<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
                                  ___________
                                   Form 10-K

   FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(k) OF THE SECURITIES EXCHANGE  ACT OF
               1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998

                                  -----------

Commission file number: 0-20215

                           MICROTOUCH SYSTEMS, INC.
            (Exact name or registrant as specified in its charter)
                                  ___________

Massachusetts                                       04-2802971
-------------                                       ----------
(State or other jurisdiction of          (I.R.S. Employer Identification No.)
incorporation or organization)

300 Griffin Park                                        01844
Methuen, MA                                             -----
-----------                                          (Zip Code)
(Address of principal executive offices)                                     


                                (978) 659-9000
                                --------------
             (Registrant's telephone number, including area code)

       Securities registered pursuant to Section 12 (b) of the Act: None

Securities registered pursuant to Section 12 (g) of the Act: Common Stock, $0.01
                                   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 check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.[ ]

The aggregate market value of voting stock held by nonaffiliates of the
registrant as of January 8, 1999, was approximately $92,660,000 (based on the
last price of such stock as reported by NASDAQ Stock Market on such date).

The number of shares outstanding of each of the registrant's classes of capital
stock, as of  January 8, 1999 was:
                Common Stock, $0.01 par value                   7,296,651

Portions of the Registrant's proxy statement for the Annual Meeting of
Stockholders to be held June 24, 1999 are incorporated by reference into Part
III of this Form 10-K.

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ITEM I    BUSINESS
          --------

General

     MicroTouch Systems, Inc. (the "Company" or "MicroTouch") is a leading
supplier of touch and pen sensitive input systems including touchscreens and
electronic whiteboards. The Company's principal products are its touch sensitive
screens, which are based on the Company's two primary technologies - analog
capacitive sensing (referred to as ClearTek(R)) and resistive membrane (known as
TouchTek/(TM)/). In both the capacitive and resistive membrane cases, the
screens are configured to CRT monitors and flat panel displays. The Company
believes its touchscreens are well suited for a wide variety of markets and
applications where ease of use, speed, accuracy and durability are desirable.

     Over the last decade, the use of personal computers has grown in a wide
range of applications. As a result, demand has increased for products that make
these systems more accessible to a broader range of users. For example, the
development of graphical user interfaces ("GUIs"), such as Microsoft Windows,
has allowed information to be displayed in an easy to understand graphic manner.
Touch products address this demand by allowing both trained and untrained
computer users to interact with computers in a natural and intuitive manner.

     Touchscreens allow individuals to access information and interact with a
computer simply by touching the computer's screen with a finger. Because
pointing is a natural instinct, touch screens offer a highly intuitive computer
interface. Touchscreens are designed to allow users to interact with their
system without the use of a keyboard, mouse or trackball. Accordingly, the ease
of use offered by touchscreen-based systems makes them well suited both for
applications for the general public and for specialized applications for trained
computer users.

     The Company has expanded its product line primarily through internal
development as well as acquisitions in the past. Technologies acquired through
acquisition include kiosk and resistive membrane technology. Over the past three
years, the Company has developed and begun marketing a new product referred to
as an electronic P.C. whiteboard. This new product, marketed under the trademark
of Ibid, allows the user to write or draw information on a whiteboard and then
to electronically view and transfer the written information to a desktop or
notebook P.C.

     The discussion contained in this section and elsewhere in this Annual
Report on Form 10-K may contain forward-looking statements based on the current
expectations of the Company's management. Such statements are subject to certain
risks and uncertainties, which could cause actual results to differ materially
from those projected. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof. The Company
undertakes no obligation to publicly release the result of any revisions to
these forward-looking statements, which may be made to reflect events or
circumstances occurring after the date hereof or to reflect the occurrence of
unanticipated events.

Strategy

     MicroTouch's objective is to be the leading worldwide supplier of touch
products and to exploit opportunities in other touch and related markets through
the development and acquisition of complementary technologies and product lines.
The key elements of the Company's strategies are as follows:

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     Focus on Vertical Markets. The Company's strategy for its touch products is
to focus on vertical markets in which the Company believes touch technology
offers significant benefits and appeals to a broad customer base. The Company's
sales force is organized into geographic territories that focus on customers
within these distinct vertical markets. In addition, specialized experts exist
within the sales force for several of the vertical markets including point-of-
sale cash registers, interactive kiosks, medical applications, mobile
information devices and gaming and entertainment equipment.

     Target Developers of End User Applications.  The Company directs its sales
efforts for its touch products toward original equipment manufacturers (OEMs),
value added resellers (VARs), system integrators and high-volume end users,
which the Company believes are best able to develop and market applications for
the Company's targeted vertical markets.  The Company seeks to have its products
designed into the end user systems or products of these customers.

     Provide Flexible Product Offerings.  The Company works closely with its
customers to understand their businesses and product requirements.  The Company
offers its ClearTek and TouchTek touchscreens, and TouchPen sensors in a variety
of standard and customized configurations to meet the diverse needs of the
markets which it serves.  The ThruGlass products which allows for gloved touch
operation of a computer through up to an inch of glass, can also be customized
to meet the requirements of emerging end user applications.  The Company's
Factura kiosk products are offered in both standard off-the-shelf format, as
well as in customized versions.

     Enhance and Expand Technology.  The Company's traditional technology is its
proprietary analog capacitive sensing technology. MicroTouch seeks to improve
its products by enhancing this technology through the development of new glass
coating techniques, custom ASICs, controllers, software algorithms and software
drivers. The Company also seeks to develop new technologies through internal
development, licensing or acquisitions. The Company has developed TouchPen, a
touch and stylus sensitive device used for pen-based applications. The Company
is also continuing to market ThruGlass, which allows touch to be sensed through
other conductive media. During the past year, the Company has significantly
enhanced its resistive membrane technology through product development programs
similar to those undertaken for the capacitive product line. Finally, the
electronic whiteboard product was developed based on resistive technology
obtained in the 1995 Touch Technology acquisition, a business engaged in the
development and marketing of touch sensitive sccreens primarily using resistive
membrane technology.

     Pursue New Market Opportunities.  The Company is currently applying its
existing technologies to new market opportunities where it believes these
technologies can have significant growth potential. These opportunities include
consumer devices for resistive technology and, with respect to TouchPen
applications, use for pen computing, videoconferencing and image manipulation in
interactive kiosks, a market in which the Company also offers its Factura
products.

     Expand International Markets.  The Company has increased its international
presence through the opening of foreign sales offices and manufacturing
facilities. The Company currently has touchscreen sales and manufacturing
facilities in the United Kingdom and Australia and sales offices in France,
Germany, Italy, Spain, Japan, Taiwan, Korea and Hong Kong. The Company's
international sales, including U.S. export sales, increased from $36.2 million
in 1996 to $57.4 million in 1997 and to $71.4 million in 1998.


Technology

     Analog Capacitive Technology.  The Company's primary touchscreen technology
is its proprietary analog capacitive sensing technology. This technology creates
a uniform voltage field on the conductive surface of the touch sensor. When a
finger comes into capacitive contact with the conductive layer, it draws a small

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amount of current to the point of contact. A controller attached to the
conductive surface determines the point of contact by measuring the relative
current flows from the four corners of the surface.

     The Company implements this technology on a glass panel that has a
transparent conductive coating fused to its surface. In most of the Company's
products, a proprietary glass overcoat is then laid over the conductive coating
for additional protection. The conductive glass panel, or sensor, is driven at
its four corners by an A/C sine wave voltage which is dispersed linearly over
the sensor by an electrode pattern located on the perimeter of the sensor. When
a user touches the screen, the controller determines the point of contact and
transmits the location to the computer for processing.

     The Company's analog capacitive sensing technology has many favorable
attributes, including:

     High Touch Sensitivity. Because the Company's touchscreens rely on
capacitive contact rather than activation by pressure, they offer a high degree
of sensitivity to input from a finger. This is important in applications
characterized by continuous usage such as cash registers, where a requirement to
exert pressure on the screen might be uncomfortable over time and slow down
input and, therefore, customer service.

     Fast Touch Speed.  The Company's proprietary software algorithms enable the
controller to detect quickly a touch on the screen.  This capability can enable
operators of products such as touch-based cash registers to input numbers as
quickly as they could using buttons or keypads.

     High Resolution.  The Company's touch screens have a resolution of at least
1,024 by 1,024 points. Because the controller averages the entire area of finger
contact and reports a single point, even a finger is able to obtain pixel-level
control of the cursor on a display. This resolution allows for the creation of
detailed menus and greater flexibility in screen design.

     Resistant Properties.  The capacitive nature of the Company's touchscreens
allows them to function unimpaired even when contaminants such as water, dirt or
grease build up on the surface. This is an important feature in factory
environments, public locations and restaurants. 

     Durability.  With its proprietary glass overcoat, the Company's
touchscreens are scratch, wear and chemical resistant. In addition, the glass
sensor may be optically bonded to the computer screen in a process designed to
give structural support to the screen. Durability is an important feature in
applications such as entertainment and point of sale, which are characterized by
frequent use.

     Ease of Integration.  The Company's glass sensors are easily fabricated
into a variety of shapes and sizes and are readily installed in displays in a
manner that results in a professional looking fit and finish.

     Resistive Membrane Technology.  The Company's TouchTek "resistive membrane"
technology has several attributes that are similar to those of its capacitive
systems. TouchTek screens work by creating a uniform voltage field on a glass
substrate. When a plastic top sheet is compressed into contact with the glass
layer, current is drawn from each side of the glass layer in proportion to the
distance from the edge. An electronic controller calculates the position of the
finger based on the current flows. Some of the Company's resistive products fall
into a category known as 5-wire resistive and the Company has recently placed
more emphasis on offering 4-wire resistive products for certain specialty
consumer device applications as customer requirements dictate.

     ThruGlass Technology.  MicroTouch's ThruGlass technology operates by
projecting voltage fields out from the conductive surfaces of transparent glass
connected to a controller. When an individual touches the window in front of the
projected capacitive touchscreen, minute changes in the voltage field are
detected and the touch is assigned to a location on the sensor.

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     TouchPen Technology.  TouchPen utilizes a modified form of the Company's
analog capacitive technology to sense both a finger and a pen touch.  TouchPen's
controller is able to electrically distinguish the hand from the pen signal,
allowing it to reject the hand signal when writing.  The touch performance of
TouchPen is equal to the Company's analog capacitive ClearTek product, while the
pen offers even higher resolution of 2,048 by 2,048 to capture handwriting.

     There are several alternative touch technologies currently in use by other
manufacturers. These technologies include (i) resistive membrane products
similar to the Company's; (ii) scanning infrared, which uses a grid of infrared
beams; (iii) surface acoustic wave or "SAW" screens, which are based on the
transmission of acoustic waves across a glass overlay; (iv) guided acoustic wave
or "GAW" screens, which are based on the transmission of acoustic waves through
a glass surface; and (v) piezo technology, in which piezo, or pressure, sensors
convert touch forces into electrical signals.
 

Products

     Markets, Applications and Customers

     The Company sells its products into a variety of markets, including self-
service kiosks, point of information displays, point of sale equipment, gaming
and entertainment systems, industrial and medical systems and training and
business systems.  Specific customer applications include; airline and movie
theatre ticketing, exhibits and trade shows, tourist information centers, museum
exhibit guides, restaurant and merchandise cash registers, customer self
service, casino video gaming machines, bartop entertainment gaming, children's
entertainment kiosks, process control, video banking and ATM's, financial
trading and portable information devices.

     Touchscreens

     The Company's principal product line over the last several years has been
the ClearTek 2000 Touch Screen. The Company recently introduced its next
generation capacitive product, the ClearTek 3000 touchscreen, in a variety of
configurations, including kits comprised of touch sensors and controllers or
chipsets, and fully configured touchscreen monitors. In addition, the Company
customizes its products to accommodate particular customer needs.

     The new ClearTek 3000 Touch Screen system has a resolution of 1,024 by
1,024 points and interprets the entire area of touch contact as a single point,
giving a finger the ability to select targets as small as a single pixel. The
screen detects a touch in as little as 8-12 milliseconds making it fast in
operations such as hitting buttons on a touchscreen-based cash register. The
TouchTek resistive touchscreen systems utilize a conductively coated plastic top
sheet over a conductively coated and rigid bottom sheet, usually glass.
Resistive kits are configured similarly to capacitive kits. The principal
elements of both the ClearTek 3000 and the TouchTek product lines include the
following:

     Sensors.  The Company's glass sensors, which are installed on the face of
computer screens, are offered in a large number of curved and flat screen sizes,
as well as in custom sizes. Screens may be optically bonded to monitors through
a process developed by the Company to fill the space between the touchscreen and
the monitor with a transparent bonding compound. Optically bonded sensors
increase optical clarity and provide greater structural support. The Company's
ClearTek sensors are overcoated with the Company's exclusive glass top-coating
for added durability and optical clarity.

                                       5
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     Controllers.  Controllers offered by the Company have USB, serial, PC bus,
ADB or TTL interfaces and will operate with any of the Company's touchscreens.
Capacitive chipsets, which include a proprietary ASIC, are sold to larger volume
OEMs for incorporation into the electronics of their systems.

     Software Drivers and Tools.  GUI drivers and software tools provided by the
Company include an MS-DOS mouse emulator; Windows, OS/2, Macintosh, Windows NT,
Amiga, and various UNIX drivers; and an MS-DOS software tool for creating and
defining touch zones.

     Options.  The Company sells a variety of options and accessories, including
power supplies, cables and privacy shields, and also offers retrofitting and
optical bonding services.

     Touch Enabled Monitors
 
     The Company also sells several lines of fully integrated standard monitors
which range in size from 13 to 25 inches and support popular graphics standards.
These monitors are typically purchased from display manufacturers and equipped
by the Company with an optically bonded sensor and a controller. The Company
also provides integration services for monitor customers.

     Electronic Whiteboard

     The Company markets a line of electronic PC whiteboards including both
personal (2 foot by 3 foot) boards as well as larger (3 foot by 4 foot and 4
foot by 6 foot) conference room boards. The Company's electronic whiteboard
product is a variation of the resistive membrane technology used in the TouchTek
line.


Sales and Marketing

     MicroTouch markets and sells its touch products primarily through VARs,
OEMs and systems integrators, and to high volume end-users. The Company employs
a direct sales force for domestic sales and supports its marketing efforts with
trade show attendance, telemarketing, advertising and public relations.

     As of December 31, 1998, the Company's sales and support function consisted
of 134 persons. The sales force is organized into several geographic sales
groups, each focusing on a separate set of regional customers, and is augmented
by several vertical market specialists.

     The Company markets its touch products in Europe through its U.K.
subsidiary, MicroTouch Systems, Ltd. MicroTouch Systems, Ltd. sells through
various European distributors and sells direct in the U.K., Germany, France,
Spain and Italy. This subsidiary also assembles touch monitors from touchscreen
kits exported from the U.S. and monitors purchased in Europe. During 1996, the
Company established a direct sales office in Italy and an office was established
in Spain in 1998. In Japan, the Company sells its products through MicroTouch
Systems, KK. In 1994 MicroTouch established a direct sales and manufacturing
presence to serve the Australian and New Zealand touchscreen markets providing a
base from which to continue sales of MicroTouch products primarily to the
Australian gaming market. The Company opened a sales office in Taiwan in 1995
and in Korea and Hong Kong in 1997. The Company's total international sales,
including U.S. export sales, accounted for approximately 38%, 45% and 49% of
total sales in 1996 ,1997 and 1998, respectively.

     The Company plans to continue to increase its sales presence, both
domestically and overseas, in an effort to broaden its potential customer base
and to intensify its efforts in its targeted markets.  As part of this plan, the
Company intends to increase its worldwide sales force and add additional
distributors and agents.

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     The Company offers a 30-day money back guaranty on its touchscreen products
to first-time buyers. This offer pertains only to the first unit purchased and
is void if the unit is altered by the customer in any way. Additionally, the
Company generally replaces products not meeting its specifications that are
returned by any customer within 30 days of receipt. The Company provides
reserves for estimated returns and believes that such reserves are adequate. The
amount of product returns was approximately $4.1 million, $4.5 million and $4.9
million for the years ended December 31, 1996, 1997 and 1998, respectively.
While the Company believes that its reserves for product returns are adequate,
there can be no assurance that the Company will not experience increased product
returns. Any such increase in product return claims could have a material
adverse effect on the Company's results of operations.

     The Company's customers generally provide direct support to end users for
the Company's products while MicroTouch, in turn, supports its resellers with
application engineers and phone support from its customer service group of
trained technicians. The Company typically offers its customers a product
warranty of up to five years. While the Company believes that its reserves for
warranty claims are adequate, there can be no assurance that the Company will
not experience increased warranty claims. Any such increase in warranty claims
could have a material adverse effect on the Company's results of operations.

Research and Development

     The Company's future success depends in large part upon the timely
enhancement of existing products and the continued development of new products
to address new market opportunities. Accordingly, the Company intends to
continue to devote significant resources to increasing the performance of its
existing products, especially its capacitive technology, developing new products
from its existing technologies and developing new technologies. The Company has,
in the past, augmented and may continue to augment its research and development
efforts through the acquisition or licensing of new technologies. The Company's
research and development efforts in the touch screen area are primarily focused
on expanding the range of configurations offered, enhancing product features,
expanding the capability of drivers to interact with different types of computer
operating systems and refining existing products to increase manufacturing
efficiency and reduce costs. The Company's development efforts are also directed
toward improving the product features and enhancing the underlying technology of
its various product lines. There can be no assurance that the Company will
successfully complete such development efforts or that these product
developments will achieve market acceptance.

     As of December 31, 1998, 75 full-time employees of the Company were engaged
in research and development activities. In addition, the Company frequently
engages independent consultants to supplement its own research and development
efforts and to gain access to expertise in specific technical areas.

Proprietary Rights and Licenses


     The Company relies on a combination of patents, trade secrets and know how
to establish and protect its proprietary rights.

     The Company acquired exclusive rights to its core analog capacitive
technology under a worldwide license from Peptek, Inc. and its affiliate, Mr.
Jim Zeeger (the "Peptek License"). Under the Peptek License, the Company has the
exclusive right to use all technology covered by the patent claims in the
manufacture and sale of the Company's touchscreen and similar products. The
patents licensed under the Peptek License include claims of rights to the
configuration of the electrodes installed around the perimeter of the glass
sensor of a touchscreen and in the method used to determine the point of finger
contact on the surface of the glass sensor. The Peptek License requires the
Company to pay royalties based on annual product sales and sublicensing revenues
and includes minimum royalty payment provisions. The Peptek License may be
terminated by the

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licensor only in the event of a breach of the license agreement by the Company,
which is not remedied within applicable cure periods and in the event of the
Company's bankruptcy.

     MicroTouch holds exclusive rights to the patents covering its core
proprietary technology until the respective expiration dates of such patents,
which currently range from 1999 to 2015. The Company also owns certain other
patents and patent applications, related primarily to improvements on, and
extensions of, its core technology, as well as certain software algorithms used
with the Company's products. Two of the Company's patents expired in 1998. The
first is one of two which covers the configuration of the electrodes installed
around the perimeter of the glass sensor used in the Company's analog capcitive
products. The other perimeter patent expires in the year 2000. The second patent
which expired in 1998 covered a video game apparatus, which is not currently
used in the Company's products. Several other patents related to the Company's
core analog capacitive technology will expire during the period from 1999 to
2000. Although the Company has developed considerable know-how and has
substantial experience in the field of analog capacitive technology, which it
believes will enable the Company to compete effectively in the future, the
expiration of patents covering the Company's core proprietary technology during
the next several years may lead to the development by third parties of products
that are competitive with those of the Company. The successful development and
marketing by third parties of competitive products could have a material adverse
effect on the Company's business, financial condition and results of operations.

     The Company acquired exclusive rights to use its ThruGlass proprietary
technology in the touchscreen field, including rights under pending patent
applications, under a worldwide license from Moonstone Designs, Ltd. (the
"Moonstone License"). Under the Moonstone License, the Company has the exclusive
right to use all technology covered by the claims of any patent that may issue
in the manufacture and sale of the Company's projected capacitive products.
There can be no assurance that such patents will issue or that the claims under
such patents may not be reduced from the claims in the patent applications.

     The Company acquired exclusive rights to use certain force based
proprietary technology in the touchscreen field, including rights under three
patents, under a worldwide license. The Company has the exclusive right to use
all technology covered by the claims of the patents in the manufacture and sale
of the Company's projected capacitive products.

     Other rights held by the Company include nonexclusive rights to use its
resistive technology, including rights under several patents acquired in 1995.
In addition, two patents have been granted and applications for two additional
U.S. patents on various technology related to whiteboard products have been
submitted.  The Company was also granted three patents covering software for
Internet public access computers and kiosks during 1998.

     The Company typically requires persons such as customers, licensees and
employees who have access to proprietary information concerning the Company's
products to sign nondisclosure agreements that prohibit the use of the Company's
proprietary information other than for the specific purpose for which it was
provided.

     Other companies are engaged in the development of technologies that may
result in products competitive with those made by the Company. These development
efforts may result in proprietary technology, and possibly patents, that could
impair the value of, or render obsolete, technology owned or licensed by the
Company. Furthermore, there can be no assurance that any patent owned or
licensed by the Company will withstand challenges or otherwise provide the
Company with adequate protection from competitors, or that the Company will be
able to afford the expense of enforcing these patents.

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Manufacturing

     MicroTouch's touchscreen manufacturing operations consist primarily of the
procurement of glass (coated and fabricated to its specifications) and the
manufacture of touch sensors from that glass, the procurement and testing of
electrical components specified or designed by MicroTouch, and the assembly,
including optical bonding, of completely integrated touchscreen monitors.  The
majority of the manufacturing activities for both analog and resistive
touchscreens are performed at the Company's principal facility in Methuen,
Massachusetts.  The Company also exports touchscreen kits to its foreign
operations for final integration with monitors for distribution in Europe,
Japan, the Pacific Rim and Australia.  Factura's kiosk manufacturing operations
consist primarily of the custom design and manufacture of kiosk enclosures
according to customer specifications. The kiosk manufacturing activities are
performed at the Factura facility in Rochester, New York. In addition, certain
resistive products are manufactured in Austin, Texas on a special project basis.

     Although the Company generally uses standard parts for its products,
certain components, such as ASICs and the coated glass used in the production of
touch sensors are currently available only from a single source. In the event
that suppliers are unable to fulfill the Company's requirements, the resulting
interruption in production would have an adverse impact on the Company's
operating results. The Company maintains an inventory of ASICs, coated glass and
other components in order to limit the potential impact of such interruptions.
While the Company believes that there are other companies that are capable of
manufacturing these sole source components, the inability to obtain sufficient
components as required, or to develop alternative sources if and when needed,
would adversely affect the Company's operating results.


Competition

     The markets for touch products are highly competitive and subject to rapid
technological change.  The Company believes that the principal competitive
factors in its markets are product characteristics such as touch performance,
durability, optical clarity and price, as well as supplier characteristics such
as quality, service, delivery time and reputation.  The Company believes that it
competes favorably with respect to these factors, although there can be no
assurance that the Company will be able to continue to compete successfully in
the future.

     The Company faces competition from several established touch product
vendors as well as a number of smaller companies. Some of these competitors
utilize analog capacitive sensing and resistive membrane technologies similar to
the Company's technologies. Two of the Company's principal touchscreen
competitors, Elo Touch Systems, Inc., a subsidiary of Raychem Corporation, and
Carroll Touch Technology, a subsidiary of AMP Incorporated, are operating
divisions of larger, diversified industrial companies with greater financial,
technical, manufacturing and marketing resources than the Company. Elo Touch
Systems markets touchscreens based primarily on resistive and surface acoustic
wave technology, and Carroll Touch Technology markets touchscreens based
primarily on infrared and guided acoustic wave technology. In addition, several
manufacturers, most notably IBM, have developed proprietary touchscreen products
in the past but are not currently marketing proprietary products. In the market
for pen-based computers, the Company's TouchPen product competes with digitizers
marketed by several companies and could compete with products that may be
developed in the future by manufacturers that have more significant resources
than the Company. While the Company believes that its Factura division is the
largest U.S. supplier of kiosk enclosures for touchscreens, the kiosk market is
quite fragmented and market share data is not readily available. Products
similar to ThruGlass are marketed by at least one competitor to the Company,
especially in the European market. Several other companies market electronic
whiteboard products similar to those of the Company.

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Backlog

     The Company maintains most standard products in inventory and manufactures
other standard, modified standard and custom products pursuant to orders from
customers.  Backlog consists of orders for products, which have a scheduled
shipment date within twelve months of the order.  Because a large percentage of
the Company's orders require products to be shipped in the same quarter in which
the order was received, and because orders in the backlog may be canceled and
delivery schedules may be changed, the Company's backlog at any particular date
is not necessarily indicative of actual sales for any succeeding period.  As of
December 31, 1997 and 1998, the Company had a backlog of $24.0 million and $23.3
million, respectively.

Employees

     As of December 31, 1998, the Company had 833 full-time employees, of which
522 were engaged in manufacturing, 160 were in sales, marketing and customer
service and 75 were in research and development. The Company considers its
relations with its employees to be good.


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

     The Company leases approximately 96,000 square feet of office, engineering
and manufacturing space located at 300 Griffin Park, Methuen, Massachusetts. The
lease covering these properties expires in April 2003. In addition, the Company
is leasing approximately 78,000 square feet in Rochester, New York, the lease
for which expires in November, 2002. The Company also leases an aggregate of
approximately 89,000 square feet of additional space at its other  locations
including those in the U.K., France, Germany, Italy, Japan, Australia, Spain,
Hong Kong and Taiwan.

     During 1998 the Company expanded the building it owns, which is adjacent to
the Methuen, Massachusetts corporate headquarters.  This facility now has 70,000
square feet of space and houses its' information technology function,
administrative staff and additional touchscreen manufacturing and warehouse
space.

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

The Company had been involved in an international arbitration entitled
MicroTouch Systems, Inc. v. Nissha Printing Co. Ltd. ("Nissha"), which was under
the auspices of the International Chamber of Commerce ("ICC").  The case was
based on the Company's claims that Nissha breached non competition provisions
and other terms of a distribution agreement between the Company and Nissha.

     In January 1997, the Company was informed that while it had won the case
based on the merits of its claims, any recovery of damages was time barred under
the terms of the original agreement between the two parties in the dispute. As a
result, the Company was required to pay a portion ($595,000) of Nissha's fees
and costs associated with the arbitration. The Company expensed these fees and
costs awarded to Nissha as part of its second quarter 1997 financial results.

     During the period from mid 1995 to early 1997, the Company was involved in
a case entitled Elo Touch Systems, Inc. v. The Graphics Technology Company,
Inc., MicroTouch Systems, Inc. et al, which was in the United States District
Court in Knoxville, Tennessee. The case arose from claims by Elo Touch Systems
("Elo") that The Graphics Technology Company, Inc. (the predecessor to the
Company's Touch Technology business) manufactured and sold, and that the Company
intended to manufacture and sell in the future, certain products which infringe
certain patent rights held by Elo. This case was settled by a cross-licensing
agreement reached among the parties during 1997.

                                       10
<PAGE>
 
The Company was a plaintiff in a pending case entitled MicroTouch Systems, Inc.
and Peptek, Inc. v. Elo Touch Systems, Inc. which was in the United States
District Court in Knoxville, Tennessee.  The case arose from claims by the
Company and Peptek, Inc. ("Peptek") that Elo manufactured and sold products that
infringed certain patent rights held by Peptek and exclusively licensed to the
Company.  This case was settled by a cross-licensing agreement reached among the
parties during 1997.

The Company is a defendant in a case entitled Behne v. MicroTouch Systems, Inc.,
which is in the United States District Court in the Northern District of
California. The case arose from claims by Ms. Behne, a former employee of
MicroTouch that the Company had discriminated against her during her employment
at the Company. The case is scheduled for hearing in late February/early March,
1999. The Company believes that the claims are without merit but no assurances
can be given as to the outcome of this legal matter.

In addition to the matters described above, the Company is subject to various
investigations, claims and legal proceedings covering a wide range of matters
that arise in the ordinary course of its business activities. Each of these
matters is subject to various uncertainties, and it is possible that some of
these matters may be resolved unfavorably to the Company. The Company has
established accruals for loss contingencies that are probable and reasonably
estimable. Management believes that any liability that may ultimately result
from the resolution of these matters in excess of amounts provided will not have
a material adverse effect on the financial position or results of operations of
the Company.


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

        The Company submitted no matters to a vote of its shareholders during
the fourth quarter of 1998.

                                    PART II

ITEM 5.    MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER
           --------------------------------------------------------------------
     MATTERS
     -------

     The Company's common stock is quoted on the Nasdaq Stock Market under the
symbol "MTSI."  The following table sets forth the range of high and low sales
prices per share.

<TABLE>
<CAPTION>
                                                        High       Low
-------------------------------------------------------------------------- 
<S>                                                   <C>        <C>
1998
First Quarter                                          $19.63     $13.38
Second Quarter                                         $20.94     $14.50
Third Quarter                                          $18.63     $10.88
Fourth Quarter                                         $16.88     $12.25
                                                                        
1997                                                                    
First Quarter                                          $28.75     $18.50
Second Quarter                                         $26.00     $17.13
Third Quarter                                          $34.88     $22.75
Fourth Quarter                                         $31.00     $13.00
-------------------------------------------------------------------------- 
</TABLE>
                                                                               
     The Company has never paid a cash dividend on its common stock and
currently expects that future earnings will be retained for use in its business.
As of January 28, 1999, the Company had 289 stockholders of record.

                                       11
<PAGE>
 
ITEM 6.                 SELECTED CONSOLIDATED FINANCIAL DATA


     The selected consolidated financial data presented below for each of the
five years in the period ended December 31, 1998 have been derived from the
Company's consolidated financial statements. The consolidated financial
statements for each of the five years in the period ended December 31, 1998 have
been audited by Arthur Andersen LLP, independent public accountants. This data
should be read in conjunction with the Consolidated Financial Statements and the
Notes thereto and other financial information appearing elsewhere in this
document.

<TABLE>
<CAPTION>
                                                                        Years Ended December 31, 
                                                     ---------------------------------------------------------------
                                                        1994          1995          1996          1997          1998
                                                     -------       -------       -------      --------      --------   
                                                                        As       
                                                                  Restated 
                                                               (in thousands, except per share amounts)
<S>                                                  <C>           <C>           <C>          <C>           <C>       
Statement of Operations Data: 
Net sales.......................................     $58,855       $76,718       $95,045      $128,481      $144,370  
Cost of sales...................................      35,464        47,735        58,995        83,553        88,950  
                                                     -------       -------       -------      --------      --------   
     Gross profit...............................      23,391        28,983        36,050        44,928        55,420  
Operating expenses:                                                                                                   
   Research and development.....................       3,411         5,027         7,225         7,985        10,904  
   Sales and marketing..........................       8,240        11,607        13,568        18,765        21,235  
   General and administrative...................       3,413         5,314         6,360         7,944        10,012  
   Amortization of intangible assets and                                                                              
      purchased technology......................         104           381           460           477           502  
   Write-off of purchased technology and                                                                              
      related assets............................         ---         1,985           ---           ---           ---  
   Purchased in-process research and                                                                                  
      development and related costs.............         ---         3,000           ---           ---           ---  
                                                     -------       -------       -------      --------      --------   
     Total operating expenses...................      15,168        27,314        27,613        35,171        42,653  
                                                     -------       -------       -------      --------      --------   
Operating income................................       8,223         1,669         8,437         9,757        12,767  
Other income, net ..............................         786         2,014         1,464           579         1,009  
Arbitration costs...............................         ---         1,019           954           595           ---  
                                                     -------       -------       -------      --------      --------  
Income before provision for income taxes........       9,009         2,664         8,947         9,741        13,776  
Provision for income taxes......................       3,336           980         3,250         3,330         4,408  
                                                     -------       -------       -------      --------      --------  
Net income......................................     $ 5,673       $ 1,684       $ 5,697      $  6,411      $  9,368  
                                                     =======       =======       =======      ========      ========  
Earnings per share:                                                                                                   
        Basic...................................     $  0.84       $  0.21       $  0.74      $   0.81      $   1.22  
        Diluted.................................     $  0.77       $  0.20       $  0.71      $   0.77      $   1.20  
Weighted average common shares                                                                                        
  outstanding and dilutive potential common                                                                           
  shares outstanding                                                                                                  
        Basic...................................       6,722         8,114         7,695         7,941         7,672  
        Diluted.................................       7,321         8,607         8,066         8,349         7,815   
</TABLE>
                 
<TABLE>
<CAPTION>
                                                                              December 31, 
                                                     ---------------------------------------------------------------
                                                        1994          1995          1996          1997          1998
                                                     -------       -------       -------       -------      --------   
                                                                        As       
                                                                  Restated 
                                                                            (in thousands)
<S>                                                  <C>           <C>           <C>           <C>           <C>
Balance Sheet Data:      
Working capital..................................     $63,245      $55,748       $58,372       $63,265      $ 59,060
Total assets.....................................      77,647       76,353        85,048        94,837       104,345
Stockholders' equity.............................      67,856       63,851        69,170        78,948        78,369
</TABLE>

                                       12
<PAGE>
 
ITEM 7.      Management's Discussion and Analysis of Financial Condition
                           and Results of Operations
                                        
Results of Operations

The discussion contained in this section as well as elsewhere in this Annual
Report on Form 10-K may contain forward-looking statements based on the current
expectations of the Company's management.  Such statements are subject to
certain risks and uncertainties which could cause actual results to differ
materially from those projected.  Readers are cautioned not to place undue
reliance on these forward-looking statements which speak only as of the date
hereof.  The Company undertakes no obligation to publicly release the result of
any revisions to these forward-looking statements which may be made to reflect
events or circumstances occurring after the date hereof or to reflect the
occurrence of unanticipated events.

The following table sets forth for the fiscal periods indicated, the percentage
of total revenues represented by certain items in MicroTouch's statement of
operations:

<TABLE>
<CAPTION>
                                        Percentage of Total Revenues

                                                                             Years Ended December 31,
                                                                             ------------------------
                                                                           1996       1997        1998
                                                                           ----       ----        ----
<S>                                                                      <C>        <C>         <C>
Total Revenues                                                           100.0%     100.0%      100.0%   
Cost of Sales                                                             62.1%      65.0%       61.6%   
   Gross Profit                                                           37.9%      35.0%       38.4%   
Operating Expenses:                                                                                      
   Research and Development                                                7.6%       6.2%        7.6%   
   Sales and Marketing                                                    14.2%      14.6%       14.7%   
   General and Administrative                                              6.7%       6.2%        6.9%   
   Amortization of intangible assets and purchased technology               .5%        .4%         .4%   
     Total Operating Expenses                                             29.0%      27.4%       29.6%   
Operating Income                                                           8.9%       7.6%        8.8%   
Other Income, net                                                          1.5%        .5%         .7%   
Arbitration costs                                                          1.0%        .5%        ---    
Income Before Provision for Income Taxes                                   9.4%       7.6%        9.5%   
Net Income                                                                 6.0%       5.0%        6.5%
</TABLE>

Years Ended December 31, 1998 and 1997

Net Sales.  Net sales in the fiscal year ended December 31, 1998 increased from
the corresponding period of 1997 by $15.9 million, or 12%, to $144.4 million.
The increase in net sales primarily reflects increased international sales
volume. Sales from international operations were $68.9 million or 48% of total
sales and represented an increase of $15.0 million or 28% over international
sales in the comparable period of 1997. This increase primarily reflects higher
touchscreen volume into the European and Asia Pacific (excluding Japan) markets.

Gross Profit.  Gross profit for the fiscal year ended December 31, 1998
increased over the fiscal year ended December 31, 1997 by $10.5 million or 23%,
to $55.4 million. As a percentage of net sales, gross profit increased from
35.0% in the fiscal year ended December 31, 1997 to 38.4% in the fiscal year
ended December 31, 1998. The increase in gross margin percent primarily reflects
the impact of a $2.3 million (pretax) special non-recurring charge related to
the Company's whiteboard products in 1997, as well as increased touchscreen
product yields and improved manufacturing efficiencies in 1998.

Research and Development.  Research and development expenses for the fiscal year
ended December 31, 1998 increased over the corresponding period of 1997 by $2.9
million, or 37%, to $10.9 million. As a percentage of net sales, research and
development expenses increased from 6.2% in the fiscal year ended December 31,
1997 to 7.6% in the fiscal year ended December 31, 1998. The increase in
spending both on an absolute dollar basis and as a percentage of net sales
reflects the initiation of a program to develop a next generation capacitive
product line with improved performance and cost savings over the existing
product line, as well as advancing its resistive technology. The Company expects
that total research and development expenses will most likely increase in the
future on an absolute spending basis and as a percentage of net sales primarily
due to the research on the Company's core touchscreen technology.

                                       13
<PAGE>
 
Sales and Marketing.  Sales and marketing expenses for the fiscal year ended
December 31, 1998 increased over the corresponding period of 1997 by $2.5
million, or 13%, to $21.2 million. As a percentage of net sales, sales and
marketing expenses increased slightly from 14.6% for the fiscal year ended
December 31, 1997 to 14.7% for the corresponding period of 1998. The increase in
absolute spending in 1998 was also the result of sales costs associated with
supporting large OEM customers and expanding the Company's Internet presence, as
well as the development of a remote sales information systems sales program.

General and Administrative.  General and administrative expenses for the fiscal
year ended December 31, 1998 increased from the corresponding period of 1997 by
$2.1 million, or 26%, to $10.0 million.  As a percentage of net sales, general
and administrative expenses increased from 6.2% for the fiscal year ended
December 31, 1997 to 6.9% for the corresponding period of 1998, primarily as a
result of spending to improve systems supporting the Company's infrastructure in
the Information Technology and E-commerce areas and legal expenses.

Amortization of Intangible Assets.  For the fiscal year ended December 31, 1998,
operating expenses included $502,000 of amortization relating to various
acquisitions and purchases of technologies, as compared to $477,000 for the
corresponding period of 1997.

Operating Income.  Operating income for the fiscal year ended December 31, 1998
of $12.8 million represented an increase of $3.0 million, or 31%, over the
fiscal year ended December 31, 1997. This increase is primarily due to the
revenue increase discussed above and the absence of the previously discussed
special whiteboard restructuring charge of $2.3 million taken in 1997.

Other Income, net.  Other income in the fiscal year ended December 31, 1998
was $1.0 million as compared to $.6 million for the corresponding period of
1997. Other income in the 1998 period included $1.5 million in interest income,
net of interest expenses, as compared to $1.4 million of net interest income for
the fiscal year ended December 31, 1997. Foreign exchange losses were $340,000
in the fiscal year ended December 31, 1998, primarily due to currency
fluctuations in the Far East, as compared to a loss of $999,000 for the
corresponding period of 1997.

Arbitration Costs.  During 1997, the Company expensed a final payment amounting
to $595,000 in its international arbitration versus Nissha Printing Company Ltd.
(See Note 8 to Consolidated Financial Statements)

Provision for Income Taxes.  The Company's effective tax rate for the fiscal
years ended December 31, 1998 and 1997 was 32.0% and 34.2%, respectively. The
effective tax rates differed from the federal statutory rate of 34% primarily as
a result of the provision for state income taxes partially offset by the benefit
related to tax-exempt interest income.

Geographic Segments.  Domestic pre-tax income of $9.3 million represented an
increase of $1.8 million or 24% over 1997. This increase in pre-tax profit
primarily reflects the impact of the $2.3 million non-recurring charge taken in
1997. International pretax income of $4.4 million represented an increase of
$2.2 million or 100% over the corresponding period of 1997 on the strength of
the previously discussed international sales increases and improved gross
margins.

Years Ended December 31, 1997 and 1996

Net Sales.  Net sales in the fiscal year ended December 31, 1997 increased from
the corresponding period of 1996 by $33.4 million, or 35.2%, to $128.5 million.
The increase in net sales primarily reflects increased international sales
volume as well as increased domestic touchscreen volume. Sales from
international operations were $53.9 million and represented an increase of $22.5
million or 71.7% over the comparable period of 1996. This increase primarily
reflects higher volume into the Japanese market due to the one-time Nagano
Olympics project, as well as increased touchscreen volume in Europe.

Gross Profit.  Gross profit for the fiscal year ended December 31, 1997
increased over the fiscal year ended December 31, 1996 by $8.9 million or 24.6%,
to $44.9 million. As a percentage of net sales, gross profit decreased from
37.9% in the fiscal year ended December 31, 1996 to 35.0% in the fiscal year
ended December 31, 1997. The decrease in gross margin percent primarily reflects
the impact of a $2.3 million (pretax) special fourth quarter non-recurring
charge for the Company's whiteboard operation, as well as the effect of lower
margin whiteboard sales throughout the year. The non-recurring charge consisted
primarily of a $1.0 million writedown of inventory and a $1.2 million write-off
of capitalized software development costs.

                                       14
<PAGE>
 
Research and Development.  Research and development expenses for the fiscal year
ended December 31, 1997 increased over the corresponding period of 1996 by $0.8
million, or 10.5%, to $8.0 million. As a percentage of net sales, research and
development expenses decreased from 7.6% in the fiscal year ended December 31,
1996 to 6.2% in the fiscal year ended December 31, 1997. The decrease as a
percentage of net sales reflects the achievement of technological feasibility in
1996 of the Company's initial whiteboard development project.

Sales and Marketing.  Sales and marketing expenses for the fiscal year ended
December 31, 1997 increased over the corresponding period of 1996 by $5.2
million, or 38.3%, to $18.8 million. As a percentage of net sales, sales and
marketing expenses increased slightly from 14.2% for the fiscal year ended
December 31, 1996 to 14.6% for the corresponding period of 1997, primarily as a
result of spending to introduce the Ibid whiteboard product line. The increase
in absolute spending in 1997 was also the result of sales costs associated with
growth in the touchscreen business and marketing programs to reinforce the
Company's worldwide leadership position in the touchscreen market.

General and Administrative.  General and administrative expenses for the fiscal
year ended December 31, 1997 increased from the corresponding period of 1996 by
$1.6 million, or 24.9%, to $7.9 million. As a percentage of net sales, general
and administrative expenses decreased from 6.7% for the fiscal year ended
December 31, 1996 to 6.2% for the corresponding period of 1997, primarily as a
result of the revenue increase and tight spending controls. The increase on an
absolute spending basis primarily reflects the expansion of infrastructure to
support both the domestic and international revenue growth.

Amortization of Intangible Assets.  For the fiscal year ended December 31, 1997,
operating expenses included $477,000 of amortization relating to various
acquisitions and purchases of technologies, as compared to $460,000 for the
corresponding period of 1996.

Operating Income.  Operating income for the fiscal year ended December 31, 1997
of $9.8 million represented an increase of $1.3 million, or 15.6%, over the
fiscal year ended December 31, 1996. This increase is primarily due to the
revenue increase discussed above, partially offset by the previously discussed
special whiteboard restructuring charge of $2.3 million (pretax).

Other Income, net.  Other income in the fiscal year ended December 31, 1997
was $0.6 million as compared to $1.5 million for the corresponding period of
1996. Other income in the 1997 period included $1.4 million in interest income,
net of interest expenses, as compared to $1.3 million of net interest income for
the fiscal year ended December 31, 1996. Foreign exchange losses were $999,000
in the fiscal year ended December 31, 1997, primarily due to currency
fluctuations in the Far East, as compared to a gain of $143,000 for the
corresponding period of 1996.

Arbitration Costs.  During 1997, the Company expensed a final payment amounting
to $595,000 in its international arbitration versus Nissha Printing Company Ltd.
as compared to $1.0 million in arbitration costs incurred in the corresponding
period of 1996. (See Note 8 to Consolidated Financial Statements.)

Provision for Income Taxes.  The Company's effective tax rate for the fiscal
years ended December 31, 1997 and 1996 was 34.2% and 36.3%, respectively. The
effective tax rates differed from the federal statutory rate of 34% primarily as
a result of the provision for state income taxes and the inability of the
Company to record a tax benefit from certain foreign operating loss
carryforwards, partially offset by the benefit related to the Company's foreign
sales corporation and tax-exempt interest income.

Geographic Segments.  Domestic pretax income for the fiscal year ended December
31, 1997 of $7.5 million decreased 20.0% over the comparable period of 1996 due
primarily to the $2.3 million nonrecurring charge recorded in 1997 (discussed
above) as well as the effect of lower gross margins. International pretax income
of $2.2 million represented an increase of $2.7 million over the $462,000 loss
for the corresponding period of 1996 on the strength of the previously discussed
international sales increases.

                                       15
<PAGE>
 
Liquidity and Capital Resources

As of December 31, 1998, the Company had net working capital of $59.1 million,
including approximately $37.7 million in cash and marketable securities. The
Company reported a net cash flow from operating activities of $18.7 million for
the fiscal year ended December 31, 1998. Additionally, the Company maintains a
$6.0 million bank line of credit, including letters of credit, in the U.S. and a
$2.5 million bank line of credit in the U.K. As of December 31, 1998, the
Company had $2.3 million outstanding under the U.S. line of credit and $1.5
million outstanding under the U.K. line of credit.

The Company's capital expenditures were approximately $9.5 million in 1998.

In November, 1998 the Board of Directors of the Company extended for the second
time a repurchase program of the Company's common stock, originally approved in
December, 1997 and extended in August, 1998. The amount of common stock to be
repurchased under the 1997 program is not to exceed $13.0 million. In the fiscal
year ended December, 1998, the Company repurchased approximately 763,000 shares
at an aggregate cost of $10.5 million under this program. These shares have been
and will be used for the Company's stock option plans, employee stock purchase
plan and for other corporate purposes, possibly including acquisitions.

Pending operational needs, the Company has invested its cash in investment
grade, short term, interest-bearing securities.  The Company believes that these
investments, together with anticipated cash flows from operations pursuant to
its current operating plan, will be sufficient to meet the Company's working
capital and capital expenditure requirements at least through 2000. While the
Company regularly evaluates acquisition candidates, conducts preliminary
discussions regarding acquisitions and intends to pursue acquisition
opportunities available to it, there can be no assurance that any such
acquisition will be made or, if made, whether such acquisition will be
financially successful.

Foreign Exchange Exposure

Significant portions of the Company's operations are conducted in foreign
countries, including the United Kingdom of Great Britain, Germany, France,
Italy, Spain, Australia, Taiwan, Japan, Hong Kong and Korea. Exchange rate
fluctuations between the U.S. dollar and the currencies of these countries,
including various European currencies and the Australian dollar, result in
fluctuations in the amounts relating to foreign operations reported in the
Company's consolidated financial statements. In general, the Company's policy is
not to enter into derivative financial instruments or other financial
instruments to manage foreign currency exchange rate risk. The Company can
provide no assurances that it will not enter into such financial instruments in
the future.

Readiness for Year 2000

The Company has taken actions to understand the nature and extent of the work
required to make its systems, products and infrastructure Year 2000 compliant.
The Company does not believe that any material year 2000 issues exist with
software or embedded technology contained within its product offerings. System
hardware, software and microprocessor controlled equipment that support the
Company's infrastructure have been inventoried and assessed for Year 2000
compliance. To the extent necessary to address material year 2000 issues, the
Company is in the process of obtaining and installing current releases or
upgrades from software vendors. All business systems have been upgraded and are
believed to be compliant. Work continues on international facilities systems,
and these conversions are expected to be completed by the end of the second
quarter of 1999. During the second quarter of 1999, the Company also plans to
conduct a testing program to confirm that all installed software upgrades, which
have been represented by software vendors as compliant, will indeed function
with dates posted as 2000. Because the upgrades are being installed by existing
employees and consultants of the Company in conjunction with their normal
duties, and the software upgrades would have been purchased in the normal course
of business, the Company has not segregated the cost of making these systems
compliant. Based on available information, including assurances from software
vendors that their products are compliant, the Company believes that it will be
able to manage its total Year 2000 transition without any material adverse
effect on its business operations, products, operating results or financial
condition.

The Company has not fully determined the extent to which the systems of
customers and vendors with whom the Company has material relationships may not
be compliant. There can be no assurance that the systems of other companies
which the Company deals with will be converted on a timely basis. No assurance
can be given that such failure to convert by another company will not have a
material negative effect on the Company's consolidated financial position,
results of operations or cash flows.

                                       16
<PAGE>
 
ITEM 8.      FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      1.  Financial Statements


                                                                        Page No.

     Report of Independent Public Accountants                             F-1
                                                                              
     Consolidated Balance Sheets as of                                        
       December 31, 1997 and 1998                                         F-2
                                                                              
     Consolidated Statements of Operations for each of the                    
       three years in the period ended December 31, 1998                  F-3
                                                                              
     Consolidated Statements of Stockholders' Equity for each of the          
       three years in the period ended December 31, 1998                  F-4
                                                                              
     Consolidated Statements of Cash Flows for each of the                    
       three years in the period ended December 31, 1998                  F-5

     Consolidated Statements of Comprehensive Income for each of
       the three years in the period ended December 31, 1998              F-6

     Notes to Consolidated Financial Statements                           F-7

                                       17
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To MicroTouch Systems, Inc:

We have audited the accompanying consolidated balance sheets of MicroTouch
Systems, Inc. (a Massachusetts corporation) and subsidiaries as of December 31,
1998 and 1997, and the related consolidated statements of operations,
stockholders' equity, cash flows and comprehensive income for each of the three
years in the period ended December 31, 1998. These consolidated financial
statements and the schedule referred to below are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and 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 financial position of MicroTouch Systems,
Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.

Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in Item 14(a)(2) is
presented for purposes of complying with the Securities and Exchange
Commission's rules and is not part of the basic financial statements. This
schedule has been subjected to the auditing procedures applied in the audits of
the basic financial statements and, in our opinion, fairly states in all
material respects the financial data required to be set forth therein in
relation to the basic financial statements taken as a whole.


                                        /s/ Arthur Andersen LLP
                                        ARTHUR ANDERSEN LLP


Boston, Massachusetts
January 22, 1999

                                      F-1
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                     (Amounts in 000s, except share data)
                                        
<TABLE>
<CAPTION>
                                                                         December 31,
                                                                         1997         1998
                                                                         ----         ----
<S>                                                                      <C>          <C> 
                                                        ASSETS
Current assets:
   Cash and cash equivalents (Note 1).............................       $ 9,477      $  5,471
   Marketable securities (Note 1).................................        25,274        32,191
   Accounts receivable, net of allowances of $5,169 at December                               
    31, 1997 and $4,955 at December 31, 1998                              17,348        23,265
   Inventories  (Note 1)..........................................        19,075        15,954
   Deferred income taxes (Note 4).................................         6,869         6,837
   Prepaid expenses and other current assets......................         1,111         1,217
                                                                         -------      --------
      Total current assets........................................        79,154        84,935
Property and equipment, at cost (Note 1)                                                      
   Machinery and equipment........................................        11,343        16,070
   Furniture and fixtures.........................................         1,421         1,560
   Leasehold improvements.........................................         2,979         4,283
   Land and buildings.............................................         4,770         6,426
                                                                         -------      --------
                                                                          20,513        28,339
Less--Accumulated depreciation and amortization...................         7,205        10,887
                                                                         -------      --------
     Net property and equipment...................................        13,308        17,452
Other assets......................................................         2,375         1,958
                                                                         -------      --------
                                                                         $94,837      $104,345  
                                                                         =======      ========  

                                         LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:                                                                            
    Notes payable (Note 2)........................................       $   ---      $  3,760
    Accounts payable..............................................         5,849         9,336
    Accrued payroll and related costs.............................         3,087         3,011
    Accrued expenses..............................................         6,953         9,768
                                                                         -------      --------
      Total current liabilities...................................        15,889        25,875
Long-term notes payable...........................................           ---           101
                                                                         -------      --------
      Total liabilities...........................................        15,889        25,976
Stockholders' equity  (Note 3)                                                                
  Preferred stock, $.01 par value per share--                                               
    500,000 shares authorized, none issued and outstanding at                                
    December 31, 1997 and 1998....................................           ---           ---
  Common stock, $.01 par value per share--                                                    
    20,000,000 shares authorized at December 31, 1997 and 1998;                               
     8,220,623 issued at December 31, 1997 and 8,256,128 issued at                             
     December 31, 1998............................................            82            82
  Additional paid-in capital......................................        61,963        62,613
  Treasury stock at cost  220,049 and 959,576 shares at                                      
    December 31, 1997 and 1998....................................        (3,333)      (13,503)
  Cumulative translation adjustment (Note 1)......................        (1,091)       (1,614)
  Net unrealized gain on securities available for sale............            84           232
  Retained earnings...............................................        21,243        30,559
                                                                         -------      --------
      Total stockholders' equity..................................        78,948        78,369
                                                                         -------      --------
                                                                         $94,837      $104,345
                                                                         =======      ========
</TABLE>

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

                                      F-2
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                   (Amounts in 000s, except per share data)

<TABLE>
<CAPTION>
                                                               Year Ended December 31,
                                                 ---------------------------------------------------
                                                      1996              1997              1998
                                                 ---------------  ----------------  ----------------
<S>                                              <C>              <C>               <C>
Net sales (Notes 1 and 6)......................         $95,045          $128,481          $144,370
Cost of sales..................................          58,995            83,553            88,950
                                                        -------          --------          --------
     Gross profit..............................          36,050            44,928            55,420
 
Operating expenses:
  Research and development.....................           7,225             7,985            10,904
  Sales and marketing..........................          13,568            18,765            21,235
  General and administrative...................           6,360             7,944            10,012
   Amortization of intangible assets and
      purchased technology.....................             460               477               502
                                                        -------          --------          --------
       Total operating expenses................          27,613            35,171            42,653
                                                        -------          --------          --------
 
          Operating income.....................           8,437             9,757            12,767
 
Other income (expense):
  Interest expense.............................            (173)              (30)             (135)
  Interest income..............................           1,485             1,400             1,662
  Other income/(expense) ......................             152              (791)             (518)
                                                        -------          --------          --------
                                                          1,464               579             1,009
Arbitration costs (Note 8 )....................             954               595               ---
                                                        -------          --------          --------
Income before provision for income
   taxes.......................................           8,947             9,741            13,776
Provision for income taxes (Note 4)............           3,250             3,330             4,408
                                                        -------          --------          --------
Net income.....................................         $ 5,697          $  6,411          $  9,368
                                                        =======          ========          ========
 
Earnings per share (Note 1):
      Basic....................................         $  0.74          $   0.81          $   1.22
      Diluted..................................         $  0.71          $   0.77          $   1.20
                                                                                            
Weighted average common shares outstanding and
 dilutive potential common shares outstanding
 (Note 1):
      Basic....................................           7,695             7,941             7,672
      Diluted..................................           8,066             8,349             7,815
</TABLE>

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

                                      F-3
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                 FOR THE TWELVE MONTHS ENDED DECEMBER 31, 1998
                      (Amounts in 000s except share data)

<TABLE>
<CAPTION>               
                                                                        Accumulated
                                          Common Stock     Additional      Other                     Treasury Stock          Total
                                        -----------------   Paid-in    Comprehensive   Retained   -------------------- Stockholders 
                                         Shares    Amount   Capital    Income (loss)   Earnings    Shares     Amount          Equity
                                        ---------  ------  ----------  --------------  ---------  ---------  --------- -------------

<S>                                     <C>        <C>     <C>         <C>             <C>        <C>        <C>       <C>
Balance December 31, 1995               8,220,623  $   82     $58,984        $  (506)   $12,804   (508,634)  $ (7,513)     $ 63,851
Exercise of stock options                                                                (1,072)   112,143      1,630           558
Employee stock purchase plan                                                                (46)    24,295        358           312
Compensation expense                                                                                                               
 related to common stock options                                   40                                                            40
Effect of exchange rate changes                                                  115                                            115
Tax benefit related to exercise of                                                                                                 
 stock options and disqualifying                                                                                                   
 dispositions                                                   1,072                                                         1,072
Unrealized loss on securities                                                                                                      
 available for sale, net of tax                                                  (37)                                           (37)

Purchase of treasury stock                                                                        (163,944)    (2,438)       (2,438)

Net income                                                                                5,697                               5,697 

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

Balance December 31, 1996               8,220,623      82      60,096           (428)    17,383   (536,140)    (7,963)       69,170
Exercise of stock options                                                                (2,551)   310,979      4,560         2,009
Employee stock purchase plan                                       42                               28,112        416           458
Compensation expense related to                                                                                                    
 common stock options                                              30                                                            30
Effect of exchange rate changes                                                 (558)                                          (558)

Tax benefit related to exercise of                                                                                                  
 stock options and disqualifying                                                                                                    
 dispositions                                                   1,795                                                         1,795 
Unrealized loss on securities                                                                                                       
 available for sale, net of tax                                                  (21)                                           (21)
Purchase of treasury stock                                                                         (23,000)      (346)         (346)
Net income                                                                                6,411                               6,411 

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

Balance December 31, 1997               8,220,623      82      61,963         (1,007)    21,243   (220,049)    (3,333)       78,948 
Exercise of stock options                  15,623                 247                       (52)     8,725        111           306 
Employee stock purchase plan               19,873                 205                               15,048        227           432 
Compensation expense related to                                                                                                     
 common stock options                                             198                                                           198 
Effect of exchange rate changes                                                 (523)                                          (523)
Unrealized loss on securities                                                                                                       
 available for sale, net of tax                                                  148                                            148 
Purchase of treasury stock                                                                        (763,300)   (10,508)      (10,508)
Net income                                                                                9,368                               9,368 

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

Balance December 31, 1998               8,256,128  $   82     $62,613        $(1,382)   $30,559   (959,576)  $(13,503)     $ 78,369 

                                        =========  ======     =======        =======    =======   ========   ========      ======== 

</TABLE>

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

                                      F-4
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                               (Amounts in 000s)
                                        
<TABLE>
<CAPTION>
                                                                                       Year Ended December 31,             
                                                                             ----------------------------------------- 
                                                                                    1996           1997          1998  
                                                                             ------------    ----------   ------------
<S>                                                                          <C>             <C>          <C>          
Cash flows from operating activities:                                                                                             
     Net income                                                                 $  5,697       $  6,411      $  9,368 
     Adjustments to reconcile net income to net cash provided by                                                
       operating activities--                                                                                   
       Depreciation and amortization                                               1,739          3,116         5,870
       Compensation expense related to common stock options                           40             30           198
       (Increase) decrease in assets--                                                                 
         Accounts receivable                                                      (3,217)        (1,372)       (5,917)
         Inventories                                                              (3,542)        (3,998)        3,121 
         Prepaid expenses and other current assets                                   480            (52)         (106)
         Deferred income taxes                                                      (194)        (1,364)           32
         Other assets                                                             (1,138)           750           (60)
       Increase (decrease) in liabilities--                                                      
         Accounts payable                                                          1,000         (1,177)        3,487
         Accrued expenses                                                          2,376          1,188         2,739      
                                                                                --------       --------      --------
             Net cash provided by operating activities                             3,241          3,532        18,732
Cash flows from investing activities:                                                                          
      Purchase of property and equipment, net                                     (3,063)        (8,551)       (9,540)
      Sale and maturity of marketable securities                                  18,038         16,287        12,240 
      Purchase of marketable securities                                          (13,723)       (14,967)      (19,006)
                                                                                --------       --------      -------- 
             Net cash provided by (used in) investing activities                   1,252         (7,231)      (16,306)
Cash flows from financing activities:                                                                                 
      Exercise of stock options and sale of common stock, net                        870          2,467           738 
      Increase in notes payable                                                  -------        -------         3,861 
      Purchase of treasury stock                                                  (2,438)          (346)      (10,508)
      Tax benefit from exercise of stock options                                                                      
        and disqualifying dispositions                                             1,072          1,795           --- 
                                                                                --------       --------      -------- 
             Net cash provided by (used in) financing activities                    (496)         3,916        (5,909)
Effect of exchange rates on cash                                                     115           (558)         (523)
                                                                                --------       --------      -------- 
Net increase (decrease) in cash and cash equivalents                               4,112           (341)       (4,006)
Cash and cash equivalents, beginning of period                                     5,706          9,818         9,477 
                                                                                --------       --------      -------- 
Cash and cash equivalents, end of period                                        $  9,818       $  9,477      $  5,471 
                                                                                ========       ========      ======== 
                                                                                                                      
Supplemental disclosures of cash flow information:                                                                    
     Interest paid                                                              $     84       $     30      $    135 
                                                                                ========       ========      ======== 
                                                                                                                      
     Income taxes paid                                                          $  2,404       $  3,369      $  1,929 
                                                                                ========       ========      ======== 
</TABLE>
                                                                                
  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-5
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
               CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME 

<TABLE>
<CAPTION>
                                                                   Year Ended December 31,
                                                                   -----------------------
                                                             1996          1997          1998
                                                            ------        ------        ------
<S>                                                         <C>           <C>           <C> 
Net Income                                                  $5,697        $6,411        $9,368

Currency translation adjustment                                115          (558)         (523)
 
Unrealized gain/(loss) on marketable securities,
   net of tax                                                  (37)          (21)          148
                                                            ------        ------        ------
 Comprehensive Income                                       $5,775        $5,832        $8,993
                                                            ======        ======        ======
</TABLE>

                                      F-6

<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                        
1)  Summary of Significant Accounting Policies

        a)  Nature of the Business

        MicroTouch Systems, Inc. develops, manufactures and sells touch and pen
input systems, including touch sensitive screens, digitizers for pen computers,
ThruGlass products, kiosk systems and electronic P.C. whiteboards.

        b)  Principles of Consolidation

        The accompanying consolidated financial statements include the accounts
of MicroTouch Systems, Inc. and its wholly owned subsidiaries (together the
"Company"). All significant intercompany accounts, transactions and profits have
been eliminated.

        c)  Earnings per Share

        Basic earnings per share data are computed using the weighted average
number of common shares outstanding during the year. Diluted earnings per share
are computed using the weighted average number of common shares outstanding
during the year and dilutive potential common shares. Dilutive potential common
shares consist of stock options and are calculated using the treasury stock
method.

        Effective January 1, 1997 the Company adopted the provisions of
Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share.
The calculation of basic and diluted earnings per share is as follows:

<TABLE>
<CAPTION>
                                                             1996               1997              1998   
                                                          ----------         ----------        ----------
<S>                                                       <C>                <C>               <C>       
Basic Earnings Per Share                                                                                 
Net Income:                                               $5,697,000         $6,411,000        $9,368,000
                                                                                                         
Weighted Average Common Shares                                                                           
Outstanding:                                               7,695,000          7,941,000         7,672,000
                                                          ----------         ----------        ----------
                                                                                                         
Basic Earnings Per Share                                  $     0.74         $     0.81        $     1.22
                                                          ----------         ----------        ----------
                                                                                                         
Diluted Earnings Per Share                                                                               
                                                                                                         
Net Income:                                               $5,697,000         $6,411,000        $9,368,000
                                                                                                         
Weighted Average Common Shares                                                                           
Outstanding:                                               7,695,000          7,941,000         7,672,000
                                                                                                         
Weighted Average Number of Dilutive                                                                      
Potential Common Shares:                                     371,000            408,000           143,000
                                                          ----------         ----------        ----------
                                                                                                         
Weighted Average Number of Shares                                                                        
Outstanding as Adjusted:                                   8,066,000          8,349,000         7,815,000
                                                          ----------         ----------        ----------
                                                                                                         
Diluted Earnings Per Share:                               $     0.71         $     0.77        $     1.20
                                                          ----------         ----------        ----------
</TABLE>
                                                                                

                                      F-7
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS- (Continued)

        d)  Cash and Cash Equivalents

        The Company held no liquid investments with original maturities of less
than 90 days at December 31, 1997 or December 31, 1998. Cash equivalents are
stated at cost, which approximates market value.

        e)  Marketable Securities

        Marketable securities consist of investment-grade, federal tax-exempt
municipal bonds. The aggregate market value, cost basis, and unrealized gains
and losses of securities available for sale, by major security type, as of
December 31, 1998 and 1997 are as follows:

<TABLE>
<CAPTION>
                                                                        Gross Unrealized       Gross Unrealized
                              Market Value          Cost Basis                Gains                Losses
                            ----------------     -----------------     ------------------     ------------------
<S>                         <C>                  <C>                   <C>                    <C>
Tax Exempt Securities            
  at December 31, 1998           $32,191,000          $31,850,000              $344,000                 $ 3,000
                                 ===========          ===========              ========                 =======  
Tax Exempt Securities
  at December 31, 1997           $25,274,000          $25,143,000              $141,000                 $10,000
                                 ===========          ===========              ========                 =======  

</TABLE>

        Securities available for sale in the accompanying balance sheet at
December 31, 1998 and 1997 include $7,782,000 and $7,341,000, respectively, with
contractual maturities of one year or less, $23,346,000 and $17,933,000,
respectively, with contractual maturities of one through five years and
$1,063,000 and none, respectively, with maturities of more than five years.
Expected maturities may differ from contractual maturities as a result of the
Company's intent to sell these securities prior to maturity and as a result of
call options that enable the issuer to redeem these securities at an earlier
date.

        f)  Inventories

        Inventories, consisting of material, material overhead, labor and
manufacturing overhead, are stated at the lower of cost (first-in, first-out) or
market and consist of the following:

<TABLE> 
<CAPTION> 
                                                               December 31,   
                                                               ------------   
                                                           1997            1998
                                                           ----            ----
     <S>                                            <C>             <C>        
     Raw materials..............................    $ 9,826,000     $ 6,286,000
     Work-in-process............................      3,061,000       1,167,000
     Finished goods.............................      6,188,000       8,501,000
                                                    -----------     -----------
                                                    $19,075,000     $15,954,000
                                                    ===========     ===========
</TABLE>
                                                                                
        g)  Property and Equipment

        The Company provides for depreciation and amortization, using the
straight-line method, through charges to operations in amounts that allocate the
cost of property and equipment over their estimated useful lives. The estimated
useful life for property and equipment is 3 to 5 years except for a building
owned by the Company, the life of which is 25 years.

        Maintenance and repairs are charged to operations as incurred. When
property and equipment is sold or otherwise disposed of, the asset cost and
accumulated depreciation are removed from the accounts, and the resulting gain
or loss, if any, is included in the results of operations.

        h)  Revenue Recognition

        The Company recognizes product revenue upon shipment. Service revenues
are recognized as the services are provided. The Company provides allowances for
estimated sales returns and bad debts and provides for the estimated cost of
warranty at the time of product shipment.

                                      F-8
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)

1)  Summary of Significant Accounting Policies - (Continued)

        i)  Foreign Currency Translation

        The Company translates the assets and liabilities of its foreign
subsidiaries at the exchange rates in effect at year end. Revenues and expenses
are translated using exchange rates in effect during the year. Gains and losses
from foreign currency translation are credited or charged to cumulative
translation adjustment included in stockholders' equity in the accompanying
consolidated balance sheets. Gains and losses from foreign currency transactions
are included in other income and amounted to a gain of approximately $143,000
for the year ended December 31,1996, a loss of approximately $999,000 for the
year ended December 31, 1997 and a loss of approximately $340,000 for the year
ended December 31, 1998.

        j)  Use of Estimates in the Preparation of Financial Statements

        The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of income and expenses during the reporting
periods. Actual results could differ from those estimates.

        k)  Disclosures About Fair Value of Financial Instruments

        SFAS No. 107, Disclosures About Fair Value of Financial Instruments,
requires that disclosure be made of estimates of the fair value of each class of
financial instrument. Financial instruments held by the Company as of December
31, 1998 consist primarily of cash equivalents and marketable securities, short-
term trade receivables, payables and notes payable for which the carrying
amounts approximate fair values.

        l)  Capitalized Software Development Costs

        Software development costs for new software and for enhancements to
existing software are expensed as incurred prior to the establishment of
technological feasibility and subsequent to general release of the product.
Otherwise software development costs have been capitalized and will be amortized
over the estimated life of the product. As of December 31, 1997 the Company had
approximately $30,000 of capitalized software included in Other Assets in the
accompanying balance sheet. There were no capitalized software costs as of
December 31, 1998. In December, 1997 the Company wrote off $1.2 million of
development costs associated with its whiteboard products.

        m)  Other Assets

        The Company periodically assesses the realizability of its long-lived
assets in accordance with SFAS No. 121, Accounting for the Impairment of Long-
Lived Assets and for Long-Lived Assets to be Disposed Of. At each balance sheet
date, the Company evaluates the realizability of goodwill based on expectations
of non-discounted future cash flows for each subsidiary having a material
goodwill balance. If the sum of the expected non-discounted cash flows is less
than the carrying amount of goodwill, the Company would recognize an impairment
loss. Based on its review, the Company does not believe that any material
impairment of its long-lived assets has occurred at December 31, 1998.

                                      F-9
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)

        n)  Comprehensive Income
 
        Effective January 1, 1998 the Company adopted the provisions of SFAS No.
130, Reporting Comprehensive Income, which establishes standards for the
reporting and display of comprehensive income and its components in the
financial statements. Comprehensive income includes all non-owner related
changes in a company's equity including, among other things, foreign currency
translation adjustments and unrealized gains and losses on marketable securities
classified as available-for-sale. Because cumulative translation adjustments are
considered a component of permanently invested unremitted earnings of
subsidiaries outside of the United States, no taxes are provided on such
amounts. 

        o)  Recent Accounting Pronouncements
 
        In March, 1998 The American Institute of Certified Public Accountants
(AICPA) issued Statement of Position (SOP) 98-1, Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use. SOP 98-1 requires
computer software costs associated with internal use software to be expensed as
incurred until certain capitalization criteria are met. The Company does not
believe that adoption of SOP 98-1 will have a material impact on the Company's
financial statements.

        In April 1998, the AICPA issued SOP 98-5, Reporting on the Costs of
Start-up Activities. SOP 98-5 requires all costs associated with pre-opening,
pre-operating and organization activities to be expensed as incurred. The
Company will adopt SOP 98-5 beginning January 1, 1999. The Company believes that
adoption of SOP 98-5 will have no material impact on the Company's financial
statements.

        In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. This statement establishes accounting and
reporting standards requiring that every derivative instrument (including
certain derivative instruments embedded in other contracts) be recorded in the
balance sheet as either an asset or liability measured at its fair value. The
statement requires that changes in the derivative's fair value be recognized
currently in earnings unless specific hedge accounting criteria are met. Special
accounting for qualifying hedge allows a derivative's gains and losses to offset
related results on the hedged item in the income statement, and requires that a
company must formally document, designate and assess the effectiveness of
transactions that receive hedge accounting. SFAS No. 133 is effective for fiscal
years beginning after June 15, 1999. SFAS No. 133 cannot be applied
retroactively. SFAS No. 133 must be applied to (a) derivative instruments and
(b) certain derivative instruments embedded in hybrid contracts that were
issued, acquired or substantially modified after December 31, 1997 (and, at the
Company's election, before January 1, 1998). The Company does not expect that
the adoption of this statement will have a material impact on the Company's
financial position and results of operations. The Company does not believe SFAS
No. 133 is currently applicable but will continue to review the impact on its
financial position or results of operation.

                                      F-10
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
 
2)  Line of Credit

        The Company has demand bank lines of credit in the U.S. totalling
$6,000,000, including letters of credit, under which the Company may borrow on
an unsecured basis at the bank's prime rate. There was nothing outstanding under
these lines at December 31, 1997 and $2,264,000 outstanding under the lines at
December 31, 1998.

        The Company has a demand bank line of credit in the United Kingdom in
the amount of approximately $2,500,000 under which the Company may borrow on a
secured basis at a negotiated rate. There was nothing outstanding under this
line at December 31, 1997 and $1,500,000 outstanding under this line at December
31, 1998.


3)  Stockholders' Equity

        a)  Equity Incentive Plans

        On April 17, 1992, the stockholders of the Company approved, effective
January 1, 1992, the 1992 Equity Incentive Plan (the 1992 Plan) which replaced
the Company's 1983 Incentive Stock Option Plan (the 1983 Plan). On June 25, 1997
and June 25, 1998, the 1992 Plan was amended by the stockholders of the Company.

        The 1992 Plan, as amended, authorizes the grant of stock options
(incentive and non-qualified), stock appreciation rights (SARs), performance
shares or restricted stock (the Awards) for the purchase of an aggregate of
2,750,000 shares of common stock, including shares that are issuable pursuant to
outstanding stock options under the 1983 Plan. The Board of Directors has
appointed the Compensation Committee (the Committee) to administer the 1992
Plan. Awards under the 1992 Plan are granted at the discretion of the Committee,
which shall determine the eligible persons to whom, and the times at which,
Awards shall be granted, the type of Award to be granted and all other related
terms, conditions and provisions of each Award granted. In the case of incentive
stock options, the exercise price will not be less than the fair market value of
the common stock on the date of Award. In the case of non-qualified stock
options, the exercise price will not be less than 50% of the fair market value
of the common stock on the date of the award.

        The Committee may award SARs in tandem with an option (at or after the
award of the option) or alone and unrelated to an option. SARs in tandem with an
option shall terminate to the extent that the related option is exercised, and
the related option shall terminate to the extent that the tandem SARs are
exercised. SARs granted in tandem with options shall have an exercise price of
not less than the exercise price of the related option.

        The Committee may award performance shares and determine the performance
cycles and performance goals. The value of performance shares will be equal to
the fair market value of the common stock on the date the performance shares are
earned.

        The Committee may award shares of restricted stock and determine the
duration of the restricted period during which, and the conditions under which,
the shares may be forfeited to the Company and the other terms and conditions of
such Awards. Shares of restricted stock shall be issued for no cash
consideration or such minimum consideration as may be required by applicable
law.

                                      F-11
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)


3)  Stockholders' Equity - (Continued)

        In 1993, options to purchase 200,000 shares were granted to the
Company's Chairman of the Board of Directors under a 10 year performance
incentive agreement pursuant to the 1992 Plan. These options became exercisable
in various installments based on the achievement of certain financial milestones
over five years. As of December 31, 1998, 160,000 shares have been exercised and
the remaining 40,000 shares were exercisable under this grant.

        Options to purchase 1,425,900 shares of common stock are outstanding
under the 1992 Plan at December 31, 1998 and have generally vested at a rate of
25% per year for four years. Options granted after July 31, 1998 vest at a rate
of 20% in the first year, 40% in the second year and 40% in the third year.
Options to purchase 3,200 shares of common stock were subject to this vesting
schedule at December 31, 1998. At December 31, 1998, no SARs, performance shares
or other restricted stock have been awarded under the 1992 Plan. As of December
31, 1998, 438,364 shares of common stock are available for future awards under
the 1992 Plan.

        Effective February 8, 1994, the Board of Directors adopted the 1994
Director Stock Option Plan (the 1994 Plan). This 1994 Plan was approved by the
stockholders of the Company at the annual stockholders' meeting held on June 16,
1995. The 1994 Plan authorizes the grant of non qualified stock options to all
directors of the Company who are not employees of the Company or any of its
subsidiaries. An aggregate of 200,000 shares of common stock have been
authorized for issuance under the 1994 Plan. The Board of Directors administers
the 1994 Plan. Under the terms of the 1994 Plan, as amended, each non-employee
director, upon initial election to the Board of Directors, shall receive options
to purchase 10,000 shares of common stock. In lieu of grants upon election,
current directors received initial grants upon the effective date of the
adoption of the 1994 Plan. Immediately following the annual meeting of the
stockholders each year, each non-employee director of the Company continuing in
office shall automatically be granted options to purchase 5,000 shares of common
stock. Options are granted at an exercise price equal to the fair market value
of the underlying common stock and have generally vested over two years. Options
granted on or after June 24, 1998 vest over three years. Options to purchase
25,000 shares of common stock were subject to this vesting schedule as of
December 31, 1998.

        Options to purchase 97,500 shares of common stock are outstanding under
the 1994 Plan at December 31, 1998. As of December 31, 1998, 82,500 shares of
common stock are available for future grants under the 1994 Plan.

        Effective July 31, 1998, the Board of Directors approved the 1998 Stock
Option Plan (the 1998 Plan). The 1998 Plan authorizes the grant of non-qualified
stock options (the Awards) for the purchase of an aggregate of 1,000,000 shares
of common stock. The Board of Directors has appointed the Compensation Committee
(the Committee) to administer the 1998 Plan. Awards under the 1998 Plan are
granted at the discretion of the Committee, which shall determine the eligible
persons to whom, and the times at which, Awards shall be granted, the amount of
the Award to be granted and all other related terms, conditions and provisions
of each Award granted. The exercise price of each non-qualified stock option
granted will not be less than the fair market value of the common stock on the
date of the award. Options generally vest over 3 years.

Options to purchase 27,600 shares of common stock were outstanding under the
1998 Plan at December 31, 1998. As of December 31, 1998 972,400 shares of common
stock are available for future grants under the 1998 Plan.

        The Company has also granted other non-qualified stock options to
purchase shares of common stock, of which options to purchase 15,000 shares of
common stock are outstanding at December 31, 1998.

                                      F-12
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)

3)  Stockholders' Equity - (Continued)

The following is a summary of the stock option activity for the years ended
December 31, 1996, 1997 and 1998:

<TABLE>
<CAPTION>
                                                                         Number of      Exercise Price   
                                                                           Shares         per Share      
                                                                           ------         ---------      
     <S>                                                                 <C>          <C>          <C>   
     Outstanding at December 31, 1995...........................           913,868    $ 1.50   -   $36.88
         Granted................................................           489,400     13.00   -    24.00
         Terminated.............................................          (121,925)     6.00   -    21.00
         Exercised..............................................          (112,143)     1.50   -    16.89
                                                                         ---------                       
     Outstanding at December 31, 1996...........................         1,169,200      1.75   -    36.88
          Granted...............................................           385,307     15.75   -    31.50
          Terminated............................................           (60,043)     6.19   -    26.00
          Exercised.............................................          (310,979)     1.75   -    17.81
                                                                         ---------                       
     Outstanding at December 31, 1997...........................         1,183,485      1.75   -    31.50
          Granted...............................................           516,745     11.81   -    19.25
          Terminated............................................          (109,873)     7.75   -    31.50
          Exercised.............................................           (24,357)     6.19   -    16.89
                                                                         ---------                       
     Outstanding at December 31, 1998...........................         1,566,000      1.75   -    31.50
                                                                         =========    ======       ======
     Exercisable at December 31,1998....................................   573,782    $ 1.75   -   $31.50
                                                                         =========    ======   =   ====== 
</TABLE>
                                                                                
        331,650 of the 1,566,000 options outstanding at December 31, 1998 have
an exercise price of between $1.75 and $14.50, with a weighted average exercise
price of $7.27 and a remaining contractual life of 5 years. Of these options,
280,400 are exercisable.  278,812 options have exercise prices between $14.56
and $15.25 with a weighted average exercise price of $14.89 and a weighted
average remaining contractual life of 7 years.  130,618 of these options are
exercisable.  356,245 options have an exercise price of $15.50 and a weighted
average remaining contractual life of 6 years.  Of these options, none are
exercisable.  430,043 options have exercise prices between $15.56 and $19.75
with a weighted average exercise price of $18.07 and a remaining contractual
life of 7 years.  106,201 of these options are exercisable.  The remaining
169,250 options have exercise prices of between $20.56 and $31.50 with a
weighted average exercise price of $23.77 and a weighted average remaining
contractual life of 8 years.  56,563 of these options are exercisable.

        Effective January 1, 1996, the Company adopted the provisions of SFAS
No. 123, Accounting for Stock-Based Compensation. The Company has elected to
continue to account for stock options at intrinsic value with disclosure of the
effects of fair value accounting on net income and earnings per share on a pro
forma basis. Had compensation costs for the stock option plans been determined
using the fair value method, the Company's pro forma net income, basic and
diluted earnings per share would have been $7.0 million, $.91 and $.89
respectively for the fiscal year ended December 31, 1998, $3.9 million, $.49 and
$.47, respectively for the fiscal year ended December 31, 1997 and $4.4 million,
$.57 and $.55, respectively for the fiscal year ended December 31, 1996.
Consistent with SFAS No. 123, pro forma net income and earnings per share have
not been calculated for options granted prior to January 1, 1995. Pro forma
compensation cost may not be representative of that to be expected in future
years.

        The Company has computed the pro forma disclosures required under SFAS
No. 123 using the Black-Sholes option pricing model prescribed by SFAS No. 123.
The weighted average assumptions used for 1998 are as follows: risk free
interest rate of 5.7%, expected dividend yield of zero, expected option life of
5 years and expected volatility of 66%. The weighted average assumptions used
for 1997 are as follows: risk free interest rate of 6.3%, expected dividend
yield of zero, expected option life of 5 years and expected volatility of 69%.
The weighted average assumptions used for 1996 are as follows: risk free
interest rate of 6.2%, expected dividend yield of zero and expected option life
of 6 years and expected volatility of 65%. The weighted average fair values of
all options granted in 1996, 1997 and 1998 were $9.56, $9.79 and $7.22,
respectively.

                                      F-13
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
                                        

3)  Stockholders' Equity - (Continued)

        b) Shareholder Rights Plan. In January 1996, the Company adopted a
Shareholder Rights Plan and declared a dividend distribution of one right for
each outstanding share of the Company's common stock to stockholders of record
on January 19, 1996 and authorized the issuance of one right for each share of
the Company's common stock issued between January 19, 1996 and the date on which
the right becomes separable from the common stock. Each right entitles the
shareholders to buy from the Company 1/100 of a share of Series A Junior
Participating Preferred Stock, $.10 par value, at a purchase price of $75 per
right. The rights will be exercisable or separable from the common stock until
ten business days after a party acquires beneficial ownership of 20% or more of
the Company's common stock or announces a tender offer for at least 20% of its
common shares outstanding.

        The rights are subject to adjustment and may be redeemed by the Company
at a price of $0.01 per right at any time until the tenth day following the
point at which they become exercisable. In the event that the Company is
acquired in a merger or other business combination transaction, each right,
other than those held by the acquiring party, will entitle its holders to
purchase an amount of shares of the Company's common stock which equals the
exercise price of the rights divided by one-half of the current market price of
the common stock. The rights will expire, unless earlier redeemed or exchanged,
on January 19, 2006, or earlier in certain circumstances.

4)  Income Taxes

        The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes." Provisions for income taxes recognize the tax
effect of all revenue and expense transactions as well as any changes during the
period in deferred tax assets and liabilities. The effects of changes in tax
rates and laws on deferred tax assets and liabilities are reflected in net
income in the period in which such changes are enacted.

The components of domestic and foreign income (loss) before the provision for
income taxes are as follows:

<TABLE>  
<CAPTION> 
                                                                         Years Ended December 31,
                                                                         ------------------------
                                                                     1996            1997            1998
                                                                    -----            ----            ----
     <S>                                                       <C>             <C>             <C>       
     Domestic.....................................             $9,409,000      $7,531,000     $ 9,336,000
     Foreign......................................               (462,000)      2,210,000       4,440,000
                                                               ----------      ----------     -----------
          Total...................................             $8,947,000      $9,741,000     $13,776,000
                                                               ==========      ==========     ===========
</TABLE>
                                                                                
The provision for federal and state income taxes consists of the following:

<TABLE>
<CAPTION>
                           1996                              1997                              1998
              -------------------------------  ----------------------------------  --------------------------------
                Federal      State    Foreign    Federal       State     Foreign    Federal     State     Foreign
              ----------   --------   -------  -----------   ---------   --------  ----------  --------  ----------
<S>           <C>          <C>        <C>      <C>           <C>         <C>       <C>         <C>       <C>
Current       $2,711,000   $733,000   $  ----  $ 2,903,000   $ 862,000   $929,000  $2,449,000  $247,000  $1,680,000
Deferred/
(Prepaid)       (163,000)   (31,000)     ----   (1,052,000)   (312,000)      ----      20,000    12,000        ----
              ----------   --------   -------  -----------   ---------   --------  ----------  --------  ----------
              $2,548,000   $702,000   $  ----  $ 1,851,000   $ 550,000   $929,000  $2,469,000  $259,000  $1,680,000
              ==========   ========   =======  ===========   =========   ========  ==========  ========  ==========
</TABLE>
                                                                               

                                      F-14
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
                                        
4)  Income Taxes - (Continued)

        
        Significant items making up net deferred tax assets as of December 31,
1997 and 1998 are as follows:

<TABLE> 
<CAPTION> 
                                                      Years Ended December 31,
                                                      ------------------------
                                                           1997           1998
                                                           ----           ----
     <S>                                             <C>            <C>       
     Reserves for inventories                        $1,174,000     $1,410,000
     Reserves for accounts receivable                 1,567,000      1,569,000
     Reserves for warranty                              837,000        790,000
     Other reserves and accruals                      3,291,000      3,068,000
                                                     ----------     ----------
          Net deferred tax assets                    $6,869,000     $6,837,000
                                                     ==========     ==========
</TABLE>
                                                                                
        The amount computed by applying the federal statutory income tax rate of
34% to income before provision for income taxes differs from the Company's
provision for income taxes due to the following:

<TABLE> 
<CAPTION> 
                                                                                     Years Ended December 31,
                                                                                     ------------------------
                                                                               1996           1997           1998
                                                                               ----           ----           ----
        <S>                                                              <C>            <C>            <C>       
        Provision at federal statutory rate......................        $3,042,000     $3,312,000     $4,684,000
        State taxes, net of federal benefit......................           504,000        479,000        171,000
        Foreign operating losses not benefited...................           325,000        135,000        138,000
        Tax-exempt interest benefit..............................          (493,000)      (392,000)      (436,000)
        Foreign sales corporation benefit........................          (294,000)      (551,000)        ------ 
        Other, net...............................................           166,000        347,000       (149,000)
                                                                         ----------     ----------     ---------- 
                                                                         $3,250,000     $3,330,000     $4,408,000
                                                                         ==========     ==========     ========== 
</TABLE>

5)  Commitments

        a)  Royalty Agreement

        The Company is a party to a licensing agreement in which it has acquired
the rights to various touch screen products and technologies. The licensing
agreement provides for the payment of royalties based on annual product sales
and sublicensing revenue and includes minimum royalty payment provisions. The
agreement will be in effect until the expiration of the last-to-expire patent
licensed under this agreement, which is in 2005.

        b)  Lease - Facility

        During 1993, the Company entered into a lease agreement expiring in
April 2003 under which the Company leases its main operating facility in
Methuen, Massachusetts. In addition to the lease payments, the Company is also
responsible for its share of real estate taxes and operating expenses, as
defined. The Company also leases space in Rochester, New York under a lease
expiring in November 2002. The Company also leases space at its operations in
the United Kingdom, France, Germany, Italy, Australia, Japan, Spain, Hong Kong
and Taiwan. Total rent expense under all leases for the years ended December 31,
1996, 1997 and 1998 was approximately $1,368,000, $1,889,000 and $1,543,000,
respectively.

                                      F-15
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)

5)  Commitments - (Continued)

      Future minimum lease payments for all noncancelable leases are as follows:

<TABLE>
<CAPTION>
        Fiscal Year Ending                                     Amount
        ------------------                                     ------
        <S>                                                <C>
        1999..........................................     $1,613,000
        2000..........................................      1,373,000
        2001..........................................      1,296,000
        2002..........................................      1,238,000
        2003..........................................        579,000
        2004 and thereafter...........................      1,047,000
                                                           ----------
        Total.........................................     $7,146,000
                                                           ==========
</TABLE>
                                                                                
     c) Post-retirement Benefits

The Company does not offer any post-retirement or post-employment benefits to
its employees.


6)  Segment Information

      Effective January 1, 1998, the Company adopted SFAS No. 131, Disclosures
about Segments of an Enterprise and Related Information. SFAS No. 131
establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements and requires
that those enterprises report selected information about operating segments in
interim financial reports issued to shareholders. It also establishes standards
for related disclosures about products and services, geographic areas, and major
customers. Operating segments are defined as components of an enterprise about
which separate financial information is available that is evaluated regularly by
the chief operating decision maker, or decision making group, in deciding how to
allocate resources and in assessing their performance. The Company's chief
operating decision maker is the Chief Executive Officer (CEO).

      The Company operates in one industry segment consisting of the
development, manufacture and sale of touch sensitive input systems. The
Company's technologies are managed as one segment, or one strategic unit,
because it offers similar products in similar markets and the factors
determining strategic decisions are comparable for all products and markets.

                                      F-16
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                                        
        Geographic area information for the years ended December 31, 1996, 1997
and 1998 is as follows:

<TABLE>
<CAPTION>
                                                          Domestic      United Kingdom            Other    Consolidated
                                                         -----------    --------------            -----    ------------
                                                                      of Great Britain    International  
                                                                      ----------------    -------------
<S>                                                      <C>          <C>                 <C>              <C>
Year Ended December 31, 1996                                       
  Net sales...........................................   $63,634,000       $19,320,000     $12,091,000     $ 95,045,000
  Income (loss) before provision for income taxes.....   $ 9,409,000       $   413,000     $  (875,000)    $  8,947,000
  Identifiable assets.................................   $66,933,000       $12,106,000     $ 6,009,000     $ 85,048,000
Year Ended December 31, 1997                                                                                           
  Net sales...........................................   $74,555,000       $35,011,000     $18,915,000     $128,481,000
  Income (loss) before provision for income taxes.....   $ 7,531,000       $  (211,000)    $ 2,421,000     $  9,741,000
  Identifiable assets.................................   $71,649,000       $16,235,000     $ 6,953,000     $ 94,837,000
Year Ended December 31, 1998                                                                                           
  Net sales...........................................   $75,511,000       $50,108,000     $18,751,000     $144,370,000
  Income before provision for income taxes............   $ 9,336,000       $ 4,119,000     $   321,000     $ 13,776,000
  Identifiable assets.................................   $78,065,000       $14,984,000     $11,296,000     $104,345,000
</TABLE>

        Intercompany transfers to the Company's foreign subsidiaries are
transacted at prices intended to allow the subsidiaries' earnings to be
comparable to unaffiliated distributors. Sales to unaffiliated customers outside
the United States, including U.S. export sales, were approximately $36,198,000
in 1996, which represented 38% of net sales, $57,409,000 in 1997, which
represented 45% of net sales and $71,351,000 in 1998, which represented 49% of
net sales.

        No single customer represented more than 10% of total sales during the
years ended December 31, 1997 or 1998.


7)      Retirement Savings Plan

        The Company has a 401(k) employee savings plan established in 1993
covering substantially all employees. Matching company contributions are at the
discretion of the Board of Directors. Effective in 1998, the Board authorized
matching contributions up to $900 of participants' contributions. Company
contributions and other expenses of the Plan amounted to $89,000 in 1996,
$156,000 in 1997 and $306,000 in 1998.


8)      Legal Proceedings
 
        The Company had been involved in an international arbitration entitled
MicroTouch Systems, Inc. v. Nissha Printing Co. Ltd., ("Nissha") which was under
the auspices of the International Chamber of Commerce ("ICC"). The case was
based on the Company's claims that Nissha breached noncompetition provisions and
other terms of a distribution agreement between the Company and Nissha.

        In January 1997, the Company was informed that while it had won the case
based on the merits of its claims, any recovery of damages was time barred under
the terms of the original agreement between the two parties in the dispute. As a
result, the Company was required to pay a portion of Nissha's fees and costs
related to the arbitration, in the amount of $595,000. The Company expensed
these fees and costs awarded to Nissha as a part of its second quarter 1997
financial results. This payment completes the Company's involvement in the
matter.

                                      F-17
<PAGE>
 
        The Company is a defendant in a case entitled Behne v. MicroTouch
Systems, Inc., which is in the United States District Court in the Northern
District of California. The case arose from claims by Ms. Behne, a former
employee of MicroTouch that the Company had discriminated against her during her
employment at the Company. The case is scheduled for hearing in late
February/early March, 1999. The Company believes that the claims are without
merit but no assurances can be given as to the outcome of this legal matter.

        The Company is subject to various investigations, claims and legal
proceedings covering a wide range of matters that arise in the ordinary course
of its business activities. Each of these matters is subject to various
uncertainties, and it is possible that some of these matters may be resolved
unfavorably to the Company. The Company has established accruals for matters
that are probable and reasonably estimable. Management believes that any
liability that may ultimately result from the resolution of these matters in
excess of amounts provided will not have a material adverse effect on the
financial position or results of operations of the Company.

                                      F-18
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                       SELECTED QUARTERLY FINANCIAL DATA


             (Unaudited - in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                    1997
                                    -------------------------------------
                                     First     Second      Third   Fourth 
                                    Quarter   Quarter    Quarter  Quarter
                                    -------   ------     -------  -------
<S>                                 <C>       <C>        <C>      <C>      
Net Sales                           $30,076   $32,275    $32,829  $33,301
Gross Profit                         11,348    11,987     12,080    9,513  (a)
Net Income                            2,057     1,967      2,370       17  (a)
Diluted Earnings per Share             0.25      0.24       0.28     ----  (a)
</TABLE>


<TABLE>
<CAPTION>
                                                    1998
                                    -------------------------------------
                                     First     Second      Third   Fourth 
                                    Quarter   Quarter    Quarter  Quarter
                                    -------   ------     -------  -------
<S>                                 <C>       <C>        <C>      <C>    
Net Sales                           $35,727   $37,125    $34,948  $36,570     
Gross Profit                         13,043    14,336     13,595   14,446  (b)
Net Income                            2,270     2,259      2,341    2,498     
Diluted Earnings per Share             0.28      0.28       0.30     0.33     
</TABLE>


(a)  Reflects non-recurring charge of $2.3 million related to the electronic
     whiteboard operation.  This charge consisted primarily of a $1.0 million
     writedown of inventory and a $1.2 million write-off of capitalized software
     development costs.

(b)  Certain reclassifications have been made to the quarterly 1998 consolidated
     statements of operation to conform to the full year 1998 presentation.

                                      F-19
<PAGE>
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURES

                None.

                                   PART III
                                   --------

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The sections entitled "Nomination and Election of Directors," "Executive
Officers" and "Compliance with Section 16(a) of the Securities Exchange Act of
1934" contained in the registrant's Proxy Statement for the 1999 Annual Meeting
of Stockholders to be filed with the Securities and Exchange Commission by April
30, 1999, are incorporated herein by reference.


ITEM 11.  EXECUTIVE COMPENSATION

     The section entitled "Executive Compensation" contained in the Proxy
Statement for the 1999 Annual Meeting of Stockholders to be filed with the
Securities and Exchange Commission by April 30, 1999, is incorporated herein by
reference.


ITEM  12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The section entitled "Security Ownership of Officers, Directors and
Principal Stockholders" contained in the Proxy Statement for the 1999 Annual
Meeting of Stockholders to be filed with the Securities and Exchange Commission
by April 30, 1999, is incorporated herein by reference.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     None.
<PAGE>
 
                                    PART IV
                                    -------


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

             The following documents are filed as a part of this Report:

     (a)(1)  Index to Consolidated Financial Statements
             ------------------------------------------

             The following consolidated financial statements of MicroTouch
             Systems, Inc. and subsidiaries are included pursuant to Item 8:

<TABLE>
<CAPTION>
 
                                                                               Page in Form 10K
                                                                               ----------------
   <S>                                                                         <C>
   Report of Independent Public Accountants                                          F - 1  

   Consolidated Balance Sheets as of December 31, 1997 and 1998                      F - 2  

   Consolidated Statements of Operations for each of the three years                        
   in the period ended December 31, 1998                                             F - 3  

   Consolidated Statements of Stockholders' Equity for each of the three years              
   in the period ended December 31, 1998                                             F - 4  

   Consolidated Statements of Cash Flows for each of the three years                        
   in the period ended December 31, 1998                                             F - 5  

   Consolidate Statements of Comprehensive Income for each of the three years        
   in the period ended December 31, 1998                                             F - 6

   Notes to Consolidated Financial Statements                                        F - 7   
 
</TABLE>

     (a)(2)  Index to Consolidated Financial Statement Schedules
             ---------------------------------------------------

             The following consolidated financial statement schedules of
             MicroTouch Systems, Inc. and subsidiaries are included pursuant to
             Item 8:

Schedule II  Valuation and Qualifying Accounts for each of the three years in
             the period ended December 31, 1998


     Schedules not listed above have been omitted because they are not
applicable, not required or the information required to be set forth therein is
included in the consolidated financial statements or notes thereto.

     (b)     The Company filed no current reports on Form 8-K during the quarter
             ended December 31, 1998.

     (c)     Exhibits
             --------
             3.1     Restated Articles of Organization, as amended to date. (5)
             3.2     Amended and Restated By-laws. (1)
             4.1     Shareholder Rights Agreement (5)
             10.1    1992 Equity Incentive Plan. (1) (4)
<PAGE>
 
             10.7    Lease Agreement between the Company and Griffin Brook Park
                     Associates Joint Venture dated November 6, 1992. (2)
             10.8    Letter Agreement with State Street Bank & Trust Co. dated
                     August 29, 1994. (3)
             10.9    Money Market Note dated August 29, 1994. (3)
             10.10   Purchase Agreement between the Company and Griffin Brook
                     Two Associates Joint Venture dated August 2, 1995. (5)
             10.11   1994 Directors Stock Option Plan. (4) (5)
             10.12   1995 Employee Stock Purchase Plan. (4) (5)
             10.13   1998 Employee and Consultant Non-Qualified Stock Option
                     Plan. Filed herewith
             10.14   Letter Agreement with Barclays Bank PLC dated April 7,
                     1998. Filed herewith
             21      Subsidiaries of the Registrant.
             23      Consent of Independent Public Accountants. Filed herewith.
             24      Power of Attorney (included on signature page).
             27      Financial Data Schedule.  Filed herewith.


             (1)     Filed as an exhibit to a Registration Statement on Form S-1
                     filed on June 26, 1992 (Registration No. 33-47874) and
                     incorporated herein by reference.
             (2)     Filed as an exhibit to the Annual Report on Form 10K filed
                     for the year ended December 31, 1992 and incorporated
                     herein by reference.
             (3)     Filed as an exhibit to Form 10-Q filed for the quarter
                     ended September 30, 1994 and incorporated herein by
                     reference.
             (4)     Indicates management contracts or compensatory plans in
                     which the executive officers or directors of the Company
                     participate.
             (5)     Filed as an Exhibit to the Annual Report on Form 10K filed
                     for the year ended December 31, 1995 and incorporated
                     herein by reference.
<PAGE>
 
                                  SIGNATURES

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

                                        MICROTOUCH SYSTEMS, INC.


                                        BY /s/ D. Westervelt Davis
                                        -----------------------------------
                                        D. Westervelt Davis
                                        President, Chief Executive Officer
                                        and Director
                                        February 22, 1999

        KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Geoffrey P. Clear and William T. Whelan, and each
of them his true and lawful attorneys-in-fact and agents, each acting alone,
with full powers 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 Annual Report on Form 10K, including amendments, 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, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully to all
intents and purposes as he might or could do in person, and hereby ratifies and
confirms all his said attorneys-in-fact and agents, each acting alone, or his
substitute or substitutes, may lawfully do or cause to be done by virtue
thereof.

        Pursuant to the requirement 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/ James D. Logan
-----------------------------------    
James D. Logan                          Chairman of the Board of Directors        February 22, 1999
 
/s/ D. Westervelt Davis
-----------------------------------    
D. Westervelt Davis                     President, Chief Executive Officer        February 22, 1999
                                        and Director
 
/s/ Geoffrey P. Clear
-----------------------------------    
Geoffrey P. Clear                       Vice President, Finance and               February 22, 1999
                                        Administration, Chief Financial Officer
                                        and Treasurer
 
/s/ Edward J. Stewart III
-----------------------------------    
Edward J. Stewart III                   Director                                  February 22, 1999
 

/s/ Frank Manning
-----------------------------------    
Frank Manning                           Director                                  February 22, 1999


/s/ Peter Brumme
-----------------------------------    
Peter Brumme                            Director                                  February 22, 1999
</TABLE> 
<PAGE>
 
                                 EXHIBIT INDEX



3.1    Restated Articles of Organization as amended to date (5)
3.2    Amended and Restated By-laws. (1)
4.1    Shareholder Rights Agreement (5)
10.1   1992 Equity Incentive Plan. (1) (4)
10.5   License Agreement between the Company, Peptek, Inc. and Mr. Jim Zeeger
       dated July 1, 1988. (1)
10.7   Lease Agreement between the Company and Griffin Brook Park Associates
       Joint Venture dated November 6, 1992. (2)
10.8   Letter Agreement with State Street Bank & Trust Co. dated August 29,
       1994. (3)
10.9   Money Market Note dated August 29, 1994. (3)
10.10  Purchase and Sale Agreement between the Company and Griffin Brook Two
       Associates Joint Venture dated  August 2, 1995. (5)
10.11  1994 Directors Stock Option Plan. (4) (5)
10.12  1995 Employee Stock Purchase Plan (4) (5)
10.13  1998 Employee and Consultant Non-Qualified Stock Opton Plan. Filed
       herewith
10.14  Letter Agreement with Barclays Bank PLC dated April 7, 1998. Filed
       herewith
21     Subsidiaries of the Registrant.
23     Consent of Independent Public Accountants filed herewith. Filed herewith
24     Power of Attorney (included on signature page).
27     Financial Data Schedule.  Filed herewith.

(1)    Filed as an exhibit to a Registration Statement on Form S-1 filed on June
       26, 1992 (Registration No. 33-47874) and incorporated herein by
       reference.
(2)    Filed as an exhibit to the Annual Report on Form 10K filed for the year
       ended December 31, 1992 and incorporated herein by reference.
(3)    Filed as an exhibit to Form 10-Q filed for the quarter ended September
       30, 1994 and incorporated herein by reference.
(4)    Indicates management contracts or compensatory plans in which the
       executive officers or directors of the Company participate.
(5)    Filed as an Exhibit to the Annual Report on Form 10K filed for the year
       ended December 31, 1995 and incorporated herein by reference.
<PAGE>
 
                                                           SCHEDULE II



                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                       VALUATION AND QUALIFYING ACCOUNTS
                           FOR THE THREE YEARS ENDED
                       DECEMBER 31, 1996, 1997 AND 1998
                            (Amounts in thousands)


<TABLE>
<CAPTION>
                                                Balance at   Charged to                               Balance at
                                                 Beginning       Cost &    Charged      Returns/          End of
                                                 of Period      Expense   to Sales    Write-offs          Period
                                                 ---------      -------   --------    ----------          ------
                                                                                                                
<S>                                             <C>          <C>          <C>         <C>             <C>        
Allowance for Doubtful Accounts and
  Sales Returns

Year Ended December 31, 1996                       $2,669         $255      $5,219      $(4,203)          $3,940
Year Ended December 31, 1997                       $3,940         $127      $1,249      $  (147)  (a)     $5,169
Year Ended December 31, 1998                       $5,169         $529      $  305      $(1,048)  (a)     $4,955
</TABLE>


(a)  Effective January 1, 1997 the Company changed its accounting procedures to
allow the value of product returns to be offset as a credit directly to sales,
rather than charged against the sales return allowance as had been previously
done. The actual value of product returns in 1997 and 1998 was $4.5 million and
$4.9 million, respectively.