FEE REQUIRED]

For the fiscal year ended October 31, 1997
                                      or
[_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period from          to

                         COMMISSION FILE NUMBER 0-22366

                          CREDENCE SYSTEMS CORPORATION
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

                    DELAWARE                        94-2878499
          (State or other jurisdiction            (I.R.S.  Employer
           of incorporation or organization)       Identification No.)

           215 FOURIER AVENUE, FREMONT, CALIFORNIA       94539
          (Address of principal executive offices)     (Zip Code)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (510) 657-7400
--------------------------------------------------------------------------------

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

     TITLE OF EACH CLASS:       NAME OF EACH EXCHANGE ON WHICH REGISTERED
     --------------------       -----------------------------------------  
            None                                   None

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, $0.001
par value
 
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [_]

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

     The aggregate market value of voting stock held by non-affiliates of the
Registrant, as of January 20, 1998 was approximately $289,104,000 (based upon
the closing price for shares of the Registrant's common stock as reported by the
Nasdaq National Market for the last trading date prior to that date). Shares of
common stock held by each officer, director and holder of 5% or more of the
outstanding common stock have been excluded in that such persons may be deemed
to be affiliates. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.

     On January 20, 1998, approximately 21,746,950 shares of the Registrant's
common stock, $0.001 par value, were outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement for the 1998 Annual Meeting of
Stockholders to be held on March 25, 1998 are incorporated by reference into
Part III.
<PAGE>
 
                                     PART I
                                     ------

ITEM 1.   BUSINESS

     Credence Systems Corporation (including its subsidiaries, the "Company" or
"Credence") designs, manufactures, sells and services automatic test equipment
("ATE") used in the production of semiconductors. The Company also develops,
publishes and distributes software products used to aid in the generation and
verification of test programs for ATE systems. The Company serves a broad
spectrum of the semiconductor industry's testing needs through a wide range of
products that test digital logic, mixed-signal and non-volatile memory
semiconductors. Credence utilizes its proprietary technologies to design
products that provide a lower total cost of ownership than many competing
products while meeting the increasingly demanding performance requirements of
today's ATE market. The Company's products are primarily designed to test
semiconductors that are produced in high volume. The Company's customers include
major semiconductor manufacturers as well as assembly and test services
companies. Through its acquisitions of the assets from Summit Design, Inc. 
("Summit Design") and Zycad Corporation ("Zycad"), the Company now offers
software for generating and verifying test programming for ATE systems.

     Credence was incorporated in California in March 1982 to succeed to the
business of a sole proprietorship and was reincorporated in Delaware in October
1993. The term "Credence" or the "Company" includes, when the context so
requires, Credence Systems Corporation, its subsidiaries and its California
predecessor corporation, the Semiconductor Test Systems Division (the "STS
Division") of Tektronix, Inc., which the Company acquired in December 1990, and
Axiom Technology Corporation ("Axiom"), ASIX Systems Corporation ("ASIX") and
EPRO and EPRO's subsidiary, which the Company acquired through mergers in March
1988, October 1989 and March 1995, respectively, the assets of Test Systems
Strategies, Inc., which the Company acquired in July 1997, and the fault
simulation and test program development products of Zycad, which the Company
acquired in August 1997./1/


BACKGROUND

     The price of integrated circuits (IC's) once limited their use to high cost
military and industrial computing applications. Dramatic advances in
semiconductor process technology have improved the performance and lowered the
average selling prices ("ASPs") of these semiconductor devices (semiconductors)
to levels that now support their use in a wide range of office, consumer,
automotive, communications, industrial and other products. In order to maintain
or improve gross margins as semiconductor ASPs decline, semiconductor
manufacturers are constantly seeking ways to reduce manufacturing costs.

     Testing is a principal element in the cost structure of high volume
production of semiconductors. As a result of improved efficiencies in wafer
fabrication, test costs have become a higher percentage of the total cost of
manufacturing. This shift in cost structure has changed the traditional criteria
for selection of ATE. Although performance was the dominant factor in the
selection of ATE in the past, the Company believes that economic considerations
have assumed much greater importance to semiconductor manufacturers. Purchasers
of ATE now examine more carefully the total cost of ownership of ATE. Total cost
of ownership includes the initial purchase price of the tester, as well as the
tester's reliability, flexibility, size, power and air conditioning
requirements, upgradeability and maintenance costs, including spare parts.

     Traditionally, semiconductor die were minimally tested at wafer probe and
incurred rigorous performance testing to full specification only at the
completion of final packaging. Today, assembly and packaging has become
increasingly expensive compared with the cost of the die, such that their costs
may exceed the cost of the die itself. This trend has influenced semiconductor
manufacturers to shift performance testing increasingly toward wafer probe. By
subjecting devices to performance testing earlier in the manufacturing process,
defective die are detected and eliminated before assembly and packaging costs
are incurred.

----------------------- 
/1/
"Credence Systems Corporation,"  "SC212," "STS," "Vista LT," VistaLogic,"
"VistaVISION," "Logic100," "ValStar,", "Kalos," and  "DUO" are  trademarks of
the Company. This Annual Report on Form 10-K also includes trademarks of other
companies.
<PAGE>
 
     Increased facility costs and the trend toward performance testing at wafer
probe have led to the increased importance of smaller testers in the
semiconductor manufacturing process. Performance testing at wafer probe requires
that the device under test be located in close physical proximity to the
measuring circuits of the tester in order to minimize potential signal
distortions that can negatively impact testing yields. Smaller testers can more
easily be placed in close physical proximity to such circuits. In addition,
wafer probe test typically occurs in a clean room where potential contaminants
must be continually removed and temperatures kept constant. These special
maintenance requirements make clean rooms expensive to operate. Smaller testers
occupy less floor space and therefore assist in reducing clean room costs. In
addition, smaller testers that consume less power generally have reduced air
conditioning requirements.

     For over 20 years, emitter-coupled logic ("ECL") has been the conventional
process technology used by the Company and others for the integrated circuits
used in ATE due to its speed, repeatability and precision. ECL technology,
however, results in low functionality per chip and requires continuous power. As
a result, conventional ATE systems generally are large, expensive and require
significant electrical power to operate.

     Another process technology commonly used in the manufacture of
semiconductors is complementary metal oxide semiconductor ("CMOS"). As compared
to ECL, CMOS technology allows higher functionality for a given chip size and
requires less power to operate. Some ATE manufacturers have used a combination
of ECL and CMOS ("BiCMOS") to lower the cost of ATE by reducing the use of ECL.

     The production of ATE based exclusively on CMOS technology, however, had
been limited by the inability of CMOS to meet the timing and measurement demands
of semiconductor testing. Although the speed of CMOS was acceptable, its timing
repeatability was not. This problem results from the tendency of CMOS circuits
to experience timing drift as a function of temperature variation. To fully
benefit from the economic and other advantages of CMOS technology, the challenge
has been to control this drift characteristic in order to produce semiconductors
for ATE that meet the performance requirements of semiconductor testing.

THE CREDENCE SOLUTION AND STRATEGY

     Credence has developed proprietary CMOS stabilization methods that minimize
the drift characteristic of CMOS and enable the Company to produce testers that
are smaller and require less power than those based upon ECL or BiCMOS
technology and that provide a lower total cost of ownership than many competing
products currently available while meeting the performance demands of today's
ATE market. CMOS technology allows the circuits used in Credence's testers to be
reduced, or "scaled" down in size as IC process technology improves, resulting
in higher performance and freeing space on the die for additional functionality.
This scalability feature enables the Company to develop and manufacture smaller,
higher performance integrated circuits for use in its testers at what Credence
believes to be a lower cost, and with a shorter development cycle, than
traditional process technologies.

     Credence's objective is to be the leading supplier of cost-effective ATE
for production testing of integrated circuits used in high volume applications.
The Company's business strategy incorporates the following key elements:

       .  Technology Leadership.  The Company believes that its proprietary CMOS
          stabilization technology enables the development of ATE that is
          designed to meet the performance and cost of ownership requirements of
          semiconductor manufacturers and assembly and test services companies.
          In addition, the Company believes the scalability of this technology
          will allow it to offer new products and enhancements in a shorter time
          and at a lower cost than many of its competitors that base their
          products on traditional less-scaleable architecture.

       .  Lower Total Cost of Ownership.  The Company seeks to provide ATE to
          its customers at a lower total cost of ownership than many competing
          products currently available while meeting the performance
          requirements of its customers. The Company believes that the system
          price, reliability, flexibility, size, power and air conditioning
          requirements, upgradeability and maintenance costs, including spare
          parts, of its testers enable its customers to more cost effectively
          test integrated circuits. Credence's proprietary CMOS stabilization
          technology is integral to the successful implementation of this
          strategy.

       .  Diverse, High-Volume Markets.  Credence's products target the testing
          of digital logic, mixed-signal and non-volatile memory devices that
          are used in a broad range of growing end-user market segments. The
          Company's products are designed to test semiconductors that are
          manufactured in high volume and are used in a variety of 
<PAGE>
 
          applications such as automobiles, appliances, personal computers,
          personal communications products, networking products, digital
          televisions and multimedia hardware.

       .  Worldwide Technical Support and Customer Service.  As semiconductor
          manufacturers expand their operations worldwide, they require that
          their ATE suppliers have the capability to provide global support and
          service. To meet this requirement, Credence utilizes a combination of
          direct sales, service and support personnel and a broad network of
          independent distributors located in close proximity to major customer
          sites. Credence and its distributors currently maintain locations
          throughout the world to service and support Credence's customers.

       .  Software Development  The Company believes that its customers require
          increasing levels of sophisticated software tools to assist in the
          utilization of ATE. The Company is focusing its software efforts on
          internal development of, and acquisition of companies or businesses,
          that develop such tools. In July 1997 the Company acquired the TSSI
          assets and in August 1997, the Company acquired the fault simulation
          and test program development products of Zycad. The Company intends to
          continue to develop and acquire software tools to expand its presence
          in the market for software tools to speed development and verify
          quality of test programming for ATE systems.


PRODUCTS

     Credence currently offers a wide variety of products that test digital
logic, mixed-signal and non-volatile memory integrated circuits. Digital logic
semiconductors produce discrete "on" and "off" logical sequences that control
functions, store data, retrieve data and move and manipulate data at high rates
of speed. Examples of digital logic semiconductors include logic devices such as
microcontrollers. Certain digital devices which store and retrieve data are
memory semiconductors. Non-volatile memory semiconductors retain their data when
the power is turned off. Mixed-signal semiconductors combine both digital and
analog functions. Analog semiconductors control external functions such as
sound, graphics, and motor controls by producing continuous varying voltage or
current. When these analog functions are integrated onto a digital integrated
circuit, the resulting device is considered a mixed-signal device.

     The Company's CMOS-based ATE products, the SC series, the Domain, the Vista
series testers, and the DUO are designed to test high speed devices used in
applications such as networking and portable computing as well as multimedia,
digital television, high-definition television and personal communications. The
Company's Domain mixed-signal products test certain semiconductors used
principally in automotive and telecommunications applications. The Company's
memory products test non-volatile memory devices, including ROM, EPROM, EEPROM
and FLASH memories used in high volume applications in the consumer, automotive
and telecommunications markets. During 1997, the Company introduced the ValStar
2000, a system which enables the testing of very complex devices, up to 1024
pins with high speed bus interfaces. Also introduced was the Kalos Flash memory
test system, a highly integrated parallel system that provides multi-site
testing and is designed to lower the overall cost of test.

     During fiscal 1997, the Company acquired the test development series
software ("TDS") from Summit Design and one of its subsidiaries and the TDX
software product ("TDX") line from Zycad. As a result of these product
acquisitions, the Company currently offers its customers software which will
help them in the generation of test programs for use on ATE.

     The following table sets forth the Company's current product offerings,
their features and examples of typical devices tested by each product. Included
in certain of the basic features are the anticipated cycle speed in megahertz
("MHz"), timing accuracy in either picoseconds ("ps") or nanoseconds ("ns"), the
number and characteristics of the pins and the density in megabits ("mb") of the
device that can be tested:
<PAGE>
 
<TABLE>
<CAPTION>
 
-----------------------------------------------------------------------------------------------------------------------------
       PRODUCT            SERIES       MODELS             BASIC FEATURES                     TYPICAL DEVICES
-----------------------------------------------------------------------------------------------------------------------------
 <S>                    <C>           <C>                 <C>                      <C> 
                            SC         SC 212              50 - 100 MHz                     Microcontrollers, ASSPs, DSPs and
                                       SC 312              64 - 304 Pins                    FPGAs
DIGITAL                                SC Micro            +  350-500 ps accuracy
                       ------------------------------------------------------------------------------------------------------
                           Vista        LOGIC              50 - 100 MHz                     Microprocessors, RISC circuits,
                                        Logic100           32 - 512 Pins                    PLDs, FPGAs, ASICs and ASSPs
                                                           +  290ps-200ps accuracy
                       -------------------------------------------------------------------------------------------------------
                          ValStar      ValStar             200MHz                           Microprocessors, RISC circuits,
                                       2000                +  200 ps accuracy               PLDs, FPGAs, ASICs and ASSPs
                                                           512-1024 Pins
------------------------------------------------------------------------------------------------------------------------------
                          Vista        VISION              Same as Vista digital            RAMDACs, graphic palettes and
                                                           series, but configured with      other multimedia devices, mass
                                                           64 analog pins in place of       storage, DSPs, ASICs, Datacom, and
                                                           64 digital pins                  specialty devices, mobile
                                                                                            communication devices, complex
                                                                                            audio devices
                       -------------------------------------------------------------------------------------------------------
                          DUO          DUO                 DUO-SE  -  50 MHz                RAMDACs, graphic palettes and
                                       DUO-SE              DUO-SX-  200MHz                  other multimedia devices, mass
                                       DUO-SX              DUO-RF-50-100MHz                 storage, DSPs, ASICs, Datacom, and
MIXED-                                 DUO-RF              Up to 128 digital pins           specialty devices, mobile
SIGNAL                                 DUO-LFI                                              communication devices, complex
                                                                                            audio devices
                       -------------------------------------------------------------------------------------------------------
                          Domain       3500                10 - 30MHz                       Codecs, converters, power devices,
                                       5000                24 - 48 Pins                     automotive modules and telecom
                                                           +  1ns accuracy                  devices
------------------------------------------------------------------------------------------------------------------------------
MEMORY                    EPRO         142/AX              10-50 MHz                        ROM, EEPROM, EPROM, and FLASH
PRODUCTS                  KALOS                            128mb                            memories
                                                           +  2ns
------------------------------------------------------------------------------------------------------------------------------
WORKCELL                  Centaur      Centaur            Integrated systems with pick     Microcontrollers, ASSPs, DSPs and
                                                          and place handler and "zero      FPGAs
                                                          footprint" tester
------------------------------------------------------------------------------------------------------------------------------
SOFTWARE                  TDS                             Generates tester specific        Tools apply to digital logic
                          Tools                           programs                         devices.
                                                          Verifies timing specifications
                       -------------------------------------------------------------------------------------------------------
                          TDX                             Verifies test vector quality     Tools apply to digital logic
                          Tools                           Supports design for test         devices.
                                                          strategies
------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<PAGE>
 
     Digital Products

     SC   The model SC 212 was first shipped in 1992 and incorporates one of the
Company's proprietary CMOS stabilization methods. This product requires
approximately 30 square feet of floor space and 4 kilowatts of power for 304
pins. The SC Micro is a cost reduced version of the SC 212.  This new system
offers the Company's customers a full capability test system at a price as low 
as $2,000 per digital pin channel. This per channel price has previously been
available only in test systems with reduced functionality - requiring users to
compromise the quality of their device testing. The SC Micro retains the
customer's test quality while continuing to lower their test costs. In 1997 the
Company expanded the SC series by introducing and shipping the SC 312, which
runs at a higher speed (100 MHz) and has improved accuracy over the SC 212. The
purchase price of these testers typically range from $350,000 to $850,000
depending upon configuration.

     Vista  The VistaLOGIC was introduced by the Company in 1992 and evolved
from its predecessor, the Vista LT. The Vista LT was first shipped by Tektronix
in 1987 and was acquired by the Company in 1990. The Logic100 was introduced by
the Company in 1994 and is the 100 MHz version of the VistaLOGIC. The VistaLOGIC
and Logic100 incorporate one of the Company's proprietary CMOS stabilization
methods. The purchase price of the Vista digital testers typically range from
$600,000 to $1,500,000, depending upon configuration.

     VALSTAR 2000  The VALSTAR 2000 was introduced in 1997 and the Company
believes it is the first system designed specifically with the performance cost
structure for volume production of high pin count VLSI devices. This product
offers up to 1,024 input/output (I/O) pins at 200 MHz data rates, and requires
less than four square meters of floor space. A fully loaded system consumes only
16 kilowatts of power, which is generally less than many competitive systems,
thus lowering operating costs. The purchase price of the ValStar 2000 ranges
from $2,500,000 to $3,600,000 depending on configuration.

     Mixed-Signal Products

     Vista and DUO  The VistaVISION, an adaptation of the VistaLOGIC, was first
shipped by the Company in 1992, and has been enhanced to test both digital and
mixed-signal devices.

     The DUO series is the Company's high performance mixed signal product line
and was first shipped in 1995. The DUO incorporates one of the Company's
proprietary CMOS stabilization methods. The Duo SE and the Duo SX are recent
additions to the Duo product family which run at 50 MHz and 200 MHz,
respectively. These systems allow customers to choose the level of technology
and cost structure that best meet their needs. The Duo SE and SX are fully
compatible with other members of the Duo family and supports the same set of
mixed signal instrumentation. In 1997 Credence also added two new versions of
the Duo system, the Duo LFI which tests complex, high performance audio devices,
and the Duo RF, a system which combines high performance digital and radio
frequency (RF) testing on the same platform. Also in 1997 embedded memory test
capability was added to bring full "system-on-a-chip" testing. The purchase
price of these testers typically range from $700,000 to $2,500,000, depending
upon configuration.

     Domain  The Domain 3500 mixed-signal tester currently offered by the
Company evolved from predecessor mixed-signal testers that were introduced by
Axiom, a mixed-signal tester manufacturer acquired by the Company in 1988. The
STS 5000 is the higher pin count version of the STS 3500. The purchase price of
these mixed-signal testers typically range from $350,000 to $750,000, depending
upon configuration.

     Memory Products

     EPRO  The Company's EPRO product line includes the model 142/AX and EDGE
testers. The model 142/AX was first shipped by EPRO in 1982. The EDGE is the
follow-on version of the model 142/AX with additional testing sites. The EDGE
was first shipped by EPRO in 1991. The purchase price of these non-volatile
memory testers typically ranges from $30,000 to $80,000, depending upon
configuration.

     KALOS  Introduced in November 1997, the Kalos is a highly integrated,
parallel system designed to test flash memory. Running at 50 MHz, it provides
multi-site testing and is designed to lower the customer's cost of test. The
Kalos features a unique "Tester-On-A-Card" architecture, which places all test
functions for each site on a single card and thus reduces floor space and power
consumption while increasing performance.
<PAGE>
 
     Workcell Products

     Centaur  In 1996, the Company established the Workcell product group.  This
group's charter is to provide complete test solutions that meet the value
expectations of the Company's  customers, and is designed to enable Credence to
compete in the IC manufacturing production environment.  The first embodiment of
this new process is the Centaur tester.  The combination of the Company's SC
Micro product and a new handling system developed by Micro Component Technology,
Inc., Centaur will offer the Company's customers a high level of integration
between a test system and the device handling equipment required for volume
production.  Centaur will provide the Company's customers with a number of
advantages including a true zero footprint test system, high reliability, high
fidelity electrical interface, multiple package types with zero changeover time,
and single point control of both handler and test system. The Company has not
sold any of its Centaur systems to date.

     Software Products

     Software products provide tools to IC manufacturers to speed the process of
moving designs from design automation environments to ATE equipment, thereby
allowing a reduced time to market for new IC designs. These products aid the
development and ensure the quality of test programs needed for ATE systems to
test IC's.



CUSTOMERS, MARKETS AND APPLICATIONS

     Credence targets digital logic, mixed-signal, non-volatile memory, and
"systems-on-a-chip" device manufacturers that serve a broad range of growing 
end-user market segments. These customers manufacture semiconductors in high
volume for use in applications such as automobiles, appliances, personal
computers, personal communications products, networking products, digital
televisions and multimedia hardware.

     In addition to marketing its products to major semiconductor manufacturers,
the Company has developed relationships with numerous assembly and test services
companies. Semiconductor manufacturers increasingly utilize these subcontractors
as a means of lowering their fixed production costs, thus minimizing the effects
of cyclicality inherent in the semiconductor industry. As a result, these
assembly and test services companies have become an increasingly important
segment of the ATE market.

     The Company believes that the Company's success depends in large part upon
the success of its major customers. The loss of or any reduction in orders by a
significant customer (including the potential for reductions in orders by
assembly and test services companies which that customer may utilize), including
reductions due to market, economic or competitive conditions in the
semiconductor industry or in other industries that manufacture products
utilizing semiconductors may continue to adversely affect the Company's
business, financial condition or results of operations as it has recently. The 
Company's ability to increase its sales in the future will depend in part upon
its ability to obtain orders from new customers as well as the financial
condition and success of its customers and the general economy. There can be no
assurance that the Company's sales will not decrease in the future or that the
Company will be able to retain existing customers or to attract new ones.

     For information on the Company's geographic data and major customers, see
Note 5 to the Consolidated Financial Statements included elsewhere herein.  The
Company's international sales are primarily denominated in United States
dollars. The Company anticipates that its international business will continue
to account for a significant portion of net sales in the foreseeable future.

     The Company schedules production of its systems based upon order backlog
and order forecast. The Company includes in its backlog only those customer
orders for systems (including upgrades) for which it has accepted purchase
orders and assigned shipment dates within the following twelve months. The
majority of the Company's orders are subject to cancellation or rescheduling by
the customer with limited or no penalties. The Company's backlog at any
particular date may not necessarily be representative of actual sales for any
succeeding period due to orders received for systems to be shipped in the same
quarter, possible changes in system delivery schedules, cancellation of orders
and potential delays in system shipments. As of October 31, 1997, the Company's
order backlog for systems (exclusive of orders for spare parts and service and
support) was approximately $97.5 million, as compared with $49.4 million as of
October 31, 1996.
<PAGE>
 
SALES, SERVICE AND SUPPORT

     The Company currently markets and sells its products in the United States
principally through its direct sales organization, with direct sales employees
in 15 locations. Outside the United States, the Company utilizes both direct
sales employees and a broad network of distributors, with direct sales employees
and distributors in over 15 countries. The Company sold its sales and service
subsidiaries in the United Kingdom and Germany in February 1994 and the Company
utilizes the purchaser of such operations as its primary distributor in Europe.

     The Company and its distributors have sales and support centers located in
the United States, Europe, Israel, Taiwan, Korea, China, Japan, Singapore,
Malaysia, Philippines, Thailand and Hong Kong from which both direct Credence
personnel and independent sales and service representatives sell and support the
equipment. The Company believes that field support is critical to its customers.
Support encompasses many of the components of the total cost of ownership for
ATE. Credence seeks to develop long-term relationships with major ATE customers
through extensive support consisting of teams of professional sales,
applications, training and service personnel. These personnel are located in
close physical proximity to key customer sites in order to provide the required
support in a timely fashion. The sales process includes consultations with
customers to help them purchase the most cost-effective equipment for their
needs, to help develop custom test programs to optimize production throughput,
to assist in long-term self-sufficiency through training of customer test
engineering personnel and to provide the service capacity and preventive
maintenance to reduce downtime for customers' systems. Customer support includes
field personnel and in-house applications personnel who work closely with design
engineering groups to modify existing equipment to meet the latest performance
requirements.

     In Japan, the Company has a wholly-owned subsidiary that provides sales and
service to its customers. In addition, the Company has a relationship with
Innotech, Inc., the distributor of the Company's products in Japan. In 1997 the
Company formed a joint venture with Innotech to engage in the customization and
manufacture of ATE products for sale by both companies. In March 1996, the
Company established a service and support subsidiary in Korea. The Company also
has a relationship with Itek, Inc., the distributor of the Company's products in
Korea.

     The Company's standard policy is to warrant its new systems against defects
in design, materials and workmanship for one year for parts and labor. The
Company offers its customers additional support after the warranty period in the
form of maintenance contracts for specified time periods. Such contracts include
various options such as board replacement, priority response, planned preventive
maintenance, scheduled one-on-one training, daily on-site support and monthly
system and performance analysis.

RESEARCH AND DEVELOPMENT

     The ATE market is subject to rapid technological change and new product
introductions. The Company's ability to be competitive in this market will
depend in significant part upon its ability to successfully develop and
introduce new products, enhancements and related software tools on a timely and
cost-effective basis. This will enable customers to integrate such products into
their operations as they begin volume manufacturing of the next generation of
semiconductors.

     Credence has pursued a technology acquisition strategy to complement its
internal research and development efforts. In 1988, the Company completed its
acquisition of Axiom, which added mixed-signal testing capability. In 1989, the
Company completed its acquisition of ASIX, which added one of the two
proprietary CMOS stabilization methods. In 1990, the Company acquired the STS
Division of Tektronix, which added the second proprietary CMOS stabilization
method. In 1993, the Company acquired various patents from Tektronix. In March
1995, the Company acquired EPRO, which added non-volatile memory testing
capability. In July 1997, the Company acquired the test development software
assets from TSSI and Summit and in August 1997 acquired the fault simulation and
test program development products of Zycad.

     Each of the stabilization methods acquired by Credence provides a different
solution to the tendency of CMOS to experience timing drift as a function of
temperature variation. The first proprietary solution uses a timing phase
detection circuit combined with a voltage control mechanism to compensate for
thermal, voltage and process instability. The second uses a unique combination
of counters and heating circuits to provide thermal stability.  These methods
allow the Company's CMOS-based integrated circuits to achieve the timing
repeatability necessary to meet the performance requirements of ATE and to
realize the economic and other advantages of CMOS technology over ECL
technology. CMOS circuits use less space than those based on ECL as the
circuits require less power and can be more closely packed together.
<PAGE>
 
     During 1997, the Company enhanced its Duo product line with new
capabilities including high performance audio testing, testing of analog
circuitry for wireless communication applications and embedded memory test
capability. These features enable single insertion "system-on-a-chip" testing
capability. The Company will continue to focus research and development efforts
on ensuring that its products have the ability to efficiently test state-of-the-
art customer devices which combine analog, high speed digital logic, and memory
on a single circuit.

     Credence's ongoing research and development efforts also include focusing
on increased cycle speed, accuracy, and pin counts of its testers. In addition,
the Company is working on a software development program that is intended to
provide for upward compatibility through the Company's products. Credence will
also continue to focus efforts on providing software solutions which allow more
rapid, cost-effective development of ATE test programs which reduce time-to-
market of customer integrated circuit designs. The Company currently intends to
continue to invest significant resources in the development of new products and
enhancements for the foreseeable future.

     Research and development expenses were $37.4 million (excluding the $6
million charge for acquired in-process research and development), $35.4 million
and $24.9 million in fiscal 1997, 1996 and 1995, respectively.

PROPRIETARY RIGHTS

     The Company currently holds 19 United States patents, which expire
beginning in May 1998 through April 2014. In addition, the Company currently has
9 foreign patents, which expire beginning in August 1999 through September 2011.
The two United States patents acquired from ASIX and Tektronix underlying the
Company's proprietary CMOS stabilization methods expire in February 2007 and
December 2007, respectively. There can be no assurance that pending patent
applications will be approved or that any patents will provide competitive
advantages for the Company's products or will not be challenged or circumvented
by competitors.

     The Company has granted a license to Tektronix with respect to patents
obtained in the acquisition of the STS Division of Textronix, Inc. and certain
other intellectual property rights (collectively, the "Tektronix Rights"),
including a patent covering one of the Company's proprietary CMOS stabilization
technologies, that were assigned to the Company by Tektronix in 1993. Tektronix
has a worldwide, perpetual, irrevocable, non-exclusive, royalty free, fully-
paid, sublicensable and transferable license to the Tektronix Rights. Tektronix
may not grant rights under the Tektronix Rights to make, use, sell or otherwise
distribute automatic test equipment for testing integrated circuits to any
entity other than Sony-Tektronix, a Tektronix joint venture affiliate that does
not currently offer production ATE, and to a successor-in-interest to Tektronix.
Tektronix may not grant or assign such rights to any other party. In addition,
Tektronix may not knowingly sell components incorporating the Tektronix Rights
to any other party. The Company and Tektronix have granted to each other a
worldwide, perpetual, irrevocable, non-exclusive, royalty free, fully-paid,
sublicensable and transferable license to all improvements, enhancements,
modifications or derivative works created before August 1996 ("Improvements") of
intellectual property that was licensed or assigned pursuant to a Technology
Agreement dated December 31, 1990, as amended on August 12, 1993, including the
Tektronix Rights, to make, use and sell ATE for testing integrated circuits.
Tektronix's license to the Improvements is subject to the same restrictions as
its license to the Tektronix Rights.

     The Company attempts to protect its intellectual property rights through
patents, copyrights, trade secrets and other measures. There can be no assurance
that others will not independently develop substantially equivalent proprietary
information and techniques or otherwise gain access to the Company's trade
secrets and other intellectual property rights or disclose such technology or
that the Company can meaningfully protect its trade secrets or other
intellectual property rights. There can be no assurance that any patent owned by
the Company will not be invalidated, circumvented or challenged, that the rights
granted thereunder will provide competitive advantages to the Company or that
any of the Company's pending patent applications will be issued. Furthermore,
there can be no assurance that others will not develop similar products,
duplicate the Company's products or design around the patents owned by the
Company. In addition, litigation has been and may continue to be necessary to
enforce the Company's patents and other intellectual property rights, to protect
the Company's trade secrets, to determine the validity and scope of the
proprietary rights of others, or to defend against claims of infringement or
invalidity. For additional information with respect to the Company's
intellectual property, review the information set forth under "Risk Factors-
Proprietary Rights."


MANUFACTURING AND SUPPLIERS
<PAGE>
 
     The Company's manufacturing objective is to produce ATE that conforms to
Credence customers' requirements at the lowest possible manufacturing cost.
Credence relies on outside vendors to manufacture certain components and
subassemblies. The Company seeks to manage its inventory levels through
agreements with both suppliers and subcontractors that provide just-in-time
delivery of these components and subassemblies. The Company assembles these
components and subassemblies to create finished testers in the configuration
specified by its customers. In general, Credence uses standard components and
prefabricated parts available from numerous suppliers. However, certain
components and subassemblies necessary for the manufacture of the Company's
testers are obtained from a sole supplier or a limited group of suppliers. The
Company purchases certain components that are available solely from Tektronix
for use in certain of its testers. The Company is in the process of qualifying
a second source for the components obtained from Tektronix. There can be no
assurance that such alternative sources will be qualified or available to the
Company. The Company's reliance on a sole or a limited group of suppliers and
on outside subcontractors involves certain risks, including a potential
inability to obtain an adequate supply of required components, and reduced
control over pricing and timely delivery of components. The yield and quality
of components and the timeliness of deliveries from the Company's outside
subcontractors have generally been acceptable to date, although there can be
no assurance that they will be acceptable in the future.


TOTAL QUALITY MANAGEMENT

     Credence believes that total quality management ("TQM") is a vital
component of customer satisfaction and internal productivity. The Company
believes it is a leader in the ATE industry in terms of productivity, as
measured by revenue per employee, and that its productivity achievements result
in significant part from its focus on TQM. The Company believes that its
position with respect to productivity per employee provides it with operational
and financial advantages, as it is able to generate revenues without incurring
many of the expenses and overhead associated with a greater number of employees.

     The Company completed ISO 9001 registration in 1997, receiving
certification from the National Standards Authority of Ireland. As a result of
efforts towards ISO registration, Credence instituted a system of internal
audits, corrective and preventative actions and management review spanning the
entire organization. The Company also is investing in business process
reengineering. During 1997, the Company implemented the first phase of this
program in order management and has seen improvements in the accuracy of
customer quotations and in management of inventory and response time. The
Company's participation in these programs is required by several of the
Company's major customers.

COMPETITION

     The ATE industry is intensely competitive. Credence faces substantial
competition throughout the world, primarily from ATE manufacturers located in
the United States, Europe and Japan, as well as from certain of its customers.
The Company's competitors in the digital semiconductor testing market include
Advantest Corporation ("Advantest"), Ando Electric Co., Ltd., LTX Corporation
("LTX"), Schlumberger Ltd., Hewlett-Packard Company ("HP") and Teradyne, Inc.
("Teradyne"). In the mixed-signal semiconductor testing market, the Company's
competitors include Teradyne, LTX, HP, Schlumberger Ltd., and Advantest.  In the
non-volatile memory testing market the Company's competitors include Teradyne,
HP and Advantest.

     The principal elements of competition in the Company's markets and the
basis upon which ATE customers select testers include throughput and product
performance and total cost of ownership. The Company believes that it competes
favorably with respect to these factors.


EMPLOYEES

     As of  October 31, 1997, the Company had a total of 646 employees,
including 161 engaged in manufacturing, 157 in research and development, 69 in
applications, 176 in sales, marketing and service, and 83 in administration.
Many of the Company's employees are highly skilled, and the Company believes its
future results of operations will depend in large part on its ability to attract
and retain such employees. None of the Company's employees are represented by a
labor union, and the Company has not experienced any work stoppages. The Company
considers its employee relations to be good.

RISK FACTORS
<PAGE>
 
     In addition to the historical information contained herein, the discussion
in this Annual Report on Form 10-K contains forward-looking statements, within
the meaning of Section 27A of the Securities Act of 1933, as amended and Section
21E of the Securities Exchange Act of 1934, as amended that involve risks and
uncertainties, such as statements of the Company's plans, objectives,
expectations, and intentions. The cautionary statements made in this Annual
Report on Form 10-K should be read as being applicable to all related forward-
looking statements whenever they appear in this Annual Report on Form 10-K. The
Company's actual results could differ materially from those discussed herein.
Factors that could cause or contribute to such differences include those
discussed below as well as those cautionary statements and other factors set
forth elsewhere herein.

FLUCTUATIONS IN OPERATING RESULTS

     The Company's operating results have in the past fluctuated significantly
and will in the future fluctuate significantly, due to a variety of factors. The
Company's operating performance from the first quarter of fiscal 1993 through
the third quarter of fiscal 1996 produced sequential quarter-to-quarter growth
in both net sales and net income. In the fourth quarter of fiscal 1996, however,
net sales decreased 34% from the third quarter of fiscal 1996 and 17% from the
fourth quarter of fiscal 1995. Net income for the fourth quarter of fiscal 1996
decreased 63% from the third quarter of fiscal 1996 and 55% from the fourth
quarter of fiscal 1995. In the first quarter of fiscal 1997, net sales decreased
9% from the fourth quarter of fiscal 1996 and decreased 34% from the first
quarter of fiscal 1996. Net income for the first quarter of fiscal 1997
decreased 75% from the fourth quarter of fiscal 1996 and decreased 90% from the
first quarter of fiscal 1996. In the second quarter of fiscal 1997, net sales
increased 8% from the first quarter of fiscal 1997 and decreased 35% from the
second quarter of fiscal 1996. Net income for the second quarter of fiscal 1997
increased 212% from the first quarter of fiscal 1997 and decreased 71% from the
second quarter of fiscal 1996. The Company's third quarter fiscal 1997 net sales
increased 18% from the second quarter of fiscal 1997 and decreased 24% from the
third quarter of fiscal 1996. The third quarter of fiscal 1997 reflected a net
loss due to a  pre-tax charge for in process research and development related to
an acquisition, without the charge third quarter net income would have been up
35% from the second quarter of fiscal 1997 and down 62% from the third quarter
of fiscal 1996. In the fourth quarter of fiscal 1997, net sales were up 36% over
the third quarter of fiscal 1997 and 57% over the fourth quarter of fiscal 1996.
Net income for the fourth quarter of fiscal 1997 increased 69% from the fourth
quarter of fiscal 1996 and represented a significant increase over the third
quarter of 1997 in which the Company incurred a loss of $0.9 million, which
included a charge of $6.0 million for acquisition related in-process research
and development. The decreases were due primarily to a significant weakness in
the ATE market which materially adversely affected the Company and several other
companies in the semiconductor equipment industry. Although the ATE industry
returned to a capacity expansion mode in fiscal 1997, resulting in sequential
increases in revenues during the second, third, and fourth quarters, there can
be no assurance that it will continue to expand in subsequent quarters. The
factors that have caused and will continue to cause the Company's results to
fluctuate include the timing of new product announcements and releases by the
Company or its competitors, market acceptance of new products and enhanced
versions of the Company's products, manufacturing inefficiencies associated with
the start up of new products, changes in pricing and payment terms and cycles by
the Company, its competitors, customers or suppliers, manufacturing capacity,
the ability to volume produce systems and meet customer requirements, inventory
obsolescence and writeoffs (which the Company has experienced), patterns of
capital spending by customers, delays, cancellations or reschedulings of orders
due to customer financial difficulties or otherwise, changes in overhead
absorption levels due to changes in the number of systems manufactured, the
timing and shipment of orders, availability of components, subassemblies and
services, expenses associated with acquisitions and alliances, product
discounts, customization and reconfiguration of systems, product reliability,
the proportion of direct sales and sales through third parties, including
distributors and original equipment manufacturers, the mix of products sold, the
length of manufacturing and sales cycles, cyclicality or downturns in the
semiconductor market and the markets served by the Company's customers, natural
disasters, political and economic instability, regulatory changes and outbreaks
of hostilities. The Company presently intends to introduce many new products and
product enhancements in the future, which will affect its operating results,
financial condition and business. The Company's gross margins on system sales
have varied significantly, especially in the last five quarters, and will
continue to vary significantly based on a variety of factors, including
manufacturing efficiencies, pricing by competitors or suppliers, product sales
mix, reserves, production volume, new product introductions, product
reliability, the rate of capacity utilization, customization and reconfiguration
of systems, international and domestic sales mix and field service margins. In
addition, new and enhanced products typically have lower gross margins in the
early stages of commercial introduction and production. While the Company has
recorded and continues to record allowances for estimated sales returns and
uncollectible accounts, there can be no assurance that such estimates regarding
allowances will be adequate.

LIMITED SYSTEMS SALES; BACKLOG

     The Company derives a substantial portion of its net sales from the sale of
a relatively small number of systems that typically range in price from $350,000
to $3.6 million, excluding the EPRO memory products, for which the price
range is typically below $100,000. As a result, the timing of recognition of
revenue from a single transaction could have a significant impact on the
Company's 
<PAGE>
 
net sales and operating results for a particular period. The Company's net sales
and operating results for a particular period could be materially adversely
affected if an anticipated order for even one system is not received in time to
permit shipment during that period. The Company's backlog at the beginning of a
quarter typically does not include all orders necessary to achieve the Company's
sales objectives for that quarter. In addition, orders in backlog are subject to
cancellation, delay, deferral or rescheduling by a customer with limited or no
penalties. Consequently, the Company's net sales and operating results for a
quarter have in the past and will in the future depend upon the Company
obtaining orders for systems to be shipped in the same quarter that the order is
received. Furthermore, products generating most of the Company's net sales
continue to be shipped near the end of each quarter. Accordingly, the failure to
receive an anticipated order or a delay or rescheduling in a shipment near the
end of a particular period due, for example, to an order cancellation, a delay
by a customer, manufacturing, technical, reliability or other difficulties,
including difficulties relating to customization and reconfiguration of systems,
a delay in the supply of components, subassemblies or services or a delay due to
competitive or economic factors, may cause net sales in a particular period to
fall significantly below the Company's expectations, which could have a material
adverse effect upon the Company's business, financial condition or results of
operations. The relatively long manufacturing cycle of many of its testers has
caused and could continue to cause future shipments of such products to be
delayed from one quarter to the next, which could materially adversely affect
the Company's business, financial condition or results of operations.
Furthermore, announcements by the Company or its competitors of new products and
technologies could cause customers to defer or cancel purchases of the Company's
existing systems, which could also have a material adverse effect on the
Company's business, financial condition or results of operations. The impact of
these and other factors on the Company's sales and operating results in any
future period cannot be forecasted with certainty. In addition, the need for
continued significant expenditures for research and development, marketing and
other expenses for new products, capital equipment purchases and worldwide
training and customer service and support, among other factors, will make it
difficult for the Company to reduce its significant fixed expenses in a
particular period if the Company's net sales goals for such period are not met.
Accordingly, there can be no assurance that the Company will be profitable or
that it will not again sustain losses in future periods. Due to all of the
foregoing factors, it is likely that in some future quarter the Company's
operating results will be below the expectations of public market analysts and
investors, as they were in fiscal 1997. In such event, the price of the
Company's Common Stock may be materially adversely affected.


CYCLICALITY OF SEMICONDUCTOR INDUSTRY

     The Company's business and results of operations depend in significant part
upon the capital expenditures of manufacturers of semiconductors and companies
which specialize in contract packaging and/or testing of semiconductors,
including manufacturers and contractors that are opening new or expanding
existing fabrication facilities, or upgrading existing equipment, which in turn
depend upon the current and anticipated market demand for semiconductors and
products incorporating semiconductors. Historically and recently, the
semiconductor industry has been highly cyclical with recurring periods of
oversupply, which often have had a severe effect on the semiconductor industry's
demand for test equipment, including the systems manufactured and marketed by
the Company. The Company believes that the markets for newer generations of
semiconductors will also be subject to similar fluctuations. The Company has in
the past experienced shipment delays, delays in commitments and purchase order
restructurings by several of its customers and anticipates that this may
continue to occur in the future. Accordingly, the Company can give no assurance
that it will be able to achieve or maintain its current or prior level of sales
or rate of growth. Through the first three quarters of 1997, the Company's net
sales, gross margins and net income were significantly below the net sales,
gross margins and net income, respectively, of the comparable prior year's
quarterly results. In the fourth quarter of 1997, the Company's net sales and
net income were significantly above the net sales and net income of the fourth
quarter of 1996; however there can be no assurance that they will continue to
exceed prior year amounts in future quarters. The Company anticipates that a
significant portion of new orders may depend upon demand from semiconductor
device manufacturers building or expanding fabrication facilities and new device
testing requirements that are not addressable by currently installed test
equipment, and there can be no assurance that such demand will develop to a
significant degree, or at all. In addition, any factor adversely affecting the
semiconductor industry or particular segments within the semiconductor industry
may adversely affect the Company's business, financial condition or results of
operations. Therefore, there can be no assurance that the Company's operating
results will not continue to be materially adversely affected if downturns or
slowdowns in the semiconductor industry continue or occur again in the future.
Company net sales to the Asia Pacific region accounted for approximately 66%,
58%, and 45% of total net sales in fiscal 1997, 1996, and 1995, and thus are
subject to the risk of economic instability in that region that might materially
adversely affect the demand for the Company's products. Although the current
economic instability in the Asia Pacific region has not materially adversely
affected the Company's order backlog, balance sheet, or results of operations,
there can be no assurance that it will not in the future.

MANAGEMENT OF FLUCTUATIONS IN OPERATING RESULTS
<PAGE>
 
     The Company has over the last several years experienced significant
fluctuations in its operating results. Since 1993, the Company has overall
significantly increased the scale of its operations to support increased sales
levels and has expanded its operations to address critical infrastructure and
other requirements, including the hiring of additional personnel, significant
investments in research and development to support product development, the
March 1995 acquisition of EPRO, the Company's establishment of a joint venture
with Innotech, Inc., the Company's acquisition in July 1997 of the assets and
certain liabilities of Test Systems Strategies, Inc. ("TSSI") and the Company's
acquisition in August 1997 of a software product line from Zycad Corporation
("Zycad").  However, the Company has during certain historical periods,
particularly in the last fiscal year, experienced revenue declines and
reductions in its operations.

     Fluctuations in the Company's sales and operations have placed a
considerable strain on its management, financial, manufacturing and other
resources. In order to effectively deal with the changes brought on by the
cyclical nature of the industry, the Company has been required to implement and
improve a variety of highly flexible operating, financial and other systems,
procedures and controls capable of expanding or contracting consistent with the
Company's business. There can be no assurance that any existing or new systems,
procedures or controls will be adequate to support fluctuations in the Company's
operations or that its systems, procedures and controls will be designed,
implemented or improved in a cost effective and timely manner. Any failure to
implement, improve and expand or contract such systems, procedures and controls
in an efficient manner at a pace consistent with the Company's business could
have a material adverse effect on the Company's business, financial condition or
results of operations.

EXPANSION OF OPERATIONS

     Currently, the Company is devoting and will continue to devote significant
resources to the development of new products and technologies. During 1998, the
Company will conduct evaluations of these new products and will continue to
invest significant additional resources in plant and equipment, leased
facilities, inventory, personnel and other costs, to begin or prepare to begin
production of these products and to provide the marketing, administration and
after-sales service and support, if any, required to service and support these
new products. Accordingly, there can be no assurance that gross profit margin
and inventory levels will not be adversely impacted in the future by start-up
costs associated with the initial production and installation of these new
product lines. These start-up costs include, but are not limited to, additional
manufacturing overhead, additional inventory and warranty reserve requirements
and the creation of after-sales service and support organizations. Additionally,
there can be no assurance that operating expenses will not increase, relative to
sales, as a result of adding additional marketing and administrative personnel,
among other costs, to support the Company's additional products. If the Company
is unable to achieve significantly increased net sales or its sales fall below
expectations, the Company's operating results will be materially adversely
affected. There can be no assurance that net sales will increase or remain at
recent levels or that  any new products will be successfully commercialized.

LIMITED SOURCES OF SUPPLY; RELIANCE ON SUBCONTRACTORS

     Certain components, subassemblies and services necessary for the
manufacture of the Company's testers are obtained from a limited group of
suppliers. The Company does not maintain long-term supply agreements with most
of its vendors and purchases most of its components and subassemblies through
individual purchase orders. The manufacture of certain of the Company's
components and subassemblies is an extremely complex process. The Company also
relies on outside vendors to manufacture certain components and subassemblies
and to provide certain services. The Company has recently experienced and
continues to experience significant reliability, quality and timeliness problems
with several critical components. In addition, the Company and certain of its
subcontractors periodically experience significant shortages and delays in
delivery of various components and subassemblies. There can be no assurance that
these or other problems will not continue to occur in the future with these or
the Company's other suppliers or outside subcontractors. The Company's reliance
on a limited group of suppliers and the Company's reliance on outside
subcontractors involve several risks, including a potential inability to obtain
an adequate supply of required components, subassemblies and services and
reduced control over the price, timely delivery, reliability and quality of
components, subassemblies and services. Shortages, delays, disruptions or
terminations of the sources for these components and subassemblies has delayed
and could continue to delay shipments of the Company's systems and could have a
material adverse effect on the Company's business, financial condition or
results of operations. Any continuing inability to obtain adequate yields or
timely deliveries or any other circumstance that would require the Company to
seek alternative sources of supply or to manufacture such components internally
could have a material adverse effect on the Company's business, financial
condition or results of operations. Such delays, shortages and disruptions would
also damage relationships with current and prospective customers and could allow
competitors to penetrate such customer accounts. There can be no assurance that
the Company's internal manufacturing capacity and that of its suppliers and
subcontractors will be sufficient to meet customer requirements.

HIGHLY COMPETITIVE INDUSTRY
<PAGE>
 
     The automatic test equipment ("ATE") industry is intensely competitive.
Because of the substantial investment required to develop test application
software and interfaces, the Company believes that once a semiconductor
manufacturer has selected a particular ATE vendor's tester, the semiconductor
manufacturer is likely to use that tester for a majority of its testing
requirements for the market life of that semiconductor and, to the extent
possible, subsequent generations of similar products. As a result, once an ATE
customer chooses a system for the testing of a particular device, it is
difficult for competing vendors to achieve significant ATE sales to such
customer for similar use. The inability of the Company to penetrate any large
ATE customer or achieve significant sales to any ATE customer could have a
material adverse effect on the Company's business, financial condition or
results of operations.

     The Company faces substantial competition throughout the world, primarily
from ATE manufacturers located in the United States, Europe and Japan, as well
as several of the Company's customers. Many of the Company's competitors have
substantially greater financial and other resources with which to pursue
engineering, manufacturing, marketing and distribution of their products.
Certain of the Company's competitors have recently introduced or announced new
products with certain performance or price characteristics equal or superior to
certain products currently offered by the Company. The Company believes that if
the ATE industry continues to consolidate through strategic alliances or
acquisitions, the Company will continue to face significant additional
competition from larger competitors that may offer more complete product lines
and services than the Company. The Company's competitors are continuing to
improve the performance of their current products and to introduce new products,
enhancements and new technologies that provide improved cost of ownership and
performance characteristics. New product introductions by the Company's
competitors could continue to cause a decline in sales or loss of market
acceptance of the Company's existing products. Moreover, increased competitive
pressure could continue to lead to intensified price-based competition, which
could materially adversely affect the Company's business, financial condition or
results of operations. The Company has experienced and continues to experience
significant price competition in the sale of all of its testers. In addition, at
the end of a product life cycle and as competitors introduce more
technologically advanced products, pricing pressures typically become more
intense as the Company has experienced with sales of its older products. The
Company believes that to be competitive, it must continue to expend significant
financial resources in order to, among other items, invest in new product
development and enhancements and to maintain customer service and support
centers worldwide. There can be no assurance that the Company will be able to
compete successfully in the future.

RAPID TECHNOLOGICAL CHANGE; IMPORTANCE OF TIMELY PRODUCT INTRODUCTION

     The ATE market is subject to rapid technological change and new product
introductions and enhancements and related software tools. The Company's ability
to be competitive in this market will depend in significant part upon its
ability to successfully develop and introduce new products and enhancements and
related software tools with greater features on a timely and cost-effective
basis, including the products under development acquired in the EPRO merger and
the TSSI and Zycad product line acquisitions. The Company's customers require
testers with additional features and higher performance and other capabilities.
The Company is therefore required to enhance the performance and other
capabilities of its existing systems and related software tools. Any success by
the Company in developing new and enhanced systems and related software tools
and new features to its existing systems depends upon a variety of factors,
including product selection, timely and efficient completion of product design,
timely and efficient implementation of manufacturing and assembly processes,
product performance and reliability in the field and effective sales and
marketing. Because new product development commitments must be made well in
advance of sales, new product decisions must anticipate both future demand and
the availability of technology to satisfy that demand. There can be no assurance
that the Company will be successful in selecting, developing, manufacturing and
marketing new products or enhancements and related software tools. The inability
of the Company to introduce new products and related software tools that
contribute significantly to net sales, gross margins and net income would have a
material adverse effect on the Company's business, financial condition or
results of operations. New product or technology introductions by the Company's
competitors could cause a decline in sales or loss of market acceptance of the
Company's existing products. In addition, new product introductions by the
Company may cause confusion among the Company's customers if they transition to
such new products, and may delay product purchases.

     Significant delays can occur between a system's introduction and the
commencement by the Company of volume production of such system. The Company has
in the past experienced and continues to experience significant delays in the
introduction, volume production and sales of its systems and related feature
enhancements, including new models within the digital, mixed-signal and non-
volatile memory product lines, due to technical, manufacturing, parts shortages,
component reliability and other difficulties and may continue to experience
similar delays in the future. As a result, certain of the Company's significant
customers have experienced significant delays in receiving and using certain of
the Company's testers in production. There can be no assurance that these or
additional difficulties will not continue to arise in the future with respect to
the Company's systems or that such delays will not materially adversely affect
customer relationships and future sales. Moreover, there can be no assurance
that the Company will not encounter these or other difficulties that could delay
future introductions or volume production or sales of its systems or
enhancements 
<PAGE>
 
and related software tools. The Company has incurred and may continue to incur
substantial unanticipated costs to ensure the functionality and reliability of
its testers and to increase feature sets. If the Company's systems continue to
have reliability, quality or other problems, or the market perceives certain of
the Company's products to be feature deficient, reduced orders, higher
manufacturing costs, delays in collecting accounts receivable and higher
service, support and warranty expenses, or inventory write-offs, among other
items, could result. The Company's failure to have a competitive tester and
related software tools available when required by a semiconductor manufacturer
could make it substantially more difficult for the Company to sell testers to
that manufacturer for a number of years. The Company believes that the continued
acceptance, volume production, timely delivery and customer satisfaction of its
newer digital, mixed signal and non-volatile memory testers are of critical
importance to its future financial results. As a result, an inability to correct
any technical, reliability, parts shortages or other difficulties associated
with the Company's systems or to manufacture and ship the Company's systems on a
timely basis to meet customer requirements could damage relationships with
current and prospective customers and would materially adversely affect the
Company's business, financial condition or results of operations.

CUSTOMER CONCENTRATION; LENGTHY SALES CYCLE

     One customer (a distributor) accounted for 30%, 25% and 17% of the
Company's net sales in fiscal 1997, 1996 and 1995, respectively. Another
customer accounted for 11% of net sales in fiscal 1995. The loss of or any
reduction in orders by this or any other significant customer, including losses
or reductions due to continuing or other technical, manufacturing, or 
reliability problems with the Company's products, continued slowdowns in the
semiconductor industry or in other industries that manufacture products
utilizing semiconductors could materially adversely affect the Company's
business, financial condition or results of operations. The Company's ability to
maintain or increase its sales levels in the future will depend in significant
part upon its ability to obtain orders from existing and new customers and to
manufacture systems on a timely and cost-effective basis, the financial
condition and success of its customers, general economic conditions, and the
Company's ability to meet increasingly stringent customer performance and other
requirements and shipment delivery dates. There can be no assurance that the
Company will be able to maintain or increase the level of its net sales in the
future or that the Company will be able to retain existing customers or attract
new ones.

     Sales of the Company's systems depend in significant part upon the decision
of a semiconductor manufacturer to develop and manufacture new semiconductor
devices or to increase manufacturing capacity. As a result, sales of the
Company's testers are subject to a variety of factors outside of the Company's
control. In addition, the decision to purchase a tester generally involves a
significant commitment of capital, with the attendant delays frequently
associated with significant capital expenditures. For these and other reasons,
the Company's systems have lengthy sales cycles during which the Company may
expend substantial funds and management effort to secure a sale and subject the
Company to a number of significant risks.


ACQUISITIONS

     The Company has developed in significant part through mergers and
acquisitions of other companies and businesses. Prior to its initial public
offering in 1993, the Company acquired two companies and the semiconductor test
division of Tektronix, Inc. In 1995, the Company acquired EPRO, a memory tester
company. In July 1997, the Company acquired the assets and assumed certain
liabilities of TSSI and, in August 1997, acquired the fault simulation and test
program development products from Zycad. The Company intends in the future to
pursue additional acquisitions of complementary product lines, technologies and
businesses. Any future acquisitions by the Company could result in potentially
dilutive issuances of equity securities, the incurrence of debt and contingent
liabilities, expenditures and reserves, and amortization expenses related to
goodwill and other intangible assets, which could materially adversely affect
the Company's business, financial condition or results of operations. The
Company's charge for in-process research and development for the TSSI asset
acquisition accounted for the Company's net loss for the third quarter of 1997.
In addition, acquisitions involve numerous other risks, including difficulties
in the assimilation of the operations, personnel, technologies and products of
the acquired companies, the diversion of management's attention from other
business concerns, risks of entering markets in which the Company has no or
limited direct prior experience, and the potential loss of key employees of the
acquired company. From time to time, the Company has engaged in and will
continue to engage in discussions with third parties concerning potential
acquisitions of product lines, technologies and businesses. In the event that
such an acquisition does occur, however, there can be no assurance as to the
effect thereof on the Company's business, financial condition or results of
operations.

DEPENDENCE ON KEY PERSONNEL

     The Company's future operating results depend in significant part upon the
continued service of its key personnel, none of whom are bound by an employment
or non-competition agreement. The Company's future operating results also depend
in significant 
<PAGE>
 
part upon its ability to attract and retain qualified management, manufacturing,
technical, engineering and marketing and sales and support personnel.
Competition for such personnel is intense, and there can be no assurance that
the Company will be successful in attracting or retaining such personnel. There
may be only a limited number of persons with the requisite skills to serve in
these positions and it may be increasingly difficult for the Company to hire
such personnel over time. The loss of any key employee, the failure of any key
employee to perform in his or her current position, or the Company's inability
to attract and retain skilled employees, as needed, could materially adversely
affect the Company's business, financial condition or results of operations.

     Recently, the Company has experienced an increased level of employee
turnover. The Company believes that this increase is due to several factors,
including the recent semiconductor industry slowdown; an expanding economy
within the geographic area where the Company maintains its principal business
offices, making it more difficult for the Company to retain its employees; and
the declining value of stock options granted to employees, relative to their
total compensation, as a result of full vesting of options granted prior to the
Company's initial public offering and recent decline in the Company's stock
price. Due to these and other factors, the Company may continue to experience
high levels of employee turnover, which could materially adversely impact the
Company's business, financial condition and results of operations.

INTERNATIONAL SALES

     International sales accounted for approximately 70%, 67% and 55% of total
net sales for fiscal years 1997, 1996 and 1995, respectively. As a result, the
Company anticipates that international sales will continue to account for a
significant portion of total net sales in the foreseeable future. These
international sales will continue to be subject to certain risks, including
changes in regulatory requirements, tariffs and other barriers, political and
economic instability, an outbreak of hostilities, integration of foreign
operations of acquired businesses, foreign currency exchange rate fluctuations,
difficulties with distributors, joint venture partners, original equipment
manufacturers, foreign subsidiaries and branch operations, potentially adverse
tax consequences and the possibility of difficulty in accounts receivable
collection. The Company is also subject to the risks associated with the
imposition of legislation and regulations relating to the import or export of
semiconductor equipment. The Company cannot predict whether quotas, duties,
taxes or other charges or restrictions will be implemented by the United States
or any other country upon the importation or exportation of the Company's
products in the future. Any of these factors or the adoption of restrictive
policies could have a material adverse effect on the Company's business,
financial condition or results of operations. Company net sales to the Asia
Pacific region accounted for approximately 66%, 58%, and 45% of total net sales
in fiscal 1997, 1996, and 1995, and thus are subject to the risk of economic
instability in that region that might materially adversely affect the demand for
the Company's products. Countries in the Asia Pacific region, including Japan,
have recently experienced weaknesses in their currency, banking and equity
markets. These weaknesses could adversely affect demand for the Company's
products, the availability and supply of product components to the Company, and
ultimately the Company's consolidated results of operations. Although the
current economic instability in the Asia Pacific region has not materially
adversely affected the Company's order backlog, balance sheet, or results of
operations, there can be no assurance that it will not in the future.

IMPORTANCE OF JAPANESE MARKET

     To date, the Company has made limited sales of its systems to Japanese
semiconductor manufacturers. The Japanese semiconductor market is large,
represents a substantial percentage of the worldwide semiconductor manufacturing
capacity, and is difficult for foreign companies to penetrate. The Company may
be at a competitive disadvantage with respect to Japanese semiconductor capital
equipment suppliers that have been engaged for some time in collaborative
efforts with Japanese semiconductor manufacturers. The Company believes that the
Japanese companies with which it competes have a competitive advantage because
of their dominance of the Japanese market segment. The Company believes that
increased penetration of the Japanese market is important to its financial
results and intends to continue to invest significant resources in Japan in
order to meet this objective. As part of its strategy to penetrate the Japanese
market, the Company entered into a joint venture agreement with Innotech
Corporation, a local distributor of products in 1997, and set up a local
subsidiary in Japan. The Company believes that Innotech is an important element
of its strategy to increase its presence in Japan. If Innotech is not successful
in selling such systems or such relationship is terminated, the Company's
strategy to increase product sales into the Japanese market would be adversely
affected. In addition, in recent years, Japanese semiconductor manufacturers
substantially reduced their level of capital spending on new fabrication
facilities and equipment, thereby increasing competitive pressures in the
Japanese market segment. There can be no assurance, however, that the Company
will be able to achieve significant sales to, or will be able to compete
successfully in, the Japanese semiconductor market segment.

PROPRIETARY RIGHTS

     The Company attempts to protect its intellectual property rights through
patents, copyrights, trade secrets and other measures, including confidentiality
agreements. There can be no assurance that others will not independently develop
<PAGE>
 
substantially equivalent proprietary information and techniques or otherwise
gain access to the Company's trade secrets and other intellectual property
rights or disclose such technology or that the Company can meaningfully protect
its trade secrets or other intellectual property rights. There can be no
assurance that patents owned by the Company will not be invalidated, deemed
unenforceable, circumvented or challenged, or that the rights granted thereunder
will provide competitive advantages to the Company or that any of the Company's
pending or future patent applications will be issued with claims of the scope
sought by the Company, if at all. Furthermore, there can be no assurance that
others will not develop similar products, duplicate the Company's products or
design around the patents owned by the Company. In addition, there can be no
assurance that foreign intellectual property laws or the Company's agreements
will protect the Company's intellectual property rights. Failure to protect the
Company's intellectual property rights could have a material adverse effect upon
the Company's business, financial condition or results of operations. The
Company has been involved in extensive, expensive and time-consuming reviews of,
and litigation concerning, patent infringement claims. In addition, the Company
has at times been notified of other claims that it may be infringing
intellectual property rights possessed by third parties and expects to continue
to receive notice of such claims in the future.

     The European patent application relating to one of the proprietary CMOS
stabilization methods owned by the Company was abandoned by the prior owner
after the European patent examiner cited prior art. This prior art was not
referenced in the corresponding United States patent application. Based upon its
review to date of the cited prior art and the European examiner's objections,
and in part upon the advice of  outside patent counsel to the Company, the
Company believes that such prior art is unlikely to affect the validity or scope
of the claims of the United States issued patent.

     This prior art may, however, render invalid or significantly narrow the
scope of certain claims set forth in the United States patent covering the
Company's other proprietary CMOS stabilization method. The European examiner
referred to this prior art in the corresponding European patent application. The
European application was approved, but with narrower claims than the United
States patent. This prior art was not referenced in the corresponding United
States patent. Based in part upon the advice of outside patent counsel, and on
the Company's review of its current products, the Company believes that this
patent will continue to be valuable to the Company in preventing imitation of
the Company's products covered by this patent. Additionally, in mid-1992, a
third party suggested that certain claims set forth in this patent might be
invalid as a result of other alleged prior art. The Company believes, based in
part upon the advice of outside patent counsel, that the prior art alleged by
the third party is less relevant than the prior art referenced by the European
examiner. However, there can be no assurance that any of the aforementioned
prior art or other prior art will not be successfully asserted and used to
invalidate or narrow the scope of any claim of the United States patents or any
other patents or other patent applications of the Company.

     Certain of the Company's customers have received notices of infringement
from Jerome Lemelson alleging that the manufacture of semiconductor products
and/or the equipment used to manufacture semiconductor products infringes
certain patents issued to such person. The Company was notified by a customer in
1990 and a different customer in late 1994 that the Company may be obligated to
defend or settle claims that the Company's products infringe such person's
patents, and, in the event it is subsequently determined that the customer
infringes such person's patents, such customer intends to seek reimbursement
from the Company for damages and other related expenses. There can be no
assurance that the Company will be successful in defending current or future
patent infringement claims or claims for indemnification resulting from
infringement claims. An award of damages, injunctive relief or expenditures by
the Company of significant amounts in defending any such action could materially
adversely affect the Company's business, financial condition or results of
operations, regardless of the outcome of any litigation. With respect to any
claims, the Company may seek to obtain a license under the third party's
intellectual property rights. There can be no assurance, however, that a license
will be available on reasonable terms or at all. The Company could decide, in
the alternative, to continue to resort to litigation to challenge such claims.
Such challenges have been and could continue to be extremely expensive and time
consuming, and could materially adversely affect the Company's business,
financial condition or results of operations, regardless of the outcome of any
litigation.


FUTURE CAPITAL NEEDS

     The development and manufacture of new ATE systems and enhancements are
highly capital intensive. In order to be competitive, the Company must make
significant investments in capital equipment, expansion of operations, systems,
procedures and controls, research and development and worldwide training,
customer service and support, among many other items. The Company expects that
cash on hand and cash equivalents, including restricted cash, short-term
investments, funds available under its bank line of credit, anticipated cash
flow from operations and equipment lease arrangements will satisfy its financing
requirements for at least the next 12 months.


YEAR 2000 COMPLIANCE
<PAGE>
 
     Many currently installed computer systems and software products are coded
to accept only two-digit entries in the date code field. Beginning in the year
2000, these date code fields will need to accept four-digit entries to
distinguish 21/st/ century dates from 20/th/ century dates. As a result, in
fewer than three years, computer systems and/or software used by many companies
may need to be upgraded to comply with such "Year 2000" requirements.
Significant uncertainty exists concerning the potential effects associated with
such compliance. Any Year 2000 compliance problem of any of the Company, its
customers, or its suppliers could result in a material adverse effect on the
Company's business, financial condition, and results of operations.

VOLATILITY OF STOCK PRICE

     The Company believes that factors such as announcements of developments
related to the Company's business, fluctuations in the Company's financial
results, general conditions or developments in the semiconductor and capital
equipment industry and the general economy, sales of the Company's Common Stock
into the marketplace, announcements of technological innovations or new products
or enhancements by the Company or its competitors, developments in patents or
other intellectual property rights, developments in the Company's relationships
with its customers and suppliers, or a shortfall or changes in revenue, gross
margins or earnings or other financial results from analysts' expectations or an
outbreak of hostilities or natural  disasters, could cause the price of the
Company's Common Stock to fluctuate, perhaps substantially. In recent years the
stock market in general, and the market for shares of small capitalization
stocks in particular, including the Company, have experienced extreme price
fluctuations, which have often been unrelated to the operating performance of
affected companies. For example, in fiscal 1997, the price of the Company's
Common Stock has ranged from a high of $55.00 to a low of $13.75. There can be
no assurance that the market price of the Company's Common Stock will not
continue to experience significant fluctuations in the future, including
fluctuations that are unrelated to the Company's performance.

LEVERAGE

     In connection with the sale of Convertible Subordinated Notes due 2002 in
September 1997, the Company incurred $115 million of indebtedness which resulted
in a ratio of long-term debt to total capitalization at October 31, 1997 of
approximately 36%. As a result of this indebtedness, the Company's principal and
interest obligations has increased substantially. The degree to which the
Company is leveraged could materially adversely affect the Company's ability to
obtain financing for working capital, acquisitions or other purposes and could
make it more vulnerable to industry downturns and competitive pressures. The
Company's ability to meet its debt service obligations will be dependent upon
the Company's future performance, which will be subject to financial, business
and other factors affecting the operations of the Company, many of which are
beyond its control.

EFFECTS OF CERTAIN ANTI-TAKEOVER PROVISIONS

     Certain provisions of the Company's Certificate of Incorporation, equity
incentive plans, Bylaws and Delaware law may discourage certain transactions
involving a change in control of the Company. In addition to the foregoing, the
Company's classified board of directors, the shareholdings of the Company's
officers, directors and persons or entities that may be deemed affiliates and
the ability of the Board of Directors to issue "blank check" preferred stock
without further stockholder approval could have the effect of delaying,
deferring or preventing a change in control of the Company and may adversely
affect the voting and other rights of holders of Common Stock.


ITEM 2.   PROPERTIES

     The Company maintains its corporate headquarters in Fremont, California.
This leased facility, totaling 104,400 square feet, contains corporate
administration, sales, engineering, local customer support and memory products
manufacturing. The lease on this facility expires in June 2004. The Company's
digital and mixed signal manufacturing facilities, as well as additional sales,
engineering and customer support functions, are located in Beaverton, Oregon.
The lease covering this 90,000 square foot facility expires in November 2002. An
additional 42,000 square foot building houses Beaverton, Oregon sales and
service groups under a lease expiring in February 2001. The Company's software
business is located in a 22,000 square foot building in Beaverton Oregon and a
14,000 square foot building in Fremont, California. The leases on these two
buildings expire in August 2002 and November 1999, respectively. In December
1997, the Company leased an additional 35,000 square feet of space in Fremont,
California which will be used primarily for sales and service. The lease on this
building expires in March 2006. The Company maintains 15 sales and service
offices in the United States. The Company believes that its existing facilities
are 
<PAGE>
 
adequate to meet its current and foreseeable requirements and that suitable
additional or substitute space will be available as needed.


ITEM 3.   LEGAL PROCEEDINGS

     The Company's litigation matters with Megatest and Teradyne have been
resolved.

     The Company is involved in various claims arising in the ordinary course of
business, none of which, in the opinion of management, if determined adversely
against the Company, will 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

     None
<PAGE>
 
                      EXECUTIVE OFFICERS AND KEY EMPLOYEES


     The executive officers and key employees of the Company, and their ages and
positions as of December 15, 1997, are as follows:


<TABLE>
<CAPTION>
               NAME                      AGE    POSITION
               ----                      ---    --------            
<S>                                  <C>              <C>
Dr. Wilmer R. Bottoms                     54    Chairman and Chief Executive Officer *
David A. Ranhoff                          42    Executive Vice President, Sales and Marketing *
Jerry Bruce                               41    Vice President, Controller, Acting Chief Financial Officer and
                                                Secretary*
Rick Carmichael                           49    Senior Vice President, Corporate Marketing
David K. Cheung                           44    Senior Vice President, Engineering
George W. DeGeer                          51    Senior Vice President, Operations
Robert E. Huston                          56    Vice President, Test Technology
Gary J. Lesmeister                        57    Chief Scientist
</TABLE>
*Executive officer


     Dr. Wilmer R. Bottoms has served as Chief Executive Officer since June 1996
and as Chairman of the Board of Directors since July, 1991 and as a member of
the Board of Directors of the Company since 1985. Dr. Bottoms served as Senior
Vice President of Patricof & Co. Ventures, Inc., from 1984 to June 1996 and
prior to his tenure at Patricof & Co. Ventures, Inc., Dr. Bottoms served as
President of the Semiconductor Equipment Group at Varian Associates.

     David A. Ranhoff was promoted to Executive Vice President in 1997 after
serving as Executive Vice President Sales and Marketing since January 1997, and
had served as Senior Vice President Sales and Marketing from July 1996 to
January 1997 and as Senior Vice President, Sales, Marketing and Service from
July 1995 to June 1996. Mr. Ranhoff served as Senior Vice President, Sales and
Service from August 1993 to July 1995 and as Vice President, Sales from January
1993 to August 1993. He served as Vice President, European Operations from July
1990 to December 1992. From March 1988 to June 1990, Mr. Ranhoff served as
Managing Director of European Operations of the Company and as National Sales
Manager from July 1985 to March 1988. Prior to joining the Company, Mr. Ranhoff
served for eight years in various sales and management positions for GenRad.

     Jerry Bruce has served as Vice President, Controller, Acting Vice
President, Chief Financial Officer and Secretary since December 1997, as Vice
President, Controller from July 1997 to December 1997, as Vice President,
Treasurer from January 1995 to July 1997 and as Vice President, Controller from
May 1993 to January 1995. From June 1988 to May 1993, Mr. Bruce held various
financial management positions at Silicon Valley Group, Inc. a semiconductor
equipment manufacturer. From July 1986 to June 1988, Mr. Bruce served as Chief
Financial Officer of CXR Telcom, Inc. a telecommunications test equipment
manufacturer. From June 1980 to July 1986, Mr. Bruce held positions of
increasing responsibility in the audit practice of Arthur Young & Co.

     Richard C. Carmichael rejoined the Company in September 1996 and has served
as Senior Vice President, Corporate Marketing since that time.  From September
1995 to December 1995 Mr. Carmichael served as Vice President of Marketing at
Megatest Corporation and then, after the acquisition of Megatest Corporation by
Teradyne, Inc., Mr. Carmichael held the position of Marketing Manager, Megatest
Division for Teradyne, Inc.  Mr. Carmichael served as Senior Vice President,
Marketing for the Company from August 1993 until August 1995 and Vice President,
Marketing from July 1992 to August 1993.  Mr. Carmichael first joined the
Company in January 1991 and served as Western Area Sales Manager from January
1991 to July 1992.  From January 1989 to December 1990, Mr. Carmichael was the
Regional Sales Manager for the STS Division of Tektronix.  Prior to joining the
Company, Mr. Carmichael served for nine years in various sales and marketing
positions, most recently as Vice President of Sales for Megatest Corporation, a
semiconductor test manufacturer.  Mr. Carmichael was also a product specialist
at Fairchild.

     David K. Cheung has served as Senior Vice President, Engineering since
January 1995, as Vice President, Engineering from May 1994 to January 1995 and
as Director of Engineering from October 1993 to May 1994. From September 1992 to
October 1993, Mr. Cheung served as Director of Engineering at Schlumberger
Technologies, Inc. where he led the 
<PAGE>
 
development of advanced digital IC testers. Mr. Cheung held various management
positions at Schlumberger from 1982 to September 1992.

     George W. DeGeer has served as Senior Vice President, Operations since
August, 1996, as Senior Vice President, Manufacturing from January 1995 to
August, 1996, as Vice President, Manufacturing from October 1993 to January
1995, as Director of Manufacturing from July 1992 to October 1993, and as Vista
Manufacturing Manager from January 1991 to July 1992. Prior to joining the
Company, Mr. DeGeer held various manufacturing management positions at
Tektronix, Inc. for more than twenty years.

     Robert E. Huston has served as Vice President, Test Technology since August
1992. From February 1983 to August 1992, Mr. Huston was a co-founder and fellow
of Trilium Corporation and was the architect of the Micromaster series of test
systems. Mr. Huston was a fellow at LTX from August 1988 to August 1992
developing high frequency test strategies. He served in various senior
engineering positions beginning in 1967 at Fairchild working with a team to
develop the LSI test system.

     Gary J. Lesmeister has served as Chief Scientist of the Company since 1991.
Mr. Lesmeister is the inventor of the Company's proprietary V-Chip technology
and has created other patent pending designs for products. Prior to joining the
Company, Mr. Lesmeister served as a consultant for TimeMaster from January 1990
to December 1990, as a Senior Staff Engineer with ASIX from March 1987 to
December 1989 and as technical staff member of research laboratories of
Rosemount Inc., and Control Data for more than ten years where he worked on
ultrasonics, supercomputers, voice recognition, bubble memory and custom VLSI
projects.

     Officers serve at the discretion of the Board of Directors, until their
successors are appointed. There are no family relationships among executive
officers or directors of the Company.
<PAGE>
 
                                    PART II
                                    -------


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

     The Company's common stock is traded on the Nasdaq National Market under
the symbol CMOS.  High and low stock prices for the last two fiscal years were:


<TABLE>
<CAPTION>
                                                      1997                                        1996
                                    --------------------------------------     -----------------------------------------
Quarter Ended                              High                  Low                  High                    Low
-------------------------------     -----------------     ----------------     -----------------     -------------------
<S>                                   <C>                   <C>                  <C>                   <C>
January 31                                     $25.75               $13.75                $41.50                  $17.75
April 30                                        24.25                13.88                 27.50                   15.75
July 31                                         36.63                15.75                 24.50                   10.62
October 31                                      55.00                26.88                 18.25                   12.50
</TABLE>

     There were approximately 263 stockholders of record at December 5, 1997. To
date, the Company has not declared or paid any cash dividends on its common
stock. The Company does not anticipate paying any dividends on its common stock
in the foreseeable future and, under the current bank agreements, such payment
would require prior bank approval.



ITEM 6.   SELECTED FINANCIAL DATA


     The comparability of the following selected financial data is affected by a
variety of factors and this data is qualified by reference to and should be read
in conjunction with the consolidated financial statements and notes thereto
elsewhere in this Annual Report on Form 10-K and the Management's Discussion and
Analysis of Financial Condition and Results of Operations.

<TABLE>
<CAPTION>
 
                                                                                          Year ended October 31,
(in thousands, except per share amounts)                                 1997         1996          1995        1994        1993
<S>                                                                   <C>          <C>          <C>           <C>        <C>
Consolidated Statement of Income Data:
Net sales                                                                $204,092     $238,788     $176,805    $118,211    $83,058
Operating income                                                           15,063       54,334       43,817      24,208      9,496
Income before taxes                                                        18,230       58,267       46,649      24,939      8,574
Net income                                                                 10,693       37,703       30,354      19,193      6,000
Net income per share                                                        $0.47        $1.72        $1.45       $0.97    $  0.39
Number  of shares used in computing per share amounts                      22,539       21,930       20,984      19,749     15,251
Consolidated Balance Sheet Data:
Working capital                                                          $250,336     $144,623     $126,395    $ 64,101    $30,452
Total assets                                                              358,141      223,042      186,593     103,668     73,355
Long-term debt, less current maturities                                   115,000            -            -         655      1,843
Retained earnings (accumulated deficit)                                    94,722       84,029       46,326      16,604     (2,589)
Stockholders' equity                                                      204,911      189,782      150,286      78,213     41.633
----------------------------------------------------------------------------------------------------------------------------------- 

Quarterly 1997
(in thousands, except per share amounts)                                 1/st/        2/nd/         3/rd/*      4/th/
(unaudited)
Net sales                                                                $ 40,261     $ 43,355     $ 51,082    $ 69,394
Gross profit                                                               20,822       24,981       29,444      38,889
Operating income (loss)                                                       585        4,039         (364)     10,803
Income before taxes                                                         1,612        4,913          647      11,058
Net income (loss)                                                           1,054        3,286         (897)      7,250
Net income (loss) per share                                              $   0.05     $   0.15     $  (0.04)   $   0.32
Number  of shares used in computing per share amounts                      22,215       22,265       21,873      22,871
</TABLE> 
<PAGE>
 
*  Includes a $6.0 million pre-tax charge related to acquired in process
research and development

<TABLE> 
<CAPTION> 
 
Quarterly 1996
<S>                                                                   <C>          <C>          <C>           <C>    
(in thousands, except per share amounts)                                 1/st/        2/nd/        3/rd/        4/th/
(unaudited)
Net sales                                                                $ 60,911     $ 66,475     $ 67,200    $ 44,202
Gross profit                                                               36,538       39,944       40,112      25,184
Operating income                                                           15,419       16,437       16,824       5,654
Income before taxes                                                        16,474       17,483       17,813       6,497
Net income                                                                 10,544       11,329       11,542       4,288
Net income per share                                                     $   0.48     $   0.52     $   0.53    $   0.20
Number  of shares used in computing per share amounts                      21,951       21,913       21,925      21,939
 
</TABLE>

In addition to the historical information contained herein, the discussion in
this Annual Report on Form 10-K contains forward-looking statements, within the
meaning of Section 27A of the Securities Act of 1933, as amended and Section 2E
of the Securities Exchange Act of 1934, as amended that involve risks and 
uncertainties, such as statements of the Company's plans, objectives,
expectations, and intentions. The cautionary statements made in this Annual
Report on Form 10-K should be read as being applicable to all related forward-
looking statements whenever they appear in this Annual Report on Form 10-K. The
Company's actual results could differ materially from those discussed herein.
Factors that could cause or contribute to such differences include those
discussed below as well as those cautionary statements and other factors set
forth elsewhere herein.


ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS
OVERVIEW

Credence was incorporated in California in March 1982 and shipped its first
automatic test equipment ("ATE") product in June 1985. The Company
reincorporated in Delaware in October 1993. The Company experienced sequential
growth in annual net sales from fiscal 1985 through fiscal 1991, followed by a
downturn in fiscal 1992 caused by weaknesses in certain sectors of the ATE
market and delayed new product introductions. From fiscal 1993 through fiscal
1996, the Company's annual net sales grew sequentially due principally to growth
in the semiconductor industry and related capacity expansion by the Company's
customers. Toward the end of fiscal 1996 and continuing through fiscal 1997, the
Company was materially adversely affected in significant part by a worldwide
downturn in demand for semiconductor capital equipment and posted a decline of
15% in net sales and a decline of  73% in net income per share in fiscal 1997
from fiscal 1996. The Company received approximately $78.0 million in net
proceeds from its initial, second and third public offerings of its common stock
in the first quarter of fiscal 1994, the second quarter of fiscal 1994 and the
third quarter of fiscal 1995, respectively. In fiscal 1997, the Company sold
$115 million of convertible subordinated notes principally to fund acquisitions
and for working capital and other general corporate purposes. In March 1995,
EPRO, a California-based manufacturer of memory testers, merged with the Company
in a stock-for-stock exchange. The Company accounted for the merger as a pooling
of interests, and, accordingly, historical financial information of the Company
includes the results of operations of EPRO for all periods presented. In July
1997, the Company, through a subsidiary, Test Systems Strategies, Inc. ("TSSI")
acquired certain assets and assumed certain liabilities of Summit Design, Inc.
and its wholly owned subsidiary, Test Systems Strategies, Inc, both Oregon
corporations for $7.0 million in cash and $0.3 million in assumed liabilities.
In August 1997, the Company, again through TSSI purchased for $2.3 million
certain assets from Zycad Corporation and one of its subsidiaries, Attest
Software, Inc. These two asset purchases were accounted for under the purchase
method of accounting and their respective results of operations have been
included in the Company's consolidated financial statements from their
respective dates of acquisition. Acquired assets and liabilities were recorded
at their estimated fair value at the dates of acquisition. The Company expensed
$6.0 million of acquired in-process research and development in the third
quarter of fiscal 1997 as a result of the Summit Design, Inc. and subsidiary
asset acquisition. As a result of the 1997 acquisitions, the Company now offers
software products and services which facilitate the generation of test programs
that run on semiconductor ATE.
<PAGE>
 
The Company's operating performance from the first quarter of fiscal 1993
through the third quarter of fiscal 1996 produced sequential quarter-to-quarter
growth in both net sales and net income. In the fourth quarter of fiscal 1996
net sales decreased 34% from the third quarter of fiscal 1996 and 17% from the
fourth quarter of fiscal 1995. The decrease was due primarily to a significant
weakness in the ATE market, which materially adversely affected the Company's
results of operations and the results of operations of several other companies
in the semiconductor capital equipment industry. Net income for the fourth
quarter of fiscal 1996 decreased 63% from the third quarter of fiscal 1996 and
55% from the fourth quarter of fiscal 1995. The Company's net sales began to
improve in the second quarter of fiscal 1997, with sequential increases in net
sales during each of the remaining quarters of the fiscal year. Fourth quarter
of fiscal 1997 net sales increased 57% over fourth quarter net sales in fiscal
1996 and indicated a 36% increase over the third quarter of fiscal 1997. The
Company experienced a net loss in the third quarter of fiscal 1997 due primarily
to the write-off of acquired in-process research and development, but reported a
profit in the fourth quarter.

The following discussion should be read in conjunction with the consolidated
financial statements, and notes thereto, and discussion of the Company's
business, and risk factors affecting its results of operations, included
elsewhere in this Annual Report on Form 10-K.

Certain of the statements contained in this Annual Report on Form 10-K are
forward-looking statements and involve a number of risks and uncertainties. In
addition to the factors discussed herein, among other factors that could
continue to cause actual results to differ materially include the following:
limited system sales; backlog; changes in market and customer demand; expansion
of operations; management of growth; sole or limited sources of supply; reliance
on subcontractors; an intensely competitive industry; rapid technological
change; dependence on key customers; dependence on key personnel; management
changes; international sales; proprietary rights; acquisitions; and need for
future capital.

RESULTS OF OPERATIONS

NET SALES.  Net sales consist of revenues from systems sales, upgrades, spare
parts sales, maintenance contracts and, in fiscal 1997, limited software sales.
Net sales decreased 14.5% to $204.1 million in fiscal 1997 from $238.8 million
in fiscal 1996. This decrease was primarily due to the effects of a worldwide
downturn in the demand for semiconductor ATE. Net sales in fiscal 1996 increased
35.1% over the $176.8 million recorded in fiscal 1995.  This increase was due
primarily to increases in system unit sales and, to a lesser extent, higher
average selling prices ("ASPs") for certain systems sold. International net
sales accounted for approximately 70%, 67% and 55% of total net sales in fiscal
1997, 1996 and 1995, respectively. The Company anticipates that its
international business will continue to account for a significant portion of net
sales for the foreseeable future. As a result, the Company's international
business will continue to be subject to certain risks, including changes in
regulatory requirements, tariffs and other barriers, political and economic
instability, integration of foreign operations of acquired businesses,
difficulties in managing distributors, original equipment manufacturers, foreign
subsidiaries and branch operations, foreign exchange rates, potentially adverse
tax consequences and the possibility of difficulty in accounts receivable
collection. The Company's  net sales to the Asia Pacific region accounted for
approximately 66%, 58%, and 45% of total net sales in fiscal 1997, 1996, and
1995, and thus are subject to the risk of economic instability in that region
that might materially adversely affect the demand for the Company's products. In
recent months, capital markets in Korea and other areas of Asia have been
highly volatile, resulting in significant fluctuation in Asian currencies,
business failures, reduced demand for semiconductor equipment and other economic
instabilities. These instabilities may continue or worsen, which could
materially adversely affect the Company's business, financial condition or
results of operations. Although the current economic instability in the Asia
Pacific region has not materially adversely affected the Company's order
backlog, balance sheet, or results of operations, there can be no assurance that
it will not in the future.
<PAGE>
 
GROSS MARGIN.  The Company's gross margin has been and will continue to be
affected by a variety of factors, including manufacturing efficiencies, new
product introductions, pricing by competitors or suppliers, product and services
sales mix, production volume, product reliability, customization and
reconfiguration of systems, international and domestic sales mix and field
service margins. The Company's gross margin as a percentage of net sales
decreased to 55.9% in fiscal 1997 from 59.4% in fiscal 1996 and 60.3% in fiscal
1995. The decreases were due primarily to a significant decrease in revenue
shipments beginning in the fourth fiscal quarter of 1996 which resulted in an
underutilization of manufacturing capacity, offset partially by decreased
expenses resulting from the resizing of certain areas in operations. The fiscal
1997 decrease was also due in part to inventory reserves taken for obsolete
items as a result of the Company's introduction of new products and modification
and phasing out of older products. There can be no assurance that the Company's
gross margin will remain at the recent levels or that recent downward trends
will not continue.

RESEARCH AND DEVELOPMENT.  Research and development expenses as a percentage of
net sales were 18.3%, 14.8% and 14.1%, in fiscal 1997, 1996 and 1995,
respectively, reflecting increased expenses and lower net sales from fiscal 1997
to fiscal 1996.  Research and development expenses increased to $37.4 million in
fiscal 1997 from $35.4 million in fiscal 1996 and $24.9 million in fiscal 1995,
reflecting continued investments in the development of new products, as well as
enhancements of existing product lines. During fiscal 1997 the Company expensed
$6.0 million of  in-process research and development resulting from the
acquisition of certain assets of Summit Design Inc. and Summit's wholly owned
subsidiary, Test Systems Strategies. Inc. The Company currently intends to
continue to invest significant resources in the development of new products and
enhancements for the foreseeable future. Accordingly, the Company expects these
expenses will increase in absolute dollars in fiscal 1998 as compared to fiscal
1997.

SELLING, GENERAL AND ADMINISTRATIVE.  Selling, general and administrative
expenses increased  to $55.7 million in fiscal 1997 from $52.0 million in fiscal
1996 and $38.0 million in 1995, increases of 7.1% and 36.8%, respectively. The
increase in fiscal 1997 resulted primarily from marketing costs associated with
new product introductions, operating expenses associated with acquisitions made
during the year, costs of increasing the Company's global infrastructure such as
offices in Southeast Asia, and legal and other expenses for patent litigation
that settled in fiscal 1997 and acquisitions. The increase in fiscal 1996 was
due primarily to increased sales commissions related to increased product sales
and increased employee compensation and expenses related to additional
personnel. In fiscal 1996, selling, general and administrative expenses as a
percentage of net sales remained flat from fiscal 1995, however in fiscal 1997
they increased over fiscal 1996 due primarily to the reduced net sales. The
Company expects selling, general and administrative expenses to increase in
absolute dollars in fiscal 1998 compared to fiscal 1997 to provide the
infrastructure to support anticipated future growth in the business.

INTEREST INCOME AND INTEREST AND OTHER EXPENSES. The Company generated interest
income of $4.8 million, $4.2 million and $3.0 million in fiscal 1997, 1996 and
1995, respectively. The increases from 1995 to 1996 and 1996 to 1997 were due to
interest earned on significantly higher cash and short-term investments balances
provided by operations and the receipt of proceeds from public offerings and a
convertible subordinated notes offering, offset in part by cash used to increase
accounts receivable and inventory, as well as for capital expenditures and
acquisitions. Interest and other expense increased to $1.6 million in fiscal
1997 from $0.2 million in fiscal 1996 primarily due to the interest expense on
the Company's convertible subordinated notes.

INCOME TAX.  The effective tax rates of 35% for fiscal 1996 and 1995 were lower
than the combined federal and state statutory rates in effect for those years,
due primarily to the foreign sales corporation benefits, utilization of tax loss
carryforwards and the recognition of certain other deferred tax assets. In
fiscal 1997, the Company's effective tax rate increased to 41% primarily due to
the recognition of only a portion of the tax benefit associated with the in-
process research and development charge. In-process research and development
amounts are deductible over an extended period of time, and therefore, a
valuation allowance has been established to offset a portion of the resulting
deferred tax asset. The Company expects that its effective tax rate to be
comparable to its 1996 rate in fiscal 1998.
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES

Operating activities used net cash of $9.7 million in fiscal 1997 and provided
$31.0 million and $14.7 million in fiscal 1996 and 1995, respectively. The net
cash used by operating activities in fiscal 1997 resulted primarily from an
increase in restricted cash of $10.0 million (due to commitments to purchase
product licenses), and increases in accounts receivable, inventories and prepaid
expenses and other current assets of $6.2 million, $16.4 million and $4.2
million, respectively. Partially offsetting these amounts in fiscal 1997 were
net income of $10.7 million and additions to depreciation and amortization of
$14.0 million. The net cash provided by operating activities in fiscal 1996 and
1995 reflected net income and adjustments for increasing levels of depreciation
and amortization, offset primarily by significant increases in inventories and
accounts receivable. Investing activities used net cash of $25.1 million, $37.7
million, and $38.0 million in fiscal 1997, 1996 and 1995, respectively. In the
last three fiscal years, the Company invested primarily in short-term
investments, capital equipment and technologies. Financing activities provided
net cash of $118.9 million, $0.8 million and $38.3 million for fiscal 1997, 1996
and 1995, respectively, due primarily to the issuance of $115 million of
convertible subordinated notes in 1997 and issuances of the Company's common
stock, offset in part by payments on capital lease obligations. As of October
31, 1997, the Company had working capital of approximately $250.3 million,
including cash, cash equivalents and short-term investments of $167.8 million,
$55.2 million of accounts receivable and $42.1 million of inventories. The
growth in accounts receivable is due primarily to the higher sales in the fourth
quarter of fiscal 1997 from the fourth quarter of fiscal 1996. Days sales in
receivables decreased from 105 at the end of fiscal 1996 to 72 at the end of
fiscal 1997 due primarily to aggressive collection efforts, shipment terms (such
as letters of credit) which generally have a shorter collection cycle and the
increase in the demand for product in fiscal 1997 which resulted in customers
paying on a more timely basis. There can be no assurance that such days sales in
receivables will remain at or be below the level achieved at the end of fiscal
1997. The Company expects accounts receivable to continue to represent a
significant portion of working capital. The growth in inventories in fiscal 1997
is due primarily to increased purchases to meet increasing shipments anticipated
during fiscal 1998 and to support the additional products introduced in fiscal
1997. The Company believes that because of the relatively long manufacturing
cycles of many of its testers as well as the necessary stocking of materials for
new products that are expected to be introduced in fiscal 1998, investments in
inventories will also continue to represent a significant portion of working
capital. Significant investments in accounts receivable and inventories may
continue to subject the Company to increased risks that could materially
adversely affect the Company's business, financial condition and results of
operations. The semiconductor industry has historically been highly cyclical and
has experienced downturns, which have had a material adverse effect on the
semiconductor industry's demand for automatic test equipment, including
equipment manufactured and marketed by the Company. In addition, the automatic
test equipment industry is highly competitive, and subject to rapid
technological change. It is reasonably possible that events related to the above
factors may occur in the near term which would cause a change to the Company's
estimate of the net realizable value of receivables, inventories or other
assets, and the adequacy of costs accrued for warranty and other liabilities.
Such changes could materially adversely affect the Company's business, financial
condition and results of operations.

The Company's principal sources of liquidity as of October 31, 1997 consisted of
approximately $167.8 million of cash, cash equivalents and short-term
investments and $20.0 million available under the Company's unsecured working
capital line of credit due to expire on July 24, 1998. As of October 31, 1997,
no amounts were outstanding under the line of credit and the Company was in
compliance with all financial covenants under the agreement. The development and
manufacture of new ATE systems and enhancements are highly capital intensive. In
order to be competitive, the Company must make significant investments in
capital equipment, operations expansion and research and development. The
Company expects that its existing cash balances and short-term investments,
together with its current or successor line of credit and anticipated cash flow
from operations will satisfy its financing requirements for at least the next
twelve months.
<PAGE>
 
COMPANY OUTLOOK

The Company's short-term results of operations weakened significantly in the
latter half of fiscal 1996, as it did in general for  other companies in the
semiconductor capital equipment industry. Delays, deferrals and cancellations in
orders for the Company's products in the second half of fiscal 1996 resulted in
a 30% decrease in backlog at October 31, 1996, as compared to backlog at October
31, 1995. Results of operations improved subsequent to the first quarter of
fiscal 1997 with the fourth quarter net sales up 57% from the fourth quarter of
fiscal 1996, and up 36% from the third quarter of 1997. Backlog at October 31,
1997 was $97.5 million, approximately twice the amount it was at the end of the
prior fiscal year. There can be no assurance that these trends will continue. In
addition, the Company's backlog at the beginning of a quarter typically does not
include all orders needed to achieve the Company's sales objectives for that
quarter. Orders in backlog are also subject to cancellation, delay, deferral or
rescheduling by a customer with limited or no penalties and cannot be relied on
as an indication of future operating results. Consequently, the Company's net
sales and operating results  for a quarter have in the past and will in the
future depend on the Company obtaining orders for systems to be shipped in the
same quarter the order is received.

The Company's sales, gross margins and operating results have in the past
fluctuated significantly, as experienced in fiscal 1992 due primarily to a
downturn caused by weakness in the ATE market and a similar experience in the
latter part of fiscal 1996 and the first quarter of fiscal 1997 and will in the
future fluctuate significantly depending upon a variety of factors. The factors
that have caused and will continue to cause the Company's results to fluctuate
include the timing of new product announcements and releases by the Company or
its competitors, market acceptance of new products and enhanced versions of the
Company's products, manufacturing inefficiencies associated with the start up of
new products, changes in pricing by the Company, its competitors, customers or
suppliers, manufacturing capacity, the ability to volume produce systems and
meet customer requirements, inventory obsolescence, patterns of capital spending
by customers, delays, cancellations or reschedulings of orders due to customer
financial difficulties or otherwise, changes in overhead absorption levels due
to changes in the number of systems manufactured, the timing and shipment of
orders, availability of components, subassemblies and services, expenses
associated with acquisitions and alliances, product discounts, customization and
reconfiguration of systems, product reliability, the proportion of direct sales
and sales through third parties, including distributors and original equipment
manufacturers, the mix of products sold, the length of manufacturing and sales
cycles, cyclicality or downturns in the semiconductor market and the markets
served by the Company's customers, natural disasters, political and economic
instability, regulatory changes and outbreaks of hostilities. The Company
presently intends to introduce many new products and product enhancements in
this current fiscal year, which will affect its operating results, financial
condition and business. The Company's gross margins on system sales have varied
significantly, especially in the last twelve months, and will continue to vary
significantly based on a variety of factors, including manufacturing
efficiencies, pricing by competitors or suppliers, product sales mix, reserves,
production volume, new product introductions, product reliability, customization
and reconfiguration of systems, international and domestic sales mix and field
service margins. In addition, new and enhanced products typically have lower
gross margins in the early stages of commercial introduction and production.
While the Company has recorded and continues to record allowances for estimated
sales returns and uncollectable accounts, there can be no assurance that such
estimates regarding allowances will be adequate.


The impact of these and other factors on the Company's sales and operating
results in any future period cannot be forecast with certainty. In addition, the
need for continued expenditures for research and development, marketing expenses
for new products, capital equipment purchases, and ongoing training and customer
service and support worldwide, among other factors, will make it difficult for
the Company to reduce its operating expenses in a particular period if the
Company's net sales goals for the period are not met. The Company has
significantly increased its expense levels to support its recent quarterly
growth, and there can be no assurance that the Company will maintain or exceed
its current level of net sales or rate of growth for any period in the future.
Accordingly, there can be no assurance that the Company will be able to be
profitable or that it will not sustain losses in future periods. Due to these
and additional factors, historical results and percentage relationships
discussed in this Annual Report on Form 10-K will not necessarily be indicative
of the results of operations for any future period.


ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

For the years ended October 31, 1997, 1996, and 1995
<PAGE>
 
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
 
                                                                                                  Page
                                                                                                  ----
<S>                                                                                               <C>
Report of Ernst & Young LLP, Independent Auditors                                                   29

Consolidated Balance Sheets -- October 31, 1997 and 1996                                            30

Consolidated Statements of Income -- Years Ended October 31, 1997, 1996 and 1995                    31

Consolidated Statements of Stockholders' Equity -- Years Ended October 31, 1997, 1996 and 1995      32

Consolidated Statements of Cash Flows -- Years Ended October 31, 1997, 1996 and 1995                33

Notes to Consolidated Financial Statements                                                          34
</TABLE>
<PAGE>
 
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS



THE BOARD OF DIRECTORS AND STOCKHOLDERS
CREDENCE SYSTEMS CORPORATION

     We have audited the accompanying consolidated balance sheets of Credence
Systems Corporation as of October 31, 1997 and 1996, and the related
consolidated statements of income, stockholders' equity, and cash flows for each
of the three years in the period ended October 31, 1997.  Our audits also
included the financial statement schedule listed in the Index at Item 14(a).
These financial statements and this schedule are the responsibility of the
Company's management.  Our responsibility is to express an opinion on these
financial statements and this schedule 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 consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Credence Systems Corporation at October 31, 1997 and 1996, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended October 31, 1997, in conformity with generally accepted accounting
principles.  Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.



                                         /s/  ERNST & YOUNG LLP



San Jose, California
November 26, 1997
<PAGE>
 
                          CREDENCE SYSTEMS CORPORATION

                          CONSOLIDATED BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
                                                                                           OCTOBER 31,
                                                                                           -----------
                                                                                          1997      1996
                                                                                        --------  --------
ASSETS
<S>                                                                                     <C>       <C>
Current assets:
       Cash and cash equivalents                                                        $132,761  $ 48,649
       Restricted cash                                                                    10,002         -
       Short-term investments                                                             35,013    37,643
       Accounts receivable, net of allowance for doubtful accounts
          of $1,763 and $1,781 in 1997 and 1996, respectively                             55,246    49,025
       Inventories                                                                        42,125    35,721
       Deferred income taxes                                                               5,853     3,939
       Prepaid expenses and other current assets                                           7,148     2,906
--------------------------------------------------------------------------------------  --------  --------
          Total current assets                                                           288,148   177,883
Long-term investments                                                                      8,561     4,284
Property and equipment, net                                                               43,050    32,764
Other assets, net of accumulated amortization of $5,043 and $4,594 in
       1997 and 1996, respectively                                                        18,382     8,111
       -------------------------------------------------------------------------------  --------  --------
                                                                                        $358,141  $223,042
--------------------------------------------------------------------------------------  --------  --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
       Accounts payable                                                                 $ 13,182  $ 13,842
       Accrued payroll and related liabilities                                             6,061     7,064
       Accrued distributor commissions                                                     3,174     3,054
       Accrued warranty                                                                    3,277     2,358
       Deferred revenue                                                                    2,748     1,565
       Other accrued liabilities                                                           5,086     3,788
       Income taxes payable                                                                4,284     1,589
--------------------------------------------------------------------------------------  --------  --------
          Total current liabilities                                                       37,812    33,260
Convertible subordinated notes                                                           115,000         -
Commitments and contingencies
Minority interest                                                                            418         -

Stockholders' equity:
       Preferred stock:
          Authorized shares -- 1,000,000 ($0.001 par value); no shares issued                  -         -
       Common stock:
          Authorized shares -- 40,000,000 ($0.001 par value)
          Issued and outstanding shares -- 21,981,005 in 1997 and 21,642,936 in 1996          22        22
          Additional paid-in capital                                                     110,167   105,731
       Retained earnings                                                                  94,722    84,029
       -------------------------------------------------------------------------------  --------  --------
          Total stockholders' equity                                                     204,911   189,782
          ----------------------------------------------------------------------------  --------  --------
                                                                                        $358,141  $223,042
--------------------------------------------------------------------------------------  --------  --------
</TABLE>
                            See accompanying notes.
<PAGE>
 
                          CREDENCE SYSTEMS CORPORATION

                       CONSOLIDATED STATEMENTS OF INCOME
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
                                                           YEAR ENDED OCTOBER 31,
                                                       ----------------------------

                                                         1997      1996      1995
                                                       --------  --------  --------
<S>                                                    <C>       <C>       <C>
Net sales:
       Systems and upgrades                            $186,264  $221,096  $160,030
       Service, spare parts and software                 17,828    17,692    16,775
-----------------------------------------------------  --------  --------  --------
          Total net sales                               204,092   238,788   176,805
Cost of goods sold                                       89,956    97,010    70,121
-----------------------------------------------------  --------  --------  --------
Gross margin                                            114,136   141,778   106,684
Operating expenses:
       Research and development                          37,350    35,442    24,859
       Selling, general and administrative               55,701    52,002    38,008
       Acquired in-process research and development       6,022         -         -
-----------------------------------------------------  --------  --------  --------
       Total operating expenses                          99,073    87,444    62,867
-----------------------------------------------------  --------  --------  --------
Operating income                                         15,063    54,334    43,817
Interest income                                           4,769     4,155     2,979
Interest and other expenses, net                          1,602       222       147
-----------------------------------------------------  --------  --------  --------
Income before income taxes and minority interest         18,230    58,267    46,649
Income taxes                                              7,531    20,564    16,295
-----------------------------------------------------  --------  --------  --------
Income before minority interest                          10,699    37,703    30,354
Minority interest                                             6         -         -
-----------------------------------------------------  --------  --------  --------
Net income                                             $ 10,693  $ 37,703  $ 30,354
-----------------------------------------------------  --------  --------  --------
Net income per share                                   $   0.47  $   1.72  $   1.45
-----------------------------------------------------  --------  --------  --------

Number of shares used in computing per share amount      22,539    21,930    20,984
-----------------------------------------------------  --------  --------  --------
</TABLE>
                            See accompanying notes.
<PAGE>

                          CREDENCE SYSTEMS CORPORATION

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>
 
                                                                             Additional                    Total
                                                       Common     Stock        Paid-in       Retained   Stockholders'
--------------------------------------------------------------------------------------------------------------------
                                                       Shares     Amount       Capital       Earnings      Equity
<S>                                                <C>           <C>         <C>            <C>        <C>       
Balance at October 31, 1994                              19,338    $     13      $ 61,596   $ 16,604   $ 78,213  
Adjustment for three-for-two stock split                      -           6            (6)         -          -  
Issuance of common stock on exercise of options                                                                  
       under incentive stock option plans                   591           1           788          -        789  
Issuance of common stock in third public                                                                         
       offering, net of issuance costs                    1,425           1        37,945          -     37,946  
Issuance of common stock under employee stock                                                                    
       purchase plan                                         67           -           734          -        734  
Income tax benefit from stock option exercises                -           -         2,882          -      2,882  
EPRO fiscal year conversion                                   -           -             -       (632)      (632) 
Net income                                                    -           -             -     30,354     30,354  
-----------------------------------------------------------------------------------------------------------------
Balance at October 31, 1995                              21,421          21       103,939     46,326    150,286  
Issuance of common stock on exercise of options                                                                  
       under incentive stock option plans                   133           1           243          -        244  
Issuance of common stock under employee stock                                                                    
       purchase plan                                         89           -         1,232          -      1,232  
Income tax benefit from stock option exercises                -           -           317          -        317  
Net income                                                    -           -             -     37,703     37,703  
-----------------------------------------------------------------------------------------------------------------
Balance at October 31, 1996                              21,643          22       105,731     84,029    189,782  
Issuance of common stock on exercise of options                                                                  
       under incentive stock option plans                   226           -         1,971          -      1,971  
Issuance of common stock under employee stock                                                                    
       purchase plan                                        112           -         1,564          -      1,564  
Income tax benefit from stock option exercises                -           -           901          -        901  
Net income                                                    -           -             -     10,693     10,693  
-----------------------------------------------------------------------------------------------------------------
 Balance at October 31, 1997                             21,981    $     22      $110,167   $ 94,722   $204,911  
-----------------------------------------------------------------------------------------------------------------
</TABLE>
                            See accompanying notes.
<PAGE>
 
                          CREDENCE SYSTEMS CORPORATION
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                         YEAR ENDED OCTOBER 31,
                                                                     -----------------------------
                                                                       1997       1996       1995
<S>                                                                  <C>        <C>        <C>
INCREASE IN CASH AND CASH EQUIVALENTS
OPERATING ACTIVITIES
Net income                                                           $ 10,693   $ 37,703   $ 30,354
Adjustments to reconcile net income to net cash
     provided by (used in) operating activities:
       Depreciation and amortization                                   13,984     11,485      6,326
       EPRO fiscal year conversion                                          -          -       (632)
       Deferred taxes                                                  (3,432)     1,039     (1,744)
       (Gain) loss on disposal of property and equipment                  430       (123)      (253)
       Minority interest                                                    6          -          -
       Changes in operating assets and liabilities:
          Restricted cash                                             (10,002)         -          -
          Accounts receivable                                          (6,221)    (4,976)   (17,537)
          Inventories                                                 (16,440)   (13,339)   (13,654)
          Prepaid expenses and other current assets                    (4,242)     1,303     (3,018)
          Accounts payable                                               (660)     2,571      6,193
          Accrued liabilities                                           2,517     (1,852)     5,222
          Income taxes payable                                          3,654     (2,794)     3,490
------------------------------------------------------------------   --------   --------   --------
              Net cash provided (used in) by operating activities      (9,713)    31,017     14,747
INVESTING ACTIVITIES
Purchases of available-for-sale securities                            (68,983)   (80,028)   (17,524)
Purchases of held-to-maturity securities                                    -          -    (32,570)
Proceeds from maturity of available-for-sale securities                56,663     55,625          -
Proceeds from the sale of available-for-sale securities                10,673          -          -
Proceeds from the maturity of held-to-maturity securities                   -     11,521     25,691
Acquisition of property and equipment                                 (16,223)   (24,689)   (11,280)
Other assets                                                           (9,201)    (4,209)    (2,925)
Proceeds from sale of assets                                            2,007      4,057        600
------------------------------------------------------------------   --------   --------   --------
              Net cash used in investing activities                   (25,064)   (37,723)   (38,008)
FINANCING ACTIVITIES
Principal payments under capital lease obligations                          -       (655)    (1,172)
Issuance of common stock, net of repurchases                            3,477      1,476     40,398
Issuance of  5  1/4% convertible subordinated notes                   115,000          -          -
Payment of expenses related to the Company's public offering                -          -       (928)
Contributions from minority interests                                     412          -          -
------------------------------------------------------------------   --------   --------   --------
              Net cash provided by financing activities               118,889        821     38,298
------------------------------------------------------------------   --------   --------   --------
Net increase (decrease) in cash and cash equivalents                   84,112     (5,885)    15,037
Cash and cash equivalents at beginning of the period                   48,649     54,534     39,497
------------------------------------------------------------------   --------   --------   --------
 Cash and cash equivalents at end of the period                      $132,761   $ 48,649   $ 54,534
------------------------------------------------------------------   --------   --------   --------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid                                                        $      1   $     48   $    124
Income taxes paid                                                    $  7,443   $ 22,319   $ 14,017
NONCASH ACTIVITIES:
Net transfers of inventory to property and equipment                 $ 10,036   $  3,505   $    712
</TABLE>
                            See accompanying notes.
<PAGE>
 
                          CREDENCE SYSTEMS CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


ORGANIZATION

   Credence Systems Corporation ("Credence" or the "Company") was incorporated
under the laws of the State of California in March 1982 and was reincorporated
in Delaware in October 1993. The principal business activity of the Company is
the design, development, manufacture, sale and service of automatic test
equipment used in the production of semiconductors. As a result of acquisitions
made during fiscal 1997, Credence is also involved in the design, development,
sale and service of software enabling the development of customer test programs
used by automatic test equipment. The Company has a subsidiary in Japan engaged
in sales, marketing and service of the Company's products and  a subsidiary in
Korea engaged in service of the Company's products. Also, the Company has a
joint venture with Innotech Corporation in Japan engaged in the customization,
development and manufacture of product for sale by both companies. The joint
venture is 50.1% owned by the Company and is consolidated in the financial
statements. The operations of and net investment in foreign subsidiaries are not
material.


BASIS OF PRESENTATION

   The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned and majority owned subsidiaries. All
significant intercompany transactions and balances have been eliminated.


REVENUE RECOGNITION

   Revenue and related warranty expenses are recognized upon product shipment.
Net sales consist of product sales less discounts and estimated allowances. A
provision for the estimated costs to enhance the functionality and reliability
of the installed base is recorded when such requirements become known. Revenues
from service contracts are recognized ratably over the contract period. Revenue
from software sales commencing in fiscal 1997 is generally recognized upon
shipment of the software provided that no vendor or post-contract support
obligations remain and that collection of the resulting receivable is deemed
probable by management. Insignificant vendor and post-contract support
obligations are accrued on shipment of the related software.


CASH, CASH EQUIVALENTS, AND SHORT-TERM INVESTMENTS

   For purposes of cash flow reporting, the Company considers all highly liquid
investments with minimum yield risks and original maturity dates of three months
or less to be cash equivalents. Short-term investments consist primarily of
commercial paper, medium term notes, U.S. Treasury notes and obligations of U.S.
Government Agencies, bank certificates of deposit, and bankers acceptances
carried at cost that approximates market.

   Management classifies investments as trading, available-for-sale or held-to-
maturity at the time of purchase and periodically reevaluates such
classification. There were no securities classified as trading as of October 31,
1997 or 1996. Securities are classified as held-to-maturity when the Company has
the positive intent and ability to hold the securities to maturity. Held-to-
maturity securities are stated at cost with corresponding premiums or discounts
amortized over the life of the investment to interest income. There were no
securities classified as held-to-maturity as of October 31, 1997 or 1996.
Securities not classified as held-to-maturity are classified as available-for-
sale and reported at fair market value. Unrealized gains or losses on available-
for-sale securities, if material, are included, net of tax, in equity until
disposition. Realized gains and losses and declines in value judged to be other-
than-temporary on available-for-sale securities are included in interest income.
The cost of securities sold is based on the specific identification method.
<PAGE>
 
   The fair market value of cash equivalents and short-term and long-term
investments is substantially equal to the carrying value and represents the
quoted market prices at the balance sheet dates. Cash and cash equivalents are
categorized as follows (in thousands):
<TABLE>
<CAPTION>
October 31,                                                             1997      1996
<S>                                                                   <C>        <C>
Money market                                                          $ 20,866   $17,284
Commercial paper                                                        73,277    16,404
Variable rate preferred stock                                           25,000         -
Auction preferred stock                                                  5,000         -
Obligations of U.S. Government Agencies                                  1,978         -
Certificates of deposit                                                      -     8,452
Other debt securities                                                    7,614         -
-------------------------------------------------------------------   --------   -------
      Cash equivalents                                                 133,735    42,140
Cash                                                                      (974)    6,509
-------------------------------------------------------------------   --------   -------
      Cash and cash equivalents                                       $132,761   $48,649
-------------------------------------------------------------------   --------   -------
</TABLE>

   The short-term investments mature in less than one year. All long-term
investments have maturities of one to two years. At October 31, 1997 and 1996
these investments are classified as available-for-sale and are categorized as
follows (in thousands):

<TABLE>
<CAPTION>
October 31,                                                    1997     1996
<S>                                                           <C>      <C>
Commercial paper and medium term notes                        $18,225  $15,067
Treasury notes and obligations of U.S. Government Agencies      4,985   11,847
Certificates of deposit                                         7,997    9,744
Banker's acceptances                                                -      985
Other debt securities                                           3,806        -
------------------------------------------------------------  -------  -------
       Short-term investments                                  35,013   37,643
       Long-term investments                                    8,561    4,284
------------------------------------------------------------  -------  -------
                                                              $43,574  $41,927
------------------------------------------------------------  -------  -------
</TABLE>

RESTRICTED CASH

Restricted cash represents cash in escrow related to the remaining purchase
commitments by the Company under an agreement with Summit Design, Inc. to
purchase product licenses of approximately $16 million through 1999.


INVENTORIES

Inventories are stated at the lower of standard cost (which approximates first-
in, first-out cost) or market. Inventories consist of the following (in
thousands):
<TABLE>
<CAPTION>
October 31,                                  1997     1996
<S>                                         <C>      <C>
Raw materials                               $24,862  $20,482
Work-in-process                              14,173   10,222
Finished goods                                3,090    5,017
------------------------------------------  -------  -------
                                            $42,125  $35,721
------------------------------------------  -------  -------
</TABLE>

PROPERTY AND EQUIPMENT AND OTHER ASSETS

Property and equipment are stated at cost and are depreciated using the
straight-line method over the estimated useful lives of three to five years.
Assets under capitalized leases are amortized using the straight-line method
over the shorter of the estimated useful life of the asset or the lease term.
Property and equipment consists of the following (in thousands):
<PAGE>
 
<TABLE>
<CAPTION>
October 31,                       1997     1996
<S>                              <C>      <C>
Machinery and equipment          $47,646  $29,845
Leasehold improvements             8,248    7,780
Furniture and fixtures             5,039    4,699
Spare parts                       17,026   20,169
-------------------------------  -------  -------
                                  77,959   62,493
Less accumulated depreciation
       and amortization           34,909   29,729
-------------------------------  -------  -------
 Net property and equipment      $43,050  $32,764
-------------------------------  -------  -------
</TABLE>

Other assets consist primarily of purchased technologies and related rights
which are amortized using the straight-line method over the assets estimated
useful lives of three to five years. Accumulated amortization associated with
intangible assets is approximately $5,043,000 and $4,594,000 at October 31, 1997
and 1996, respectively.

In 1995, the Financial Accounting Standards Board (FASB) released the Statement
of Financial Accounting Standards No. 121 (SFAS 121), "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be disposed of."
SFAS 121 requires recognition of impairment of long-lived assets in the event
the net book value of such assets exceeds the future undiscounted cash flows
attributable to such assets. SFAS 121 is effective for fiscal years beginning
after December 15, 1995. The Company adopted SFAS 121 on November 1, 1996.
Adoption of SFAS 121 did not have a material impact on the Company's financial
position or results of operations.


NET INCOME PER SHARE

     Net income per share is based upon the weighted average number of common
stock and common stock equivalent shares outstanding during the period. The
common stock equivalents include shares issuable upon the assumed exercise of
stock options reflected under the treasury stock method. The Company's
convertible subordinated notes are not common stock equivalents and,
accordingly, were excluded from the calculation of net income per share.
 
     In 1997, the FASB released Statement of Financial Accounting Standards No.
128 "Earnings Per Share" (SFAS 128), which is required to be adopted in the
Company's quarter ended January 31, 1998. At that time, the Company will be
required to change the method currently used to compute earnings per share and
to restate all prior periods. Under the new requirements for calculating  net
income per share, the dilutive effect of stock options will be excluded  from
basic earnings per share but included in the computation of diluted earnings per
share.  The Company's earnings per share as calculated according to SFAS 128
would have been as follows:

                                         1997   1996   1995

Basic                                    $0.49  $1.76  $1.51
Diluted                                  $0.47  $1.72  $1.45


RECENT ACCOUNTING PRONOUNCEMENTS

   In June 1997, the FASB released  Statement of Financial Accounting Standards
No. 130 "Reporting Comprehensive Income" (SFAS 130). SFAS 130 establishes
standards for the reporting and display of comprehensive income and its
components in a full set of general purpose financial statements and is
effective for fiscal years beginning after December 15, 1997. Adoption of SFAS
130 is not expected to have a material impact on the Company's consolidated
financial statements.

   In June 1997, the FASB released  Statement of Financial Accounting Standards
No. 131 "Disclosures about Segments of an Enterprise and Related Information"
(SFAS 131). SFAS 131 will change the way companies report selected segment
information in annual financial statements and also requires those companies to
report selected segment information in interim financial reports to
stockholders. SFAS 131 is effective for fiscal years beginning after December
15, 1997. Adoption of SFAS 131 will require disclosure by operating segment of
information such as profit and loss, assets and capital expenditures, major
customers and types of products from which revenue is derived.
<PAGE>
 
USE OF ESTIMATES

   The preparation of financial statements in conformity with generally accepted
accounting principles ("GAAP") requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results inevitably will differ from those estimates and
such differences may be material to the financial statements.


CONCENTRATIONS OF OTHER RISKS

   The semiconductor industry has historically been cyclical and has experienced
downturns, which have had a material adverse effect on the semiconductor
industry's demand for automatic test equipment, including equipment manufactured
and marketed by the Company. Differences between the Company's forecast of
market demand for its products and actual demand could have a material effect on
the financial statements. In addition, the automatic test equipment industry is
highly competitive, and subject to rapid technological change. It is reasonably
possible that events related to the above factors may occur in the near term
which would cause a change to the Company's estimate of the net realizable value
of receivables, inventories or other assets, and the adequacy of costs accrued
for warranty and other liabilities. Such changes could materially adversely
affect the Company's business, financial condition and results of operations.

   In addition, the Company relies on several suppliers and manufacturing
subcontractors to provide many of the key components and subassemblies used in
the Company's products. Some of these items are available from only one or a
limited group of suppliers. Any disruption in the delivery of these items could
materially adversely affect the Company's business, financial condition and
results of operations.


NOTE 2
MERGER WITH EPRO

   In March 1995, the Company completed a merger with EPRO whereby EPRO was
merged with a wholly-owned subsidiary of Credence. The Company issued
approximately 2.1 million shares of common stock in exchange for all of the
outstanding common stock of EPRO. In addition, outstanding options to purchase
EPRO common stock were converted into options to purchase approximately 81,000
shares of Credence common stock. The transaction was accounted for as a pooling
of interests and, therefore, all prior period consolidated financial statements
presented, and the consolidated financial statements as of October 31, 1995 and
for the year then ended, were restated as if the merger took place at the
beginning of the earliest period presented.

   EPRO had a calendar year and, in order to conform EPRO's year end to
Credence's fiscal year end, the consolidated statement of operations for fiscal
1995 includes two months (November and December 1994) for EPRO that are also
included in the consolidated statement of income for the fiscal year ended
October 31, 1994. Accordingly, an adjustment was made in fiscal 1995 to retained
earnings for the duplication of net income of $632,000 for such two-month
period. Other results of operations for such two-month period of EPRO include
net sales of $2,896,000, income before taxes of $1,100,000, and income tax
expense of $468,000.


NOTE 3
ACQUISITION OF THE TEST DEVELOPMENT SYSTEMS PRODUCT LINE OF TEST SYSTEMS
STRATEGIES, INC. AND SUMMIT DESIGN, INC.

     In July 1997, the Company, through a subsidiary, Test Systems Strategies,
Inc., a Delaware corporation ("TSSI"), acquired certain assets and assumed
certain liabilities from Summit Design, Inc. and its wholly owned subsidiary,
Test Systems Strategies, Inc., an Oregon corporation, including the test
development series software products ("TDS") and TSSI trademark of Test Systems
Strategies, Inc, the Oregon corporation.  TDS includes tools designed to convert
gate-level simulation data from electronic design automation simulators to
programs that operate on targeted automatic test equipment ("ATE") for testing
integrated circuits characterized by the gate-level simulation data.  TDS
facilitates simulation analysis, stimulus generation, simulation rules checking,
tester resource checking, ATE test program generation, and test program
conversion. The consolidated financial statements reflect the impact of TDS
operations subsequent to the acquisition date.
<PAGE>
 
The purchase price of $7.3 million, consisted of a cash payment of $7.0 million
to Summit Design, Inc. and $300,000 for the assumption of liabilities.  Acquired
assets and liabilities were recorded at their estimated fair market value at the
date of the acquisition. The aggregate purchase price, plus related acquisition
expenses, have been allocated to the assets and liabilities acquired based on
valuations. Amounts allocated to in-process research and development of
approximately $6.0 million were written-off at the acquisition date,
representing an estimated value (using risk-adjusted cash flows, discounted at
35%) of development programs that have not yet reached technological
feasibility. Amounts allocated to developed technology, $1.0 million, and
workforce in place, $0.3 million, are being amortized on a straight line basis
over periods of six and three years respectively.


NOTE 4
TRANSACTION WITH ZYCAD CORPORATION

In August 1997, the Company through a subsidiary, Test Systems Strategies, Inc.
purchased from Zycad Corporation ("Zycad") and one of its subsidiaries, Attest
Software, Inc. certain assets, including the TDX software product line ("TDX").
TDX consists of  software products that speed the development of ATE test
programs to aid in ensuring the integrity of integrated circuit designs prior to
incurring the expense of wafer fabrication.

The purchase price consisted of a cash payment to Zycad of $2,250,000. Acquired
assets were recorded at their estimated fair market value at the date of the
acquisition. The aggregate purchase price, plus related acquisition expenses,
have been allocated to the assets acquired based on valuations. Amounts
allocated to developed technology, $2.0 million, workforce in place, $0.1
million, and fixed assets, $0.1 million are being amortized on a straight line
basis over periods of five, three and five years respectively.


NOTE 5
CONCENTRATION OF CREDIT RISK AND GEOGRAPHIC DATA

Financial instruments that potentially subject the Company to concentrations of
credit risk consist principally of investments in cash equivalents, restricted
cash, short-term and long-term investments and trade receivables. The Company is
exposed to credit risks in the event of default by the financial institutions or
customers to the extent of the amount recorded on the balance sheet.

The Company and its subsidiaries operate in two industry segments; the design,
development, manufacture, sale and service of automatic test equipment used in
the production of semiconductors, and, as a result of acquisitions made in
fiscal 1997, the design, development, sale and service of software assisting the
development of test programs used by automatic test equipment. Revenues from
software were not material to the Company's operations in fiscal 1997.

The Company sells its products primarily to semiconductor manufacturers located
in the United States, Asia Pacific and Europe. The Company performs ongoing
credit evaluations of its customers and generally does not require collateral.
The Company maintains reserves for potential credit losses and such losses
historically have been both immaterial and within management's expectations.

Export sales, which are denominated in U.S. dollars, represent sales to the
Company's customers primarily throughout Asia Pacific and Europe. Sales by the
Company to customers in different geographic areas, expressed as a percentage of
revenue, for the periods ended were:

Year ended October 31,    1997   1996   1995

Domestic                    30%    33%    45%
Asia Pacific                66     58     45
Europe                       4      9     10
------------------------  ----   ----   ----
Total sales                100%   100%   100%
------------------------  ----   ----   ----

One customer (a distributor) accounted for 30%, 25% and 17% of the Company's net
sales in fiscal 1997, 1996 and 1995, respectively. Another customer accounted
for 11% of net sales in fiscal 1995. The Company's major distributor sells
product 
<PAGE>
 
into one country in Asia. This subjects a significant portion of the Company's
receivables and future revenues to the risks associated with doing business in a
foreign country, including political and economic instability, currency exchange
rate fluctuations and regulatory changes. Disruption of business in Asia caused
by the previously mentioned factors could have a material impact on the
Company's business, financial condition or results of operations.


NOTE 6
BANK CREDIT LINE

The Company has a $20,000,000 unsecured bank line of credit, with interest at
the bank's prime rate (8.50% at October 31, 1997) which expires July 24, 1998.
This line supports the issuance of letters of credit and foreign exchange
contracts. At October 31, 1997, the Company had no borrowings outstanding under
this line of credit. Borrowings under the line of credit are subject to the
Company's ability to meet certain financial covenants and require the Company to
obtain certain bank approvals for the payment of dividends. The Company was in
compliance with all financial covenants at October 31, 1997. There were no
foreign exchange contracts outstanding at October 31, 1997 or 1996.


NOTE 7
LEASE OBLIGATIONS AND OTHER COMMITMENTS

The Company entered into operating leases for test and other equipment totaling
approximately $0.9 million and $3.3 million in fiscal 1997 and 1996,
respectively. These leases call for monthly rental payments for three years from
the inception of each lease, and contain multiple end-of-lease options
including: 1) renewal of the lease; 2) purchase of the equipment at
predetermined or fair market values; or 3) return of the equipment to the
lessor.

The Company leases its facilities under operating leases that expire
periodically through 2004.

The approximate future minimum lease payments under operating leases for
facilities and equipment at October 31, 1997 are as follows (in thousands):

               Lease
              Payments

1998           $ 3,656
1999             3,218
2000             2,392
2001             2,003
2002             1,813
Thereafter       1,548
------------   -------
               $14,630
               -------

Rent expense was approximately $4,147,000, $4,132,000 and $1,936,000 for the
years ended October 31, 1997, 1996 and 1995, respectively.

The Company has an agreement with a distributor whereby the Company issued a
guaranty in favor of a bank with respect to certain obligations of the
distributor to the bank. Under this agreement, the distributor agreed to grant
to the Company a security interest to secure the obligations of the distributor
as a result of any payments by the Company pursuant to the guaranty. At October
31, 1997, the maximum allowable debt of the distributor subject to this guaranty
was $1,000,000 and the amount outstanding was $1,000,000.

In May 1997, the Company entered into an agreement with Summit Design, Inc.
(Summit) for the Company to purchase approximately $16 million of Summit's
Visual Testbench (VTB) product licenses through 1999. The $10.0 million of
restricted cash on the consolidated balance sheet relates to cash in escrow for
amounts  yet to be purchased under this agreement.
<PAGE>
 
NOTE 8
CONVERTIBLE SUBORDINATED NOTES

In September 1997, the Company sold $115 million of 5 1/4% convertible
subordinated notes (the "Notes") due 2002 through a private placement. The Notes
are unsecured obligations of the Company and are subordinated to all present and
future senior indebtedness of the Company. The Notes do not provide for a
sinking fund and are redeemable at the option of the Company, in whole or in
part, at any time on or after September 20, 2000 at certain redemption prices.
Interest is payable semiannually on March 15 and September 15, commencing March
15, 1998. The Notes are convertible into common stock of the Company at a
conversion price of $69.15 per share. Expenses of $3.3 million associated with
the offering have been deferred and included in other assets. Such expenses are
being amortized to interest expense over the term of the Notes. In November
1997, the Company filed a Registration Statement with the Securities and
Exchange Commission under Form S-3 to permit public secondary trading of the
Notes, and, upon conversion, the underlying common stock. Such registration
statement was declared effective in December 1997. As of October 31, 1997, the
fair value of the Notes based on quotes from a major brokerage firm was
approximately $97.2 million.


NOTE 9
STOCKHOLDERS' EQUITY

STOCK OPTION PLANS AND STOCK PURCHASE PLAN

The Company grants options to employees and members of the Board of Directors
under the 1993 Stock Option Plan (the "1993 Plan"). The 1993 Plan is divided
into two separate components: (i) the Discretionary Option Grant Program and
(ii) the Automatic Option Grant Program. Options granted under the Discretionary
Option Grant Program will have an exercise price equal to 100% of the fair
market value of such shares on the date of grant, a maximum term of ten years
and are exercisable over a vesting period, generally four to five years. Under
the Automatic Option Grant Program, options are granted automatically at
periodic intervals to non-employee members of the Board at an exercise price
equal to 100% of the fair market value of the option shares on the date of grant
and a maximum term of ten years.

In 1997, the Company's subsidiary, TSSI, adopted a 1997 Stock Option Plan (the
"TSSI Plan") under which incentive stock options to purchase TSSI common stock
could be granted to employees, non-employee members of the Board or the non-
employee members of the Board of Directors of any parent or subsidiary, and
consultants and other independent advisors who provide services to TSSI (or any
parent or subsidiary). Under the TSSI Plan, options to purchase TSSI common
stock can be granted at prices no less than 85% of their fair value on the date
of grant. Generally, options granted are immediately exercisable and the
resulting shares issued to employees under the TSSI Plan are subject to certain
repurchase rights by TSSI, at the discretion of TSSI, upon the individual's
cessation of service prior to vesting in the shares at the original purchase
price. As of October 31, 1997, 851,000 options were granted and exercisable to
employees at an exercise price of $0.10. These shares vest over a four year
period. Activity under this plan (in thousands, except per share amounts) is as
follows:

<TABLE>
<CAPTION>
                                                             Options Outstanding
------------------------------------------------------------------------------------- 
                                      Options Available   Number of  Weighted Average
                                          For Grant        Shares     Exercise Price
<S>                                   <C>                 <C>        <C>
Balance at October 31, 1996                      -              -            $    -
Initial shares authorized                    2,000              -                 -
Options granted                               (851)           851              0.10
------------------------------------------------------------------------------------- 
Balance at October 31, 1997                  1,149            851             $0.10
------------------------------------------------------------------------------------- 
</TABLE>

TSSI has reserved for issuance approximately 2,000,000 shares of common stock in
connection with the TSSI Plan. At October 31,1997, approximately 851,000 shares
were exercisable at an aggregate exercise price of $85,100.

The following table summarizes information about options outstanding under the
TSSI Plan at October 31, 1997 (option amounts are recorded in thousands except
per share amounts):
<PAGE>
 
<TABLE>
<CAPTION>
                                             Options Outstanding             Options Exercisable
                                             -------------------             -------------------
                                                                              Options        Weighted
                     Options        Weighted-Avg.                            Currently       Average
Range of           Outstanding        Remaining         Weighted-Avg.     Exercisable at     Exercise
Exercise Price     at Oct. 31,     Contractual Life    Exercise Price    October 31, 1997     Price
                      1997             (years)
<S>                <C>             <C>                 <C>               <C>                  <C>  
 $0.10              851                 9.90               $0.10                 851           $0.10
</TABLE>

These options will expire if not exercised before October 2007.

In 1994, the Company adopted the 1994 Employee Stock Purchase Plan, which
provides eligible employees with the opportunity to acquire shares of the
Company's common stock. The purchase price is 85% of the fair market value per
share of common stock on the date on which the purchase period begins or on the
date on which the purchase period ends, whichever is lower. Approximately
114,940, 89,000, and 67,000 shares were acquired pursuant to the plan in 1997,
1996, and 1995 respectively. At October 31, 1997, approximately 214,357 shares
were reserved for issuance under the plan.

The Company has elected to follow APB Opinion No. 25, "Accounting for Stock
Issued to Employees," in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under SFAS
No. 123, "Accounting for Stock-Based Compensation," requires the use of option
valuation models that were not developed for use in valuing employee stock
options.  Under APB No. 25, because the exercise price of the Company's employee
stock options equals the market price of the underlying stock on the date of the
grant, no compensation expense is recognized in the Company's financial
statements.

Pro forma information regarding net income and earnings per share is required by
SFAS No. 123.  This information is required to be determined as if the Company
had accounted for its employee stock options (including shares issued under the
Employee Stock Purchase Plan, collectively called "options") granted subsequent
to October 31, 1995 under the fair value method of SFAS No. 123.

In calculating pro forma compensation, the fair value of each option grant is
estimated on the date of grant using the Black-Scholes option pricing model.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable.  In addition, the Black-Scholes model requires the input of highly
subjective assumptions including the expected stock price volatility.  Because
the company's stock-based awards to employees have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of its stock-based awards to its employees.  The fair value of each
option grant is estimated assuming no expected dividends and the following
weighted-average assumptions:

                                             1997   1996
 
          Expected life (years)              3.35   3.19
          Expected stock price volatility    0.65   0.58
          Risk-free interest rate            5.67%  5.64%

The weighted average grant date fair value of options granted during the year
were $25.23 and $15.48 for 1997 and 1996 respectively.

The pro forma net income and earnings per share include expense related to the
Company's Employee Stock Purchase Plan.  The fair value of issuances under the
Employee Stock Purchase Plan is estimated on the issuance date using the Black-
Scholes model assuming no expected dividends and the following weighted average
assumptions for issuances made in 1997 and 1996:

                                             1997   1996
 
          Expected life (years)              0.50   0.50
          Expected stock price volatility    0.65   0.58
          Risk-free interest rate            5.67%  5.64%
 
The weighted average fair value of purchase rights granted during the year were
$7.49 and $6.82 for 1997 and 1996 respectively.
<PAGE>
 
For pro forma purposes, the estimated fair value of, the Company's stock-based
awards to its employees is amortized over the option's vesting period and the
Employee Stock Purchase Plan's six month purchase period. The Company's pro
forma information is as follows (in thousands, except per share amounts):
 
                                             1997     1996
 
          Net income as reported            $10,693  $37,703
          Pro forma net income              $ 8,316  $36,547
          Earnings per share as reported    $  0.47  $  1.72
          Pro forma earnings per share      $  0.37  $  1.67

Because SFAS 123 is applicable only to options granted subsequent to October 31,
1995, its pro forma effect will not be fully reflected until fiscal 2000.

A summary of the activity under all plans, excluding the TSSI Plan (in
thousands, except per share amounts) is as follows:

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------
                                     Options Available      Number of Shares   Price Per Share  Weighted Average
                                        for Grant             Outstanding                        Exercise Price
                                       (Authorized)
<S>                                  <C>                    <C>                <C>              <C>
Balance at October 31, 1994                   304                  1,231       $ 0.08 - $17.08            $ 3.03
Increase in authorized shares                 749                      -              -                        -
Options granted                              (442)                   442       $ 1.61 - $33.00            $26.11
Options canceled                               41                    (41)      $ 0.54 - $33.00            $11.13
Options exercised                               -                   (591)      $ 0.08 - $17.08            $ 1.33
----------------------------------------------------------------------------------------------------------------
Balance at October 31, 1995                   652                  1,041       $ 0.44 - $33.00            $13.46
Increase in authorized shares                 500                      -
Options granted                            (1,107)                 1,107       $12.75 - $29.00            $15.48
Options canceled                              227                   (227)      $ 0.54 - $33.00            $23.48
Options exercised                               -                   (133)      $ 0.52 - $16.50            $ 1.83
Options expired                                (8)                     -              -                        -
----------------------------------------------------------------------------------------------------------------
Balance at October 31, 1996                   264                  1,788       $ 0.44 - $33.00            $14.29
Increase in authorized shares                 500                      -              -                        -
Options granted                              (408)                   408       $19.00 - $29.50            $25.23
Options canceled                              170                   (170)      $ 1.00 - $33.00            $19.11
Options exercised                               -                   (226)      $ 0.44 - $33.00            $ 9.69
Options expired                                (2)                     -              -                        -
----------------------------------------------------------------------------------------------------------------
Balance at October 31, 1997                   524                  1,800       $ 0.44 - $33.00            $16.90
----------------------------------------------------------------------------------------------------------------
</TABLE>

The Company has reserved for issuance approximately 2,324,000 shares of common
stock in connection with the stock option plans. At October 31, 1997,
approximately 602,000 shares were exercisable at an aggregate exercise price of
$7,801,000.
<PAGE>
 
The following table summarizes information about options outstanding and
exercisable at October 31, 1997 excluding the TSSI Plan (in thousands except per
share amounts).

<TABLE>
<CAPTION>
                                   Options Outstanding                     Options Exercisable
--------------------------------------------------------------------------------------------------
                                                                            Options       Weighted
                       Options         Weighted-Avg.                       Currently      Average
Range of             Outstanding         Remaining      Weighted-Avg.    Exercisable at   Exercise
Exercise Prices    at Oct. 31, 1997  Contractual Life   Exercise Price  October 31, 1997   Price
                                          (years)
--------------------------------------------------------------------------------------------------
<S>                <C>               <C>                <C>             <C>               <C>
$ 0.44 - $12.75                 565              7.32           $ 9.56               298    $ 6.92
$13.25 - $14.63                 500              8.60           $13.40               149    $13.38
$16.25 - $29.50                 635              9.02           $23.98               109    $21.26
$30.00 - $33.00                 100              7.91           $30.81                46    $31.01
--------------------------------------------------------------------------------------------------
$ 0.44 - $33.00               1,800              8.31           $16.90               602    $12.96
--------------------------------------------------------------------------------------------------
</TABLE>

These options will expire if not exercised at specific dates from October 2003
to October 2007.  Prices for options exercised during the three-year period
ending October 31, 1997 ranged from $0.44 to $33.00.


NOTE 10
EMPLOYEE BENEFIT PLANS

The Company maintains a 401(k) retirement savings plan for its full-time
domestic employees, which allows them to contribute up to 20% of their pre-tax
wages subject to IRS limits. The Company made its initial contribution to this
plan of  approximately $441,000 in fiscal 1997.

The Company maintains a profit sharing plan for those domestic employees that
are not otherwise eligible for incentive based compensation. Contributions to
this plan are subject to the discretion of the Board of Directors. The Company
made contributions of $476,000, $3,721,000 and $3,467,000 in fiscal 1997, 1996,
and  1995, respectively.


NOTE 11
INCOME TAXES

The tax provision consists of the following (in thousands):

<TABLE>
<CAPTION>
Year Ended October 31,                                             1997     1996      1995
<S>                                                               <C>       <C>      <C>
Federal:
   Current                                                        $ 9,062   $16,317  $15,310
   Deferred                                                        (3,059)    1,647   (1,140)
----------------------------------------------------------------  -------   -------  -------
                                                                    6,003    17,964   14,170
State:                                                          
   Current                                                          1,818     2,358    2,928
   Deferred                                                          (373)      220     (803)
----------------------------------------------------------------  -------   -------  -------
                                                                    1,445     2,578    2,125
Foreign:                                                        
   Current                                                             83        22        -
----------------------------------------------------------------  -------   -------  -------
                                                                  $ 7,531   $20,564  $16,295
----------------------------------------------------------------  -------   -------  -------
</TABLE>

Pre-tax income (loss) from foreign operations was approximately $(206,000) in
1997, $56,000 in 1996 and $0 in 1995.

A reconciliation between the Company's effective tax rate (41%, in 1997, 35% in
1996 and 1995) and the U.S. statutory rate is as follows (in thousands):

       Year Ended October 31,           1997      1996      1995
<PAGE>
 
Tax computed at statutory rate         $6,380   $20,394   $16,327
State income tax
       (net of federal benefit)           935     1,687     1,381
Foreign sales corporation benefit        (862)   (1,626)   (1,388)
In-process research and development
          not currently benefited       1,264         -         -
Net operating loss
       carryforward benefit              (141)     (141)     (141)
Research and development credits         (370)        -         -
Other items                               325       250       116
-------------------------------------  ------   -------   -------
                                       $7,531   $20,564   $16,295
-------------------------------------  ------   -------   -------

At October 31, 1997 the Company has unused net operating loss and research tax
credit carryforwards for federal income tax purposes of approximately $2,000,000
and $194,000, respectively, which expire in 2003 through 2005. Utilization of
the net  operating loss carryforwards at October 31, 1997 is limited to
approximately $401,000 annually under the provisions of Section 382 of the
Internal Revenue Code of 1986, as amended. Utilization of the credit
carryforwards is similarly limited.

Significant components of the Company's deferred tax assets are as follows (in
thousands):

October 31,                                      1997      1996
Deferred tax assets:
Accounting for inventories                     $ 4,417   $ 3,173
Allowance for doubtful accounts                    884       748
Accruals not currently deductible                2,236     1,621
Net operating loss carryforwards                   703       843
Acquired technology                              2,283         -
Research credit carryforwards                      194       194
---------------------------------------------  -------   -------
       Total deferred tax assets                10,717     6,579
Valuation allowance for deferred tax assets     (2,106)     (897)
---------------------------------------------  -------   -------
                                                 8,611     5,682
Deferred tax liability:
Tax over book depreciation                      (1,239)   (1,742)
Other                                                -         -
---------------------------------------------  -------   -------
       Total deferred tax liability             (1,239)   (1,742)
---------------------------------------------  -------   -------
       Net deferred tax assets                 $ 7,372   $ 3,940
---------------------------------------------  -------   -------

The change in the valuation allowance was a net increase of $1,209,000 in 1997
and a net decrease of $140,000 and $984,000 in 1996 and 1995, respectively.


NOTE 12
CONTINGENCIES

Since 1994, the Company had been involved in a number of lawsuits with Megatest
Corporation and Teradyne, Inc. concerning various patent infringement matters.
In 1997, the Company's litigation matters with Megatest Corporation and
Teradyne, Inc. were settled. There was no impact on the financial statements as
a result of this settlement.

The Company is involved in various claims arising in the ordinary course of
business, none of which, in the opinion of management, if determined adversely
against the Company, will have a material adverse effect on the Company's
business, financial condition or results of operations.


NOTE 13
RELATED PARTY TRANSACTIONS
<PAGE>
 
Bernard V. Vonderschmitt, a director of the Company, is the founder and chairman
of Xilinx, Inc. For the years ended October 31, 1997, 1996 and 1995, the Company
sold approximately $1,356,000, $7,887,000 and $3,135,000, respectively, of
products and services to Xilinx. The amounts receivable from Xilinx were
approximately $2,000 and $126,000 at October 31, 1997 and 1996, respectively.

The Company sells products and services to  ITH, Inc., a company in which the
Company has an investment. For the years ended October 31, 1997 and 1996, sales
totaled approximately $6,000 and  $2,754,000, respectively. The amounts
receivable from ITH, Inc. were approximately $324,000 and $1,865,000 at October
31, 1997 and 1996 respectively. The Company had no transactions with ITH, Inc.
in fiscal 1995.
<PAGE>
 
ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL DISCLOSURE.

     Not Applicable.


                                    PART III
                                    --------

ITEM 10.  DIRECTORS AND OFFICERS OF THE REGISTRANT.

     The information required by this item relating to the Company's directors
and nominees and disclosure relating to compliance with Section 16(a) of the
Securities Exchange Act of 1934 is included under the captions "Election of
Directors" and "Compliance with Section 16(a) of the Securities Exchange Act of
1934" in the Company's Proxy Statement for the 1998 Annual Meeting of
Stockholders and is incorporated herein by reference. The information required
by this item relating to the Company's executive officers and key employees is
included under the caption "Executive Officers and Key Employees" in Part I of
this Form 10-K Annual Report.

ITEM 11.  EXECUTIVE COMPENSATION.

     The information required by this item is included under the caption
"Executive Compensation and Related Information" in the Company's Proxy
Statement for the 1998 Annual Meeting of Stockholders and is incorporated herein
by reference.

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

     The information required by this item is included under the caption
"Ownership of Securities" in the Company's Proxy Statement for the 1998 Annual
Meeting of Stockholders and is incorporated herein by reference.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     The information required by this item is included under the caption
"Certain Relationships and Related Transactions" in the Company's Proxy
Statement for the 1998 Annual Meeting of Stockholders and is incorporated herein
by reference.
<PAGE>
 
                                    PART IV
                                    -------

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

(a)  The following documents are filed as part of the Annual Report on Form 10-
     K:

     1.   Financial Statements.  The following Consolidated Financial Statements
     of Credence Systems Corporation are included in Item 8 of this Annual
     Report on Form 10-K:

                                                                        Page
                                                                        ----
          Report of Ernst & Young LLP, Independent Auditors               29
          Consolidated Balance Sheets --                           
               October 31, 1997 and 1996                                  30
          Consolidated Statements of Income --                 
               Years Ended October 31, 1997, 1996 and 1995                31
          Consolidated Statements of Stockholders' Equity --       
               Years Ended October 31,1997, 1996 and 1995                 32
          Consolidated Statements of Cash Flows --                 
               Years Ended October 31,1997, 1996 and 1995                 33
          Notes to Consolidated Financial Statements                      34

     2.   Financial Statement Schedule. The following financial statement
     schedule of Credence Systems Corporation, for the years ended October 31,
     1997, 1996 and 1995, is filed as part of this Annual Report on Form 10-K
     and should be read in conjunction with the Consolidated Financial
     Statements of Credence Systems Corporation:

                                                                        Page
                                                                        ----
          Schedule II -- Valuation and Qualifying Accounts                50

     Schedules other than the one listed above have been omitted since they are
     either not required, are not applicable or the required information is
     shown in the consolidated financial statements or related notes.

     3.   Exhibits.  See Exhibit Index on page 51.
 
(b)  Reports on Form 8-K were filed during the last quarter of the fiscal year
     covered by this Annual Report on Form 10-K. Reports on Form 8-K were filed
     on September 4, 1997, September 9, 1997 and September 12, 1997.

(c)  See Exhibit Index on page 51.

(d)  The following financial statement schedule of Credence Systems Corporation,
for the years ended October 31, 1997, 1996 and 1995, is filed as part of this
Annual Report on Form 10-K and should be read in conjunction with the
Consolidated Financial Statements of Credence Systems Corporation:

                                                                         Page
                                                                         ----
          Schedule II -- Valuation and Qualifying Accounts                 50
 
     Schedules other than the one listed above have been omitted since they are
either not required, are not applicable or the required information is shown in
the consolidated financial statements or related notes.
<PAGE>
 
                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, on
January 26, 1998.


                                 CREDENCE SYSTEMS CORPORATION
                                 --------------------------------------------
                                         (Registrant)



                                 By: /s/ WILMER R. BOTTOMS
                                     ------------------------------------------
                                     Wilmer R. Bottoms
                                     Chairman of the Board of Directors and
                                     Chief Executive Officer
 
                                     /s/ JERRY BRUCE
                                     -------------------------------------------
                                     Jerry Bruce
                                     Vice President, Controller, Acting Chief
                                     Financial Officer and Secretary (Principal
                                     Financial and Accounting Officer)
<PAGE>
 
                               POWER OF ATTORNEY
                               -----------------

     KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Wilmer R. Bottoms and Jerry Bruce, and
each of them, as his true and lawful attorneys-in-fact and agents, with full
power of substitution and resubstitution, for him and in his name, place and
stead, in any and all capacities, to sign any and all amendments  to this Report
on Form 10-K, and to file the same, with all exhibits thereto, and other
documents in connection therewith, with the Securities and Exchange Commission,
granting unto said attorneys-in-fact and agents, and each of them, full power
and authority to do and perform each and every act and thing requisite and
necessary to be done in connection therewith, as fully to all intents and
purposes as he might or could do in person, hereby ratifying and confirming all
that said attorneys-in-fact and agents, or any of them, or their or his
substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
               SIGNATURE                                              TITLE                                       DATE
               ---------                                              -----                                       ----           
<S>                                          <C>                                                           <C>
/s/ WILMER R. BOTTOMS                        Chairman of the Board of Directors and                        January 26, 1998
---------------------------------------      Chief Executive Officer
Wilmer R. Bottoms                            
 
/s/ JERRY BRUCE                              Vice President, Controller, Acting Chief Financial            January 26, 1998
---------------------------------------      Officer and Secretary (Principal Financial and 
Jerry Bruce                                  Accounting Officer)                             
                                                                                             
/s/ HENK J. EVENHUIS                         Director                                                      January 26, 1998
---------------------------------------
Henk J. Evenhuis
 
/s/ WILLIAM G. HOWARD, JR.                   Director                                                      January 26, 1998
---------------------------------------
William G. Howard, Jr.
 
/s/ JOS C. HENKENS                           Director                                                      January 26, 1998
---------------------------------------
Jos C. Henkens
 
/s/ BERNARD V. VONDERSCHMITT                 Director                                                      January 26, 1998
---------------------------------------
Bernard V. Vonderschmitt
</TABLE>
<PAGE>
 
SCHEDULE II

                          CREDENCE SYSTEMS CORPORATION
                       VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                          Additions
                                                   Balance at             Charged to                                    Balance at
                                                   Beginning              Costs and                                        End
Description                                         of Year                Expenses              Write-offs              of Year
-----------                                         -------                --------              ----------              -------  
<S>                                                <C>                    <C>                    <C>                    <C>
 
Year ended October 31, 1997
   Allowance for doubtful accounts                   $1,781                   $762                   $780                  $1,763
                                           
Year ended October 31, 1996                
     Allowance for doubtful accounts                 $1,692                   $270                   $181                  $1,781
                                           
Year ended October 31, 1995                
     Allowance for doubtful accounts                 $1,472                   $360                   $140                  $1,692
</TABLE>
<PAGE>
 
                                 EXHIBIT INDEX
<TABLE>
<CAPTION>
 EXHIBIT
  NUMBER                                                                                                              
----------                                                                                                           
<C>         <S>                                                                                                      
  2.1(1)    Agreement and Plan of Merger dated October 5, 1993 between Credence Systems Corporation, a California
            Corporation, and the Company.
  2.2(1)    Asset Purchase Agreement dated December 31, 1990 between Tektronix, Inc. and the Company, including
            Amendment No. 1 to the Asset Purchase Agreement dated December 31, 1990.
  2.3(1)    Technology Agreement between Tektronix, Inc. and the Company dated December 31, 1990.
  2.4(1)    Letter Agreement between Tektronix, Inc. and the Company dated September 30, 1992.
  2.5(1)    Amendment Agreement dated as of August 12, 1993 between Tektronix, Inc. and the Company.
  2.6(1)    1990 Plan of Purchase Price Adjustment Recapitalization.
  2.7(1)    Letter Agreement between Tektronix, Inc. and the Company dated August 11, 1993.
  2.8(11)   Agreement and Plan of Reorganization dated as of February 6, 1994 among the Registrant, Semiconductor
            Test Solutions, Inc., EPRO and the shareholders of EPRO listed therein.
  2.9(18)   Asset Purchase Agreement, dated as of May 19, 1997, among Credence Systems Corporation, Test Systems
            Strategies, Inc., a Delaware corporation and wholly-owned subsidiary of Credence Systems Corporation,
            and Test Systems Strategies, Inc. an Oregon Corporation and wholly-owned subsidiary of Summit Design,
            Inc.
  2.10      Asset Purchase Agreement, dated as of August 20, 1997, among Zycad Corporation, a Delaware
            Corporation, its wholly owned subsidiary, Attest Software and Test Systems Strategies, Inc., a
            Delaware Corporation and wholly owned subsidiary of the Company.
  3.1(14)   Amended and Restated Certificate of Incorporation of the Company.
  3.2(1)    Bylaws of the Company.
  4.1(1)    Investor Rights Agreement dated October 15, 1989 by and among the Company and the investors listed
            therein, including Amendment Agreement to the Investor Rights Agreement dated June 15, 1990, Second
            Amendment Agreement to the Investor Rights Agreement dated September 30, 1992, the Third Amendment
            Agreement to Investor Rights Agreement dated August 8, 1993 and the Fourth Amendment Agreement to
            Investor Rights Agreement dated March 10, 1994.
  4.2(10)   Fifth Amendment Agreement to the Investor Rights Agreement dated May 26, 1995.
  4.3(19)   Purchase Agreement between the Company and Smith Barney, Inc. for purchase of $115,000,000  5 1/4%
            Convertible Subordinated Notes due 2002, dated September 4, 1997.
  4.4(19)   Indenture between the Company and State Street Bank and Trust Company of California, N.A., as Trustee
            dated September 10, 1997.
  4.5(19)   Form of 5 1/4% Convertible Subordinated Note due 2002.
  4.6(19)   Registration Rights Agreement between the Company and Smith Barney, Inc. dated as of September 4, 1997.
 10.1(1)    Form of Indemnification Agreement Between the Company and each of its officers and directors
 10.2(1)    Underwriting Agreement dated October 28, 1993 by and among the Company and the underwriters named
            therein.
 10.3(4)    Underwriting Agreement dated March 31, 1994 by and among the Company and the underwriters named
            therein.
 10.4(10)   Underwriting Agreement dated June 14, 1995 by and among the Company and the underwriters named therein.
</TABLE> 
<PAGE>
 
<TABLE> 
<CAPTION>
 EXHIBIT
  NUMBER                                                                                                              
----------                                                                                                          
<C>         <S>                                                                                                     
 10.5(1)    Industrial Space Lease between Renco Investment Company and the Company dated August 12, 1992
            including the First Addendum dated August 14, 1992, Option to renew Lease dated August 14, 1992, First
            Amendment to Lease dated October 22, 1992 and Acceptance Agreement dated November 25, 1992.
 10.6(1)    Indenture (lease agreement) between Pen Nom I Corporation and the Company dated April 3, 1991,
            including the First Amendment to Lease dated August 16, 1991, the Second Amendment to Lease dated
            December 10, 1991, the Third Amendment to Lease dated August 7, 1992, the Fourth Amendment to Lease
            dated October 13, 1992 and the Fifth Amendment to Lease dated November 15, 1993.
 10.7(1)    Master Equipment Lease Agreement between the Company and Financing for Science and Industry, Inc.
            dated February 26, 1993.
 10.8(6)    Settlement Agreement between MCT and the Company dated May 9, 1994.
 10.9(7)    Leaseline Agreement between Comdisco and the Company dated July 29, 1994.
 10.10(2)   Indemnification and Security Agreement between Credence Capital Corporation and the Company dated
            October 28, 1994.
 10.11(4)   Stock Transfer Agreement by and among the Company, Richard Cann, Rene Verhaegen and Credence Europa
            Limited dated as of February 28, 1994.
 10.12(4)   Secured Line of Credit Agreement between Credence Europa Limited and the Company dated as of February
            28, 1994.
 10.13(9)   Lease by and between the Company and The Mutual Life Insurance Company of New York dated June 16, 1995.
 10.14(13)  First Amendment to Lease by and between the Company and The Mutual Life Insurance Company of New York
            dated December 29, 1995.
 10.15(14)  Loan and Security Agreement between the Company and Silicon Valley Bank and Comerica Bank-California
            dated April 28, 1995, as amended.
 10.16(12)  Domestic and International Master Agreement for Purchase of Equipment and Product Support between the
            Company and Comdisco, Inc., dated January 31, 1995.
 10.17(13)  Employment Agreement by and between the Company and Elwood H. Spedden dated October 31, 1995.
 10.18(14)  Master Lease Purchase Agreement, Lease Purchase Closing Schedule and Lease Purchase Addendum No. One
            between Metlife Capital Corporation and the Company dated April 30, 1996.
 10.19(15)  Loan Agreement among Silicon Valley Bank, Bank of Hawaii and the Company, dated July 26, 1996.
 10.20(16)  License Agreement between the Company and Kinetix Test Systems, LLC, dated July 31, 1996.
 10.21(16)  Lease Agreement between Petula Associates, Ltd and Koll Portland Associates, dba KBC - Tigard II and
            the Company dated September 12, 1995.
 10.22(16)  Sixth Amendment to Lease by and between the Company and Pen Nom I Corporation dated March 10, 1995.
 10.23(18)* Software OEM License Agreement between the Company, Test Systems Strategies, Inc. and Summit Design,
            Inc. dated May 19, 1997.
 10.24(18)  Joint Venture Agreement dated June 10, 1997, between the Company and Innotech Corporation.
 11.1       Statement of Computation of Net Income per Share.
 21.1       Subsidiaries of the Company.
</TABLE> 
<PAGE>
 
<TABLE> 
<CAPTION>
 EXHIBIT
  NUMBER                                                                                                              
----------                                                                                                          
<C>         <S>                                                                                                     
 23.1       Consent of Ernst & Young LLP, Independent Auditors.
 24.1       Power of Attorney (reference is made to page 49 of this report).
 27.1       EDGAR Financial Data Schedule.
 99.1(20)   1993 Stock Option Plan
 99.2(20)   Form of Notice of Grant to be generally used in connection with the 1993 Stock Option Plan.
 99.3(20)   Form of Stock Option Agreement to be generally used in connection with the 1993 Stock Option Plan.
 99.4(20)   Addendum to the Stock Option Agreement (Special Tax Elections).
 99.5(20)   Addendum to the Stock Option Agreement (Limited Stock Appreciation Rights).
 99.6(20)   Addendum to the Stock Option Agreement (Change in Control).
 99.7(20)   Addendum to the Stock Option Agreement (Financial Assistance).
 99.8(20)   Form of Notice of Grant of Stock Option (Non-Employee Director) to be generally used in connection
            with the automatic option grant program of the 1993 Stock Option Plan.
 99.9(20)   Form of Stock Option Agreement (Non-Employee Director) to be generally used in connection with the
            automatic option grant program of the 1993 Stock Option Plan.
 99.10(17)  Employee Stock Purchase Plan
 99.11(8)   Compensation Agreement between the Company and Jos C. Henkens, dated November 5, 1993.
 99.12(8)   Compensation Agreement between the Company and Wilmer R. Bottoms, dated November 5, 1993.
 99.13(8)   Compensation Agreement between the Company and Robert F. Kibble, dated November 5, 1993.
 99.14(8)   Compensation Agreement between the Company and Bernard V. Vonderschmitt, dated November 5, 1993.
 99.15(8)   Compensation Agreement between the Company and Henk J. Evenhuis, dated November 4, 1993.
 99.16(18)  Form of Stock Purchase Agreement
 99.17(18)  Form of Enrollment/Change Form
</TABLE>
_____________________
       (1)  Incorporated by reference to an exhibit to the Company's
            Registration Statement on Form S-1 (Registration No. 33-68438) as
            amended.
       (2)  Incorporated by reference to an exhibit to the Company's 1994 Annual
            Report on Form 10-K (Commission File No. 0-22366).
       (3)  Incorporated by reference to an exhibit to the Company's
            Registration Statement on Form S-8 (Registration No. 33-71856).
<PAGE>
 
       (4)  Incorporated by reference to an exhibit to the Company's
            Registration Statement on Form S-1 (Registration No. 33-76264) as
            amended.
       (5)  Incorporated by reference to an exhibit to the Company's
            Registration Statement on Form S-8 (Registration No. 33-76542).
       (6)  Incorporated by reference to an exhibit to the Company's Quarterly
            Report on Form 10-Q (Commission File No. 0-22366) for the quarterly
            period ended April 30, 1994.
       (7)  Incorporated by reference to an exhibit to the Company's Quarterly
            Report on Form 10-Q (Commission File No. 0-22366) for the quarterly
            period ended July 31, 1994.
       (8)  Management contract or compensatory plan filed pursuant to Item
            14(c).
       (9)  Incorporated by reference to an exhibit to the Company's Quarterly
            Report on Form 10-Q (Commission File No. 0-22366) for the quarterly
            period ended July 31, 1995.
      (10)  Incorporated by reference to an exhibit to the Company's
            Registration statement on Form S-3 (Registration No. 33-92802), as
            amended.
      (11)  Incorporated by reference to an exhibit to the Company's Current
            Report on Form 8-K as filed with the Commission on March 29, 1995,
            as amended on May 26, 1995.
      (12)  Incorporated by reference to an exhibit to the Company's Quarterly
            Report on Form 10-Q (Commission File No. 0-22366) for the quarterly
            period ended April 30, 1995.
      (13)  Incorporated by reference to an exhibit to the Company's 1995 Annual
            Report on Form 10-K (Commission File No. 0-22366).
      (14)  Incorporated by reference to an exhibit to the Company's Quarterly
            Report on Form 10-Q (Commission File No. 0-22366) for the quarterly
            period ended April 30, 1996.
      (15)  Incorporated by reference to an exhibit to the Company's Quarterly
            Report on Form 10-Q (Commission File No. 0-22366) for the quarterly
            period ended July 31, 1996.
      (16)  Incorporated by reference to an exhibit to the Company's 1996 Annual
            Report on Form 10-K (Commission File No. 0-22366).
      (17)  Incorporated by reference to an exhibit to the Company's Quarterly
            Report on Form 10-Q (Commission File No. 0-22366) for the quarterly
            period ended April 30, 1997.
      (18)  Incorporated by reference to an exhibit to the Company's Quarterly
            Report on Form 10-Q (Commission File No. 0-22366) for the quarterly
            period ended July 31, 1997.
      (19)  Incorporated by reference to an exhibit to the Company's
            Registration Statement on Form S-3 (Registration No. 333-39387) as
            amended.
      (20)  Exhibits 99.1 through 99.9 and Exhibit 99.16 and 99.17 are
            incorporated herein by reference to identically numbered exhibits
            included in the Company's Registration Statement on Form S-8 (File
            No. 333-27499) declared effective with the Securities and Exchange
            Commission on May 20, 1997.

    *       Confidential treatment has been granted for certain portions of this
            exhibit.