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

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

                                   Form 10-K

   FOR ANNUAL AND TRANSITION REPORT 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, 1997

                              -------------------
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 February 25, 1998, was approximately $118,946,000 (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  February 25, 1998 was:

          Common Stock, $0.01 par value          7,855,000


Portions of the Registrant's proxy statement for the Annual Meeting of
Stockholders to be held June 11, 1998 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 known as touchscreens. The Company's
principal products are its touch sensitive screens, which are based on the
Company's primary technology - analog capacitive sensing (referred to as
ClearTek(R)) and a second significant technology - 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 through both internal development
and acquisitions. In 1994, the Company acquired ThruGlass/TM/ technology, which,
for example, allows users to interact with computer systems inside a store by
simply touching the shop window. In addition, the Company has extended its core
technology to develop TouchPen/TM/, an input sensor that can detect and
distinguish both hand and pen input. TouchPen products are available on flat
panel or CRT displays and are being marketed for use in point-of-sale, signature
capture, medical image manipulation and pen computing. In 1995, the Company
acquired Factura Composites, Inc. a leading U.S. supplier of kiosk housings
which are frequently used in conjunction with the Company's touchscreen
products. Also during 1995, the Company acquired certain assets and technologies
developed by Touch Technology, a business engaged in the development and
marketing of touch sensitive screens primarily using resistive membrane
technology.

  Over the past two years, the Company has developed a new product referred to
as an electronic P.C. whiteboard. This new product, marketed under the trademark
of ibid/TM/, 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:

                                       2
<PAGE>
 
  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 groups that focus on these distinct vertical
markets, including those for point-of-sale cash registers, interactive kiosks,
industrial and medical applications, gaming and entertainment machines and
training and business information systems.

  Target Developers of End User Applications.  The Company directs its sales
efforts for its touch products toward OEMs, 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 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 core 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 enhance ThruGlass, which allows touch to be sensed through
up to two inches of glass.  The Company also seeks to improve its resistive
membrane technology through  programs similar to its capacitive line.  Finally,
the whiteboard product was developed based on resistive technology obtained in
the 1995 Touch Technology acquisition.

  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, with respect to ThruGlass, products for gaming and industrial as well
as retail applications; and TouchPen applications, not only for pen computing,
but for videoconferencing and image manipulation in interactive kiosks, a market
in which the Company also offers its Factura products.

  Expand International Markets.  The Company is increasing its international
presence through the opening of foreign sales offices and manufacturing
facilities.  The Company currently has sales and manufacturing facilities in the
United Kingdom and Australia and sales offices in France, Germany, Italy, Japan,
Taiwan, Korea and Hong Kong.  The Company's international sales increased from
$23.7 million in 1995 to $36.2 million in 1996 and to $57.4 million in 1997.

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
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.

                                       3
<PAGE>
 
  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 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 gaming 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.  Most of the Company's resistive products
fall into a category known as 5-wire resistive although the Company does offer
4-wire resistive products for certain specialty applications as customer
requirements dictate.

  THRUGLASS TECHNOLOGY.  MicroTouch's ThruGlass technology operates by
projecting voltage fields out from the conductive surfaces of transparent glass
or opaque pads connected to a controller.  These pads would typically be placed
behind printed graphics or photographs mounted against a store window, allowing
users outside the establishment to interact with a CRT placed behind the pads.
When an individual touches the window in front of the projected capacitive touch
pads, minute changes in the voltage field are detected and the touch is assigned
to one of the pad sensors.

  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; and (iv) guided acoustic
wave or "GAW" screens, which are based on the transmission of acoustic waves
through a glass surface.

                                       4
<PAGE>
 
  WHITEBOARD TECHNOLOGY.  The Company's whiteboard product is a variation of the
resistive membrane technology used in the TouchTek line.  Two opaque conductive
surfaces are suspended under tension with a small distance (less than .040")
between them.  When a user writes on the surface of the whiteboard, a contact is
made between the conductive surfaces and an electrical charge is transferred. An
electronic controller calculates the position based on the measured charge.
Resistive sensor technology such as this is a common, low cost, and reliable
means of creating a touchscreen for small format devices, such as Personal
Digital Assistants (PDAs).  The Company has developed a number of processes that
allow this technology to be used on much larger formats, such as the whiteboard,
with the same inherent advantages. The Company has also developed several
processes for the manufacturing of writeable opaque conductive films in
conjunction with the whiteboard product line. The Company has also developed a
proprietary PC software application which facilitates efficient use of the
whiteboard in both individual and group environments.

Products

The following table shows principal markets, applications and customers for the
Company's products.

Markets, Applications & Customers

<TABLE>
<CAPTION>

             Markets                        Applications                   Customers
             -------                        ------------                   ---------               
                                                                        
<S>                                    <C>                               <C> 
Self-Service Kiosks                    Video Rental Preview              Music Stores
                                       Customer Service                  Department Stores
                                       Airline Ticketing                 Airlines
                                       Movie Theater Ticketing           Theaters
                                                                        
Point of Information Display           Exhibits, Trade Shows             Shopping Malls
                                       Tourist Information Centers       Real Estate Firms
                                       Museum Exhibit Guides             Museums
                                       Parts Look-up                     Airports
                                       Product Locators                  Discount Stores
                                                                         Grocery Stores
                                                                        
Point of Sale Equipment                Fast Food Cash Registers          Fast Food Restaurants
                                       Fine Dining Order Entry           Fine Dining Restaurants
                                       Customer Self Service             Convenience Stores
                                       Merchandise Cash Registers        Department Stores
                                       Personalized Couponing            Grocery Stores
                                                                        
                                                                        
Gaming and Entertainment Systems       Casino Video Gaming Machines      Gaming Companies
                                       Video Lottery Terminals           Video Lottery Companies
                                       Video Bingo                       Bars and Taverns
                                       Bartop Entertainment Games        Fast Food Restaurants
                                       Children's Entertainment Kiosks   Casinos
                                                                        
Industrial and Medical Applications    Process Control                   Manufacturing Companies
                                       Machine Operation                 Hospitals
                                       Vision Systems                    Power Plants
                                       Medical Image Manipulation       
                                                                        
Training and Business Systems          Video Banking                     Banks
                                       ATMs                              Stock Exchanges
                                       Computer-Based Training (CBT)     CBT Providers
                                       Financial Trading                 Large Corporations
                                       Executive Information Systems
</TABLE>

                                       5
<PAGE>
 
  Touchscreens

  The Company's principal product line is based on the ClearTek 2000 Touch
Screen.  The Company offers the ClearTek 2000 touchscreen in a variety of
configurations, including kits that include touch sensors and controllers and
chipsets, and fully configured touchscreen monitors.  In addition, the Company
will often customize its products to accommodate particular customer needs.

  The ClearTek 2000 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
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 2000 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.

  Controllers.  Each sensor is sold with a proprietary MicroTouch controller.
Controllers offered by the Company have 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.

  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.

  TouchPen

  TouchPen enables users to use a finger or stylus to enter handwritten data and
control various computer functions by writing, sketching and pointing directly
on the computer display.  TouchPen consists of a chip set or controller, an
optional stylus, a transparent glass sensor that fits over a flat LCD or CRT
display, and software drivers.  The Company is currently marketing this product
for use in various pen-computing applications.

  ThruGlass

  In 1994, the Company acquired exclusive, worldwide rights to use its ThruGlass
technology in the touchscreen field from Moonstone Designs, Ltd.  ThruGlass
allows customers to access computer-based information through plate glass as
thick as two inches.  When projected through storefront windows, for example,
this technology allows retailers to extend their marketing reach beyond their
existing floor space in order to reach the potential shopper on the sidewalk or
in the mall.  The ThruGlass product line includes touch-sensitive pads, in the
form of standard keypads or PicturePads, touchpads with pictures attached,
controllers and ThruGlass speakers, all of which can be purchased in various
combinations depending on the end user application. The

                                       6
<PAGE>
 
Company introduced a new touchscreen format of ThruGlass in late 1996 and this
product is marketed for use in rugged or hostile environment applications.

  Factura

  During 1995, MicroTouch acquired its Factura kiosk division from Factura
Composites, Inc. ("Factura"). Factura is believed by the Company to be a leading
supplier of these enclosures to the kiosk marketplace in the U.S and, to a
lesser extent, in other international markets.

  Resistive

  Also during 1995, MicroTouch acquired the MicroTouch Resistive Products
operation, which was based in Austin, Texas, until it was relocated to Methuen,
Massachusetts, in 1996.  The Company manufactures high volume resistive products
in Massachusetts although it still provides custom, specialty resistive products
from a small operation in Austin, Texas.

  Whiteboard

  In 1996, the Company established a new Business Products Division in order to
develop, manufacture and market its ibid electronic P.C. whiteboard.  This
operation markets a line of whiteboards including both personal (2 foot by 3
foot) boards as well as larger (3 foot by 4 foot) conference room boards.


SALES AND MARKETING

  MicroTouch markets and sells its touch products primarily through VARs (value 
added resellers), OEMs (original equipment manufacturers) 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, 1997, the Company's domestic touchscreen sales force
consisted of 34 persons. This 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 and Italy.
This subsidiary also assembles touch monitors from touchscreen kits exported
from the U.S. and monitors purchased in Europe.  During 1995, the Company
established sales offices in France and Germany and in 1996, in Italy.  In
Japan, the Company sells its products through MicroTouch Systems, KK, which
arranges for touch monitors to be assembled by an outside contractor. 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 accounted for approximately
31%, 38% and 45% of total sales in 1995, 1996 and 1997, 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 overseas.

  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 $4.0 million, $4.1 million and
$4.5 million for the years ended December 31, 1995, 1996 and 1997, respectively.
While the Company believes that its reserves for product returns are adequate,
there can be no assurance that the Company will not experience

                                       7
<PAGE>
 
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, 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 resistive,
ThruGlass and TouchPen products. 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, 1997, 66 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 and trade secrets 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 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 2000 to 2015. The Company also owns certain other
patents and patent applications, relating primarily to improvements on and
extensions of it's core technology, as well as certain software algorithms used
with the Company's products. A patent covering a resistive touchscreen input
device, which is not currently used in the Company's products, expired in
January, 1998. Certain additional patents relating to the Company's core analog
competitive technology will expire during the period from 2001 to 2005. Although
the Company has developed considerable know-how and substantial experience in
the field of analog capacitive technology which it believes will enable the
Company to compete effectively in the future, the expirations of patents
covering the Company's core proprietary technology may lead to developments 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.

                                       8
<PAGE>

  The Company acquired exclusive rights to use its ThruGlass proprietary
technology in the touch screen 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 nonexclusive rights to use its resistive technology when
it acquired MicroTouch Resistive Products, Inc. in 1995.

  The Company, through its Business Products Division, has made three
applications for U.S. patents on various technology related to its ibid PC
whiteboard product.

  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.

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 assembly onto 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, a small number of
resistive products are still 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,

                                       9
<PAGE>
 
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 touch screen
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. At least two other companies market
whiteboard products similar to those of the Company.

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, 1996 and 1997, the Company had a backlog of $21.0 million and $24.0
million, respectively.

EMPLOYEES

  As of December 31, 1997, the Company had 682 full-time employees, of which 435
were engaged in manufacturing, 120 were in sales, marketing and customer service
and 66 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 100,000 square feet of additional space at its other  locations
including those in the U.K., France, Germany, Italy, Japan, Australia and
Taiwan.

  In June, 1997 the Company completed construction of and occupied a 60,000-
square-foot facility on land which it owns adjacent to the Methuen,
Massachusetts corporate headquarters.  The facility houses the Business Products
Division and provides 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.

                                       10
<PAGE>
 
  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.

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.

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 1997.

                                    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>
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
                     
1996                 
First Quarter         $17.00                     $11.38
Second Quarter        $22.25                     $14.00
Third Quarter         $19.25                     $12.88
Fourth Quarter        $29.75                     $16.63
----------------------------------------------------------
</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 26, 1998, the Company had 312 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, 1997 have been derived from the Company's
consolidated financial statements.  The Company's December 31, 1995 consolidated
financial statements have been restated (see Note 10 of the consolidated
financial statements, page F-15). The consolidated financial statements for each
of the five years in the period ended December 31, 1997 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,                            
                                                    --------------------------------------------------------------       
                                                       1993       1994         1995          1996          1997         
                                                    ----------  ---------  ------------    ---------    ----------      
                                                                            AS RESTATED                                 
                                                               (in thousands, except per share amounts)
<S>                                                 <C>         <C>        <C>             <C>          <C>
STATEMENT OF OPERATIONS DATA:                                
Net sales.......................................      $31,043     $58,855       $76,718      $95,045      $128,481
Cost of sales...................................       18,520      35,464        47,735       58,995        83,553
                                                      -------     -------       -------      -------      --------
     Gross profit...............................       12,523      23,391        28,983       36,050        44,928
Operating expenses:.............................                                           
   Research and development.....................        2,061       3,411         5,027        7,225         7,985
   Sales and marketing..........................        4,787       8,240        11,607       13,568        18,765
   General and administrative...................        2,566       3,413         5,314        6,360         7,944
   Amortization of intangible assets and                                                   
      purchased technology......................          ---         104           381          460           477
   Write-off of purchased technology and                                                   
      related assets............................          ---         ---         1,985          ---           ---
   Purchased in-process research and                                                       
      development and related costs.............          ---         ---         3,000          ---           ---
                                                      -------     -------       -------      -------      --------
     Total operating expenses...................        9,414      15,168        27,314       27,613        35,171
                                                      -------     -------       -------      -------      --------
Operating income................................        3,109       8,223         1,669        8,437         9,757
Other income, net...............................          312         786         2,014        1,464           579
Arbitration costs...............................          ---         ---         1,019          954           595
                                                      -------     -------       -------      -------      --------
Income before provision for income taxes........        3,421       9,009         2,664        8,947         9,741
Provision for income taxes......................        1,230       3,336           980        3,250         3,330
                                                      -------     -------       -------      -------      --------
Net income......................................      $ 2,191     $ 5,673       $ 1,684      $ 5,697      $  6,411
                                                      =======     =======       =======      =======      ========
Earnings per share:                                                                        
        Basic...................................        $0.33       $0.84         $0.21        $0.74         $0.81
        Diluted.................................        $0.32       $0.77         $0.20        $0.71         $0.77
Weighted average common shares outstanding
   and dilutive potential common 
   shares outstanding                                                           
        Basic...................................        6,550       6,722         8,114        7,695         7,941
        Diluted.................................        6,948       7,321         8,607        8,066         8,349
<CAPTION> 

                                                                            DECEMBER 31,                           
                                                     --------------------------------------------------------------
                                                        1993       1994         1995          1996          1997        
                                                     ----------  --------   ------------    ---------    ----------     
                                                                            AS RESTATED                                 
                                                                           (in thousands) 
<S>                                                  <C>         <C>        <C>             <C>          <C> 
BALANCE SHEET DATA:                                                      
Working capital..................................     $17,043     $63,245       $55,748       $58,372      $63,265
Total assets.....................................      24,218      77,647        76,353        85,048       94,837
Stockholders' equity.............................      18,665      67,856        63,851        69,170       78,948
</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,
                                                          ------------------------------------------
                                                             1995            1996            1997
                                                          -----------  ----------------  ------------
                                                          As Restated
<S>                                                       <C>          <C>               <C>
Total Revenues                                                 100.0%            100.0%        100.0%
Cost of Sales                                                   62.2%             62.1%         65.0%
   Gross Profit                                                 37.8%             37.9%         35.0%
Operating Expenses:                                     
   Research and Development                                      6.6%              7.6%          6.2%
   Sales and Marketing                                          15.1%             14.2%         14.6%
   General and Administrative                                    6.9%              6.7%          6.2%
   Amortization of intangible assets and                
     purchased technology                                         .5%               .5%           .4%
   Write-off of purchased technology and related assets          2.6%             ----          ----
   Purchased in-process research and development and             3.9%             ----          ----
      related costs                                     
     Total Operating Expenses                                   35.6%             29.0%         27.4%
Operating Income                                                 2.2%              8.9%          7.6%
Other Income (net)                                               2.6%              1.5%           .5%
Arbitration costs                                                1.3%              1.0%           .5%
Income Before Provision for Income Taxes                         3.5%              9.4%          7.6%
Net Income                                                       2.2%              6.0%          5.0%
</TABLE>

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 write down of inventory and a $1.2 
million write-off of capitalized software development costs.

                                       13
<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. While there will
be ongoing whiteboard engineering spending, the level is not expected to be as
significant as it was in 1996. The Company expects that total research and
development expenses, while remaining relatively constant as a percentage of net
sales, will most likely increase in the future on an absolute spending basis
primarily due to research on the Company's core touchscreen technology.

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.
("Nissha") as compared to $1.0 million in arbitration costs incurred in the
corresponding period of 1996. (See Note 9 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

                                       14
<PAGE>
 
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.

YEARS ENDED DECEMBER 31, 1996 AND 1995

Net Sales.  Net sales in the fiscal year ended December 31, 1996 increased from
the corresponding period of 1995 by $18.3 million, or 23.9%, to $95.0 million.
The increase in net sales primarily reflects increased volume in domestic
touchscreen and kiosk products and higher European touchscreen sales volume.
Sales from international operations were $31.4 million and represented an
increase of 36.5% over the comparable period of 1995.  This increase primarily
reflects the above mentioned higher touchscreen volume in Europe as well as
higher volume into the Japanese market.

Gross Profit.   Gross profit for the fiscal year ended December 31, 1996
increased over the fiscal year ended December 31, 1995 by $7.1 million or 24.4%,
to $36.1 million.  As a percentage of net sales,  gross profit increased
slightly from 37.8% in the fiscal year ended December 31, 1995 to 37.9% in the
fiscal year ended December 31, 1996. This increase reflects a mix of higher
margin kit revenue and improved operating leverage in the kiosk business
resulting from increased revenue, partially offset by lower margins from the
Company's Japanese operations.

Research and Development.   Research and development expenses for the fiscal
year ended December 31, 1996 increased over the corresponding period of 1995 by
$2.2 million, or 43.7%, to $7.2 million.  As a percentage of net sales, research
and development expenses increased from 6.6% in the fiscal year ended December
31, 1995 to 7.6% in the fiscal year ended December 31, 1996.  The increase in
research and development expenses resulted primarily from development related to
the Company's new electronic whiteboard products and resistive membrane
technology, as well as continued development in the Company's ThruGlass and
TouchPen product lines.   The Company expects that research and development
expenses may increase in the future on an absolute spending basis primarily due
to research on the Company's electronic whiteboard products.

Sales and Marketing.   Sales and marketing expenses for the fiscal year ended
December 31, 1996 increased over the corresponding period of 1995 by $2.0
million, or 16.9%, to $13.6 million.  As a percentage of net sales, sales and
marketing expenses decreased from 15.1% for the fiscal year ended December 31,
1995 to 14.2% for the corresponding period of 1996, primarily as a result of the
increase in revenues and tight controls over spending.  The increase in absolute
spending in 1996 reflects the sales and marketing costs associated with the
launch of a new Internet Kiosk product (Prospector) and a new electronic
whiteboard product (ibid), the resistive membrane technology business acquired
in 1995 and the expenses resulting from the opening of two new international
sales offices in France and Germany in mid-1995.

General and Administrative.  General and administrative expenses for the fiscal
year ended December 31, 1996 increased from the corresponding period of 1995 by
$1.0 million, or 19.7%, to $6.4 million.  As a percentage of net sales, general
and administrative expenses decreased from 6.9% for the fiscal year ended
December 31, 1995 to 6.7% for the corresponding period of 1996 primarily as a
result of the revenue increase.  The increase on an absolute spending basis
includes approximately $150,000 in costs associated with the move to a new
headquarters facility in the United Kingdom.

Amortization of Intangible Assets.   For the fiscal year ended December 31,
1996, operating expenses included $460,000 of amortization relating to various
acquisitions and purchases of technologies, as compared to $381,000 for the
corresponding period of 1995.

Write-off of Purchased Technology and Related Assets.   During the second
quarter of 1995, the Company, as a result of an extensive technology review and
a strategic decision to focus on product development in the resistive technology
area rather than the TouchMate technology, recorded a one-time pretax charge of
$2.0 million.  This charge included the write-off of the TouchMate technology
and the write-down of related inventory to net realizable value.

                                       15
<PAGE>
 
Charge for Purchased Research and Development and Related Costs.   During the
second quarter of 1995, the Company expensed $3.0 million of costs associated
with in-process research and development projects which were part of the
acquisition of its Touch Technology business.

Operating Income.   Operating income for the fiscal year ended December 31, 1996
of $8.4 million represented an increase of $6.8 million, or 405.5%, over the
fiscal year ended December 31, 1995. This increase is primarily due to  the $5.0
million in nonrecurring charges recorded during the 1995 period as described
above, as well as increased operating leverage on the 23.9% sales increase over
the fiscal year ended December 31, 1995.

Other Income.   Other income in the fiscal year ended December 31, 1996 was $1.5
million as compared to $2.0 million for the corresponding period of 1995.  Other
income in the 1996 period included $1.3 million in interest income, net of
interest expenses, as compared to $1.9 million of net interest income for the
fiscal year ended December 31, 1995.  The decrease in interest income reflects
declining short-term interest rates and a decrease in the size of the Company's
investment portfolio to support working capital requirements and repurchases by
the Company of its common stock.  Foreign exchange gains were $143,000 in the
fiscal year ended December 31, 1996, as compared to $3,000 for the corresponding
period of 1995.

Arbitration Costs.   During 1996, the Company incurred $1.0 million in
arbitration costs related to its international arbitration versus Nissha
Printing Company Ltd. ("Nissha") as compared to $1.0 million incurred in the
corresponding period of 1995. (See Note 9 to Consolidated Financial Statements)

Provision for Income Taxes.   The Company's effective tax rate for the fiscal
years ended December 31, 1996 and 1995 was 36.3% and 36.8%, 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, 1996 of $9.4 million increased 195.8% over the comparable period of 1995 due
to the nonrecurring charges recorded in 1995 (discussed above) as well as
domestic sales increases.  Pretax loss from international operations of $462,000
represented an improvement of 10.6% over the corresponding period of 1995 on the
strength of the previously discussed international sales increases, partially
offset by the non recurring charges in the U.K. and the lower margins
experienced at the Company's Japanese operations. (discussed above).

Restatement of December 31, 1995 Financial Statements.  In December 1996, the
Company restated its December 31, 1995 financial statements to reflect Nissha
arbitration costs as an expense rather than as a charge to stockholders' equity
representing a cost incurred in connection with a treasury stock transaction.
The following table summarizes the effect on net income and related per share
amounts.

Amounts in 000's, except per share data

<TABLE>
<CAPTION>
                                        As Reported         As Restated
                                            1995                1995
                                        ------------       --------------
<S>                                     <C>                <C>
Pretax income                                 $3,683               $2,664
Net income                                     2,327                1,684
Earnings per share
    Primary                                   $ 0.27               $ 0.20
    Fully diluted                             $ 0.27               $ 0.20
</TABLE>


LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 1997, the Company had net working capital of $63.3 million,
including approximately $34.8 million in cash and marketable securities.  The
Company reported a net cash flow from operating activities of $3.5 million for
the fiscal year ended December 31, 1997.  Additionally, the Company maintains a
$3,000,000 bank line of credit.  As of December 31, 1997, the Company had no
borrowings under its bank line of credit.

                                       16
<PAGE>
 
The Company's capital expenditures were approximately $8.5 million in 1997.

In June, 1997 the Company completed construction of a 60,000 square foot
facility on Company owned land adjacent to the Methuen, Massachusetts
headquarters.  The construction cost approximately $2.9 million.

In December, 1997 the Board of Directors of the Company authorized a repurchase
program of the Company's common stock, not to exceed $5 million.   In the fiscal
year ended December, 1997 the Company repurchased 23,000 shares at an aggregate
cost of $346,000 under this program.    Between January 1, 1998 and March 5, 
1998 the Company has purchased an additional 198,000 shares at an aggregate cost
of $3.0 million. These shares have been and will be used for the Company's stock
option plan, 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 1999.  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.

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 continues to evaluate the estimated costs  associated with this work
as actual information becomes available.  Based on available information, 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.

                                       17
<PAGE>
 
ITEM 8.      FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


1.  FINANCIAL STATEMENTS

<TABLE> 
<CAPTION> 
 
                                                                        PAGE NO.
                                                                  
<S>                                                                     <C>
Report of Independent Public Accountants                                F - 1

Consolidated Balance Sheets as of                                 
  December 31, 1996 and 1997                                            F - 2

Consolidated Statements of Operations for each of the             
  three years in the period ended December 31, 1997                     F - 3

Consolidated Statements of Stockholders' Equity for each of the   
  three years in the period ended December 31, 1997                     F - 4

Consolidated Statements of Cash Flows for each of the             
  three years in the period ended December 31, 1997                     F - 5

Notes to Consolidated Financial Statements                              F - 6
</TABLE>



                                        

                                       18
<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,
1996 and 1997, and the related consolidated statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. 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, 1996 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.

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
February 12, 1998


                                      F-1
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS
                      (AMOUNTS IN 000S, EXCEPT SHARE DATA)
                                        
<TABLE>
<CAPTION>
                                                                                   December 31,
                                                                               1996            1997
                                                                            -----------     -----------
<S>                                                                         <C>              <C>
                                 ASSETS
Current assets:
   Cash and cash equivalents (Note 1).............................              $ 9,818         $ 9,477
   Marketable securities (Note 1).................................               26,922          25,274
   Accounts receivable, net of allowances of $3,940 at December                               
    31, 1996 and $5,169 at December 31, 1997......................               15,976          17,348
                                                                                              
   Inventories  (Note 1)..........................................               15,077          19,075
   Deferred income taxes (Note 4).................................                5,505           6,869
   Prepaid expenses and other current assets......................                  952           1,111
                                                                                -------         -------
      Total current assets........................................               74,250          79,154
Property and equipment, at cost (Note 1)                                                      
   Machinery and equipment........................................                7,954          11,343
   Furniture and fixtures.........................................                  894           1,421
   Leasehold improvements.........................................                1,255           2,979
   Land and buildings.............................................                1,859           4,770
                                                                                -------         -------
                                                                                 11,962          20,513
Less--Accumulated depreciation and amortization...................                4,765           7,205
                                                                                -------         -------
     Net property and equipment...................................                7,197          13,308
Other assets......................................................                3,601           2,375
                                                                                -------         -------
                                                                                $85,048         $94,837
                                                                                =======         =======
              LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
     Accounts payable.............................................              $ 7,026         $ 5,849
  Accrued payroll and related costs...............................                2,658           3,087
  Accrued expenses................................................                6,194           6,953
                                                                                -------         -------
         Total current liabilities................................               15,878          15,889
Commitments and contingencies (Note 5 and 9)                                                 
Stockholders' equity  (Note 3)                                                               
    Preferred stock, $.01 par value per share--                                              
        500,000 shares authorized, none issued and outstanding                               
         at December 31, 1996 and 1997............................                  ---             ---
                                                                                             
  Common stock, $.01 par value per share--                                                   
        20,000,000 shares authorized at December 31, 1996 and                                
         1997; 8,220,623 issued at December 31, 1996 and 1997.....                   82              82
                                                                                             
  Additional paid-in capital......................................               60,096          61,963
   Treasury stock at cost -- 536,140 and 220,049 shares at                                   
         December 31, 1996 and 1997...............................               (7,963)         (3,333)
  Cumulative translation adjustment (Note 1)......................                 (533)         (1,091)
   Net unrealized gain on securities available for sale...........                  105              84
  Retained earnings...............................................               17,383          21,243
                                                                                -------         -------
          Total stockholders' equity..............................               69,170          78,948
                                                                                -------         -------
                                                                                $85,048         $94,837
                                                                                =======         =======
</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,
                                                       --------------------------------------------
                                                         1995              1996              1997
                                                       --------          --------          --------
                                                    (AS RESTATED)
<S>                                               <C>             <C>               <C>
 
Net sales (Notes 1 and 6)......................         $76,718           $95,045          $128,481
Cost of sales..................................          47,735            58,995            83,553
                                                        -------           -------          --------
Gross profit...................................          28,983            36,050            44,928
 
Operating expenses:
Research and development.......................           5,027             7,225             7,985
Sales and marketing............................          11,607            13,568            18,765
General and administrative.....................           5,314             6,360             7,944
Amortization of intangible assets and
purchased technology...........................             381               460               477
Write-off of purchased technology and
related assets ................................           1,985              ----              ----
Purchased in-process research
and development and related costs..............           3,000              ----              ----
                                                        -------           -------          --------
Total operating expenses.......................          27,314            27,613            35,171
                                                        -------           -------          --------
 
Operating income...............................           1,669             8,437             9,757
 
Other income (expense):
Interest expense...............................            (132)             (173)              (30)
Interest income................................           2,051             1,485             1,400
Other income/(expense).........................              95               152              (791)
                                                        -------           -------          --------
                                                          2,014             1,464               579
Arbitration costs (Notes 9 and 10).............           1,019               954               595
                                                        -------           -------          --------
Income before provision for income
taxes..........................................           2,664             8,947             9,741

Provision for income taxes (Note 4)............             980             3,250             3,330
                                                        -------           -------          --------
Net income.....................................         $ 1,684           $ 5,697          $  6,411
                                                        =======           =======          ========
 
Earnings per share (Note 1):
Basic..........................................           $0.21             $0.74             $0.81
Diluted........................................           $0.20             $0.71             $0.77
 
Weighted average common shares outstanding and 
dilutive potential common shares outstanding
(Note 1)
Basic..........................................           8,114             7,695             7,941
Diluted........................................           8,607             8,066             8,349 

</TABLE>


  THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL
                                  STATEMENTS.

                                      F-3
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  FOR THE THREE YEARS ENDED DECEMBER 31,1997
                     (AMOUNTS IN 000S, EXCEPT SHARE DATA)


<TABLE>
<CAPTION>
                                                                                                 Net Unrealized
                                                                                                 Gain(Loss) On  
                                                    Common Stock      Additional     Cumulative    Securities   
                                                 -----------------      Paid-in     Translation     Available   
                                                  Shares     Amount     Capital      Adjustment     for Sale    
                                                 ---------   ------    --------      --------    -------------- 
<S>                                              <C>         <C>       <C>           <C>         <C>             

Balance, December 31, 1994                       8,107,024      $81     $57,023       $  -306      $        -12  
Exercise of stock options                           81,600        1         338                                  
Employee stock purchase plan                                                                                    

Compensation expense related                                                                                   
  to common stock options                                                    27                                  
Effect of exchange rate changes                                                          -342                    
Tax benefit related to exercise                                                                                
  of stock options and                                                                                         
  disqualifying dispositions                                                516                                  
Unrealized gain on securities                                                                                  
  available for sale, net of tax                                                                            154  
Shares issued in connection                                                                                    
 with Touch Technology acquisition                  31,999     ---        1,080                                  
Purchase of treasury stock                                                                                      
Net income                                                                                                      
                                                 ---------   ------    --------      --------    -------------- 
Balance, December 31, 1995                       8,220,623       82      58,984          -648               142  
Exercise of stock options                                                                                       
Employee stock purchase plan                                                                                    
Compensation expense related                                                                                   
  to common stock options & other adj.                                       40                                  
Effect of exchange rate changes                                                           115                    
Tax benefit related to exercise                                                                                
  of stock options and                                                                                          
  disqualifying dispositions                                              1,072                                  
Unrealized loss on securities                                                                                  
  available for sale, net of tax                                                                            -37  
Purchase of treasury stock                                                                                      
Net income                                                                                                      
                                                 ---------   ------    --------      --------    -------------- 
Balance, December 31, 1996                       8,220,623       82      60,096          -533               105  
Exercise of stock options                                                                                       
Employee stock purchase plan                                                 42                                  
Compensation expense related                                                                                    
   to common stock options                                                   30                                 
Effect of exchange rate changes                                                          -558                    
Tax benefit related to exercise of stock                                                                        
  options and disqualified dispositions                                   1,795                                 
Unrealized loss on securities                                                                                  
  available for sale, net of tax                                                                            -21    
Purchase of treasury stock                                                                                      
Net income                                       ---------   ------    --------      --------    -------------- 
Balance, December 31, 1997                       8,220,623      $82     $61,963       $-1,091              $ 84  
                                                 =========   ======    ========      ========    ==============
<CAPTION>                                                                                                   
                                                                          Treasury Stock                   Total    
                                                  Retained           ------------------------            Stockholders'
                                                  Earnings            Shares         Amount                Equity
                                              ---------------        -----------  ------------         --------------- 
<S>                                           <C>                    <C>          <C>                  <C> 
Balance, December 31, 1994                      $      11,132             -4,076   $       -62         $        67,856
Exercise of stock options                                                                                          339 
Employee stock purchase plan                              -12             11,780           182                     170
Compensation expense related              
  to common stock options                                                                                           27
Effect of exchange rate changes                                                                                   -342
Tax benefit related to exercise           
  of stock options and                    
  disqualifying dispositions                                                                                       516
Unrealized gain on securities             
  available for sale, net of tax                                                                                   154
Shares issued in connection               
 with Touch Technology acquisition                                                                               1,080
Purchase of treasury stock                                              -516,338        -7,633                  -7,633
Net income                                              1,684                                                    1,684
                                              ---------------        -----------  ------------         --------------- 
Balance, December 31, 1995                             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 & other adj.                                                                              40
Effect of exchange rate changes                                                                                    115
Tax benefit related to exercise           
  of stock options and                    
  disqualifying dispositions                                                                                     1,072
Unrealized loss on securities             
  available for sale, net of tax                                                                                   -37
Purchase of treasury stock                                              -163,944        -2,438                  -2,438
Net income                                              5,697                                                    5,697
                                              ---------------        -----------  ------------         ---------------
Balance, December 31, 1996                             17,383           -536,140        -7,963                  69,170
Exercise of stock options                              -2,551            310,979         4,560                   2,009
Employee stock purchase plan                                              28,112           416                     458
Compensation expense related              
   to common stock options                                                                                          30    
Effect of exchange rate changes                                                                                   -558
Tax benefit related to exercise of stock  
  options and disqualified dispositions                                                                          1,795
Unrealized loss on securities             
  available for sale, net of tax                                                                                   -21
Purchase of treasury stock                                               -23,000          -346                    -346
Net income                                              6,411                                                    6,411         
Balance, December 31, 1997                    ---------------        -----------  ------------         ---------------
                                              $        21,243           -220,049  $     -3,333         $        78,948
                                              ===============        ===========  ============         ===============

</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,
                                                                  ---------------------------------------------------------
                                                                           1995              1996                1997
                                                                  ------------------  -----------------  -------------------
                                                                     (AS RESTATED)
<S>                                                                <C>                <C>                  <C>
Cash flows from operating activities:                             
     Net income                                                            $  1,684           $  5,697             $  6,411
     Adjustments to reconcile net income to net cash provided by  
      operating activities--                            
        Depreciation and amortization                                         1,630              1,739                3,116
        Compensation expense related to common stock options                     27                 40                   30
          Write-off of purchased technology and related assets                1,985                ---                  ---
          Purchased research and development and related costs                3,000                ---                  ---
        (Increase) decrease in assets--                           
Accounts receivable                                                          (5,223)            (3,217)              (1,372)
Inventories                                                                   3,939             (3,542)              (3,998)
Prepaid expenses and other current assets                                      (924)               480                  (52)
Deferred income taxes                                                        (2,241)              (194)              (1,364)
Other assets                                                                 (1,549)            (1,138)                 750
        Increase (decrease) in liabilities--                      
Accounts payable                                                                576              1,000               (1,177)
Accrued expenses                                                                752              2,376                1,188
Accrued income taxes                                                           (123)               ---                  ---
                                                                           --------           --------             --------
             Net cash provided by operating activities                        3,533              3,241                3,532
Cash flows from investing activities:                             
     Purchase of property and equipment, net                                (3,478)            (3,063)              (8,551)
      Sale and maturity of marketable securities                             13,775             18,038               16,287
      Purchase of marketable securities                                     (42,300)           (13,723)             (14,967)
      Investments in and acquisitions of businesses, net of cash  
         acquired                                                            (2,486)               ---                  ---        
                                                                           --------           --------             --------
             Net cash provided by (used in) investing activities            (34,489)             1,252               (7,231)
Cash flows from financing activities:                             
     Exercise of stock options and sale of common stock, net                    520                870                2,467
      Purchase of treasury stock                                             (7,633)            (2,438)                (346)
      Tax benefit from exercise of stock options                  
        and disqualifying dispositions                                          516              1,072                1,795
                                                                           --------           --------             --------
             Net cash provided by (used in) financing activities             (6,597)              (496)               3,916
Effect of exchange rates on cash                                               (354)               115                 (558)
                                                                           --------           --------             --------
Net increase (decrease) in cash and cash equivalents                        (37,907)             4,112                 (341)
Cash and cash equivalents, beginning of period                               43,613              5,706                9,818
                                                                           --------           --------             --------
Cash and cash equivalents, end of period                                   $  5,706           $  9,818             $  9,477
                                                                           ========           ========             ========
Supplemental disclosures of cash flow information:
     Interest paid                                                         $     72           $     84             $     30
                                                                           ========           ========             ========       
     Income taxes paid                                                     $  3,390           $  2,404             $  3,369
                                                                           ========           ========             ========
</TABLE>

  THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL
                                  STATEMENTS.

                                      F-5
<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 averge 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>
                                             1995              1996               1997
                                        --------------    ---------------   ----------------
<S>                                     <C>               <C>               <C>
BASIC EARNINGS PER SHARE                                                   
                                                                           
Net Income:                                 $1,684,000         $5,697,000         $6,411,000
                                                                           
Weighted Average Common Shares                                          
Outstanding:                                 8,114,000          7,695,000          7,941,000
                                            ----------         ----------         ----------
                                                                           
Basic Earnings Per Share                    $     0.21         $     0.74         $     0.81
                                            ----------         ----------         ----------
                                                                           
DILUTED EARNINGS PER SHARE                                                 
                                                                           
Net Income:                                 $1,684,000         $5,697,000         $6,411,000
                                            ----------         ----------         ----------
                                                                           
Weighted Average Common Shares
Outstanding:                                 8,114,000          7,695,000          7,941,000
                                                                           
Weighted Average Number of 
Dilutive Potential Common Shares:              493,000            371,000            408,000
                                            ----------         ----------         ----------
                                                                           
Weighted Average Number of Shares                                          
Outstanding as Adjusted:                     8,607,000          8,066,000          8,349,000
                                            ----------         ----------         ----------
                                                                           
Diluted Earnings Per Share:                 $     0.20         $     0.71         $     0.77
                                            ----------         ----------         ----------
</TABLE>
                                                                                


                                      F-6
<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, 1996 or December 31, 1997. 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, 1997 are as follows:

<TABLE>
<CAPTION>
                                                                                   GROSS UNREALIZED             GROSS UNREALIZED
                                 MARKET VALUE             COST BASIS                    GAINS                        LOSSES
                            --------------------     -------------------     ---------------------------     -----------------------

<S>                           <C>                     <C>                     <C>                             <C>
Tax Exempt Securities            $25,274,000              $25,143,000                  $141,000                      $10,000
 
</TABLE>

     Securities available for sale in the accompanying balance sheet at December
31, 1997 include $7,341,000 with contractual maturities of one year or less and
$17,933,000 with contractual maturities of one through 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,
                                      -------------------------------
                                             1996                1997
                                      -----------         -----------
<S>                                  <C>                 <C>
     Raw materials..................  $ 4,901,000         $ 9,826,000
     Work-in-process................    3,596,000           3,061,000         
     Finished goods.................    6,580,000           6,188,000         
                                      -----------         -----------         
                                      $15,077,000         $19,075,000         
                                      ===========         ===========          
</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 their building, 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-7
<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 gains of approximately $3,000 and
$143,000 for the years ended December 31, 1995 and 1996, respectively and a loss
of approximately $999,000 for the year ended December 31, 1997.

     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)  Disclosure 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, 1997 consist primarily of cash equivalents and marketable securities, short-
term trade receivables and payables, 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, 1996 and 1997 the
Company had approximately $800,000 and $30,000 of capitalized software included
in Other Assets in the accompanying balance sheets. In December, 1997 the
Company wrote off $1.2 million of development costs associated with its
whiteboard operation as part of a non-recurring charge for this business.

     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. Based on its review,
the Company does not believe that any material impairment of its long-lived
assets has occurred.

     n)  Recent Accounting Pronouncements
 
     Effective January 1, 1998 the Company will adopt the provisions of SFAS No.
130, Reporting Comprehensive Income.  SFAS No. 130 establishes standards for
reporting and display of comprehensive income and its components in the
financial statements.  Reclassification of financial statements for earlier
periods provided for comparative purposes is required.  The Company is in the
process of determining its preferred format. The adoption of SFAS No. 130  will
not have a material impact on the Company's consolidated results of operations,
financial position or cash flows.

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

1)  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED)

     The Company will adopt the provisions of SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information, effective with the financial
statements for the year ended December 31, 1998. 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. Financial statement disclosures for prior periods are required to be
restated. The Company is in the process of evaluating the disclosure
requirements but anticipates that touch input devices will be the sole
reportable segment in its future financial statements. The adoption of SFAS No.
131 will not have a material impact on the Company's consolidated results of
operations, financial position or cash flows.

2)  LINE OF CREDIT

     The Company has a demand bank line of credit in the amount of $3,000,000
under which the Company may borrow on an unsecured basis at the bank's prime
rate and on a secured basis at a negotiated rate. There were no amounts
outstanding under this line at December 31, 1996 or 1997.

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, 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 2,375,000
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-9
<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 the last five years. As of December 31, 1997, 160,000 shares have been
exercised and the remaining 40,000 shares were exercisable under this grant.

     Options to purchase 1,095,985 shares of common stock are outstanding under
the 1992 Plan at December 31, 1997 and generally vest at a rate of 25% per year
for four years. At December 31, 1997, no SARs, performance shares or other
restricted stock have been awarded under the 1992 Plan. As of December 31, 1997,
417,636 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 generally vest over two years.

     Options to purchase 72,500 shares of common stock are outstanding under the
1994 Plan at December 31, 1997. As of December 31, 1997, 107,500 shares of
common stock are available for future grants under the 1994 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, 1997.


                                     F-10
<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, 1995, 1996 and 1997.

<TABLE>
<CAPTION>
                                                NUMBER OF           EXERCISE PRICE
                                                 SHARES               PER SHARE
                                                ---------      -----------------------
<S>                                           <C>            <C>       <C>      <C>
Outstanding at December 31, 1994...........     864,868       $  .30     -      $45.00
    Granted................................     230,050        12.13     -       36.88
    Terminated.............................     (99,450)        5.00     -       45.00
    Exercised..............................     (81,600)         .30     -       11.88
                                              ---------
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
                                              =========
Exercisable at December 31,1997............     308,333       $ 1.75     -      $28.13
                                              =========
</TABLE>

     239,750 of the 1,183,485 options outstanding at December 31, 1997 have an
exercise price of between $1.75 and $7.06, with a weighted average exercise
price of $4.93 and a remaining contractual life of 5 years. Of these options,
155,650 are exercisable.  363,050 options have exercise prices between $7.63 and
$15.00 with a weighted average exercise price of $14.31 and a weighted average
remaining contractual life of 8 years.  90,964 of these options are exercisable.
407,435 options have exercise prices between $15.13 and $19.75 with a weighted
average exercise price of $18.47 and a weighted average remaining contractual
life of 9 years.  Of these options, 45,469 are exercisable.  165,750 options
have exercise prices between $20.56 and $28.13 with a weighted average exercise
price of $23.53 and a remaining contractual life of 9 years.  16,250 of these
options are exercisable.  The remaining 7,500 options have an exercise price of
$31.50 and a remaining contractual life of 10 years.  None 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 $3.9 million, $.49 and $.47,
respectively for the fiscal year ended December 31, 1997, $4.4 million, $.57 and
$.55, respectively for the fiscal year ended December 31, 1996 and $1.2 million,
$.15 and $.14 respectively for the fiscal year ended December 31, 1995.
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 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 1995
and 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 1995, 1996 and
1997 were $8.18, $9.56 and $9.79, respectively.

                                      F-11
<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, 
                                   ------------------------------------------------ 
                                      1995               1996               1997
                                   ----------         ----------         ----------
<S>                               <C>                <C>                <C>
Domestic.....................      $3,181,000         $9,409,000         $7,531,000
Foreign......................        (517,000)          (462,000)         2,210,000
                                   ----------         ----------         ----------
     Total...................      $2,664,000         $8,947,000         $9,741,000
                                   ==========         ==========         ==========
</TABLE>
                                                                                
The provision for federal and state income taxes consists of the following:

<TABLE>
<CAPTION>
                              1995                                1996                                1997   
              ---------------------------------    -------------------------------    ---------------------------------- 
                FEDERAL       STATE     FOREIGN      FEDERAL      STATE    FOREIGN      FEDERAL       STATE      FOREIGN  
              ------------  ----------  -------    -----------  ---------  -------    ------------  ----------  -------- 
<S>           <C>           <C>         <C>        <C>          <C>        <C>        <C>           <C>         <C>      
Current       $ 2,285,000   $ 567,000       ---    $2,711,000   $733,000     $ ---    $ 2,903,000   $ 862,000   $929,000 
Prepaid        (1,484,000)   (388,000)      ---      (163,000)   (31,000)      ---     (1,052,000)   (312,000)       --- 
              -----------   ---------   -------    ----------   --------     -----    -----------   ---------   -------- 
              $   801,000   $ 179,000     $ ---    $2,548,000   $702,000     $ ---    $ 1,851,000   $ 550,000   $929,000 
              ===========   =========   =======    ==========   ========     =====    ===========   =========   ========  
</TABLE>
                                                                               

                                      F-12
                                        
<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, 
1996 and 1997 are as follows:

<TABLE> 
<CAPTION> 
                                                 YEARS ENDED DECEMBER 31,
                                                ---------------------------
                                                   1996              1997
                                                ----------        ----------
<S>                                           <C>               <C>
Reserves for inventories                        $1,175,000        $1,174,000
Reserves for accounts receivable                 1,016,000         1,567,000
Reserves for warranty                              587,000           837,000
Intangibles                                      1,517,000         1,927,000
Other reserves and accruals                      1,210,000         1,364,000
                                                ----------        ----------
     Net deferred tax assets                    $5,505,000        $6,869,000
                                                ==========        ==========
</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,  

                                                       -----------------------------------------------
                                                          1995               1996               1997
                                                       ---------         ----------         ----------
<S>                                                   <C>               <C>                <C>
Provision at federal statutory rate............        $ 906,000         $3,042,000         $3,312,000
State taxes, net of federal benefit............          225,000            504,000            479,000
Foreign operating losses not benefited.........          176,000            410,000            135,000
Foreign operating losses benefited.............              ---            (85,000)               ---
Tax-exempt interest benefit....................         (659,000)          (493,000)          (392,000)
Foreign sales corporation benefit..............         (223,000)          (294,000)          (551,000)
Other tax reserves provided....................          590,000             88,000            315,000
Other, net.....................................          (35,000)            78,000             32,000
                                                       ---------         ----------         ----------
                                                       $ 980,000         $3,250,000         $3,330,000
                                                       =========         ==========         ==========
</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 and Taiwan . Total
rent expense under all leases for the years ended December 31, 1995, 1996 and
1997 was approximately $1,200,000, $1,368,000 and $1,889,000, respectively.

                                      F-13
<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>
     1998.............................          1,818,000
     1999.............................          1,813,000
     2000.............................          1,468,000
     2001.............................          1,477,000
     2002.............................          1,410,000
     2003 and thereafter..............          2,327,000
                                              -----------
     Total............................        $10,313,000
                                              ===========
</TABLE>
                                                                                
     c)  Post-retirement Benefits

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

6)  GEOGRAPHIC AND CUSTOMER INFORMATION

     The Company operates in one industry segment consisting of the development,
manufacture and sale of touch sensitive input systems.  Geographic area
information for the years ended December 31, 1995, 1996 and 1997 is as follows:

<TABLE>
<CAPTION>
                                                                       Domestic         International        Consolidated
                                                                     -----------         -----------          ------------
<S>                                                                 <C>                  <C>                  <C>
YEAR ENDED DECEMBER 31, 1995
  Net sales................................................          $53,699,000         $23,019,000          $ 76,718,000
  Income (loss) before provision for income taxes..........          $ 3,181,000         $  (517,000)         $  2,664,000
  Identifiable assets......................................          $63,754,000         $12,599,000          $ 76,353,000
YEAR ENDED DECEMBER 31, 1996                                         
  Net sales................................................          $63,634,000         $31,411,000          $ 95,045,000
  Income (loss) before provision for income taxes..........          $ 9,409,000         $  (462,000)         $  8,947,000
  Identifiable assets......................................          $66,933,000         $18,115,000          $ 85,048,000
YEAR ENDED DECEMBER 31, 1997
  Net sales................................................          $74,555,000         $53,926,000          $128,481,000
  Income before provision for income taxes.................          $ 7,531,000         $ 2,210,000          $  9,741,000
  Identifiable assets......................................          $71,649,000         $23,188,000          $ 94,837,000

</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 $23,748,000 in 1995,
which represented 31% of net sales, $36,198,000 in 1996, which represented 38%
of net sales and $57,409,000 in 1997, which represented 45% of net sales.

     No single customer represented more than 10% of total sales during the
years ended December 31, 1996 or 1997.

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 1996, the Board authorized
matching contributions up to $600 of participants' contributions.  Company
contributions and other expenses of the Plan amounted to $33,000 in 1995,
$89,000 in 1996 and $156,000 in 1997.

                                      F-14
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
                                        
8)  Acquisitions of Technologies

     During 1995, the Company acquired net assets and technology related to
Factura, a kiosk manufacturing operation and Touch Technology, a resistive
membrane touchscreen technology.  Purchased technology related to these
acquisitions is being amortized over a five-year period.

     In connection with the acquisition of Touch Technology, the Company issued
approximately 32,000 shares of common stock and, in July 1995, made a cash
payment of approximately $2,100,000. This acquisition was accounted for as a
purchase with the assets and results of operations incorporated into the
Company's financial statements as of the date of acquisition.  It is the
intention of the Company to further develop and improve these resistive membrane
technologies and to continue to manufacture and sell the related products to end
users.

     As a result of the Touch Technology acquisition, the Company recorded a
non-recurring pre-tax charge of $3,000,000 for purchased research and
development in process. Projects pursuant to this research and development had
not yet reached technological feasibility and the technology had no alternative
future use. The Company also completed a review of existing technology
investments to ensure proper valuation in the financial statements in relation
to the acquisition of resistive technologies. As a result of this review, the
Company recorded an additional nonrecurring pretax charge of $1,985,000
primarily related to the write-off of TouchMate technology acquired from Visage,
Inc. in June, 1994 and the write-down of related inventory to net realizable
value.

9)  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.

     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.

10)  RESTATEMENT OF DECEMBER 31, 1995 FINANCIAL STATEMENTS  In December 1996,
the Company restated their 1995 financials to reflect the arbitration costs
related to its case with Nissha.  These costs were changed from a deduction in
stockholders' equity reflecting a treasury stock treatment to a charge against
current earnings.  The following table summarizes the effect on net income and
related per share amounts in 1995.

                    Amounts in 000's except per share data

<TABLE>
<CAPTION>
                                As Reported           As Restated
                                   1995                   1995
                                -----------           -----------
<S>                             <C>                   <C>
Pre-tax income                    $3,683                  $2,664
Net income                        $2,327                  $1,684
Earnings per share     
    Primary                       $ 0.27                  $ 0.20
    Fully diluted                 $ 0.27                  $ 0.20

</TABLE>
                                      F-15
<PAGE>
 
                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                       SELECTED QUARTERLY FINANCIAL DATA

              (Unaudited - in thousands, except per share amounts)


<TABLE> 
<CAPTION>

                                                       1996                            
                            ---------------------------------------------------------- 
                              FIRST          SECOND           THIRD            FOURTH  
                             QUARTER        QUARTER          QUARTER           QUARTER 
                            ---------      ---------        ---------        ---------  
<S>                         <C>            <C>              <C>              <C>
Net Sales                     $21,055       $22,891           $24,077          $27,022 
Gross Profit                  $ 7,926       $ 8,623           $ 9,180          $10,321 
Net Income                    $ 1,168       $ 1,073           $ 1,522          $ 1,934 
Earnings per Share
  Diluted                     $  0.14       $  0.13           $  0.19          $  0.24  

<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)
Earnings per Share
  Diluted                        $  0.25       $  0.24          $  0.28        $  ----  (a)

</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.


                                      F-16
<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 1998 Annual Meeting
of Stockholders to be filed with the Securities and Exchange Commission by April
30, 1998, are incorporated herein by reference.


ITEM 11. EXECUTIVE COMPENSATION

     The section entitled "Executive Compensation" contained in the Proxy
Statement for the 1998 Annual Meeting of Stockholders to be filed with the
Securities and Exchange Commission by April 30, 1998, 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 1998 Annual
Meeting of Stockholders to be filed with the Securities and Exchange Commission
by April 30, 1998, 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, 1996 and 1997             F - 2
                                                                  
Consolidated Statements of Operations for each of the three years 
in the period ended December 31, 1997                                    F - 3
                                                                  
Consolidated Statements of Stockholders' Equity for each of the   
three years in the period ended December 31, 1997                        F - 4
                                                                  
Consolidated Statements of Cash Flows for each of the three years 
in the period ended December 31, 1997                                    F - 5
                                                                  
Notes to Consolidated Financial Statements                               F - 6
 
</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, 1997

     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, 1997.

  (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)                                     
  10.4  Registration Agreement between the Company and the purchasers of the    
        Company's Series D, Series F and Series G Preferred Stock dated November
        20, 1984, as amended on November 21, 1985 and September 12, 1986. (1)   
                                                                                
<PAGE>
 
  10.5  License Agreement between the Company, Peptek, Inc. and Mr. Jim Zeeger  
        dated July 1, 1988. (1)                                                 
  10.6  Distribution Agreement between the Company and Nissha Printing Co., Ltd.
        dated January 10, 1989. (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 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)                              
  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>
 
                                 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)                                     
  10.4  Registration Agreement between the Company and the purchasers of the    
        Company's Series D, Series F and Series G Preferred Stock dated November
        20, 1984, as amended on November 21, 1985 and September 12, 1986. (1)   
  10.5  License Agreement between the Company, Peptek, Inc. and Mr. Jim Zeeger  
        dated July 1, 1988. (1)                                                 
  10.6  Distribution Agreement between the Company and Nissha Printing Co., Ltd.
        dated January 10, 1989. (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 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)                              
  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                      
                                             March 11, 1998                     

     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.

Signature                  Title                                  Date
---------                  -----                                  ----

/s/ James D. Logan
------------------      
James D. Logan             Chairman of the Board of Directors     March 11, 1998
 

/s/ D. Westervelt Davis
-----------------------
D. Westervelt Davis        President, Chief Executive Officer     March 11, 1998
                           and Director

/s/ Geoffrey P. Clear
---------------------
Geoffrey P. Clear          Vice President, Finance and            March 11, 1998
                           Administration, Chief Financial
                           Officer and Treasurer

/s/ Ronald D. Fisher
--------------------
Ronald D. Fisher           Director                               March 11, 1998


/s/ Edward J. Stewart III
-------------------------
Edward J. Stewart III      Director                               March 11, 1998


/s/ Frank Manning
-----------------
Frank Manning              Director                               March 11, 1998
<PAGE>
 
                                                                   SCHEDULE II


                   MICROTOUCH SYSTEMS, INC. AND SUBSIDIARIES
                       VALUATION AND QUALIFYING ACCOUNTS
                           FOR THE THREE YEARS ENDED
                       DECEMBER 31, 1995, 1996  AND 1997
                            (AMOUNTS IN THOUSANDS)


<TABLE>
<CAPTION>
                                                 
                                                 
                                               Balance at     Charged to                                  Balance at  
                                               Beginning       Cost &     Charged to       Returns/        End of  
                                               of Period      Expense        Sales        Write-offs       Period   
                                               ---------     ---------    ---------       ---------       ---------
<S>                                            <C>            <C>           <C>           <C>             <C> 
ALLOWANCE FOR DOUBTFUL ACCOUNTS AND
SALES RETURNS

Year Ended December 31, 1995                   $2,638        $  289        $3,725        $(3,983)        $2,669
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
                                                                                                               
</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 was $4.5 million.