INTEGRATED SYSTEMS INC, 10-K, 1997-05-29

INTEGRATED SYSTEMS INC
10-K, 1997-05-29
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR FISCAL YEAR ENDED FEBRUARY 28, 1997 OR

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

Commission file number: 0-18268

INTEGRATED SYSTEMS, INC.
(Exact name of Registrant as specified in it's charter)

California 94-2658153
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification number)

201 Moffett Park Drive
Sunnyvale, CA 94089
(408) 542-1500

(Address,including zip code, of Registrant's principal executive offices
and 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

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Sections 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. [ ]

As of April 30, 1997, the aggregate market value of the voting stock of the
Registrant held by non-affiliates of the Registrant was $167,432,389. The
aggregate market value was computed by reference to the closing price of the
common stock on the Nasdaq National Market on April 30, 1997.

As of April 30, 1997, there were 23,165,870 shares of Registrant's common
stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Registrant's definitive Proxy Statement for its Annual Meeting of
Shareholders to be held July 15, 1997 are incorporated by reference in Part III
hereof.

The Exhibit Index is located on page 48.
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<PAGE>

INTEGRATED SYSTEMS, INC.

1997 FORM 10-K ANNUAL REPORT

Table of Contents
<TABLE>

PART I
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Page
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No.
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<S> <C> <C>
Item 1. Business......................................................................... 1
Item 2. Properties....................................................................... 14
Item 3. Legal Proceedings................................................................ 14
Item 4. Submission of Matters to a Vote of Security Holders.............................. 14
Item 4a. Executive Officers of the Registrant............................................. 15

PART II

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters........ 17
Item 6. Selected Financial Data.......................................................... 17
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations.................................................................... 19
Item 7a Quantitative and Qualitative Disclosures About Market Risks...................... 22
Item 8. Financial Statements and Supplementary Data...................................... 23
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosures................................................................... 23

PART III

Item 10. Directors and Executive Officers of the Registrant............................... 24
Item 11. Executive Compensation........................................................... 24
Item 12. Security Ownership of Certain Beneficial Owners and Management................... 24
Item 13. Certain Relationships and Related Transactions................................... 24

PART IV

Item 14. Exhibits, Financial Statements, Schedule, and Reports on Form 8-K ............... 25
Signatures................................................................................... 47
Index to Exhibits............................................................................ 48
</TABLE>

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PART I

Item 1. Business.

Integrated Systems, Inc. ("the Company") designs, develops, markets and
supports software products and provides related engineering services principally
for embedded microprocessor-based applications. Embedded microprocessors are
used to add functionality and intelligence to a variety of products and to
operate as an integral part of these products, generally without any direct
human intervention. The Company offers software that consists of a real-time
operating system, a development suite and a series of component modules and
design tools that aid software development. The Company's products are designed
to enable users to accelerate the design, development, debugging, implementation
and maintenance of embedded software. The Company's products and services reduce
the expense associated with embedded software and system development and enable
customers to develop systems that have greater functionality, enhanced
performance, improved reliability and ease of use. Integrated Systems markets
and supports its products and provides services on a worldwide basis to a
variety of users in a broad range of industries, including telecommunications
and data communications, automotive, multimedia and consumer, office and
industrial automation and the embedded Internet. The Company was incorporated in
California in February 1980.

Industry Background

Embedded systems consist of a microprocessor and related software dedicated
to a specialized task or set of tasks and are found in many common products such
as telephones, automobiles, VCRs and facsimile machines. Many of these products
require real-time embedded systems that provide an immediate, predictable
response to unpredictable sequences of external events under severe deadlines.
For example, the embedded system that controls the engine in an automobile must
set airflow, fuel quantity, spark advance and other engine parameters for each
cycle within milliseconds based on engine speed, engine temperature, atmospheric
conditions and accelerator position in order to optimize fuel efficiency,
emissions control and responsiveness.

As more powerful microprocessors have become available and decreased in
price, embedded systems are being used in or with a wider range of applications.
Today, embedded systems are found in: telecommunications and data communications
products such as routers, access devices and switches; automotive products such
as engine controllers and anti-lock braking systems; multimedia and consumer
products such as digital video broadcast and security systems; and office and
industrial automation products such as printers, copiers and point-of-sale
terminals. Emerging embedded Internet applications for interactive
entertainment, network computers, remote maintenance and other areas may offer
significant new opportunities for embedded systems.

The development of applications software for embedded systems requires
software development and design tools and a real-time operating system.
Real-time operating systems and software development tools, including compilers,
debuggers and simulators, are used by developers to create applications software
that enables the embedded system to perform its required functions. Embedded
systems are increasingly based upon 32-bit microprocessors, which run
significantly larger and more sophisticated application software than embedded
systems based upon less powerful microprocessors. In addition, the cost of some
32-bit microprocessors has decreased substantially to below $10, thereby opening
new markets for high-volume embedded applications that can now be cost
justified. As a result, 32-bit microprocessors represent the fastest growing
segment of the embedded microprocessor industry. The complexity and size of
these new software applications and the proliferation of multiple types of
microprocessors require a more substantial engineering effort, necessitating
more sophisticated development tools and real-time operating systems.

Developers of embedded systems are increasingly replacing internally
developed real-time operating systems with commercially available products as
organizations find internal development and maintenance to be costly and a
diversion of core engineering resources. Also, developers of embedded systems
often find that internally developed real-time operating systems designed for a
single project are not easily ported to other microprocessors or scalable for
different applications within the organization, which increases development time
and cost. As a result, organizations are seeking to improve engineering
productivity by standardizing on third-party software in order to eliminate
software incompatibilities and reduce training and

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support costs. With productivity becoming a more strategic issue, selection of
tools and real-time operating system technology is increasingly being evaluated
by senior managers for division or company-wide deployment. The Company believes
that more organizations will need to replace internally developed tools with
commercial products and to standardize on integrated enterprise-wide solutions
that are highly reliable, easily customizable and scalable so that they can be
used for simple as well as complex applications.

Integrated Systems' Solution

Integrated Systems provides comprehensive solutions for the development of
highly reliable and sophisticated embedded microprocessor-based applications.
The Company offers operating software that consists of a real-time system, the
pSOSystem, an integrated development environment, and a series of component
modules and design tools. The Company's products are designed to enable users to
accelerate the design, development, debugging, implementation and maintenance of
embedded software and to develop systems that have greater functionality,
enhanced performance, improved reliability and ease of use. The Company also
offers a range of consulting services, including product and system design,
training in the use of the Company's products and development of specialized
application code or drivers for incorporation into customers' applications.
These services have allowed the Company to offer customers complete designs
based on the Company's products and have allowed more rapid use of the Company's
technology in customers' product designs. The solution offered by Integrated
Systems provides the following features and benefits:

High Reliability. The Company's pSOS+ operating system is highly reliable,
making it suitable for deeply embedded applications where human intervention to
remedy software operating problems is not feasible. High reliability reduces
maintenance costs and allows the Company's customers to develop sophisticated
mass market products based on Integrated Systems' solution.

Suitability For High Volume Applications. The Company offers a full-featured
high performance operating system with memory requirements as low as 16 Kbytes.
In addition, the Company's operating system is very efficient, enabling the
Company's customers to minimize hardware costs while increasing the
functionality of their application designs. The Company's solutions are suitable
for low-cost, high-volume applications because of their low memory and other
hardware requirements and for hand-held applications in which less complex
hardware conserves battery power.

Scalability. The Company's product architecture is modular, scalable and
readily customizable. As a result, the Company's solution is used in a broad
range of industries for a wide array of applications. In addition, these product
features enable the Company to enter new and emerging markets rapidly. The
Company endeavors to be first to market with support for new applications and
microprocessors.

Cross-Development Capabilities. To accelerate the application development
process, the Company offers a set of tools specifically designed for embedded
software development that fully supports object-oriented methodologies. The
Company's solution provides an integrated development environment ("IDE"),
called pRISM+ to which individual development tools can be connected. Built on
the industry-standard CORBA (Common Object Request Broker Architecture)
framework, pRISM+ is a graphical programming environment which brings a
comprehensive set of application oriented tools to the embedded market. pRISM+
currently operates on certain Unix-based workstations. The Company also offers
SNiFF+, which is an advanced, object-oriented environment for the development of
sophisticated applications. The Company offers comprehensive cross-development
capabilities that allow its development tools to operate on a personal computer
or workstation, while the embedded software runs on an embedded processor. The
Company offers MATRIXx, a high-level set of tools for modeling, simulation and
code generation from a graphical description of real-time control software
functionality.

Application Specific Modules. While the Company's products are suitable for
a broad range of embedded applications, the Company provides additional support
for large application areas through the availability of application-specific
modules.

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Business Strategy

The Company's objective is to maintain a leadership position in the
telecommunications and data communications, automotive, multimedia and consumer
and office and industrial automation markets, and leverage its experience in
embedded applications to enter new markets, such as embedded Internet
applications, in which the Company believes it can establish a leadership
position. To achieve these objectives, the Company is pursuing the following
business strategy:

Maintain Technology Leadership. The Company's extensive expertise in
embedded software development tools and real-time operating systems has enabled
it to be a technology leader in the embedded software development market. The
Company seeks to capitalize on this existing technology base to accelerate the
development of new products that leverage the features of its existing product
line. The Company intends to maintain its technological leadership through rapid
response to emerging opportunities and customer requirements by continuing to
make significant investments in research and development and continuing to
enhance the architecture of its development tools and operating software.

Offer Comprehensive Solutions. The Company's products and services offer a
comprehensive solution to users of embedded microprocessors. This approach
simplifies customers' purchasing decisions, eliminates the need for customers to
integrate products from multiple sources, improves customer support, accelerates
the integration of the Company's technology into customers' products and allows
the Company's products to be used effectively by less experienced engineers. The
Company expects to continue to expand and refine its solution through internal
development activities and strategic acquisitions.

Maintain Market Focus. While the Company's products and services are
suitable for a wide variety of applications and are sold to a broad range of
customers, the Company has focused its development and marketing efforts on the
telecommunications and data communications, automotive, multimedia and consumer
and office and industrial automation markets. The Company has developed a
complete suite of products to address these markets in order to achieve deeper
penetration, as well as to provide products that reduce the time and expense
associated with system development. The Company seeks to participate in the
rapid growth of low-cost, high-volume applications for embedded systems through
run-time license arrangements with its customers based on the number of products
sold that incorporate the Company's products.

Address Emerging Market Opportunities. From time to time, the Company
evaluates strategic opportunities and applies its technology to develop products
for new markets more quickly. The Company believes its products and services are
suitable for emerging markets because its products are scalable, reliable and
rapidly reconfigurable.

Portability and Support for Widely-Used Embedded Microprocessors and Host
Platforms. The Company has expended significant resources to make its products
available on a broad range of host platforms and 32-bit embedded
microprocessors. This has allowed the Company to sell into a broad range of
markets. Because large companies use a range of host platforms and
microprocessors, it also makes it possible for large customers to standardize on
Integrated Systems' solution.

Products and Services

The Company offers three major families of products to support the embedded
software development market: real-time or embedded operating software, software
development tools and graphical design products.

Embedded Operating Software. Integrated Systems' embedded operating software
consists of the pSOS+ operating system and special purpose modules that run on
the pSOS+ operating system. The combination of real-time operating software and
development tools is marketed and licensed as pSOSystem. pSOS+ is a
priority-based, interrupt-oriented, multitasking operating system that is small
in size (requiring as little as 16 Kbytes of storage) and highly reliable and
efficient. Based on a scalable software component architecture, pSOS+ represents
a complete solution for advanced 32-bit embedded applications development and
run-time. The Company also offers a multiprocessing version, called pSOS+m, that
operates on tightly coupled or

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loosely coupled microprocessors. pSOS+ operating system is currently available
for the Motorola 68xxx, Intel x86 and i960, Power PC, MIPS and Hitachi SH
product families. The Company is currently porting pSOS+ for ARM, Sparc and
Mitsubishi M32.

The special purpose modules that run on the pSOS+ operating system are used
to support development of pSOS+ application software, to debug embedded code, to
provide file support for embedded applications and to develop user interfaces.
In addition, the Company offers a number of modules that address networking,
telecommunications and data communications, automotive, multimedia and consumer
and embedded Internet applications. These modules provide complete
implementation of certain aspects of the applications at which they are focused,
which improves customers' time to market and reliability. For example, the
TCP/IP module offered by the Company provides a complete implementation of the
TCP/IP communication protocol.

Software Development Tools. The Company offers a broad line of tools to
support the development of embedded software applications. The Company's
development tools consist of an integrated development environment ("IDE"),
called pRISM+, which provides sophisticated cross development frameworks, and
individual tools that are connected to these frameworks. pRISM+ allows
tool-to-tool and tool-to-target communications over local and wide-area
networks, allowing a project to readily move from a single workstation to a
distributed network. pRISM+ is built around an object bus conforming to the
CORBA standard. pRISM+ currently operates on Unix-based workstations
manufactured by Sun Microsystems and Hewlett-Packard, and is currently being
developed to operate on Windows-based personal computers.

The Company also offers SNiFF+, which is an advanced, object-oriented
environment for the development of sophisticated applications including the
development of complex object-oriented desktop and client-server applications.
Individual tools offered by the Company include C and C++ cross-compilers,
source level debuggers, browsers, pSOS+ simulators and profilers. The Company
also offers a visual debugging and analysis tool called ESp that graphically
displays component configurations, memory stack usage and errors, static and
dynamic views of all kernel objects, user specified events and CPU use graphs.
The Company also offers IDE products and individual tools that are licensed from
third parties or that include technology licensed from third parties. These
tools operate on Windows-based personal computers and workstations manufactured
by Sun Microsystems, Hewlett-Packard and IBM.

Graphical Design Products. The Company's graphical design product line,
called MATRIXx, includes control system engineering tools for analysis, design,
simulation and prototyping. Products and modules in the MATRIXx family include
the following:

--Xmath is a mathematically-based engineering analysis tool that
provides analysis capabilities, plot generation facilities and specialized
function libraries for control design, robust control, optimization, digital
signal processing, system identification and model reduction applications.

--SystemBuild is a system modeling and simulation tool used to create
interactive, dynamic system models that include plant dynamics and real-time
software logic. SystemBuild includes a block diagram editor, tools to create
animated system simulations and state transition diagrams. In addition,
customers can order special purpose libraries for a variety of needs,
including fuzzy logic systems. The architecture of SystemBuild allows the
creation of application-specific libraries.

--AutoCode automatically generates programming code from SystemBuild
diagrams in the C or Ada languages. This accelerates application development
by relieving engineers of line-by-line programming and sharply reducing
programming errors committed as projects move from design analysis to
programming phases.

--DocumentIt software further accelerates the design process by
automatically incorporating information about a design into a documentation
format.

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--RealSim Series prototyping tools complete the family by providing the
software and real-time computing hardware to verify an application in its
intended environment. C or Ada code generated in the AutoCode environment
automatically loads and runs on RealSim Series hardware.

--BetterState is a Statechart modeling, simulation, and automatic code
generation tool. BetterState's Statecharts allow developers to model complex
software system's reactions to asynchronous external stimulus and to
generate production-quality embedded code automatically. It is currently
available for the Windows 95 and Windows NT operating systems.

Engineering Services. In addition to the products described above, the
Company offers engineering services to its customers. The Company's engineering
services group helps customers design and implement specific solutions typically
using tools provided by the Company. The Company provides engineering services
to develop close relationships with key customers, to accelerate acceptance of
advanced tools in the industry, to demonstrate the effectiveness of the
products, to learn more about specific systems and customer's development needs
and to work with the Company's product development group to incorporate
appropriate features into new versions of products or into new modules or
libraries. Engineering services projects can last from a few weeks to several
years and are generally performed on a time and materials basis.

Sales and Support

The Company markets its products primarily through a direct sales force
augmented by a telemarketing organization, distributors and sales
representatives. The Company believes that use of a direct sales force allows
the Company to influence customer purchasing decisions, to provide superior
support to its customers and to understand better evolving customer needs. The
Company has significantly expanded the number of markets where it uses a direct
sales force and expects to continue to do so in the future.

The Company's direct sales organization in North America operates through 19
United States sales offices and a subsidiary in Canada. Direct sales managers
are typically supported by field application engineers who are experts in the
Company's technology and products. In addition, a small telemarketing
organization focuses on selling maintenance and renewal contracts, licensing
lower-priced products and licensing to universities.

Sales internationally are supported by a direct sales force that operates
from subsidiaries based in Austria, Canada, France, Germany, Israel, Japan,
Italy, Sweden, and the United Kingdom. In addition, the Company has sales and
support offices in Korea and India. The sales and support personnel in these
subsidiaries and offices are complemented by distributors and sales
representatives that address certain geographical areas, market segments or
product families. Sales representatives market and support the Company's
products in Australia, China, India, Korea, Taiwan and several other countries
in Asia, while distributors cover the rest of the world. In fiscal 1996, the
Company initiated direct selling operations in Japan and Italy, replacing its
existing third party distributor arrangements, and implemented certain
substantial changes to its direct sales operations in Germany and France in the
first quarter of fiscal 1997.

The Company's software development products are typically licensed on a
per-user basis. The Company's real-time operating systems and run-time packages
are also generally licensed for development on a per-project basis. Run-time
license fees are typically charged on a per-unit basis when the customer's
application is deployed. List prices for the Company's software development
tools and real-time operating systems development licenses generally range from
less than $4,000 to over $100,000, with a typical development license averaging
between $25,000 and $50,000. Prices for run-time license fees generally range
from less than $1 per-unit to over $100 per-unit depending, in part, on
production quantities.

Approximately 28%, 34% and 38% of the Company's total revenue was derived
from sales outside of North America in fiscal 1995, 1996 and 1997, respectively.
No single customer accounted for more than 10% of the Company's total revenue in
fiscal 1995, fiscal 1996, and fiscal 1997. The Company has made significant
investments in developing its distribution and support channels outside North
America to increase the percentage of revenue derived from international sales.
There can be no assurance that changes from distribution sales to direct sales
or these additional investments will lead to increased revenue. See "--Risk
Factors--Risks Associated with International Operations."

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Product Development

The Company's product development activities address the needs of the market
segments upon which the Company focuses, offer customers open cross-development
capability and enhance the capabilities of current products and modules to
address user requirements. In addition, the Company seeks to port the pSOSystem
to additional microprocessors, make the pSOSystem suitable for additional
high-volume applications, add new products and modules to the Company's product
lines, create interfaces between the Company's products and other key
computer-aided design and software development tools and provide the end user
greater flexibility to integrate automatically-generated code with
manually-written code, thereby allowing the end user to accelerate application
development.

The Company attempts to release upgrades and to introduce new products or
modules on a regular basis. In connection with each release, the Company works
closely with its customers to define improvements and enhancements that are
incorporated into the next release of the product. This approach includes
customer feedback in the Company's product design process, as well as in the
evaluation stage, thereby permitting customers to influence functionality early
in the product's life-cycle. The Company believes that its engineering services
group provides the Company with a competitive advantage for product development
by defining needs for new products, guiding future enhancements and testing new
implementations. In addition, this group contracts with customers to research
new methodologies that can serve as prototypes for new features, products or
modules. As of February 28, 1997, the Company employed 132 engineers in the
product development group and 70 in the engineering services group. The
Company's engineers include experts in software engineering, software
development tools, multimedia, telecommunications, real-time controls and
operating systems technology.

For fiscal 1995, 1996 and 1997, the Company's research and development
expenses were approximately $8.3 million, $11.4 million, and $17.3 million or
14%, 13%, and 16% of its total revenue, respectively. Research and development
expenses increased faster than revenue in fiscal 1997 to support the development
of pRISM+. The Company capitalizes certain costs of developing computer software
to be licensed or otherwise marketed to customers in accordance with Statement
of Financial Accounting Standards No. 86 ("SFAS No. 86"), "Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed. The Company
capitalized approximately $492,000, $335,000, and $1,540,000 of research and
development expenditures related to the development of software products in
fiscal 1995, 1996 and 1997, respectively. The amounts capitalized represented
approximately 6%, 3%, and 8%, respectively, of total research and development
expenditures for fiscal 1995, 1996 and 1997. Such capitalized costs are being
amortized using the greater of the amount computed using the ratio that current
gross revenues for a product bear to the total of current and anticipated future
gross revenues for that product, or on a straight-line basis over three years.
Amortization of capitalized cost for fiscal 1995, 1996 and 1997 was $607,000,
$921,000, and $968,000, respectively. The amount of research and development
expenses capitalized in a given time period depends upon the nature of the
development performed and, accordingly, amounts capitalized may vary from period
to period.

The market for embedded applications is fragmented and is characterized by
ongoing technological developments, evolving industry standards and rapid
changes in customer requirements. The Company's success depends upon its ability
to continue to develop and introduce in a timely manner new products that take
advantage of technological advances, to continue to enhance its existing product
lines, to offer its products across a spectrum of microprocessor families used
in the embedded systems market and to respond promptly to customers'
requirements. The Company must continuously update its existing products to keep
them current with changing technology and must develop new products to take
advantage of new technologies that could render the Company's existing products
obsolete. The Company has recently experienced delays in the development of new
products and the enhancement of existing products. Specifically, the development
of pRISM+ to operate on Windows-based personal computers has been subject to
delays. Such delays are commonplace in the software industry and are likely to
be experienced by the Company in the future. The Company's future prospects
depend upon the Company's ability to increase the functionality of existing
products in a timely manner and to develop new products that address new
technologies and achieve market acceptance. New products and enhancements must
keep pace with competitive offerings, adapt to evolving industry standards and
provide additional functionality. There can be no assurance that the Company
will be successful in developing and marketing, on a timely basis or at all,
competitive products, product enhancements and new products that respond to
technological change, changes

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in customer requirements and emerging industry standards, or that the Company's
enhanced or new products will adequately address the changing needs of the
marketplace. The inability of the Company, due to resource constraints or
technological or other reasons, to develop and introduce new products or product
enhancements in a timely manner could have a material adverse effect on the
Company's business, financial condition or results of operations. From time to
time, the Company or its competitors may announce new products, capabilities or
technologies that have the potential to replace or shorten the life cycles of
the Company's existing products. There can be no assurance that announcements of
currently planned or other new products will not cause customers to defer
purchasing existing Company products. Any failure by the Company to anticipate
or respond adequately to changing market conditions, or any significant delays
in product development or introduction, would have a material adverse effect on
the Company's business, financial condition and results of operations. If the
results of product development efforts are inadequate or delayed, the Company's
business, financial condition and results of operations would be materially
adversely affected. See "-- Risk Factors -- Risks Associated with New or
Emerging Markets."

Competition

The market for commercially available software tools and embedded operating
systems is fragmented, highly competitive, and is characterized by pressures to
incorporate new features and accelerate the release of new product versions. The
Company's products compete with software developed internally by embedded
systems manufacturers and software offered by other third parties. Many
organizations that internally develop and maintain real-time operating systems
have substantial programming resources and can develop specific products for
their needs. Many of these companies have significant investments in their
existing software and there can be no assurance that the Company will be able to
persuade existing and potential customers to replace or augment their internally
developed real-time operating systems with the Company's products.

The Company's principal competitors for third-party embedded software
development and related tools (pSOSystem) are Wind River Systems, Inc., Mentor
Graphics (through its acquisition of Microtec Research, Inc.), and Microware
Systems Corporation. The MATRIXx product family competes with products offered
by Mathworks Incorporated and a number of other companies that provide design
and analysis, modeling and simulation, and code generation products. The Company
also competes with a number of other vendors that address one or more segments
of the system design process, including vendors that have modified general
purpose software engineering products for real-time and control design
applications.

As the industry continues to develop, the Company expects competition to
increase in the future from existing competitors and from other companies that
may enter the Company's existing or future markets with similar or substitute
solutions that may be less costly or provide better performance or functionality
than the Company's products. Some of the Company's existing and many of its
potential competitors have substantially greater financial, technical, marketing
and sales resources than the Company and there can be no assurance that the
Company will be able to compete successfully against these companies. In the
event that price competition increases significantly, competitive pressures
could cause the Company to reduce the prices of its products, which would result
in reduced profit margins. Prolonged price competition would have a material
adverse effect on the Company's business, financial condition and results of
operations. Also, run-time licenses, which provide for per-unit royalty payments
for each embedded system that incorporates the Company's real-time operating
systems, may be subject to significant pricing pressures. A variety of other
potential actions by the Company's competitors, including increased promotion
and accelerated introduction of new or enhanced products, could have a material
adverse effect on the Company's business, financial condition and results of
operations.

The Company believes that the principal bases for a customer's decision to
license the Company's products are product functionality and performance, degree
of integration, ease of product use, quality of support services and corporate
reputation. The Company believes that it competes favorably in these areas.

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Proprietary Rights

The Company's success is heavily dependent upon its proprietary technology.
To protect its proprietary rights, the Company relies on a combination of
copyright, trade secret, patent and trademark laws, nondisclosure and other
contractual restrictions on copying and distribution and technical measures. The
Company seeks to protect its software, documentation and other written materials
through trade secret and copyright laws, which provide only limited protection.
In addition, the Company holds two United States patents and has additional
United States patent applications pending. There can be no assurance that
patents held by the Company will not be challenged and invalidated, that patents
will issue from any of the Company's pending applications or that any claims
allowed from existing or pending patents will be of sufficient scope or strength
(or be issued in all countries where the Company's products can be sold) to
provide meaningful protection or any commercial advantage to the Company. As
part of its confidentiality procedures, the Company generally enters into
nondisclosure agreements with its employees, consultants, distributors and
corporate partners and limits access to and distribution of its software,
documentation and other proprietary information. End user licenses of the
Company's software are frequently in the form of shrink wrap license agreements
which are not signed by licensees, and therefore may be unenforceable under the
laws of many jurisdictions. The source code of the Company's products is also
protected as a trade secret and is generally not licensed to customers. Despite
the Company's efforts to protect its proprietary rights, it may be possible for
unauthorized third parties to copy the Company's products or to reverse engineer
or obtain and use information that the Company regards as proprietary. There can
be no assurance that the Company's competitors will not independently develop
technologies that are substantially equivalent or superior to the Company's
technologies. Policing unauthorized use of the Company's products is difficult,
and while the Company is unable to determine the extent to which software piracy
of its products exists, software piracy can be expected to be a persistent
problem. In addition, effective protection of intellectual property rights may
be unavailable or limited in certain countries. The status of United States
patent protection in the software industry is not well defined and will evolve
as the United States Patent and Trademark Office grants additional patents.
Patents have been granted on fundamental technologies in software, and patents
may issue that relate to fundamental technologies incorporated into the
Company's products.

As the number of patents, copyrights, trademarks and other intellectual
property rights in the Company's industry increases, products based on its
technology may increasingly become the subject of infringement claims. There can
be no assurance that third parties will not assert infringement claims against
the Company in the future. Any such claims with or without merit could be time
consuming, result in costly litigation, cause product shipment delays or require
the Company to enter into royalty or licensing agreements. Such royalty or
licensing agreements, if required, might not be available on terms acceptable to
the Company, or at all, which could have a material adverse effect on the
Company's business, financial condition and results of operations. In addition,
the Company may initiate claims or litigation against third parties for
infringement of the Company's proprietary rights or to establish the validity of
the Company's proprietary rights. Litigation to determine the validity of any
claims, whether or not such litigation is determined in favor of the Company,
could result in significant expense to the Company and divert the efforts of the
Company's technical and management personnel from productive tasks. In the event
of an adverse ruling in any such litigation, the Company might be required to
pay substantial damages, discontinue the use and sale of infringing products,
expend significant resources to develop non-infringing technology or obtain
licenses to infringing technology. The failure of the Company to develop or
license a substitute technology could have a material adverse affect on the
Company's business, financial condition and results of operations.

The Company licenses certain software development tool products from other
companies to distribute with its own products. The inability of such third
parties to provide competitive products with adequate features and high quality
on a timely basis or to provide sales and marketing cooperation could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, the Company's products compete with products
produced by certain of the Company's licensors. There can be no assurance that,
upon the termination or expiration of these licenses, such licenses will be
available on reasonable terms or at all, or that similar products could be
obtained to substitute into the tool suites. The inability to license such
products could have a material adverse effect on the Company's business,
financial condition and results of operations.

8
<PAGE>
Backlog

The Company generally ships its products within 30 days after acceptance of
a customer purchase order and, therefore, has insignificant product backlog. The
insignificant product backlog makes it difficult to predict with accuracy
quarterly revenue and quarterly earnings prior to the end of a quarterly
reporting period. Engineering services backlog, consisting of orders for
engineering services scheduled to be performed within the following twelve
months, was approximately $4.1 million, $7.2 million, and $10.4 million at
February 28, 1995, 1996 and 1997, respectively. Most of the contracts with the
Company's engineering services customers are terminable at the convenience of
the customer. The Company has experienced termination in the past and expects
terminations to continue to occur in the future.

Employees

As of February 28, 1997, the Company employed 510 persons, including 229 in
marketing, sales and support services, 202 in engineering (70 in engineering
services and 132 in product development) and 79 in management, administration
and finance. Of these employees, 399 are located in the United States and 111
are located at the Company's subsidiaries and sales offices outside of the
United States. In addition, from time to time the Company employs temporary
employees and consultants. None of the Company's employees is represented by a
labor union or is the subject of a collective bargaining agreement. The Company
has never experienced a work stoppage and believes that its employee relations
are good. The Company believes its future success will depend in large part upon
its ability to attract and retain highly skilled managerial, engineering, sales,
marketing and operations personnel, many of whom are in great demand.
Competition for such personnel has intensified dramatically over the last twelve
months in Santa Clara County, California, where the Company is headquartered,
and there can be no assurance that the Company will be successful in attracting
and retaining such personnel. See "--Risk Factors--Dependence on Key Personnel;
Need for Additional Personnel."

Risk Factors

The statements contained in this Annual Report that are not purely
historical are forward looking statements, including statements regarding the
Company's expectations, hopes or intentions regarding the future. Actual results
could differ materially from those discussed in the forward-looking statements.
Among the factors that could cause actual results to differ materially are those
discussed below. In addition to the other information in this Annual Report, the
following risk factors should be considered carefully in evaluating the Company
and its business.

Fluctuations in Quarterly Results. The Company's quarterly operating results
vary significantly depending on a number of factors, including the volume and
timing of orders received during the quarter, the mix of and changes in
distribution channels through which the Company's products are sold, the timing
and acceptance of new products and product enhancements by the Company or its
competitors, changes in pricing, buyouts of run-time licenses, product life
cycles, the level of the Company's sales of third party products, purchasing
patterns of distributors and customers, competitive conditions in the industry,
foreign currency exchange rate fluctuations, business cycles affecting the
markets in which the Company's products are sold, extraordinary events, such as
litigation or acquisitions, including related charges, and economic conditions
generally or in various geographic areas. All of the foregoing factors are
difficult to forecast. The future operating results of the Company may fluctuate
as a result of these and other factors, including the Company's ability to
continue to develop innovative and competitive products.

The Company historically has operated with insignificant product backlog
because its products are generally shipped as orders are received. As a result,
product revenue in any quarter depends on the volume and timing of orders
received in that quarter. In addition, the Company has at times recognized a
substantial portion of its total revenue from sales booked and shipped in the
last two weeks of the quarter such that the magnitude of quarterly fluctuations
may not become evident until very late in, or after the end of, a particular
quarter. Because the Company's staffing and operating expenses are based on
anticipated total revenue levels, and a high percentage of the Company's costs
are fixed in the short term, small variations between anticipated orders and
actual orders, as well as non-recurring or large orders, can cause
disproportionate variations in the Company's operating results from quarter to
quarter.

9
<PAGE>

The procurement process of the Company's customers typically ranges from a
few weeks to several months or longer from initial inquiry to order, making the
timing of sales and license fees difficult to predict. Moreover, as licensing of
the Company's products increasingly becomes a more strategic decision made at
higher management levels, there can be no assurance that sales cycles for the
Company's products will not lengthen. The Company's results of operations may
also be affected by seasonal trends. The Company's total revenue and net income
during the first fiscal quarter have historically been lower than the previous
fourth fiscal quarter for a variety of reasons, including customer purchase
cycles related to expiration of budgetary authorizations, and the Company
expects that total revenue and net income in the first quarter of fiscal 1998
will be lower than the fourth quarter of fiscal 1997. In addition, the Company's
acquisitions in fiscal 1996 and 1997, as well as any future acquisitions,
involve numerous risks and could have a material adverse effect on the Company's
business, financial condition and results of operations. Due to all of the
foregoing factors, the Company believes that period-to-period comparisons of its
results of operations are not necessarily meaningful and should not be relied
upon as an indication of future performance. During the last fiscal year, the
Company's actual performance did not meet market expectations. It is likely
that, in some future quarters, the Company's operating results will again be
below the expectations of stock market analysts and investors. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

Rapid Technological Change; Dependence on New Products. The market for
embedded applications is fragmented and is characterized by ongoing
technological developments, evolving industry standards and rapid changes in
customer requirements. The Company's success depends upon its ability to
continue to develop and introduce in a timely manner new products that take
advantage of technological advances, to continue to enhance its existing product
lines, to offer its products across a spectrum of microprocessor families used
in the embedded systems market and to respond promptly to customers'
requirements. The Company must continuously update its existing products to keep
them current with changing technology and must develop new products to take
advantage of new technologies that could render the Company's existing products
obsolete. The Company has recently experienced delays in the development of new
products and the enhancement of existing products. Specifically, the development
of pRISM+ to operate on Windows-based personal computers has been subject to
delays. Such delays are commonplace in the software industry and are likely to
be experienced by the Company in the future. The Company's future prospects
depend upon the Company's ability to increase the functionality of existing
products in a timely manner and to develop new products that address new
technologies and achieve market acceptance. New products and enhancements must
keep pace with competitive offerings, adapt to evolving industry standards and
provide additional functionality. There can be no assurance that the Company
will be successful in developing and marketing, on a timely basis or at all,
competitive products, product enhancements and new products that respond to
technological change, changes in customer requirements and emerging industry
standards, or that the Company's enhanced or new products will adequately
address the changing needs of the marketplace. The inability of the Company, due
to resource constraints or technological or other reasons, to develop and
introduce new products or product enhancements in a timely manner could have a
material adverse effect on the Company's business, financial condition or
results of operations. From time to time, the Company or its competitors may
announce new products, capabilities or technologies that have the potential to
replace or shorten the life cycles of the Company's existing products. There can
be no assurance that announcements of currently planned or other new products
will not cause customers to defer purchasing existing Company products. Any
failure by the Company to anticipate or respond adequately to changing market
conditions, or any significant delays in product development or introduction,
would have a material adverse effect on the Company's business, financial
condition and results of operations. If the results of product development
efforts are inadequate or delayed, the Company's business, financial condition
and results of operations would be materially adversely affected. See
"Business--Product Development."

10
<PAGE>

Risks Associated with New or Emerging Markets. From time to time, the
Company embarks on product development for new or emerging markets. Currently,
the Company is continuing to expend substantial time and financial resources to
develop product lines for applications that use Internet technology with
embedded microprocessors. The Company has introduced both embedded operating
software and development tools for Internet applications. The commercial
Internet market has only recently begun to develop, is rapidly changing and is
characterized by an increasing number of new entrants with competitive products.
It is difficult to predict with any assurance whether the Internet will prove to
be a viable commercial marketplace, or whether demand for Internet related
products and services will emerge or increase in the future. If the Internet
market, or any other new market targeted by the Company in the future, fails to
develop or develops more slowly than anticipated or becomes saturated with
competitors, or if the Company's products and services do not achieve or sustain
market acceptance, the Company's business, financial condition and results of
operations would be materially adversely affected. See "Business--Product
Development."

Competition. The market for commercially available software tools and
embedded operating systems is fragmented and highly competitive and is
characterized by pressures to incorporate new features and accelerate the
release of new product versions. The Company's products compete with software
developed internally by embedded systems manufacturers and software offered by
other third parties. Many organizations that internally develop and maintain
real-time operating systems have substantial programming resources and can
develop specific products for their needs. Many of these companies have
significant investments in their existing software and there can be no assurance
that the Company will be able to persuade existing and potential customers to
replace or augment their internally developed real-time operating systems with
the Company's products. The Company's principal competitors for third-party
embedded software development and related tools (pSOSystem) are Wind River
Systems, Inc., Mentor Graphics (through its acquisition of Microtec Research,
Inc.), and Microware Systems. The MATRIXx product family competes with products
offered by Mathworks Incorporated and a number of other companies that provide
design and analysis, modeling and simulation, and code generation products. The
Company also competes with a number of other vendors that address one or more
segments of the system design process, including vendors that have modified
general purpose software engineering products for real-time and control design
applications.

Acquisition-Related Risks. The Company completed a number of acquisitions in
fiscal 1996 and one in fiscal 1997 and may complete additional acquisitions in
the future. The process of integrating an acquired company's business into the
Company's operations may result in unforeseen operating difficulties and
expenditures and may absorb significant management attention that would
otherwise be available for the ongoing development of the Company's business.
Moreover, there can be no assurance that the anticipated benefits of an
acquisition will be realized. Future acquisitions by the Company could result in
potentially dilutive issuances of equity securities, the incurrence of debt and
contingent liabilities and amortization expenses related to goodwill and other
intangible assets, which could materially adversely affect the Company's
business, financial condition and results of operations. In addition,
acquisitions involve numerous risks, including difficulties in the assimilation
of the operations, technologies and products of the acquired companies,
difficulties in managing diverse geographic sales and research and development
operations, the diversion of management attention from other business concerns,
risks of entering markets in which the Company has no or limited direct prior
experience and the potential loss of key employees of the acquired company. The
inability of the Company's management to respond to changing business

11
<PAGE>

conditions effectively, including the changes associated with its recent
acquisitions, could have a material adverse effect on the Company's business,
financial condition and results of operations. From time to time, the Company
evaluates potential acquisitions of businesses, products or technologies. The
Company has no present understandings, commitments or agreements with respect to
any material acquisition of other businesses, products or technologies, and no
material acquisition is currently being pursued actively. In the event that such
an acquisition were to occur, however, there can be no assurance that the
Company's business, operating results and financial condition would not be
materially adversely affected. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

Risks Associated with International Operations. In fiscal 1995, 1996 and
1997, the Company derived approximately 28%, 34%, and 38%, respectively, of its
total revenue from sales outside of North America. The Company expects that
international sales will continue to generate a significant percentage of its
total revenue in the foreseeable future. International operations are subject to
a number of special risks, including foreign government regulation, more
prevalent software piracy, longer payment cycles, unexpected changes in, or
imposition of, regulatory requirements, tariffs, import and export restrictions
and other barriers and restrictions, greater difficulty in accounts receivable
collection, potentially adverse tax consequences, the burdens of complying with
a variety of foreign laws, staffing and managing foreign operations, general
geopolitical risks, such as political and economic instability, hostilities with
neighboring countries and changes in diplomatic and trade relationships,
possible recessionary environments in economies outside the United States and
other factors beyond the control of the Company. The Company generally
denominates sales to and by foreign subsidiaries in local currency, and an
increase in the relative value of the dollar against such currencies, as has
recently occurred, would reduce the Company's revenue in dollar terms or make
the Company's products more expensive and, therefore, potentially less
competitive in foreign markets. The Company has little experience in hedging its
foreign currency sales and often does not hedge such sales. There can be no
assurance that the Company's future results of operations will not be adversely
affected by currency fluctuations. The Company relies on distributors for sales
of its products in certain foreign countries and, accordingly, is dependent on
their ability to promote and support the Company's products and, in some cases,
to translate them into foreign languages. The Company's international
distributors generally offer products of several different companies, including
in some cases products that are competitive with the Company's products, and
such distributors are not subject to any minimum purchase or resale
requirements. There can be no assurance that the Company's international
distributors will continue to purchase the Company's products or provide them
with adequate levels of support. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

Risks of Product Defects; Product and Other Liability. As a result of their
complexity, software products may contain undetected errors or compatibility
issues, particularly when first introduced or as new versions are released.
There can be no assurance that, despite testing by the Company and testing and
use by current and potential customers, errors will not be found in new products
after commencement of commercial shipments. The occurrence of such errors could
result in loss of or delay in market acceptance of the Company's products, which
could have a material adverse effect on the Company's business, financial
condition and results of operations. The increasing use of the Company's
products for applications in systems that interact directly with the general
public, particularly applications in transportation, medical systems and other
markets where the failure of the embedded system could cause substantial
property damage or personal injury, could expose the Company to significant
product liability claims. In addition, the Company's products are used for
applications in mission-critical business systems where the failure of the
embedded system could be linked to substantial economic loss. The Company's
license and other agreements with its customers typically contain provisions
designed to limit the Company's exposure to potential product liability and
other claims. It is likely, however, that the limitation of liability provisions
contained in the Company's agreements are not effective in all circumstances and
in all jurisdictions. Although the Company has not experienced any product
liability or economic loss claims to date, the sale and support of the Company's
products may entail the risk of such claims. The Company currently does not have
insurance against product liability risks or errors or omissions coverage and
there can be no assurance that such insurance will be available to the Company
on commercially reasonable terms or at all. A product liability claim or claim
for economic loss brought against the Company, or a product recall involving the
Company's software, could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Business--Product
Development."

12
<PAGE>

Dependence on Key Personnel; Need for Additional Personnel. The Company's
future performance depends to a significant degree upon the continued
contributions of its key management, product development, sales, marketing and
operations personnel. The Company does not have employment agreements with any
of its key personnel and does not maintain any key person life insurance
policies. In addition, the Company believes its future success will also depend
in large part upon its ability to attract and retain highly skilled managerial,
engineering, sales, marketing and operations personnel, many of whom are in
great demand. Competition for such personnel has intensified dramatically over
the last twelve months in Santa Clara County, California, where the Company is
headquartered, and there can be no assurance that the Company will be successful
in attracting and retaining such personnel. The failure of the Company to
attract, assimilate and retain the necessary personnel could have a material
adverse effect on the Company's business, financial condition and results of
operations. See "Business--Employees."

Limited Protection of Proprietary Technology. The Company's success is
heavily dependent upon its proprietary technology. To protect its proprietary
rights, the Company relies on a combination of copyright, trade secret, patent
and trademark laws, nondisclosure and other contractual restrictions on copying
and distribution and technical measures. The Company seeks to protect its
software, documentation and other written materials through trade secret and
copyright laws, which provide only limited protection. In addition, the Company
holds two United States patents and has additional United States patent
applications pending. There can be no assurance that patents held by the Company
will not be challenged and invalidated, that patents will issue from any of the
Company's pending applications or that any claims allowed from existing or
pending patents will be of sufficient scope or strength (or be issued in all
countries where the Company's products can be sold) to provide meaningful
protection or any commercial advantage to the Company. As part of its
confidentiality procedures, the Company generally enters into nondisclosure
agreements with its employees, consultants, distributors and corporate partners
and limits access to and distribution of its software, documentation and other
proprietary information. End user licenses of the Company's software are
frequently in the form of shrink wrap license agreements, which are not signed
by licensees, and therefore may be unenforceable under the laws of many
jurisdictions. The source code of the Company's products is also protected as a
trade secret and is generally not licensed to customers. Despite the Company's
efforts to protect its proprietary rights, it may be possible for unauthorized
third parties to copy the Company's products or to reverse engineer or obtain
and use information that the Company regards as proprietary. There can be no
assurance that the Company's competitors will not independently develop
technologies that are substantially equivalent or superior to the Company's
technologies. Policing unauthorized use of the Company's products is difficult,
and while the Company is unable to determine the extent to which software piracy
of its products exists, software piracy can be expected to be a persistent
problem. In addition, effective protection of intellectual property rights may
be unavailable or limited in certain countries. The status of United States
patent protection in the software industry is not well defined and will evolve
as the United States Patent and Trademark Office grants additional patents.
Patents have been granted on fundamental technologies in software, and patents
may issue that relate to fundamental technologies incorporated into the
Company's products.

As the number of patents, copyrights, trademarks and other intellectual
property rights in the Company's industry increases, products based on its
technology may increasingly become the subject of infringement claims. There can
be no assurance that third parties will not assert infringement claims against
the Company in the future. Any such claims with or without merit could be time
consuming, result in costly litigation, cause product shipment delays or require
the Company to enter into royalty or licensing agreements. Such royalty or
licensing agreements, if required, may not be available on terms acceptable to
the Company, or at all, which could have a material adverse affect on the
Company's business, financial condition and results of operations. In addition,
the Company may initiate claims or litigation against third parties for
infringement of the Company's proprietary rights or to establish the validity of
the Company's proprietary rights. Litigation to determine the validity of any
claims, whether or not such litigation is determined in favor of the Company,
could result in significant expense to the Company and divert the efforts of the
Company's technical and management personnel from productive tasks. In the event
of an adverse ruling in any such litigation, the Company may be required to pay
substantial damages, discontinue the use and sale of infringing products, expend
significant resources to develop non-infringing technology or obtain licenses to
infringing technology. The failure of the Company to develop or license a
substitute technology could have a material adverse affect on the Company's
business, financial condition and results of operations. See "Business --
Proprietary Rights."

13
<PAGE>

Dependence on Licenses from Third Parties. The Company licenses certain
software development tool products from other companies to distribute with its
own products. The inability of such third parties to provide competitive
products with adequate features and high quality on a timely basis or to
cooperate in sales and marketing activities could have a material adverse effect
on the Company's business, financial condition and results of operations. In
addition, the Company's products compete with products produced by certain of
the Company's licensors. There can be no assurance that, upon the termination or
expiration of these licenses, such licenses will be available on reasonable
terms or at all, or that the Company could obtain similar products to substitute
into the tool suites. The inability to license such products could have a
material adverse effect on the Company's business, financial condition and
results of operations.

Volatility of Stock Price. The prices for the Company's common stock have
fluctuated widely in the past. The management of the Company believes that such
fluctuations may have been caused by actual or anticipated variations in the
Company's operating results, announcements of technical innovations or new
products or services by the Company or its competitors, changes in earnings
estimates by securities analysts and other factors, including changes in
conditions of the software and other technology industries in general. Stock
markets have experienced extreme price volatility in recent years. This
volatility has had a substantial effect on the market prices of securities
issued by the Company and other high technology companies, often for reasons
unrelated to the operating performance of the specific companies. In the past,
following periods of volatility in the market price of a company's securities,
securities class action litigation has often been instituted against such a
company. Such litigation, if instituted, could result in substantial costs and a
diversion of management attention and resources, which would have a material
adverse effect on the Company's business, financial condition and results of
operations even if the Company is successful in such suits. These market
fluctuations, as well as general economic, political and market conditions such
as recessions, may adversely affect the market price of the common stock.

Item 2. Properties.

In March 1996, the Company purchased for approximately $12.0 million in cash
a building in Sunnyvale, California covering approximately 150,000 square feet.
The Company occupies approximately 100,000 square feet of this facility and
leases out the remaining space. The Company leases a number of offices in North
America, Europe, Asia and Israel.

Item 3. Legal Proceedings.

In January 1997, a former employee filed a complaint in the Superior Court
of the State of California, County of San Diego, against the Company and certain
of its officers, alleging claims for, among other things, breach of contract,
fraud, negligent misrepresentation and labor code violations. The complaint
seeks general and specific damages of no less than $1.5 million plus exemplary
damages, attorney's fees and costs of suit. The Company has filed answers to the
complaint denying all of the allegations and asserting various affirmative
defenses.

In fiscal 1997, a distributor for the Company's sales and service subsidiary
in Paris, France filed a complaint against the subsidiary alleging breach of
contract. The complaint seeks damages of approximately $850,000. An answer to
the complaint has been filed denying the allegations.

The Company believes it has meritorious defenses to these claims and intends
to defend these suits vigorously. However, litigation is subject to inherent
uncertainties and thus, there can be no assurance that these lawsuits will be
resolved favorably to the Company or that they will not have a material adverse
effect on the Company's results of operations.

Item 4. Submission of Matters to a Vote of Security Holders.

Not applicable.

14
<PAGE>
<TABLE>

Item 4a. Executive Officers of the Registrant.
<CAPTION>

Name Age Position
---- --- --------

<S> <C> <C>
Narendra K. Gupta............ 48 Chairman of the Board of Directors and Secretary
Hamid Mirab.................. 35 Vice President, European Operations
Greg Olson................... 47 Vice President, Marketing
William C. Smith............. 58 Vice President, Finance and Chief Financial Officer
David P. St. Charles......... 48 President, Chief Executive Officer and Director
David E. Stepner............. 52 Vice President, Research and Development
Janice Waterman.............. 37 Vice President, Human Resources and Operations
</TABLE>

Executive officers are chosen by and serve at the discretion of the Board of
Directors of the Company.

Dr. Gupta is a founder of the Company and has been a director of the Company
since its formation in 1980. He has been the Chairman of the Board of the
Company since March 1993 and Secretary since September 1989. Dr. Gupta was Chief
Executive Officer from 1987 to May 1994 and President from the Company's
formation in 1980 to May 1994. He was elected a Fellow of the Institute of
Electrical and Electronic Engineers ("IEEE") in November 1991. Dr. Gupta serves
on the board of Digital Link Corporation, a data communications and wide-area
networking equipment manufacturer and Simulation Sciences, Inc., a developer of
chemical simulation software. Dr. Gupta holds an M.S. in Engineering from the
California Institute of Technology and a Ph.D. in Engineering from Stanford
University.

Dr. Mirab joined the Company in November 1989 and has been Vice President,
European Operations since October 1995. From November 1989 to September 1992,
Dr. Mirab served as Manager, Technical Support in the United Kingdom and from
September 1992 to February 1995 he served as Managing Director of the Company's
United Kingdom subsidiary. From February 1995 to October 1995, Dr. Mirab served
as General Manager, European Operations. Dr. Mirab holds a B.S. in General
Engineering and a Ph.D. in Control Systems from the University of Glasgow.

Mr. Olson has been Vice President, Marketing since he joined the Company in
July 1996. From June 1992 to March 1996, Mr. Olson held Vice President positions
in product strategy, tools products, and strategic planning at Sybase, Inc., a
data-base software company. Mr. Olson holds a B.S. in Information Sciences from
the University of California, Santa Cruz.

Mr. Smith joined the Company in January 1997 as the Chief Financial Officer
and Vice President, Finance. From June 1995 to October 1996, Mr. Smith was the
Chief Financial Officer and Vice President, Finance for Meta Software, Inc. From
March 1993 to June 1995, Mr. Smith was the Chief Financial Officer and Vice
President, Finance of Bell Microproducts, Inc. Mr. Smith also served as the
Chief Financial Officer of Wodsworth, Inc, from 1983 to 1992. Mr. Smith holds a
B.S. in Financial Management from San Jose State University and an M.B.A from
Gonzaga University.

Mr. St. Charles joined the Company in August 1993 and was appointed
President and Chief Executive Officer of the Company in May 1994. He has been a
director since he joined the Company in August 1993. From April 1990 until
August 1993, Mr. St. Charles served as President and a director of Wind River
Systems, Inc., a real-time software company. He holds a B.A. in Liberal Arts and
an M.A. in International Economics from Carleton University and an M.S. from the
Sloan School of Management at the Massachusetts Institute of Technology.

Dr. Stepner has been Vice President, Research and Development since he
joined the Company in December 1993. From April 1984 until March 1993, he served
as Founder, President and Chief Executive Officer of Greyhawk Systems, Inc., a
manufacturer of high resolution liquid crystal displays. In March 1993, Greyhawk
Systems, Inc. was sold to AmPro Corporation and Dr. Stepner served as Executive
Vice President of AmPro Corporation and General Manager of the AmPro/Greyhawk
Division from March 1993 until December 1993. Dr. Stepner holds a B.S. in
General Engineering from Brown University and an M.S. and a Ph.D., both in
Electrical Engineering, from Stanford University.

15
<PAGE>

Ms. Waterman joined the Company in July 1995 as Vice President, Human
Resources and has served as Vice President, Human Resources and Operations of
the Company since March 1996. From September 1994 to July 1995, she served as
Vice President, Human Resources and Administration for Salick Health Care Inc.,
a health care provider. From May 1991 until September 1994, she served as Vice
President of Human Resources and Administration of Tekelec, Inc., a
telecommunications company. Ms. Waterman holds a B.A. in Sociology and Economics
from the University of California at Davis and an M.S. in Industrial Psychology
from California State University, Hayward.

16
<PAGE>

PART II

Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters.

The Company's common stock is listed on the Nasdaq National Market under the
trading symbol "INTS". The range of high and low sale prices for the Company's
common stock on that market for each of the four quarters during the last two
fiscal years are as follows:

Q1 Q2 Q3 Q4
----------------------------------
FY97 High............ $36.750 $40.062 $41.250 $29.625
Low............. $22.750 $25.000 $15.875 $19.625

FY96 High............ $12.000 $15.375 $21.000 $23.875
Low............. $ 9.875 $10.000 $14.625 $16.000

All share prices have been adjusted to reflect the two-for-one split of the
Company's common stock effected on April 5, 1996.

As of April 30, 1997, there were 242 holders of record of the Company's
common stock.

The Company has never declared or paid cash dividends on its capital stock
and anticipates that, for the foreseeable future, it will continue to retain any
earnings for use in the operation of its business.

Item 6. Selected Financial Data.

The following selected consolidated financial data is qualified by reference
to and should be read in conjunction with the consolidated financial statements
and the notes thereto included elsewhere herein. The consolidated statement of
income data set forth below with respect to the years ended February 28, 1995,
1996, and 1997 and the consolidated balance sheet data at February 28, 1996 and
1997 are derived from, and are qualified by reference to, the audited
consolidated financial statements and notes thereto included in this Annual
Report. The consolidated statement of income data set forth below with respect
to the years ended February 28, 1993 and 1994 and the consolidated balance sheet
data at February 28, 1993, 1994, and 1995 are derived from audited consolidated
financial statements not included in this Annual Report. During fiscal 1996, the
Company acquired TakeFive Software GmbH and Doctor Design, Inc. in transactions
accounted for as poolings of interests. Fiscal 1994 and 1995 annual financial
information includes the combined results of the Company and Doctor Design, Inc.
Fiscal 1996 and 1997 annual financial information includes the results of Doctor
Design, Inc. and TakeFive Software GmbH. The annual financial information has
not been restated for earlier years because such financial information was not
material to the Company.

During fiscal 1997, the Company acquired Epilogue Technology Corporation in
a transaction accounted for as a pooling of interests. The results of Epilogue
Technology Corporation have been combined with the results of the Company since
the date of acquisition. Prior period information has not been restated for the
results of Epilogue Technology Corporation because such financial information
was not material to the Company. Also during fiscal 1997, the Company revised
the terms of the acquisition of Diab Data, Inc., which was acquired in fiscal
1996 in a transaction accounted for under the equity method of accounting.

17
<PAGE>
<TABLE>
<CAPTION>

Year Ended February 28,
------------------------------------------------------
1993 (1) 1994 1995 1996 1997
-------- ---- ---- ---- ----
(in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Consolidated Statements of Income Data:
Revenue:
Product.............................. $19,690 $26,350 $34,952 $51,597 $ 69,282
Services............................. 12,698 19,433 23,102 32,845 36.181
------- ------- ------- ------- ---------
Total revenue................... 32,388 45,783 58,054 84,442 105,463
------- ------- ------- ------- ---------
Costs and expenses:
Cost of product revenue.............. 3,221 4,986 5,980 9,046 9,755
Cost of services revenue............. 4,170 8,262 9,547 15,824 16,392
Marketing and sales.................. 11,564 16,515 20,565 27,209 40,546
Research and development............. 6,133 5,926 8,341 11,379 17,264
General and administrative........... 2,468 3,567 4,311 6,637 8,891
Amortization of intangible assets 1,199 1,764 1,311 556 --
Acquisition-related and other........ -- -- -- 7,327 5,676
------- ------- ------- ------- ---------
Total costs and expenses........ 28,755 41,020 50,055 77,978 98,524
------- ------- ------- ------- ---------
Income from operations..... 3,633 4,763 7,999 6,464 6,939
Interest and other income............... 1,575 1,258 1,601 2,331 4,220
------- ------- ------- ------- ---------
Income before income taxes. 5,208 6,021 9,600 8,795 11,159
Provision for income taxes.............. 1,771 1,935 3,110 3,512 3,905
------- ------- ------- ------- ---------
Net income................ $ 3,437 $ 4,086 $ 6,490 $ 5,283 $ 7,254
======= ======= ======= ======= =========
Earnings per share(2)................... $ 0.18 $ 0.21 $ 0.33 $ 0.24 $ 0.31
======= ======= ======= ======= =========
Earnings per share before
acquisition-related
and other costs(3)................... $ 0.18 $ 0.21 $ 0.33 $ 0.50 $ 0.47
======= ======= ======= ======= =========
Shares used in per share calculations(2) 18,636 19,122 19,964 22,088 23,508
======= ======= ======= ======= =========

February 28,
--------------------------------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(in thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents and marketable
securities............................ $27,150 $33,156 $36,517 $49,476 $ 54,695
Working capital.......................... 13,005 12,298 17,783 31,431 38,019
Total assets............................. 40,918 52,970 66,101 85,264 112,502
Total shareholders' equity............... 32,447 38,032 47,948 58,276 86,172
<FN>

- -------------------
(1) Fiscal 1993 has not been restated to reflect the annual financial
information for Doctor Design, Inc. as such financial information was not
material to the Company.
(2) See Note 1 of Notes to Consolidated Financial Statements for an explanation
of the determination of the number of shares used in per share
calculations.
(3) Fiscal 1996 and 1997 earnings per share before acquisition-related and
other costs reflect earnings per share as if the Company had not incurred
such acquisition-related and other costs, net of any tax effects.
</FN>
</TABLE>

18
<PAGE>

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.

The following discussion provides an analysis of the Company's financial
condition and results of operations, and should be read in conjunction with the
"Selected Financial Data" and the Consolidated Financial Statements and the
Notes thereto of the Company.

Overview

Integrated Systems designs, develops, markets and supports software products
and provides related engineering services principally for embedded
microprocessor-based applications. The Company currently derives substantially
all of its revenues from licensing of these products and providing related
maintenance and engineering and consulting services. In October 1995, the
Company acquired TakeFive Software GmbH ("TakeFive"), an Austrian corporation in
the business of developing and marketing software tools used in software
development, including SNiFF+, an advanced object-oriented IDE. In January 1996,
the Company completed a merger with Doctor Design, Inc. ("Doctor Design"), a
California corporation that develops multimedia hardware, software and
application specific integrated circuit technology. In July 1996, the Company
acquired Epilogue Technology Corporation ("Epilogue"), a New Mexico corporation
which develops and distributes network management and embedded Internet software
for telecommunications and data communications equipment manufactures, embedded
software suppliers and networking related integrated circuit manufactures. Each
of these business combinations has been accounted for as a pooling of interests.
The results of operations for Epilogue have been included only since the date of
acquisition, as previous results were not significant. The results of operations
for fiscal 1996 include the results of TakeFive and Doctor Design for the whole
year. The fiscal 1995 results have been restated to include only the results of
Doctor Design, since those of TakeFive were not significant. In November 1996,
the Company revised the terms of the acquisition of Diab Data, Inc. ("Diab
Data") which was acquired in fiscal 1996 in a transaction accounted for under
the equity method of accounting. Revising the terms of the original acquisition
agreement requires the Company to consolidate the results of Diab Data from the
fourth quarter of fiscal 1997 onwards. See "Business -- Risk
Factors--Acquisition-Related Risks."

Forward-Looking Information is Subject to Risk and Uncertainty

Except for the historical statements contained herein, this Form 10-K
contains "forward-looking" statements and information (as defined in the Private
Securities Litigation Reform Act of 1995) that involve risk and uncertainty,
including expectations for fiscal 1998 and various business environment and
trends. Actual future results and trends may differ materially depending on a
variety of factors, including the volume and timing of orders received during
the quarter, the mix of and changes in distribution channels through which the
Company's products are sold, the timing and acceptance of new products and
product enhancements by the Company or its competitors, changes in pricing,
buyouts of run-time licenses, product life cycles, the level of the Company's
sales of third party products, purchasing patterns of distributors and
customers, competitive conditions in the industry, business cycles affecting the
markets in which the Company's products are sold, extraordinary events, such as
litigation or acquisitions, including related charges, and economic conditions
generally or in various geographic areas. All of the foregoing factors are
difficult to forecast. The future operating results of the Company may fluctuate
as a result of these and the other risk factors detailed from time-to-time in
the Company's Securities and Exchange Commission reports and in the section of
this Annual Report entitled "Business -- Risk Factors."

Due to all of the foregoing factors, the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as an indication of future performance.
During the last fiscal year, the Company's actual performance did not meet
market expectations. It is likely that, in some future quarters, the Company's
operating results will again be below the expectations of stock market analysts
and investors.

19
<PAGE>

Results of Operations
<TABLE>

The following table sets forth for the periods presented the percentage of
total revenue represented by each line item in the Company's consolidated
statements of income and the percentage change in each line item from the prior
period.

<CAPTION>
Percentage of Period-to-Period
Total Revenue Percentage Changes
------------- ------------------
Year Ended February 28, Fiscal 1995 Fiscal 1996
----------------------- to to
1995 1996(1) 1997(1) Fiscal 1996 Fiscal 1997
---- ------- ------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Revenue:
Product........................... 60% 61% 66% 48% 34%
Services.......................... 40 39 34 42 10
-- -- --
Total revenue.................. 100 100 100 45 25
--- --- ---
Costs and expenses:
Cost of product revenue.......... 10 11 9 51 8
Cost of services revenue......... 17 19 16 66 4
Marketing and sales.............. 36 32 38 32 49
Research and development......... 14 13 16 36 52
General and administrative....... 7 8 9 54 34
Amortization of intangible assets 2 1 -- (58) --
--- --- ---
Total costs and expenses....... 86 84 88 41 31
--- --- ---
Income from operations....... 14 16 12 72 (9)
Interest and other income........... 3 3 4 46 81
--- --- ---
Income before income taxes... 17 19 16 68 4
Provision for income taxes.......... 6 6 6 66 11
--- --- ---
Net income................... 11% 13% 10% 69% 1%
=== === ===
<FN>
- -------------------------
(1) The table excludes acquisition-related and other costs of $7.3 million,
including related tax effects, in 1996 and $5.7 million, including related
tax effects, in 1997, since inclusion of such costs would render
year-to-year comparisons less meaningful.
</FN>
</TABLE>

Revenue. The Company's total revenue increased 45% from fiscal year 1995 to
fiscal year 1996, or from $58.1 million to $84.4 million, and 25% from fiscal
year 1996 to fiscal year 1997 to $105.5 million. A majority of the Company's
total revenue came from product revenue, which increased 48% from $35.0 million
in fiscal year 1995 to $51.6 million in fiscal year 1996 and an additional 34%
to $69.3 million in fiscal year 1997. The increase in product revenue from
fiscal years 1995 to 1996 was primarily due to increased unit shipments of
pSOSystem and MATRIXx and the inclusion of SNiFF+ product revenue in fiscal year
1996. Product revenue increased from fiscal year 1996 to fiscal year 1997 as
unit shipments of pSOSystem and SNiFF+ continued to increase in all geographic
regions. In addition, fiscal year 1997 product revenue includes revenues from
product sales of Epilogue Technology Corporation, which was acquired in July
1996. MATRIXx revenue was flat from fiscal year 1996 to fiscal year 1997.
Services revenue increased 42% from $23.1 million in fiscal year 1995 to $32.8
million in fiscal year 1996 as a result of increases in the number and size of
consulting contracts and increases in maintenance revenue from the Company's
growing installed base of customers. Services revenue increased 10% from fiscal
year 1996 to fiscal year 1997 to $36.2 million. The decrease in the rate of
services revenue growth in fiscal year 1997 as compared to the fiscal year 1996
growth rate, was due to a decrease in some of the Company's consulting
activities.

The percentage of the Company's total revenue from customers located
internationally was 28%, 34% and 38% in fiscal years 1995, 1996 and 1997,
respectively. In Europe and Japan, revenues and expenses are primarily
denominated in local currencies. In fiscal year 1997, the U.S. dollar
strengthened significantly against the major European currencies and the
Japanese Yen, which resulted in lower revenues and expenses when translated into
U.S. dollars, as compared to prior years. In fiscal years 1995 and 1996 revenues
were less influenced by fluctuations in foreign exchange rates. The Company's
operating and pricing strategies take into account changes in exchange rates
over time, however, the Company's results of operations may be significantly
affected in the short term by fluctuations in foreign currency exchange rates.

20
<PAGE>

Costs and Expenses. Cost of product revenue as a percentage of product
revenue was 17%, 18%, and 14% in fiscal years 1995, 1996 and 1997, respectively.
The decrease in fiscal year 1997 is a result of a lower proportion of product
sales subject to third-party royalties. In addition, fiscal year 1997 product
revenue has a smaller proportion of lower margin hardware revenue than in fiscal
year 1996. The Company's cost of services revenue as a percentage of services
revenue was 41%, 48%, and 45% in fiscal years 1995, 1996 and 1997, respectively.
Fluctuations in these percentages result from shifts in the services revenue mix
between higher margin maintenance revenue and lower margin consulting contract
revenue.

Marketing and sales expenses in fiscal years 1995, 1996 and 1997, were 36%,
32% and 38%, respectively, of total revenue. The percentage decrease from fiscal
year 1995 to fiscal year 1996 was the result of pooling the operating results of
several acquired companies whose marketing and sales expenses had represented a
smaller percentage of their total revenue. The percentage increase from fiscal
year 1996 to fiscal year 1997 was primarily due to additional expenses
associated with the Company's continued expansion of its marketing and sales
organization both domestically and internationally, as well as increased
marketing activity associated with new product introductions.

Research and development expenses in fiscal years 1995, 1996 and 1997, were
14%, 13% and 16%, respectively, of total revenue. The increase from fiscal year
1996 to fiscal year 1997 was primarily the result of increased activity
associated with the development of several products, including increased
personnel and consulting expenses. Costs that are required to be capitalized
under Statement of Financial Accounting Standards No. 86 ("SFAS No. 86"),
"Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise
Marketed" were $1,540,000 in fiscal year 1997 compared to $335,000 in fiscal
year 1996 and $492,000 in fiscal year 1995. The amount capitalized represents
approximately 8% of total research and development expenditures for fiscal year
1997 compared to 3% for fiscal year 1996 and 6% for fiscal year 1995. The amount
of research and development expenditures capitalized in a given time period
depends upon the nature of the development performed and, accordingly, amounts
capitalized may vary from period to period. Capitalized costs are being
amortized using the greater of the amount computed using the ratio that current
gross revenues for a product bear to the total of current and anticipated future
gross revenues for that product, or on a straight-line basis over three years.
Amortization for fiscal year 1997 was $968,000, compared to $921,000 for fiscal
year 1996 and $607,000 for fiscal year 1995.

General and administrative expenses in fiscal years 1995, 1996 and 1997,
were 7%, 8%, and 9% respectively, of total revenue. The increases from fiscal
year 1995 to fiscal year 1996 and from fiscal year 1996 to fiscal year 1997 were
primarily the result of higher personnel-related expenses.

Amortization of intangible assets decreased from $1.3 million in fiscal year
1995 to $556,000 in fiscal year 1996, as the Company reached the end of the
amortization period for software purchased in an earlier acquisition. For fiscal
1997 amortization of intangible assets was not significant and is included in
general and administrative expenses.

Acquisition-related and other costs in fiscal year 1996 totaled $7.3 million
and comprised direct costs and write-offs related to the acquisitions of
TakeFive and Doctor Design. Acquisition-related and other costs in fiscal year
1997 of $5.7 million related to a one-time payment to the executives and
employees of Diab Data, the write-off during the year of intangible assets
related to a prior acquisition, and direct costs related to the acquisition of
Epilogue. See Note 2 to Notes to Consolidated Financial Statements.

Interest and other income was $1.6 million, $2.3 million, and $4.2 million
in fiscal years 1995, 1996 and 1997, respectively. Interest and other income in
fiscal year 1997 increased due to the inclusion of net operating income from
Diab Data during the period it was accounted for under the equity method of
accounting. In addition, interest and other income increased in both comparative
periods due to an increase in the amount of cash equivalents and marketable
securities.

The effective tax rate was 32% in fiscal year 1995 compared to 40% in fiscal
year 1996 and 35% in fiscal year 1997. The increase in the effective rate from
fiscal year 1995 to 1996 was due to the effect of non-deductible
acquisition-related and other costs. After adjusting for such items, the
effective rate for fiscal year 1996 was 32%. Non-deductible acquisition-related
costs in fiscal year 1997, combined with a higher statutory federal income tax
rate, resulted in an effective tax rate of 35% in fiscal year 1997.

21
<PAGE>

Recent Accounting Pronouncements

In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128 ("SFAS No. 128"), "Earnings Per
Share," which specifies the computation, presentation and disclosure
requirements for earnings per share. SFAS No. 128 supersedes Accounting
Principles Board Opinion No. 15, is effective for financial statements issued
for periods ending after December 15, 1997, and requires that prior periods be
restated. The impact of the adoption of SFAS No. 128 on the financial statements
of the Company has not yet been determined.

Liquidity and Capital Resources

The Company has funded its operations to date principally through cash flows
from operations. As of February 28, 1997, the Company had $54.7 million of cash,
cash equivalents and marketable securities. This represents an increase of $5.2
million from February 28, 1996. During the first quarter of fiscal year 1995,
the Company announced that the Board of Directors had authorized the Company to
repurchase up to an additional 1,000,000 shares of common stock for cash, from
time-to-time at market prices, pursuant to a repurchase program announced in
September 1992. In the second quarter of fiscal year 1995, under this program,
the Company repurchased 250,000 shares of common stock for $1.1 million. During
fiscal year 1997, the Board of Directors rescinded this program. Subsequent to
fiscal year 1997 year end, the Company announced that the Board of Directors had
authorized a new repurchase program allowing the Company to repurchase up to
1,000,000 shares of common stock for cash, from time-to-time at market prices.
No time limit was set for the completion of the program. In April 1997, the
Company repurchased 20,000 shares of common stock for $187,500.

Net cash provided by operating activities during fiscal year 1997 decreased
$15.9 million over the amount generated in fiscal year 1996, which increased by
$9.4 million over fiscal year 1995. The decrease in net cash provided by
operating activities in fiscal year 1997 was due to an increase in accounts
receivable, the inclusion of net income from an unconsolidated subsidiary,
write-downs of intangible assets and decreases in current liabilities and income
taxes payable, offset in part, by an increase in deferred revenue. The increase
in net cash provided by operating activities in fiscal year 1996 was due to
increases in depreciation and amortization, write-downs of intangible assets,
increases in current liabilities, income taxes payable and deferred revenue,
partially offset by increases in accounts receivable and other current assets.

Net cash used in investing activities totaled $16.7 million in fiscal year
1997 compared to $6.0 million in fiscal year 1996 and $9.3 million in fiscal
year 1995. The increase in net cash used in investing activities in fiscal year
1997 was due primarily to the purchase of the corporate headquarters building in
Sunnyvale, California in March 1996, for approximately $12.0 million, offset in
part, by cash acquired through acquisitions. The decrease in net cash used in
investing activities from fiscal year 1995 to fiscal year 1996 was due primarily
to a reduction in net purchases of marketable securities, offset by increases in
additions to property and equipment and net cash paid in acquisitions.

Net cash provided by financing activities totaled $20.6 million in fiscal
year 1997 compared to $4.0 million in fiscal year 1996 and $2.0 million in
fiscal year 1995. The increase in net cash provided by financing activities in
fiscal year 1997 was due primarily to the issuance and sale of 500,000 shares of
common stock in April 1996, for net proceeds of $12.8 million, and from an
increase in the tax benefits from disqualifying dispositions of common stock.
The increase in net cash provided by financing activities from fiscal year 1995
to fiscal year 1996 was due to an increase in proceeds from the exercise of
options to purchase common stock and purchases under the Employee Stock Purchase
Plan, and the absence of common stock repurchases. The Company believes that the
cash flows from operations, together with existing cash and investment balances,
will be adequate to meet the Company's cash requirements for working capital,
capital expenditures and stock repurchases for the next 12 months and the
foreseeable future.

Item 7a. Quantitative and Qualitative Disclosures About Market Risks

Not applicable.

22
<PAGE>

Item 8. Financial Statements and Supplementary Data.

Quarterly Financial Data
<TABLE>

The following table sets forth selected unaudited quarterly financial data
for the Company's last eight fiscal quarters. This unaudited information has
been prepared on the same basis as the audited information and, in management's
opinion, reflects all adjustments (which include only normal recurring
adjustments) necessary for the fair presentation of the information for the
periods presented. Based on the Company's operating history and factors that may
cause fluctuations in the quarterly results, quarter-to-quarter comparisons
should not be relied upon as indicators of future performance.
<CAPTION>

Fiscal 1996
--------------------------------------------
Q1 Q2 Q3 Q4
-- -- -- --
(in thousands, except per share data)
<S> <C> <C> <C> <C>
Total revenue............................. $18,458 $19,851 $21,510 $24,623
Income from operations.................... 1,862 2,928 406 1,268
Net income................................ 1,578 2,434 584 687
Earnings per share........................ 0.07 0.11 0.03 0.03
Shares used in per share calculations..... 21,714 21,994 22,284 22,362
</TABLE>
<TABLE>
<CAPTION>

Fiscal 1997
--------------------------------------------
Q1 Q2 Q3 Q4
-- -- -- --
(in thousands, except per share data)
<S> <C> <C> <C> <C>
Total revenue............................. $23,151 $26,105 $26,803 $29,404
Income (loss) from operations............. 2,319 2,909 (1,153) 2,864
Net income (loss)......................... 2,451 2,372 (94) 2,525
Earnings per share........................ 0.11 0.10 0.00 0.11
Shares used in per share calculations..... 22,709 23,511 22,909 23,875
</TABLE>

The financial statements required by this item are submitted as a separate
section of this Form 10-K. See Item 14.

Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures.

None.

23
<PAGE>

PART III

Item 10. Directors and Executive Officers of the Registrant.

The information required by Item 10 as to directors is incorporated by
reference from the section entitled "Election of Directors" in the Company's
definitive Proxy Statement for its Annual Meeting of Shareholders to be held
July 15, 1997. The information required by this Item as to executive officers is
included in Part I under "Executive Officers of the Registrant."

The information required by this item as to compliance with Section 16(a) of
the Securities Exchange Act of 1934 is incorporated by reference from "Section
16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive
Proxy Statement for its Annual Meeting of Shareholders to be held July 15, 1997.

Item 11. Executive Compensation.

The information required by this item is incorporated by reference from
"Executive Compensation" and "Compensation Committee Interlocks and Insider
Participation" in the Company's definitive Proxy Statement for its Annual
Meeting of Shareholders to be held July 15, 1997.

Item 12. Security Ownership of Certain Beneficial Owners and Management.

The information required by this item is incorporated by reference from
"Security Ownership of Certain Beneficial Owners and Management" in the
Company's definitive Proxy Statement for its Annual Meeting of Shareholders to
be held July 15, 1997.

Item 13. Certain Relationships and Related Transactions.

The information required by this item is incorporated by reference from
"Certain Transactions" in the Company's definitive Proxy Statement for its
Annual Meeting of Shareholders to be held July 15, 1997.

24
<PAGE>

PART IV

Item 14. Exhibits, Financial Statements, Schedule, and Reports on Form 8-K.
<TABLE>

(a)(1) Financial Statements
<CAPTION>

Page
----
<S> <C>
Report of Independent Accountants 28
Consolidated Balance Sheets at February 28, 1996 and 1997 29
Consolidated Statements of Income for the years ended February 28, 1995, 1996 and
1997 30
Consolidated Statements of Shareholders' Equity for the years ended February 28,
1995, 1996 and 1997 31
Consolidated Statements of Cash Flows for the years ended February 28, 1995, 1996
and 1997 32
Notes to Consolidated Financial Statements 33
</TABLE>

(a)(2) Financial Statement Schedule. Registrant's financial statement schedule
filed herewith is as follows:

Schedule:
Report of Independent Accountants on Schedule
Schedule II: Valuation and Qualifying Accounts for the years ended
February 28, 1995, 1996 and 1997

(a)(3) Exhibits. The following exhibits are filed herewith or incorporated
herein by reference:

Exhibit

2.01 Stock Exchange Agreement dated as of October 31, 1995 by and
between the Registrant and TakeFive Software GmbH and the
holders of share interests in TakeFive Software GmbH
(incorporated herein by reference to Exhibit 2.01 to the
Registrant's Current Report on Form 8-K, dated October 31,
1995).

2.02 Agreement and Plan of Reorganization dated as of December 14,
1995, as amended January 26, 1996, by and among Registrant,
ISI Purchasing Corporation and Doctor Design, Inc. and
related documents (incorporated herein by reference to
Exhibit 2.01 to the Registrant's Current Report on Form 8-K,
dated January 26, 1996 (the "January 26, 1996 Form 8-K")).

2.03 Agreement of Merger dated as of January 26, 1996 by and
between ISI Purchasing Corporation and Doctor Design, Inc.
(incorporated herein by reference to Exhibit 2.02 to the
January 26, 1996 Form 8-K).

3.01(i) Registrant's Articles of Incorporation, as amended to date
(incorporated by reference to Exhibit Number 3.01(i) to the
Registrant's Form 10-K for the fiscal year ended February 28,
1996).

3.01(ii) Registrant's Bylaws, as amended June 12, 1996 (incorporated
by reference to Exhibit Number 4.02 to Registrant's
Registration Statement on Form S-8 under the Securities Act
of 1933, as amended, filed September 27, 1996, Registration
No. 333-12799).

4.01 Registration Rights Agreement dated as of April 13, 1987
(incorporated by reference to Exhibit 4.02 to Registrant's
Registration Statement on Form S-1 under the Securities Act
of 1933, as amended, filed January 26, 1990, Registration No.
33-33219 (the "S-1 Registration Statement")).

25
<PAGE>

10.01* Registrant's 401(k) Plan (incorporated by reference to
Exhibit Number 10.01 to the S-1 Registration Statement).

10.02* Registrant's 1983 Incentive Stock Option Plan, as amended to
date, and related documents (incorporated by reference to
Exhibit Number 10.02 to the S-1 Registration Statement).

10.03* Registrant's 1988 Stock Option Plan, as amended to date
(incorporated by reference to Exhibit Number 4.01 to the
Registrant's Form S-8 filed with the Securities and Exchange
Commission on June 16, 1992).

10.04* Registrant's 1990 Stock Purchase Plan, as amended to date
(incorporated by reference to Exhibit Number 4.03 to the
Registrant's Form S-8 filed with the Securities and Exchange
Commission on October 18, 1993).

10.05* Dr. Design, Inc. 1991 Stock Option Plan, as amended to date
(incorporated by reference to Exhibit Number 4.03 to the
Registrant's Form S-8 filed with the Securities and Exchange
Commission on February 22, 1996).

10.06* Form of Indemnity Agreement with Directors (incorporated by
reference to Exhibit Number 10.06 to the S-1 Registration
Statement).

10.07* Form of Stock Option Grant and Stock Option Exercise Form
used in connection with Registrant's 1988 Stock Option Plan,
as amended to date (incorporated by reference to Exhibit
Number 19.01 to Registrant's Form 10-Q for the quarter ended
August 31, 1990).

10.08* Form of Option Modification Agreement (incorporated by
reference to Exhibit Number 19.01 to the Registrant's Form
10-Q for the quarter ended August 31, 1991).

10.09* Registrant's 1994 Directors Stock Option Plan (incorporated
by reference to Exhibit Number 10.10 to the Registrant's Form
10-Q for the quarter ended August 31, 1991).

10.10* Form of Stock Option Grant and Stock Option Exercise Form
used in connection with Registrant's 1994 Directors Stock
Option Plan (incorporated by reference to Exhibit Number
10.11 to the Registrant's Form 10-K for the fiscal year ended
February 28, 1994).

10.11 Agreement of Purchase and Sale between Connecticut General
Life Insurance Company and the Registrant dated February 9,
1996 (incorporated by reference to Exhibit Number 10.14 to
the Registrant's Form 10-K for fiscal year ended February 28,
1996).

10.12* Form of Stock Option Exercise Form used in connection with
Registrant's 1988 Stock Option Plan, as amended to date
(incorporated by reference to Exhibit Number 10.13 to the
Registrant's Form 10-Q for the quarter ended May 31, 1995).

10.13* Epilogue Technology Corporation 1994 Stock Option Plan, as
amended to date (incorporated by reference to Exhibit Number
4.03 to the Registrant's Form S-8 filed with the Securities
and Exchange Commission on September 27, 1996, Registration
No. 333-12799).

26
<PAGE>

11.01 Statement regarding computation of net income per share.

21.01 List of Registrant's Subsidiaries.

23.01 Consent of Independent Accountants.

27.01 Financial Data Schedule

- -------------------
* Represents a management contract or compensatory plan or arrangement.

(b) Reports on Form 8-K.

No reports on Form 8-K were filed during the last quarter of the fiscal year
covered by this Report.

(d) Financial Statement Schedules. See (a)(2) above.

27
<PAGE>

REPORT OF INDEPENDENT ACCOUNTANTS

The Board of Directors and Shareholders
Integrated Systems, Inc.:

We have audited the accompanying consolidated balance sheets of Integrated
Systems, Inc. as of February 28, 1996 and 1997 and the related consolidated
statements of income, shareholders' equity and cash flows for each of the three
years in the period ended February 28, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Integrated Systems, Inc. as of February 28, 1996 and 1997, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended February 28, 1997 in conformity with generally accepted accounting
principles.

COOPERS & LYBRAND L.L.P.

San Jose, California
March 26, 1997, except for Note 6,
as to which the date is April 28, 1997

28
<PAGE>
<TABLE>
INTEGRATED SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS
(in thousands)

<CAPTION>
February 28,
------------
1996 1997
---- ----
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents ............................................. $ 21,822 $ 25,585
Marketable securities ................................................. 12,231 4,483
Accounts receivable, net of allowance for doubtful accounts of $852 and
$1,540 in 1996 and 1997, respectively .............................. 19,822 28,266
Deferred income taxes ................................................. 373 1,676
Prepaid expenses and other ............................................ 3,587 4,136
--------- ---------
Total current assets .......................................... 57,835 64,146
Marketable securities ................................................... 15,423 24,627
Property and equipment, net ............................................. 5,593 17,956
Intangible assets, net .................................................. 2,106 3,136
Deferred income taxes ................................................... 1,906 1,293
Other assets ............................................................ 2,401 1,344
--------- ---------
Total assets .................................................. $ 85,264 $ 112,502
========= =========

LIABILITIES
Current liabilities:
Accounts payable ...................................................... $ 4,309 $ 4,143
Accrued payroll and related expenses .................................. 3,673 3,407
Other accrued liabilities ............................................. 4,842 4,514
Income taxes payable .................................................. 4,191 1,442
Deferred revenue ...................................................... 9,389 12,621
--------- ---------
Total current liabilities ..................................... 26,404 26,127
Other liabilities ....................................................... 584 203
--------- ---------
Total liabilities ............................................. 26,988 26,330
--------- ---------
Commitments and contingencies (Note 5)

SHAREHOLDERS' EQUITY

Preferred stock, no par value, 5,000 shares authorized:
Issued and outstanding: none in 1996 and 1997
Common stock, no par value, 50,000 shares authorized:
Issued and outstanding: 21,206 and 23,039 shares in 1996 and 1997,
respectively ....................................................... 40,283 61,158
Unrealized holding gain on marketable securities, net ................... 333 148
Translation adjustment .................................................. -- (1,130)
Retained earnings ....................................................... 17,660 25,996
--------- ---------
Total shareholders' equity .................................... 58,276 86,172
--------- ---------
Total liabilities and shareholders' equity .................... $ 85,264 $ 112,502
========= =========
<FN>

The accompanying notes are an integral part of these
consolidated financial statements.
</FN>
</TABLE>
29
<PAGE>
INTEGRATED SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)

Year Ended February 28,
-----------------------
1995 1996 1997
---- ---- ----
Revenue:
Product ................................. $ 34,952 $ 51,597 $ 69,282
Services ................................ 23,102 32,845 36,181
-------- -------- --------
Total revenue ......................... 58,054 84,442 105,463
-------- -------- --------
Costs and expenses:
Cost of product revenue ................. 5,980 9,046 9,755
Cost of services revenue ................ 9,547 15,824 16,392
Marketing and sales ..................... 20,565 27,209 40,546
Research and development ................ 8,341 11,379 17,264
General and administrative .............. 4,311 6,637 8,891
Amortization of intangible assets ....... 1,311 556 --
Acquisition-related and other ........... -- 7,327 5,676
-------- -------- --------
Total costs and expenses .............. 50,055 77,978 98,524
-------- -------- --------
Income from operations .............. 7,999 6,464 6,939
Interest and other income .................. 1,601 2,331 4,220
-------- -------- --------
Income before income taxes .......... 9,600 8,795 11,159
Provision for income taxes ................. 3,110 3,512 3,905
-------- -------- --------
Net income .......................... $ 6,490 $ 5,283 $ 7,254
======== ======== ========
Earnings per share ......................... $ 0.33 $ 0.24 $ 0.31
======== ========= ========
Shares used in per share calculations ...... 19,964 22,088 23,508
======== ========= ========

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

30
<PAGE>
<TABLE>

INTEGRATED SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(in thousands)
<CAPTION>

Unrealized
Holding
Common Stock Gain (Loss), Translation Retained
Shares Amount Net Adjustment Earnings Total
-------- -------- -------- ---------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Balances, February 28, 1994 ............... 18,977 $ 31,262 $ 227 $ 6,543 $ 38,032
Exercise of common stock options ......... 585 1,858 1,858
Common stock purchased under Employee
Stock Purchase Plan ................... 94 420 420
Amortization of deferred compensation .... 183 183
Tax benefit from disqualifying
dispositions of common stock .......... 1,009 1,009
Repurchase of common stock ............... (250) (430) (664) (1,094)
Issuance of common stock in connection
with acquisition ...................... 316 1,386 1,386
Unrealized holding loss on marketable
securities, net ....................... (336) (336)
Net income ............................... 6,490 6,490
-------- -------- ------- -------- --------
Balances, February 28, 1995 ................ 19,722 35,688 (109) 12,369 47,948
Exercise of common stock options ......... 540 2,050 2,050
Common stock purchased under Employee
Stock Purchase Plan ................... 72 557 557
Tax benefit from disqualifying
dispositions of common stock .......... 2,323 2,323
Pooling of interests with TakeFive
Software .............................. 872 50 8 58
Purchase of TakeFive Software common stock
for cash .............................. (400) (400)
Payment of note receivable from
shareholder ........................... 15 15
Unrealized holding gain on marketable
securities, net ....................... 442 442
Net income ............................... 5,283 5,283
-------- -------- ------- -------- --------
Balances, February 28, 1996 ................ 21,206 40,283 333 17,660 58,276
Exercise of common stock options ......... 651 2,344 2,344
Common stock purchased under Employee
Stock Purchase Plan ................... 51 975 975
Tax benefit from disqualifying
dispositions of common stock .......... 4,908 4,908
Pooling of interests with Epilogue ....... 631 26 1,082 1,108
Issuance of common stock in connection
with secondary offering ............... 500 12,774 12,774
Foreign currency translation
adjustment ............................ $(1,130) (1,130)
Purchase of Doctor Design common stock
for cash .............................. (152) (152)
Unrealized holding loss on marketable
securities, net ....................... (185) (185)
Net income ............................... 7,254 7,254
-------- -------- ------- ------- -------- --------
Balances, February 28, 1997 .............. 23,039 $ 61,158 $ 148 $(1,130) $ 25,996 $ 86,172
======== ======== ======= ======= ======== ========

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

</FN>
</TABLE>
31
<PAGE>

<TABLE>
INTEGRATED SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

<CAPTION>
Year Ended February 28,
-----------------------
1995 1996 1997
-------- -------- --------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income ....................................................... $ 6,490 $ 5,283 $ 7,254
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization ................................... 3,584 4,103 4,955
Write-downs of intangible assets ................................ -- 3,083 616
Deferred income taxes ........................................... (558) (1,768) (399)
Provisions for doubtful accounts receivable ..................... 147 223 688
Net income from unconsolidated subsidiary ....................... -- -- (604)
Changes in assets and liabilities:
Accounts receivable ........................................... (5,468) (4,570) (8,748)
Prepaid expenses and other .................................... (1,171) (794) (257)
Accounts payable, accrued payroll and other accrued liabilities 2,201 5,255 (1,448)
Income taxes payable .......................................... 970 1,837 (3,397)
Deferred revenue .............................................. 640 3,125 2,326
Other assets and liabilities .................................. (68) 375 (779)
-------- -------- --------
Net cash provided by operating activities ..................... 6,767 16,152 207
-------- -------- --------
Cash flows from investing activities:
Purchases of marketable securities .............................. (8,041) (16,878) (24,836)
Maturities of marketable securities ............................. 3,593 18,731 14,374
Sales of marketable securities .................................. -- -- 8,697
Additions to property and equipment ............................. (2,089) (4,332) (16,012)
Disposals of property and equipment ............................. 46 149 805
Capitalized software development costs .......................... (492) (335) (1,540)
Net cash (paid) acquired in acquisitions ........................ (2,081) (2,885) 2,868
Other ........................................................... (200) (480) (1,042)
-------- -------- --------
Net cash used in investing activities .......................... (9,264) (6,030) (16,686)
-------- -------- --------
Cash flows from financing activities:
Repurchase of common stock ...................................... (1,094) -- --
Proceeds from issuance of common stock .......................... -- -- 12,774
Proceeds from exercise of common stock options and purchases
under Employee Stock Purchase Plan ............................ 2,278 2,607 3,319
Tax benefit from disqualifying dispositions of common stock ..... 1,009 2,323 4,908
Other ........................................................... (223) (976) (374)
-------- -------- --------
Net cash provided by financing activities ..................... 1,970 3,954 20,627
-------- -------- --------
Effect of exchange rate fluctuations on cash and cash equivalents .. -- -- (385)
Net increase (decrease) in cash and cash equivalents ............... (527) 14,076 3,763
Cash and cash equivalents at beginning of year ..................... 8,273 7,746 21,822
-------- -------- --------
Cash and cash equivalents at end of year ........................... $ 7,746 $ 21,822 $ 25,585
======== ======== ========
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes, net ................. $ 1,741 $ 700 $ 2,346
Supplemental schedule of noncash investing activities:
Unrealized holding gain (loss) on marketable securities ......... $ (560) $ 736 $ (309)
Supplemental schedule of noncash financing activities:
Issuance of common stock in connection with acquisition (Note 2). $ 1,386 -- --

<FN>
The accompanying notes are an integral part of these consolidated
financial statements.
</FN>
</TABLE>
32
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Significant Accounting Policies

Nature of Operations

Integrated Systems, Inc. ("the Company") designs, develops, markets and
supports software products and provides related engineering services principally
for embedded microprocessor-based applications. Embedded microprocessors are
used to add functionality and intelligence to a variety of products and to
operate as an integral part of these products, generally without any direct
human intervention. The Company offers software that consists of a real-time
operating system, a development suite and a series of component modules and
design tools that aid software development. The Company markets and supports its
products and provides services on a worldwide basis to a variety of users in a
broad range of industries, including telecommunications and data communications,
automotive, multimedia and consumer, office and industrial automation, and the
embedded Internet, through a direct sales force augmented by a telemarketing
organization, distributors and sales representatives.

Principles of Consolidation

The consolidated financial statements include the accounts of Integrated
Systems, Inc. and its wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated. Investments in affiliated
companies that are not controlled are carried at cost plus the Company's equity
in undistributed earnings since acquisition (see Note 2).

Use of Estimates

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
disclosure of contingent assets and liabilities at the dates of the financial
statements and the reported amounts of revenues and expenses during a reporting
period. Actual results could differ from those estimates.

Cash and Cash Equivalents

Cash and cash equivalents, which are held at a variety of financial
institutions, include demand deposits, money market accounts and all highly
liquid debt instruments with an original or remaining maturity at the date of
purchase of three months or less. The Company has not experienced any material
losses relating to any investment instruments.

Fair Value of Financial Instruments and Concentrations

The amounts reported for cash equivalents, accounts receivable, accounts
payable and accrued liabilities are considered to approximate fair values based
upon comparable market information available at February 28, 1997. The fair
values of the Company's marketable securities are set forth in Note 3.

Financial instruments that potentially subject the Company to concentrations
of credit risks comprise, principally, cash, cash equivalents, investments in
marketable securities and accounts receivable. The Company invests its excess
cash in government securities, tax exempt municipal securities, preferred stock,
Eurodollar notes and bonds, time deposits, certificates of deposit, commercial
paper rated Aa or better and other specific money market and corporate
instruments of similar liquidity and credit quality. With respect to accounts
receivable, the Company's customer base is dispersed across many different
geographic areas. The Company performs ongoing evaluations of its customers'
financial condition and generally does not require collateral. The Company
maintains allowances for potential credit losses and such losses have been
within management's expectations.

33
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

1. Summary of Significant Accounting Policies - (continued)

Fair Value of Financial Instruments and Concentrations - (continued)

The Company licenses certain software development tool products from other
companies to distribute with its own products. The inability of such third
parties to provide competitive products with adequate features and high quality
on a timely basis or to cooperate in sales and marketing activities could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, the Company's products compete with products
produced by certain of the Company's licensors. There can be no assurance that,
upon the termination or expiration of these licenses, such licenses will be
available on reasonable terms or at all, or that the Company could obtain
similar products as substitutes. The inability to license such products could
have a material adverse effect on the Company's business, financial condition
and results of operations.

Marketable Securities

All marketable securities are classified as available-for-sale and therefore
are carried at fair value. Marketable securities classified as current assets
have scheduled maturities of less than one year, while marketable securities
classified as noncurrent assets have scheduled maturities of more than one year.
Unrealized holding gains and losses on such securities are reported net of
related taxes as a separate component of shareholders' equity. Realized gains
and losses on sales of all such securities are reported in interest and other
income and computed using the specific identification cost method.

Revenue Recognition

Product Revenue

Product revenue consists principally of revenue from product licensing fees.
Product licensing fees, including advanced production royalty payments, are
generally recognized when a customer purchase order has been received, a license
agreement has been executed, the software has been shipped, remaining
obligations are insignificant and collection of the resulting account receivable
is probable. Generally, the Company's distributors do not have the right of
return. Provisions for estimated product returns, warranty costs and
insignificant vendor obligations are recorded at the time products are shipped.

Services Revenue

Services revenue consists principally of maintenance and renewal fees for
providing product updates, technical support and related services for software
products, and engineering and consulting services fees. Software maintenance
revenue bundled with the initial product license revenue is deferred and
recognized ratably over the related service period. The Company unbundles a
portion of its initial product license revenue related to software maintenance
revenue based upon product license renewal amounts, which are substantially less
than the initial product license fee, or based upon the amount charged for such
services when they are sold separately. License renewal fees, which are
substantially less than the initial license, are deferred and recognized ratably
over the license term. Revenue from separately sold maintenance contracts is
recognized ratably over the related service period. Engineering and consulting
services revenue from short-term and long-term contracts is generally recognized
on the percentage-of-completion method. For cost reimbursement and firm fixed
price contracts, revenues are recognized as the work is performed, based on the
ratio of incurred costs to estimated total completion costs. For
time-and-material contracts, revenues are recognized on the basis of direct
labor hours and other direct costs incurred. Provisions for anticipated losses
are made in the period in which they first become determinable.

34
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

1. Summary of Significant Accounting Policies - (continued)

Property and Equipment

Property and equipment are recorded at cost. Depreciation is computed using
the straight-line method over the estimated useful lives of the respective
assets (three to twenty years). Leasehold improvements are amortized over the
lease term or the estimated useful life of the asset, whichever is shorter. The
cost and accumulated depreciation of assets sold or retired are removed from the
accounts and any resulting gain or loss is reflected in results of operations.

Software Development Costs

The Company capitalizes certain costs to develop computer software to be
licensed or otherwise marketed to customers. Such costs are amortized using the
greater of the amount computed using the ratio that current gross revenues for a
product bear to the total of current and anticipated future gross revenues for
that product, or on a straight-line basis over three years. The Company
evaluates the estimated net realizable value of each software product at each
balance sheet date and records write-downs to net realizable value for any
products for which the net book value is in excess of net realizable value.
Software development costs included in intangible assets at February 28, 1996
and 1997, were $1,177,000 and $1,749,000, respectively, net of accumulated
amortization of $1,743,000 and $2,711,000, respectively. Capitalized software
development costs were $492,000, $335,000, and $1,540,000 in fiscal 1995, 1996
and 1997, respectively. Amortization, which is included in cost of product
revenue, was $607,000, $921,000, and $968,000 in fiscal 1995, 1996 and 1997,
respectively.

Intangible Assets

Intangible assets consist primarily of goodwill, purchased software and
capitalized software development costs. Goodwill and purchased software are
amortized on a straight-line basis over their estimated useful lives. The
Company periodically evaluates the recoverability of goodwill and purchased
software based upon estimated undiscounted future cash flows from the related
products and businesses acquired.

Employee Stock Plans

The Company accounts for its stock option plans and its employee stock
purchase plan in accordance with provisions of the Accounting Principles Board's
Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees." In 1995,
the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based
Compensation." SFAS No. 123 establishes a fair value based method of accounting
for stock-based plans and is effective for fiscal years beginning after December
15, 1995. The Company is continuing to account for its employee stock plans in
accordance with the provisions of APB 25, and has provided pro forma disclosure
in Note 6 as if the measurement provisions of SFAS No. 123 had been adopted.

Income Taxes

The Company's provision for income taxes is comprised of its current tax
liability and the change in its deferred tax assets and liabilities. Deferred
tax assets and liabilities are determined based on differences between financial
reporting and tax bases of assets and liabilities and are measured using the
enacted tax rates and laws that will be in effect when the differences are
expected to reverse.

Advertising

The Company expenses advertising costs as they are incurred. Advertising
expense for fiscal 1995, 1996 and 1997 was $800,000, $927,000, and $1,566,000,
respectively.

35
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

1. Summary of Significant Accounting Policies - (continued)

Computation of Earnings Per Share

Earnings per share is computed using the weighted average number of common
and common equivalent shares outstanding during the period. Common equivalent
shares result from the assumed exercise of outstanding stock options that have a
dilutive effect when applying the treasury stock method.

Foreign Currency Translation

Assets and liabilities of foreign operations where the functional currency
is the local currency, are translated into U.S. dollars at the fiscal year end
exchange rate. Revenues and expenses are translated at the average rate
prevailing during the year. The related gains and losses from translation are
recorded as a translation adjustment in a separate component of shareholder's
equity. Foreign currency transaction gains and losses, as well as translation
adjustments for assets and liabilities of foreign operations where the
functional currency is the U.S. dollar, are included in results of operations.

Fiscal Year

Prior to fiscal 1996, the Company's fiscal year was reported on a 52/53 week
period ending on the last Saturday in February of each year. Beginning in fiscal
1996, the Company's fiscal year end is the last day in February. Accordingly,
the fiscal year end for fiscal 1995, 1996 and 1997 was February 25, 29 and 28,
respectively. The effect of this change was not material to the Company's
financial statements for fiscal 1996 or 1997. For clarity of presentation
herein, all fiscal years are referred to as ending on February 28.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current
year presentation.

Recent Accounting Pronouncements

In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128 ("SFAS No. 128"), "Earnings Per
Share," which specifies the computation, presentation and disclosure
requirements for earnings per share. SFAS No. 128 supersedes Accounting
Principles Board Opinion No. 15, is effective for financial statements issued
for periods ending after December 15, 1997 and requires that prior periods be
restated. The impact of the adoption of SFAS No. 128 on the financial statements
of the Company has not yet been determined.

2. Acquisitions

Merger With TakeFive

In October 1995, the Company acquired TakeFive Software GmbH ("TakeFive"),
an Austrian corporation by issuing 871,980 shares of its common stock in
exchange for 97% of the shares of TakeFive. The remaining 3% of the shares of
TakeFive were purchased for cash. The business combination was accounted for as
a pooling of interests and the Company's results of operations for fiscal 1996
and 1997 include those of TakeFive. The prior years' results have not been
restated to include TakeFive operations as such operations were insignificant.
Prior to the business combination, TakeFive was in the business of developing,
marketing and supporting software tools used in software development. The
Company has continued the business of TakeFive and operates TakeFive as an
independent subsidiary.

36
<PAGE>
INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

2. Acquisitions - (continued)

Merger With Doctor Design

In January 1996, the Company acquired Doctor Design, Inc. ("Doctor
Design"), an engineering services company specializing in multimedia hardware,
software and application specific integrated circuit technology. The Company
issued 743,214 shares of its common stock for substantially all the outstanding
stock of Doctor Design. The Company also assumed stock options that converted
into options to purchase 263,724 shares of the Company's common stock. The
business combination was accounted for as a pooling of interests and the
Company's results of operations include those of Doctor Design for all periods
presented. The Company has continued the business of Doctor Design and operates
Doctor Design as an independent subsidiary.

Merger with Epilogue

In July 1996, the Company acquired Epilogue Technology Corporation
("Epilogue"), a New Mexico corporation, by issuing 630,963 shares of common
stock in exchange for all outstanding Epilogue common and preferred stock. The
Company also assumed stock options that converted into options to purchase
69,033 shares of the Company's common stock. The business combination was
accounted for as a pooling of interests. Results of operations have been
included from the date of acquisition. Prior period results have not been
restated to include Epilogue operations as such operations were insignificant.
Prior to the business combination, Epilogue was a developer and distributor of
network management and embedded Internet software for telecommunications and
datacommunications equipment manufacturers, embedded software suppliers and
networking related integrated circuit manufacturers. The Company intends to
integrate the business of Epilogue with that of the Company.

Combined and Separate Results of Mergers
<TABLE>

Combined and separate results of the Company, Doctor Design and TakeFive
during the periods preceding the mergers were as follows (in thousands):
<CAPTION>

Integrated Doctor
Systems Design TakeFive Combined
------- ------ -------- --------
<S> <C> <C> <C> <C>
Nine months ended November 30, 1995 (unaudited):
Net revenue................................ $47,455 $9,171 $3,193 $59,819
Net income................................. 3,134 882 580 4,596
Year ended February 28, 1995:
Net revenue................................ 51,979 6,075 58,054
Net income................................. 5,754 736 6,490
</TABLE>

Net revenues and net income of Epilogue for the pre-acquisition periods were
insignificant.

Acquisition of Diab Data

In December 1995, the Company acquired certain technology, related assets
and all of the outstanding common stock of Diab Data, Inc. ("Diab Data") for
$1,735,000. The acquisition was accounted for under the equity method of
accounting and was included in other assets in the balance sheet as at February
28, 1996. The acquisition cost exceeded the underlying equity in net assets by
$1,395,000, of which $756,000, $425,000 and $214,000 was allocated to existing
software products which had reached technological feasibility, goodwill, and
in-process software development which had not reached technological feasibility,
respectively, based on their respective fair values. The costs allocated to
goodwill and existing products are amortized over periods of five and two years,
respectively, and the costs allocated to in-process software development were
charged to acquisition-related and other costs. In addition to the purchase
price, the Company paid bonuses to non-shareholder management and employees
totaling $1,645,000, which were expensed and are included as part of acquisition
and other expenses in the consolidated statement of income for fiscal 1996. The
operations of Diab Data were not material to the consolidated financial
statements of

37
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

2. Acquisitions - (continued)

Acquisition of Diab Data - (continued)

the Company in fiscal 1996 or fiscal 1997, and accordingly, separate financial
information for Diab Data has not been presented.

In November 1996, the Company revised the terms of the acquisition of Diab
Data and paid bonuses to management and employees of Diab Data of $4.8 million.
In addition, as a result of the revision in terms, the Company is now required
to consolidate the results of this subsidiary, which previously had been
accounted for under the equity method of accounting. Accordingly, the operating
results of Diab Data have been consolidated with those of the Company beginning
December 1, 1996.

Other Acquisitions

In September 1994, the Company acquired certain software products and other
assets for a total purchase price of approximately $3,467,000, consisting of
$2,081,000 in cash and non-cash consideration of approximately 316,000 shares of
restricted common stock with a value of approximately $1,386,000. The
acquisition was accounted for using the purchase method of accounting and
accordingly, its operations were included with those of the Company since the
date of acquisition. Substantially all of the purchase price was allocated to
purchased software, which prior to the third quarter of fiscal 1996, was being
amortized on a straight-line basis over a seven-year period. During the third
quarter of fiscal 1996, the Company determined that the recoverability of the
purchased software was not probable as the products purchased would be replaced
by the products acquired in the merger with TakeFive. Accordingly, capitalized
purchased software totaling $3,083,000 was charged to acquisition-related and
other costs in the consolidated statement of income.

Acquisition-Related and Other Costs

Acquisition-related and other costs for fiscal 1996 and 1997
consist of (in thousands):

Year Ended February 28,
----------------------
1996 1997
------ ------
In-process software development costs written-off ........ $ 214 --
Bonus payments to management and employees
of acquired company .................................... 1,645 $4,750
Purchased software written-off ........................... 3,083 616
Professional fees and other acquisition costs ............ 1,585 310
Termination fees payable to a distributor ................ 800 --
------ ------
$7,327 $5,676
====== ======

The termination fees payable to a distributor relate to amounts payable
resulting from the termination of the Company's reseller arrangement with a
Japanese distributor in February 1996.

3. Marketable Securities

At February 28, 1996 and 1997, marketable securities consisted of
fixed-income U.S. Government securities, primarily treasury notes, municipal
securities and preferred stock, held by two investment banks.
<TABLE>

Marketable securities at February 28, 1996 are summarized below (in
thousands):
<CAPTION>

Fair Cost Unrealized Unrealized Unrealized
Value Basis Gains Losses Net Gains
----- ----- ----- ------ ---------

<S> <C> <C> <C> <C> <C>
U.S. Government securities ............. $ 12,678 $ 12,471 $ 221 $ (14) $ 207

Municipal securities ................... 11,550 11,456 94 -- 94

Preferred stock ........................ 3,426 3,172 254 -- 254
-------- -------- -------- ------ --------
$ 27,654 $ 27,099 $ 569 $ (14) 555
======== ======== ======== ======
Related deferred taxes ................. (222)
--------
Unrealized holding gain, net ........... $ 333
========

</TABLE>

38
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

3. Marketable Securities - (continued)
<TABLE>

Marketable securities at February 28, 1997 are summarized below (in
thousands):
<CAPTION>

Fair Cost Unrealized Unrealized Unrealized
Value Basis Gains Losses Net Gains
----- ----- ----- ------ ---------

<S> <C> <C> <C> <C> <C>
U.S. Government securities...... $19,818 $19,737 $ 101 $ (20) $ 81

Municipal securities............ 5,832 5,783 49 -- 49

Preferred stock................. 3,460 3,344 135 (19) 116
------- ------- ----- ----- ------
$29,110 $28,864 $ 285 $ (39) 246
======= ======= ===== =====
Related deferred taxes.......... (98)
------
Unrealized holding gain, net.... $ 148
======
</TABLE>

At February 28, 1997, all marketable debt securities classified as current
assets have scheduled maturities of less than one year. Marketable debt
securities classified as noncurrent assets have scheduled maturities of one to
five years.

4. Property and Equipment, net (in thousands):

February 28,
------------
1996 1997
---- ----
Buildings .......................................... $ 908 $ 6,587
Furniture and fixtures ............................. 1,373 1,766
Computer equipment ................................. 11,642 14,724
Leasehold improvements ............................. 258 596
-------- --------
14,181 23,673
Less accumulated depreciation and amortization ..... (8,588) (11,117)
-------- --------
5,593 12,556
Land ............................................... -- 5,400
-------- --------
$ 5,593 $ 17,956
======== ========

In March 1996, the Company purchased its principal facility, for cash of
approximately $12,000,000. Depreciation expense was $1,531,000, $2,203,000, and
$3,131,000 in fiscal 1995, 1996 and 1997, respectively.

5. Leasehold Commitments and Contingencies

Operating Leases

Future minimum lease payments under all noncancelable operating leases
amount to approximately $1,408,000, $1,151,000, $822,000, $130,000, $81,000 and
$206,000 for fiscal 1998, 1999, 2000, 2001, 2002 and thereafter, respectively.
Rent expense for fiscal 1995, 1996 and 1997 was $1,148,000, $1,455,000, and
$1,633,000, respectively.

Contingencies

In January 1997, a former employee filed a complaint against the Company and
certain of its officers, alleging claims for, among other things, breach of
contract, fraud, negligent misrepresentation and labor code violations. The
complaint seeks general and specific damages of no less than $1.5 million plus
exemplary damages, attorney's fees and costs of suit. The Company has filed
answers to the complaint denying all of the allegations and asserting various
affirmative defenses. The Company believes it has meritorious defenses to the
claims and intends to defend the suit vigorously.

39
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

5. Leasehold Commitments and Contingencies - (continued)

Contingencies - (continued)

The Company is involved in a contract dispute with a customer. Management
believes it has meritorious defenses in relation to this dispute.

No accrual for the above matters has been made in the accompanying
consolidated financial statements as the ultimate outcomes of the litigation and
dispute presently are not determinable. The litigation and dispute are subject
to inherent uncertainties and thus, there can be no assurance that the
litigation or dispute will be resolved favorably to the Company or that they
will not have a material adverse effect on the Company's financial position or
results of operations.

6. Shareholders' Equity

Common Stock Split and Common Stock Repurchase

On March 4, 1996, the Company's Board of Directors authorized a two-for-one
stock split to be effective on April 5, 1996 for the shareholders of record on
March 18, 1996. All share and per share information in the accompanying
financial statements has been restated to give retroactive recognition to the
stock split for all periods presented.

In April 1997, the Company announced that the Board of Directors had
authorized the Company to repurchase up to 1,000,000 shares of common stock for
cash from time-to-time at market prices. In April 1997, the Company repurchased
20,000 shares of common stock in open market transactions for $187,500 under
this stock repurchase program.

Common Stock Option Plans

At February 28, 1997, the Company had reserved 3,976,155 shares of common
stock for issuance under various stock option plans, including plans resulting
from the business combinations with Doctor Design and Epilogue (see Note 2). The
plans provide for the granting of incentive stock options to officers and
employees of the Company and nonqualified stock options to officers, employees,
directors and consultants of the Company at prices not less than fair market
value (as determined by the Compensation Committee of the Board of Directors) on
the date of grant. Options are exercisable at times and in increments as
specified by the Compensation Committee. Options generally vest over four or
five years and expire in six to ten years.
<TABLE>

Activity under these plans is as follows (in thousands, except share and per
share amounts):
<CAPTION>

Shares Number Weighted
Available of Average
for Grant Options Price Per Share Total
--------- ------- --------------- -----
<S> <C> <C> <C> <C>
Balances, February 28, 1994..................... 773,966 2,519,896 $ 3.35 $ 8,449
Adoption of 1994 Directors Stock Option Plan.. 400,000
Shares added to 1988 Plan..................... 2,000,000
Options granted............................... (826,164) 826,164 $ 5.92 4,894
Options exercised ............................ (584,848) $ 3.18 (1,858)
Options canceled.............................. 337,344 (337,344) $ 3.64 (1,227)
---------- --------- -------
Balances, February 28, 1995..................... 2,685,146 2,423,868 $ 4.23 10,258
Options granted............................... (882,272) 882,272 $13.50 11,915
Options exercised............................. (540,254) $ 3.79 (2,050)
Options canceled.............................. 239,966 (239,966) $ 5.91 (1,419)
---------- --------- -------
Balances, February 28, 1996..................... 2,042,840 2,525,920 $ 7.40 18,704
Assumption of Epilogue Options ............... 69,033 $ 7.50 518
Options granted............................... (1,051,798) 1,051,798 $23.64 24,867
Options exercised ............................ (651,390) $ 3.60 (2,344)
Options canceled ............................. 184,453 (194,701) $12.85 (2,501)
---------- --------- -------
Balances, February 28, 1997..................... 1,175,495 2,800,660 $14.01 $39,244
========== ========= ====== =======
</TABLE>

40
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

6. Shareholders' Equity - (continued)

Common Stock Option Plans - (continued)
<TABLE>

The following table summarizes information with respect to stock options
outstanding at February 28, 1997:

<CAPTION>
(number of options in thousands)
Options Outstanding Options Exercisable
------------------------------------------------ ------------------------------
Weighted
Number Average Number
Outstanding at Remaining Weighted Exercisable at Weighted
February 28, Contractual Average February 28, Average
Range of Exercise Price 1997 Life (years) Exercise Price 1997 Exercise Price
----------------------- -------------- ------------ -------------- -------------- --------------
<S> <C> <C> <C> <C> <C>
$ 0.67 - $ 1.35 92 6.76 $ 1.05 57 $ 0.90
$ 2.46 - $ 3.88 408 5.19 $ 3.25 276 $ 3.19
$ 4.50 - $ 7.41 479 7.22 $ 5.50 246 $ 5.80
$ 7.62 - $11.13 297 7.94 $ 9.07 110 $ 8.95
$14.25 - $20.75 874 8.42 $17.25 139 $16.84
$22.75 - $35.63 651 9.07 $26.14 5 $25.66
----- ---
2,801 7.79 $14.01 833 $ 6.99
===== ===
</TABLE>

At February 28, 1996, options to purchase 799,630 shares of common stock at
a weighted average exercise price of $3.48 were exercisable.

In April 1997, the Company offered employees the right to cancel certain
outstanding stock options at original exercise prices and receive new options
with a new exercise price. The new exercise prices range from $8.75 to $10.50
per share, based on the closing price of the common stock on the date individual
employees agreed to cancel their original outstanding stock options. Options to
purchase a total of 1,222,132 shares at original exercise prices ranging from
$14.625 to $35.625 per share were canceled and new options were issued in April
1997. Vesting under the new options commenced on the date the individual
employees agreed to cancel their original options, and occurs over a four year
period.

Employee Stock Purchase Plan

At February 28, 1997, the Company had reserved a total of 553,632 shares of
common stock for issuance under its 1990 Employee Stock Purchase Plan ("the
ESPP"). The purpose of the ESPP is to provide eligible employees of the Company
with a means of acquiring common stock of the Company through payroll
deductions. The purchase price of such stock under the ESPP cannot be less than
85% of the lower of the fair market value on the specified purchase date or the
beginning of the offering period. During fiscal 1995, 1996 and 1997,
approximately 94,000 shares, 72,000 shares, and 51,000 shares, respectively,
were sold through the ESPP. The aggregate fair value and weighted average fair
value per share of purchase rights under the ESPP in fiscal 1996 and 1997 were
$237,000 and $667,000, and $4.41 and $11.09, respectively.

41
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

6. Shareholders' Equity - (continued)

Pro Forma Stock-Based Compensation

The Company has elected to continue to follow the provisions of APB No. 25,
"Accounting for Stock Issued to Employees", for financial reporting purposes and
has adopted the disclosure-only provisions of Statement of Financial Accounting
Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based Compensation".
Accordingly, no compensation cost has been recognized for the Company's Stock
Option Plans or ESPP. Had compensation cost for the Company's Stock Option Plans
and ESPP been determined based on the fair value at the grant date for awards in
fiscal 1996 and 1997 consistent with the provisions of SFAS No. 123, the
Company's net income and net income per share for the years ended February 28,
1996 and 1997 would have been reduced to the pro forma amounts indicated below
(in thousands, except per share amounts):

Year Ended
February 28,
------------
1996 1997
---- ----
Net income - as reported ...................... $5,283 $7,254
Net income - pro forma ........................ 4,704 4,497
Net income per share - as reported ........... 0.24 0.31
Net income per share - pro forma ............. 0.21 0.19

The above pro-forma disclosures are not necessarily representative of the
effects on reported net income for future years.

The aggregate fair value and weighted average fair value per share of options
granted in fiscal 1996 and 1997 were $9.1 million and $17.0 million, and $10.30
and $16.15 per share, respectively. The fair value of each option grant is
estimated on the date of grant using the Black-Scholes Option Pricing Model with
the following weighted average assumptions:

1996 1997
---- ----
Expected volatility .......................... 79.47% 79.67%
Risk-free interest rate ...................... 6.34% 6.15%
Expected life ................................ 5.5 years 5.0 years
Expected dividend yield ...................... 0.00% 0.00%

The Company has also estimated the fair value for the purchase rights under the
Employee Stock Purchase Plan using the Black-Scholes Option Pricing Model, with
the following assumptions for rights granted in 1996 and 1997:

1996 1997
---- ----
Expected volatility .......................... 52.25% 83.16%
Risk-free interest rate ...................... 5.81% 5.81%
Expected life ................................ 0.5 years 0.5 years
Expected dividend yield ...................... 0.00% 0.00%

7. 401(k) Plans

The Company has two 401(k) Plans (the Plans), including a plan resulting
from the business combination with Doctor Design (see Note 2), that cover
essentially all domestic employees. Each eligible employee may elect to
contribute to the Plans, through payroll deductions, up to 15% of their
compensation, subject to certain limitations. The Company is obligated to make
matching contributions on behalf of each participating employee in an amount
equal to 25% of an employee's contribution, up to 2% of the employee's
compensation. For individuals who were employed by the Company prior to December
1, 1994, Company contributions are fully vested on the date of contribution. For
individuals who became employed subsequent to November 30, 1994, Company
contributions vest ratably over a six-year period. The Company's contributions
charged against income totaled approximately $228,000, $390,000, and $410,000 in
fiscal 1995, 1996 and 1997, respectively.

42
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

8. Income Taxes

The provision for income taxes included the following (in thousands):

Year Ended February 28,
-----------------------
1995 1996 1997
---- ---- ----
Federal:
Current ............................ $ 1,838 $ 3,211 $ 2,546
Deferred ........................... (429) (1,584) 245
------- ------- -------
1,409 1,627 2,791
------- ------- -------
State:
Current ............................ 647 1,208 884
Deferred ........................... (58) (593) 43
------- ------- -------
589 615 927
------- ------- -------
Foreign .............................. 1,112 1,270 187
------- ------- -------
$ 3,110 $ 3,512 $3,905
======= ======== =======

The reconciliation between the effective tax rates and statutory federal
income tax rates is shown in the following table:

Year Ended February 28,
-----------------------
1995 1996 1997
---- ---- ----
Statutory federal income tax rate ................. 34.0% 34.0% 35.0%
State taxes, net of federal income tax benefit .... 4.6 5.4 5.5
Acquisition-related costs ......................... -- 8.0 1.0
Research and development tax credit and
credit carry forwards ........................... (1.2) (2.0) (4.0)
Foreign sales corporation tax benefit ............. (3.7) (3.5) (1.5)
Other ............................................. (1.3) (1.9) (1.0)
---- ---- ----
Effective tax rate ................................ 32.4% 40.0% 35.0%
==== ==== ====

Domestic and foreign components of income before income taxes were (in
thousands):

Year Ended February 28,
-----------------------
1995 1996 1997
---- ---- ----
Domestic..................................... $8,558 $7,430 $ 9,493
Foreign...................................... 1,042 1,365 1,666
------ ------ -------
$9,600 $8,795 $11,159
====== ====== =======

The significant components of deferred tax assets and liabilities consist of
the following (in thousands):

February 28,
------------
1996 1997
---- ----
Deferred tax assets:
Purchased intangibles .................................. $2,572 $1,274
Tax credit carryforwards ............................... -- 1,087
Accelerated depreciation ............................... 296 299
Accrued vacation and holiday ........................... 262 368
Allowance for doubtful accounts ........................ 387 574
Other .................................................. 58 359
------ ------
$3,575 $3,961
====== ======
Deferred tax liabilities:
Software development costs ............................. $ 510 $ 545
Marketable securities .................................. 222 98
Cash to accrual adjustment and other ................... 564 349
------ ------
$1,296 $ 992
====== ======

The Company has not provided a valuation allowance for its net deferred tax
assets as it expects such amounts to be realized through taxable income from
future operations, or by carryback to prior years' taxable income.

43
<PAGE>

INTEGRATED SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)

9. Business Segment Information

The Company operates in one business segment: the design, marketing and
support of products for automating the process of real-time software development
and system design, including engineering services to assist customers in
implementing specific solutions.
<TABLE>

The Company's foreign operations primarily consist of an operating
subsidiary and sales and customer service organizations. Net revenues, operating
income and identifiable assets of the Company's foreign subsidiaries were not
material to the consolidated financial statements in fiscal 1995 and 1996. For
fiscal 1997 the net revenues, operating income and identifiable assets for the
Company's North American, European and Asia/Pacific operations are summarized
below:
<CAPTION>
(in thousands)
North
America Europe Asia/Pacific Eliminations Total
------- ------ ------------ ------------ -----
<S> <C> <C> <C> <C> <C>
1997:
Net revenues $88,870 $20,366 $12,472 $(16,245) $105,463
Operating income 5,944 436 559 0 6,939
Identifiable assets 48,013 8,865 5,234 (4,305) 57,807
</TABLE>

Sales and transfers between geographic areas are accounted for at prices which
the Company believes are arm's length prices, which in general are in accordance
with the rules and regulations of the respective governing tax authorities. Such
transfers are eliminated in the consolidated financial statements. Identifiable
assets are those that can be directly associated with a particular geographic
area. Corporate assets include cash and cash equivalents, short-term investments
and long-term investments and totaled $54,695,000 at February 28, 1997.

Export revenues consisting of sales from the Company and it's U.S. operating
subsidiaries to non-affiliated customers were as follows:

Year Ended February 28,
-----------------------
(in thousands) 1995 1996 1997
---- ---- ----
Europe $ 6,472 $ 9,458 $ 1,869
Asia/Pacific 6,790 11,305 6,588
------- ------- -------
Total $13,262 $20,763 $ 8,457
======= ======= =======

No customer accounted for 10% or more of total revenue in the reported periods.

44
<PAGE>

REPORT OF INDEPENDENT ACCOUNTANTS ON SCHEDULE

In connection with our audits of the consolidated financial statements of
Integrated Systems, Inc. and Subsidiaries as of February 28, 1996 and 1997, and
for the each of the three years in the period ended February 28, 1997, which
financial statements are included in the Registrant's Annual Report on Form
10-K, we have also audited the financial statement schedule listed in Item 14
herein.

In our opinion, the financial statement schedule, when considered in
relation to the basic financial statements taken as a whole, presents fairly, in
all material respects, the information required to be included therein.

COOPERS & LYBRAND L.L.P.

San Jose, California
March 26, 1997, except for Note 6,
as to which the date is April 28, 1997

45
<PAGE>
<TABLE>
SCHEDULE II

INTEGRATED SYSTEMS, INC.

VALUATION AND QUALIFYING ACCOUNTS

<CAPTION>
Column A Column B Column C Column D Column E
-------- -------- --------------------- --------- --------
Charged
Balance at to Costs Charged Balance
Beginning and to Other at End
Description of Period Expenses Accounts Write-offs of Period
----------- ---------- ---------- ----------- ---------- ----------
<S> <C> <C> <C> <C>
For the year ended February 28, 1995:
Allowance for doubtful accounts $482,000 $253,000 -- $106,000 $ 629,000
For the year ended February 28, 1996:
Allowance for doubtful accounts $629,000 $286,000 -- $ 63,000 $ 852,000
For the year ended February 28, 1997:
Allowance for doubtful accounts $852,000 $750,000 $150,000 $212,000 $1,540,000
</TABLE>

<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, on May 28, 1997.

INTEGRATED SYSTEMS, INC.

By: /s/ NARENDRA K. GUPTA
-------------------------
Narendra K. Gupta,
Chairman of the Board and Secretary

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

Name Title Date
---- ----- ----

<S> <C> <C>
Principal Executive Officer:

/s/ DAVID P. ST. CHARLES President, Chief Executive Officer May 28, 1997
- ---------------------------------------- and Director
David P. St. Charles

Principal Financial and Accounting Officer:

/s/ WILLIAM C. SMITH Vice President, Finance and Chief May 28, 1997
- ---------------------------------------- Financial Officer
William C. Smith

Additional Directors:

/s/ NARENDRA K. GUPTA Chairman of the Board and May 28, 1997
- ---------------------------------------- Secretary
Narendra K. Gupta

/s/ JOHN C. BOLGER Director May 28, 1997
- ----------------------------------------
John C. Bolger

/s/ VINITA GUPTA Director May 28, 1997
- ----------------------------------------
Vinita Gupta

/s/ THOMAS KAILATH Director May 28, 1997
- ----------------------------------------
Thomas Kailath

/s/ RICHARD C. MURPHY Director May 28, 1997
- ----------------------------------------
Richard C. Murphy
</TABLE>
47
<PAGE>

INDEX TO EXHIBITS

Sequentially
Exhibit Numbered
Number Exhibit Page
------ ------- ----
11.01 Statement Regarding Computation of Net Income Per Share ... 49
21.01 List of Registrant's Subsidiaries ......................... 50
23.01 Consent of Independent Accountants ........................ 51
27.01 Financial Data Schedule ................................... 52

EXHIBIT 11.01

INTEGRATED SYSTEMS, INC.

COMPUTATION OF NET INCOME PER SHARE (1)
(Amounts in thousands, except per share amounts)

Year Ended February 28,
-----------------------
1995 1996 1997
---- ---- ----
Primary:

Net income $ 6,490 $ 5,283 $ 7,254
======= ======= =======
Reconciliation of weighted
number of shares outstanding to amount
used in net income per share
computation:
Weighted average number of common
shares outstanding 19,318 20,962 22,437
Dilutive effect of options 646 1,126 1,071
------- ------- -------
19,964 22,088 23,508
======= ======= =======
Net income per share $ 0.33 $ 0.24 $ 0.31
======= ======= =======
Fully Diluted:

Net income $ 6,490 $ 5,283 $ 7,254
======= ======= =======
Reconciliation of weighted
number of shares outstanding
to amount used in net income
per share computation:
Weighted average number of common
shares outstanding 19,318 20,962 22,437
Dilutive effect of options 936 1,130 1,105
------- ------- -------
20,254 22,092 23,542
======= ======= =======
Net income per share $ 0.32 $ 0.24 $ 0.31
======= ======= =======

(1) See Note 1 of Notes to Consolidated Financial Statements.

EXHIBIT 21.01

INTEGRATED SYSTEMS, INC.

LIST OF REGISTRANT'S SUBSIDIARIES

State or Jurisdiction of
Incorporation or
Name Organization
----------------------------------- -------------------------
Integrated Systems, Inc. F.S.C U.S. Virgin Islands
Integrated Systems, Inc. Limited United Kingdom
Integrated Systems, Inc. S.A. France
Integrated Systems, GmbH Germany
Integrated Systems, Inc. A.B. Sweden
Integrated Systems (Israel) Ltd. Israel
Integrated Systems, Inc. GmbH Austria
TakeFive Software GmbH Austria
TakeFive Software AG Switzerland
TakeFive Software, Inc. California
TakeFive Software, Ltd. United Kingdom
Doctor Design, Inc. California
ISICAN Integrated Systems (Canada) Inc. Canada
Integrated Systems Japan K.K. Japan
Integrated Systems, Inc. Italia SRL Italy
Epilogue Technology Corporation New Mexico
Diab Data, Inc. California

EXHIBIT 23.01

CONSENT OF INDEPENDENT ACCOUNTANTS

We consent to the incorporation by reference in the Registration Statements
of Integrated Systems, Inc. on Form S-8 (File Nos. 33-35281, 33-48626, 33-70494,
333-1145, 333-12799) of our reports dated March 26, 1997, except for Note 6, as
to which the date is April 28, 1997, on our audits of the consolidated financial
statements and financial statement schedule of Integrated Systems, Inc. as of
February 28, 1996 and 1997, and for each of the three years in the period ended
February 28, 1997 which reports are included in this Form 10-K.

Coopers & Lybrand L.L.P.

San Jose, California
May 28, 1997

<ARTICLE> 5
<LEGEND>
THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE FY97
FORM 10-K FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO
SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> FEB-28-1997
<PERIOD-START> MAR-01-1996
<PERIOD-END> FEB-28-1997
<CASH> 25,585
<SECURITIES> 4,483
<RECEIVABLES> 29,806
<ALLOWANCES> 1,540
<INVENTORY> 0
<CURRENT-ASSETS> 65,439
<PP&E> 29,073
<DEPRECIATION> 11,117
<TOTAL-ASSETS> 112,502
<CURRENT-LIABILITIES> 26,127
<BONDS> 0
0
0
<COMMON> 61,158
<OTHER-SE> 25,014
<TOTAL-LIABILITY-AND-EQUITY> 112,502
<SALES> 69,282
<TOTAL-REVENUES> 105,463
<CGS> 9,755
<TOTAL-COSTS> 26,147
<OTHER-EXPENSES> 72,377
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 11,159
<INCOME-TAX> 3,905
<INCOME-CONTINUING> 7,254
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 7,254
<EPS-PRIMARY> 0.31
<EPS-DILUTED> 0.31

</TABLE>