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

                                    FORM 10-K

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

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

                        COMMISSION FILE NUMBER 000-21129

                                   AWARE, INC.
                                   -----------
             (Exact Name of Registrant as Specified in Its Charter)


       MASSACHUSETTS                                           04-2911026
       -------------                                           ----------
(State or Other Jurisdiction of                             (I.R.S. Employer
Incorporation or Organization)                             Identification No.) 
                          

              40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730
              ----------------------------------------------------
                    (Address of Principal Executive Offices)
                                   (Zip Code)

                                 (781) 276-4000
                                 --------------
              (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, PAR VALUE $.01 PER SHARE
                                (Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]

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

The aggregate market value of the voting stock held by non-affiliates of the
registrant as of February 27, 1998, based on the closing price of the Common
Stock on February 27, 1998 as reported on the Nasdaq National Market, was
approximately $169,226,281.

The number of shares outstanding of the registrant's common stock as of February
27, 1998 was 19,774,682.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement to be delivered to
shareholders in connection with the registrant's Annual Meeting of Shareholders
to be held on May 27, 1998 are incorporated by reference into Part III of this
Annual Report on Form 10-K.

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                                   AWARE, INC.
                                    FORM 10-K
                      FOR THE YEAR ENDED DECEMBER 31, 1997


                                TABLE OF CONTENTS



                                     PART I


Item 1.   Business.........................................................   3

Item 2.   Properties.......................................................  16

Item 3.   Legal Proceedings................................................  16

Item 4.   Submission of Matters to a Vote of Security Holders..............  16


                                     PART II


Item 5.   Market for Registrant's Common Equity and Related 
          Stockholder Matters.............................................   17

Item 6.   Selected Financial Data..........................................  18

Item 7.   Management's Discussion and Analysis of Financial 
          Condition and Results of Operations..............................  19

Item 8.   Financial Statements and Supplementary Data......................  27

Item 9.   Changes in and Disagreements with Accountants on 
          Accounting and Financial Disclosure..............................  41


                                    PART III


Item 10.  Directors and Executive Officers of the Registrant...............  42

Item 11.  Executive Compensation...........................................  43

Item 12.  Security Ownership of Certain Beneficial Owners
          and Management...................................................  43

Item 13.  Certain Relationships and Related Transactions...................  43


                                     PART IV


Item 14.  Exhibits, Financial Statement Schedule, and 
          Reports on Form 8-K..............................................  44

Signatures.................................................................  47






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                                     PART I



ITEM 1.  BUSINESS


                                     GENERAL

   Aware, Inc. (the "Company" or "Aware") was incorporated in Massachusetts in
1986. During its first seven years, the Company was engaged primarily in
research, specializing in wavelet mathematics, image and video compression, and
channel modulation and coding. The Company holds nineteen patents in areas
related to wavelet mathematics, data compression and similar technologies. The
Company's revenue during this period consisted largely of research grants from
agencies of the U.S. government and certain commercial companies. In 1993, the
Company began to shift its business from contract research toward development
of: (i) Digital Subscriber Line ("xDSL") technologies, and (ii) image
compression products. Two principal lines of business emerged as a result of the
decision to commercialize the Company's core technology: telecommunications and
image compression.

   The Company's telecommunications business is dedicated to developing
technology and products that increase the speed of data communications over
conventional copper telephone networks. The Company believes that its technology
and products will enable telephone companies ("telcos") to utilize their
installed bases of copper telephone lines to provide both residential and
business customers with interactive data transmission at speeds much higher than
currently available. The Company's core telecommunications technology includes
algorithms, software, hardware designs, and chipsets that implement Asymmetric
Digital Subscriber Line ("ADSL"), splitterless lite Digital Subscriber Line
("DSL Lite"), Very High Speed Digital Subscriber Line ("VDSL"), and Symmetric
Digital Subscriber Line ("SDSL") technologies.

   The Company has co-developed an ADSL chipset with Analog Devices, Inc.
("ADI"), a leading supplier of integrated circuits. ADI has a non-exclusive
technology and software license to manufacture and sell such chipsets for which
the Company receives royalty payments. In 1997, the Company entered into an
agreement with Lucent Technologies, Inc. ("Lucent") to develop DSL Lite software
that will operate on Lucent digital signal processors ("DSPs"). Lucent has a
non-exclusive technology and software license to manufacture and sell such chips
for which the Company will receive royalty payments. The Company's
telecommunications business is also engaged in the design and development of
access routers, modems, transceiver modules, and other communications products
that incorporate the Company's technologies.

    The Company's image compression products include WSQ by Aware, AccuPress for
Radiology, AccuPress for Remote Sensing, AccuPress for Multimedia, and SeisPact.
In addition, the Company's image compression organization continues to perform
some contract research for the U.S. government.

    The Company's executive offices are located at 40 Middlesex Turnpike,
Bedford, Massachusetts, 01730, and its telephone number is (781) 276-4000.




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                              PRODUCTS AND MARKETS

TELECOMMUNICATIONS

TELECOMMUNICATIONS MARKET

    With the rise of the Internet and World Wide Web, network service providers
are experiencing a fundamental shift in the type of communications traffic
transmitted over their networks. The existing network infrastructure of
twisted-pair copper wiring, which was originally designed to provide analog
voice service ("Plain Old Telephone Service" or "POTS" ), and fiber coaxial
cable, which was designed to provide broadcast cable television service, are
increasingly required to carry large amounts of data produced by computers.
Service providers are faced with the challenge of providing high-speed data
communications at reasonable costs, while preserving their investment in copper
wire and coaxial cable networks.

    Copper wire telephone networks are estimated to include over 170 million
lines in the United States and over 700 million lines worldwide, according to
industry sources. These networks represent a massive undepreciated capital
investment. Cable television service is currently available to approximately
ninety percent of the homes in the U.S. and approximately sixty-five percent of
the homes in the U.S. subscribe to the service.

    To date, the telcos' copper wire and cable companies' infrastructures have
not proven adequate for the increasing volume of traffic generated by computers
remotely connected to each other and the Internet. Digital information requires
more bandwidth than traditional analog voice communications if it is to be
transmitted at a speed that is satisfactory to the computer user. Currently, the
fastest transmission rate readily available to typical home or remote office
computer users over existing copper wire is achieved through the use of a 56
kilobits per second ("Kbps") modem, although many users still employ modems that
are slower than this. For the over 80 million and growing Internet users, these
transmission rates are one of the chief frustrations of using the World Wide
Web, which is the fastest growing and most data intensive segment of the
Internet.

    Service providers, recognizing the need for higher speed data
communications, are increasingly seeking to upgrade their networks. The telcos
are replacing copper wire with fiber optic cable, which permits high speed data
transmissions, particularly through the backbone of the network that links their
central offices to one another. However, installing fiber optic cable all the
way into customers' homes or businesses is prohibitively expensive and would
take decades. Similarly, cable companies have deployed hybrid fiber coaxial
("HFC") networks, and are providing two-way data transmissions over these
networks using cable modems.

    Telcos are seeking cost-effective technologies to accommodate high speed
data transmission over copper wires. Some of these technologies are described
below:

              ISDN. In the early 1980s, telcos introduced Integrated Service
           Digital Network ("ISDN") technology, which provides digital
           transmission over copper wire typically at basic rates up to 144
           Kbps. Although this technology is several times faster than a
           voiceband modem, the market penetration of existing ISDN technology
           is limited because its equipment and installation costs are
           relatively high, and it does not allow simultaneous POTS and data
           transmission on those wires.



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              T-1. T-1 (E-1 in countries outside the U.S.) is a multiplexing
           format that allows digital conversion of an analog line. Once
           converted, a T-1 digital line can deliver data at speeds up to 1.544
           megabits per second ("Mbps"). However, T-1 service cannot use the
           existing copper wire networks without expensive and time-consuming
           modifications, including installation of repeaters every 3,000 to
           5,000 feet to regenerate the signal as it passes along the line. T-1
           also requires two sets of twisted-pair copper wires and does not
           allow simultaneous POTS and data transmission on those wires.

              HDSL. In 1992, telcos introduced High bit-rate Digital Subscriber
           Line ("HDSL") technology, which reduces the cost of installing T-1
           service. HDSL increases the distance of T-1 transmission over copper
           wires to approximately 12,000 feet, which reduces the need for
           repeaters. As a result, some telcos are deploying HDSL technology in
           their local access networks. However, HDSL requires two sets of
           twisted-pair copper wires and does not allow simultaneous POTS and
           data transmission on those wires.

              ADSL. For several years telcos have been evaluating the deployment
           of ADSL technology, which uses digital signal processing technology
           to expand the useable bandwidth of copper telephone wire. ADSL was
           initially created in the late 1980s by Bellcore, the research entity
           jointly created and funded by the Regional Bell Operating Companies
           ("RBOCs"). ADSL technology allows non-repeated transmissions of data
           at a distance of up to 18,000 feet over telcos' existing copper
           networks at a rate of up to 8 Mbps downstream to the customer and at
           a rate of up to 768 Kbps upstream from the customer, with the speed
           of transmission decreasing as distance increases. ADSL allows
           simultaneous POTS and high speed digital data transmission on a
           single set of twisted-pair copper wires. To accomplish this, ADSL
           uses a filtering device, called a POTS splitter, to isolate the POTS
           and ADSL signals from one another.

              DSL Lite. In 1997, the Company helped pioneer a new xDSL
           technology alternatively referred to as DSL Lite, G.lite,
           splitterless DMT, and Universal ADSL ("UADSL"). Similar to ADSL, DSL
           Lite enables voice and high-speed data communications to coexist on a
           single copper telephone wire. DSL Lite has the added advantage that
           it eliminates, in most cases, the need for a POTS splitter to
           separate voice and data signals on the customer premise side of the
           connection. The omission of a POTS splitter vastly reduces the
           installation cost of DSL Lite service over that of ADSL service by
           eliminating the need to send a technician for service installation.
           DSL Lite technology allows downstream data transmissions speeds of up
           to 1.5 Mbps without any disruption to the customer's telephone
           service. Also in 1997, a consortium of leading companies from the
           personal computer, networking and telecommunications industries
           formed a group known as the Universal ADSL Working Group ("UAWG") to
           write a specification for UADSL. Upon completion of the
           specification, the UAWG intends to submit the document to the
           International Telecommunications Union ("ITU") for consideration as
           the worldwide G.lite standard.


    In addition to these telco technologies, cable company suppliers are working
to improve HFC technology, which would permit two-way broadband digital
communications over typical cable networks. HFC technology uses digital signal
processing to allow efficient sharing of upstream bandwidth so that a cable line
can be used for two-way transmissions. According to industry sources,
approximately 100,000 lines of cable modems had been installed as of December
31, 1997. New HFC networks are also being installed by telcos so that they can
offer television service as well as telephone and data dial-tone services.




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    Telcos typically put new products through a rigorous approval process before
deploying them on a broad basis. The approval process usually involves a number
of different phases, including (i) laboratory evaluations, in which the product
is tested against relevant industry standards; (ii) technical trials, in which
the product is tested in the field with a small number of users; (iii) marketing
trials, in which the product is tested in the field with a larger number of
users and telcos begin to train their personnel to install and maintain the
product; (iv) initial commercial deployment, in which telcos make the product
available to selected customers for selected applications; and (v) commercial
deployment, in which telcos make the product available to a substantial number
of customers.

    During 1997, telcos continued laboratory, technical, and marketing trial
evaluations of ADSL. While the Company believes the telcos' trial experience has
provided them with evidence that ADSL technology is capable of delivering
high-speed data transmissions rates, the telcos have been slow to initiate
commercial deployment. The Company believes that the telcos have moved
cautiously due to two primary reasons: (i) they have not had commercially
deployable central office equipment available to them and (ii) they have been
concerned about their ability to meet the demand for customer premises equipment
installation requests should ADSL become widely available. The Company believes
that DSL Lite will act as a catalyst to increase the speed at which the telcos
adopt xDSL technologies, including DSL Lite and ADSL. Since DSL Lite largely
solves the customer premises installation issue, the telcos and
telecommunications equipment suppliers appear to have increased their commitment
to deployment as evidenced by the formation of the UAWG. While the timing of
wide-scale xDSL deployment is difficult to predict, recent events suggest the
industry is increasing the pace at which it is moving toward that objective.



TELECOMMUNICATIONS PRODUCTS

    The Company designs and develops products utilizing its proprietary software
to implement xDSL that it believes have advantages over its competitors' xDSL
products. The xDSL products developed by Aware incorporate proprietary software
and algorithms based on digital signal processing technology as well as
application specific integrated circuits (ASICs). In contrast to the approach
taken by some competing developers of xDSL technology, Aware's approach is to
maintain a high level of functionality in the software component of the product
as opposed to the ASIC. The Company believes that this approach allows it to
engineer improvements in its technology quickly and efficiently, rather than
having to design and produce a new ASIC each time an improvement is made. The
Company's xDSL technology enables data communications protocols, such as Frame
Relay, TCP/IP, and ATM, to operate at higher transmission rates over copper
wire. The Company has chosen to use the multi-carrier Discrete Multi-Tone
("DMT") modulation for ADSL, rather than the single-carrier Carrierless
Amplitude Phase ("CAP") modulation technique. The Company believes that xDSL/DMT
technology has greater potential for deployment than CAP, because (i) DMT is
more flexible, (ii) the standardization process for DMT is more advanced, (iii)
DMT has been endorsed by the UAWG and the ITU for DSL Lite, and (iv) there are
multiple vendors who supply DMT as opposed to CAP which is offered by one
vendor. (See Item 1. Business - TECHNOLOGY)

    Existing Telecommunications Products

    Chipsets. The Company and ADI developed a second generation ADSL chipset,
which began shipping in June 1997. The chipset uses a combination of ASICs,
digital signal processors, and proprietary software to provide all of the ADSL
transceiver functions necessary in a modem chipset. The ADSL chipset meets the
performance objectives of the DMT multi-carrier modulation chosen by the
American National Standards Institute ("ANSI") as the standard for ADSL.




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    In 1993 ADI and the Company entered into an agreement, under which ADI
produces and markets chipsets incorporating the Company's DMT-based ADSL
technology, and for which the Company receives royalties and development
funding. Effective March 1998, ADI and the Company modified this agreement from
an exclusive to a non-exclusive business relationship. Even though the Company
may enter into additional semiconductor partnerships, the Company's ability to
achieve its business objectives will still depend on ADI's ability and desire to
deliver chipsets to the market place. (See Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations - FACTORS THAT MAY
AFFECT FUTURE RESULTS.)

    Software and Hardware Interfaces. The Company develops software and hardware
interfaces for its ADSL chipset which can be used to connect the chipset with
PCs, network and central office equipment, and other telephony and data
communications devices. The interfaces are custom developed by the Company for
OEMs, who seek to incorporate the Company's ADSL technology into their systems.

    Access Routers. The Company has developed and markets an ADSL access router,
called the x200 Access Router. The x200 contains the ADI/Aware ADSL chipset
along with software and hardware interfaces and designs developed by the
Company, and routing capability for Frame Relay, TCP/IP, and ATM data
communications protocols. In a typical configuration, the Company's ADSL access
router is designed to receive data at speeds over 9 Mbps and send data at speeds
of up to 768 Kbps, is fully rate adaptive in 32 Kbps increments and is capable
of transmitting data over distances of more than 18,000 feet over standard
copper wire while maintaining POTS service through the use of a POTS splitter.

    Board-Level Products. The Company has developed and markets an ADSL
transceiver module, called the AW-910. The AW-910 is a 3" by 5" transceiver
card, which contains the ADI/Aware ADSL chipset and software and hardware
interfaces. The AW-910, which is primarily sold to OEMs for inclusion in their
ADSL product offerings, also transmits and receives data at rates over 9 Mbps
downstream and 768 Kbps upstream.

    Test and development systems. The Company has developed and markets an ADSL
test and development system, called the ADS-910. The ADS-910, which is designed
to help OEMs test their ADSL systems, allows a wide range of tests, including
ADSL line testing and bit rate testing. The development system houses two
transceiver modules; one central office (CO) module and one remote terminal (RT)
module, and provides power, data, and ADSL line signals to the modules.


PRODUCTS UNDER DEVELOPMENT

     The Company has publicly announced the following product development
projects:

     Chipsets. The Company and ADI are currently developing their next
generation full rate ADSL chipset. This release includes improvements to the two
ASICs in the chipset as well as upgrades to the signal processing software for
the DSP in the chipset.

     The Company has announced that it is working with Lucent to develop DSL
Lite software that will operate on Lucent DSPs along with analog front end
chips. The resulting chipset will be targeted at personal computer OEM
customers. The Company is also working with ADI to develop DSL Lite software
that will operate on various ADI chip platforms. The resulting chipset will be
primarily targeted at central office OEM customers.




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     The Company has begun in-house design and development of a chip that
implements the Company's proprietary DWMT technology. The resulting chip is
intended to have applications in the SDSL marketplace. The chip will be
fabricated by a third party semiconductor manufacturer.

     Access routers and transceivers. The Company has announced that it intends
to begin shipping x200 Lite Access Routers that contain DSL Lite functionality
and AW-910 DSL Lite transceiver modules in the first half of 1998. These
products, which will incorporate the second generation ADI/Aware ADSL chipset
operating in DSL Lite mode, will be rate adaptive and support speeds up to 1.5
Mbps downstream and 512 Kbps upstream and will achieve high-speed data transfer
over local loops of up to 22,000 feet.


IMAGE COMPRESSION

     In 1993, the Company began an effort to produce commercially marketable
wavelet image compression software products. The Company currently offers five
software-based compression products and has an agreement with ADI to produce and
market a wavelet video compression ASIC, for which the Company receives
royalties. The Company's compression products include the following: WSQ by
Aware (which compresses digital fingerprint data for use by law enforcement
agencies, such as the FBI); AccuPress for Radiology (which is used to compress
digital radiographs and other types of medical imagery); AccuPress for
Multimedia (which is a general purpose compression product); AccuPress for
Remote Sensing (which is designed for compression of satellite-based remote
sensing imagery); and SeisPact (which companies in the oil and gas industry can
use to store and transmit large amounts of seismic data).



                                   TECHNOLOGY

    The Company's core technology is based on its research into wavelet
mathematics, digital communications, and data compression. From that core
technology, four principal technologies have emerged, including: (i) DMT-based
ADSL technology, (ii) splitterless DMT DSL Lite technology, (iii) DWMT
technology, and (iv) image compression technology.

    ADSL Technology

    ADSL is a method for expanding the useable bandwidth of copper wire.
Typically, ADSL systems divide a one megahertz (MHz) bandwidth on copper wire
into three segments: (i) the 0 to 4 kilohertz (KHz) range is used for POTS, (ii)
the 25 KHz to 100 KHz range is used to transmit data upstream and (iii) the 100
KHz to 1 MHz range is used to transmit information downstream. The ANSI
specification for ADSL calls for operation rates of 1.5 to 8 Mbps downstream and
64 to 640 Kbps upstream when operating over existing copper wires at a distance
of up to 18,000 feet.

    There are two primary ADSL modulation techniques for transmitting data
signals: (i) DMT, which the Company uses, and (ii) CAP. DMT is a multi-carrier
modulation technique that was chosen by ANSI as the telecommunications industry
standard for ADSL. CAP is a single-carrier modulation technique originally
developed by AT&T Paradyne Corporation (now Globespan Technologies, Inc.). The
fundamental difference between CAP and DMT is that CAP treats each of the
upstream and downstream frequency ranges as a single element over which as many
information bits as possible are transmitted. In contrast, DMT divides the
upstream and downstream bands into groups of different smaller subchannel
frequency ranges (approximately 4 KHz each) into which a much smaller number of
bits are coded and transmitted simultaneously.



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    The Company believes that DMT technology is better able than CAP technology
to address the inherent problems of the telcos' copper wire networks. Because of
its multiple small frequency bands, DMT is able to adjust and adapt the
information signal to both extract more throughput from a wire and to avoid
sending information into frequency ranges that are not useable. Since CAP treats
the entire frequency range as a single element, it does not have the ability to
balance as easily the use of the frequency spectrum to match efficiently the
performance of a given wire.


    Splitterless DMT DSL Lite Technology

    In 1997, the Company helped to pioneer a new form of xDSL technology, known
as splitterless DMT DSL Lite technology. DSL Lite allows for downstream data
transmissions over telephone networks in the 1.0 to 1.5 Mbps range, and upstream
data transmissions of up to 512 Kbps in a "splitterless" environment.
Splitterless means that modems employing this technology do not require special
equipment, known as POTS splitters, to separate the telephone service from the
data service. The omission of a POTS splitter vastly reduces the installation
cost of DSL Lite service over that of ADSL service by removing the need to send
a technician for service installation. Further, this technology will enable end
users to install DSL Lite modems in the same way as today's voiceband modems.
For these reasons, the Company believes that DSL Lite technology may act as a
catalyst to increase the speed at which service providers deploy xDSL
technologies.

    DMT operating in a splitterless DSL Lite mode has been endorsed by both the
UAWG and the ITU for two primary reasons: (i) DMT DSL Lite can be made to
interoperate with full-rate DMT-based ADSL, the ANSI standard for ADSL
modulation, and (ii) DMT DSL Lite equipment and software provide a clear
migration path to full rate standards-based ADSL central office and customer
premises equipment.

    The UAWG intends to submit a specification for splitterless DMT DSL Lite to
the ITU in 1998. While predicting the timing or outcome of standard body actions
is difficult, the ITU has preliminarily indicated that it will attempt to adopt
a standard for this technology by the end of 1998.


    DWMT Technology

    The Company has invented a proprietary technology based on wavelet
mathematics called DWMT. The Company believes that, as a result of its research
and development of DWMT technology, it is a leader in commercialization of
wavelets for telecommunications.

    Multi-carrier systems divide a frequency range into the desired number of
subchannels by using a time-domain to frequency-domain transform, which is a
mathematical process. Because of fundamental limits associated with such
transforms, the process of creating isolated subchannels is imperfect. These
imperfections inhibit modems from achieving theoretical performance limits. The
subchannelization method used in creating DMT modems utilizes a Fourier
transform. This technique has been used in the telecommunications industry since
the 1960s, but has become more practical for high speed, high volume use as
digital signal processors have improved. The wavelet transform yields
significantly better subchannelization than the Fourier transform. Because this
technique more closely approximates ideal subchannelization, the performance of
a wavelet-based DWMT system can produce performance superior to a non-wavelet
DMT system operating in a noisy environment.

    The Company intends to apply DWMT technology to new products using SDSL,
VDSL, and HFC applications. The Company is seeking to incorporate DWMT
techniques into industry standards body




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recommendations. The following is a brief description of possible applications
using SDSL, VDSL, and HFC:

    SDSL. Symmetric Digital Subscriber Line technology is similar to ADSL, but
allows two-way data transmission at the same rates. The Company is developing an
SDSL application using its DWMT technology. SDSL is not an officially defined
standard, but can provide data transmission rates from 1 Mbps to 10 Mbps
simultaneously in both directions on single twisted-pair copper wire over
distances of 5,000 to 18,000 feet. The Company expects that this SDSL
application can be used for LAN interconnecting and enhanced telephony
applications.

    VDSL. The Company believes that Very high-speed Digital Subscriber Line
technology will be the next generation of high-speed user access, critical to
the implementation of fiber-to-the-neighborhood and fiber-to-the-curb
architectures. These architectures involve the deployment of an access node that
utilizes fiber optic cable from a telco's central office to the access node,
thus bringing fiber closer to the user. The final connection to the user is new
or existing copper wire or new coaxial cable. VDSL is being designed with the
objective of providing performance up to six times faster than ADSL, but over a
shorter distance. The goal of VDSL is to enable telcos to provide a combination
of digital TV, data dial-tone and regular telephony service on a single
twisted-pair of copper wire.

    HFC. By using the frequency band from 5 to 40 MHz for upstream transmission
and the frequency band from 450 to 750 MHz for downstream transmission, it is
possible to provide two-way services, such as telephony and data communications,
on existing HFC networks. Each of these frequency bands is typically divided
into smaller bands, 1 to 2 MHz wide. The Company's HFC technology is based upon
DWMT and can provide up to 8 Mbps transmission over a 2 MHz band. HFC telephony
and cable modem technology enables cable companies to re-use their existing
network to provide two-way data transmission services.


    Image Compression Technology

    Since 1988, the Company has developed expertise, trade secrets, and
intellectual property in the field of wavelet transform-based data compression
and has obtained several patents in this area. The Company's wavelet compression
technology enables digital image, video and certain types of data to be
compressed to between 1% and 10% of their original size. Using wavelet
compression, the decompressed data are not bit for bit identical to the original
data. A risk with this technique is that, as the original data get smaller, a
larger amount of error is introduced into the decompressed data. However,
compressed data can be transmitted across networks faster and storage costs are
reduced.





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                            RESEARCH AND DEVELOPMENT

    The Company believes that its future success depends on its ability to adapt
to the rapidly changing telecommunications environment and to meet its
customers' needs. The timely development and introduction of new products is
essential to maintain the Company's competitive position. The Company's product
development activities are focused on delivering technology and products to its
OEM customers that will enable them to offer end-to-end systems that will allow
their service provider customers to make maximum use of the capabilities of
their existing copper wire networks. Key development objectives include
enhancements to the Company's ADSL and DSL Lite technologies as well as on
products incorporating DWMT technology for SDSL and VDSL applications. In 1996
and 1997, the Company spent approximately $1,100,000 on the development of its
HFC technology. In the third quarter of 1997, the Company suspended development
of its HFC technology due to a lack of customer demand for such technology at
that time. The Company may recommence HFC development activities if and when
there is sufficient customer demand.

    Most of the Company's products are developed internally. As of December 31,
1997, the Company had a research and development staff of 47 employees,
including ten employees holding doctorate degrees related to digital signal
processing and digital communications theory. The Company supplemented its staff
of 47 engineering employees with 8 additional contract engineers at December 31,
1997. Subject to its ability to effectively source, hire and retain engineers,
the Company anticipates that its research and development organization will grow
significantly in the future as the Company attempts to strengthen its technology
and product position in the telecommunications marketplace.

    During the years ended December 31, 1997, 1996 and 1995, research and
development costs charged to operations were $6,874,137, $3,234,799, and
$2,333,200, respectively. Such costs are net of software development costs
capitalized in accordance with Statement of Financial Accounting Standards
("SFAS") No. 86. There were no SFAS 86 costs capitalized in 1997, 1996 or 1995.

    New product development schedules are difficult to predict, because
telecommunications product development, quality assurance testing and debugging
are complex processes that often take longer than expected. Accordingly,
although the Company estimates the shipment dates of proposed new products for
internal purposes, such estimates are subject to frequent adjustment based on
the Company's own periodic assessment of its progress in the development
process. No assurance can be given that any of the development projects referred
to in the "Products and Markets" section will be successful or that any
announced shipping dates for new products will be met.



                               SALES AND MARKETING

    To date, the Company's principal telecommunications sales and marketing
strategy has been to propagate its technology and products with OEM equipment
suppliers. These OEM customers manufacture and sell telephone network equipment,
cable plant equipment, data communications equipment, and end user customer
premises equipment. The Company's objective is to incorporate its technology and
products into solutions offered by its OEM customers. The Company has three
types of OEM customers with whom it has business relationships: (i) licensees of
intellectual property, such as U.S. Robotics/3Com, (ii) semiconductor
manufacturing partners, such as ADI and Lucent, and (iii) customers who purchase
the Company's existing telecommunications products, such as Advanced Fibre
Communications, DSC Communications, Ericsson, Siemens, ADC, Phillips, ECI,
Sumitomo, and PulseCom.




                                       11

<PAGE>   12

    Due to the complexity of the Company's telecommunications technology, the
Company's sales people must have a high degree of technical sophistication in
order to market its products effectively. The Company believes that technology
selections involving the Company's products are frequently made at senior levels
within a prospective customer's organization. Consequently, the Company relies
significantly on presentations by senior management to key employees of OEMs.

    As of December 31, 1997, the Company had ten people in its
telecommunications sales and marketing organization. Although the Company's
primary sales and marketing objective is to sell to OEM's, during 1997 the
Company began selling its ADSL products to resellers, Internet service providers
and competitive local access providers. As xDSL technologies are more broadly
adopted, the Company expects to hire additional sales and marketing employees to
support the efforts of senior management with its OEM customers and to create
awareness for the Company's products and technology with its OEMs' service
provider customers.

    The Company sells its software-based compression products primarily through
OEMs and systems integrators. As of December 31, 1997, there were three people
in the Company's compression software sales organization.

    The Company has in the past and expects in the future to derive a
substantial portion of its revenues from a limited number of customers. There
are relatively few OEM equipment suppliers to whom the Company can sell its
technology and products. Consequently, the Company's future success will depend
to a large extent upon: (i) the timing and size of future purchase orders for
the Company's products from these customers, (ii) the financial and operating
success of these customers, and (iii) the success of products offered by these
customers that use the Company's technology and products. Any attempt by such
customers to seek out additional or alternative suppliers or to undertake the
internal development and sale of technology and products comparable to those of
the Company could have a material adverse effect on the Company's business,
financial condition and results of operations. (See Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations -
FACTORS THAT MAY AFFECT FUTURE RESULTS.)

    The Company derived approximately 16%, 13%, and 12% of its total revenue in
1997 from U.S. Robotics/3Com, the United States government and ADI,
respectively. The Company derived approximately 22%, 17%, 12%, and 10% of its
total revenue in 1996 from DSC Communications Corporation, ADI, the United
States government, and Teltrend, Inc., respectively. The Company derived
approximately 23%, 18%, 12%, and 10% of its total revenue in 1995 from ADI,
General Instrument Corporation, the United States government, and GSS/Array
Technology, respectively. Predominately all revenue in 1997, 1996, and 1995 was
sold to unaffiliated customers in North America.



                                  MANUFACTURING

    The Company's manufacturing capacity is relatively limited and as such it
relies on a third party contractor manufacturer to assemble and test
substantially all of its xDSL products. The Company's third party manufacturer
is located in Canada, and obtains component parts directly from the Company, and
from suppliers chosen by the Company or itself. Other than the ADSL chipset,
which is available through ADI, the Company believes that other components for
its products are available from a number of suppliers. Further, the Company
believes that other qualified third party contract manufacturers exist to
assemble and test the Company's products in the event its relationship with its
current contract manufacturer is not successful. (See Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations -
FACTORS THAT MAY AFFECT FUTURE RESULTS.)




                                       12

<PAGE>   13

                                   COMPETITION

    The markets for the Company's products are intensely competitive and the
Company expects competition to increase in the immediate future, especially in
the emerging ADSL and DSL Lite market. The Company intends to compete on the
basis of technology, price, the timing of product delivery, product features,
quality, reliability, and customer satisfaction. The Company currently competes,
or expects to compete in the future, with the following categories of companies:
(i) other vendors of DMT-based ADSL technology, such as Orckit Communications
Limited ("Orckit"), Amati Communications Corporation/ Texas Instruments Inc.
("Amati/TI"), PairGain Technologies, Inc. ("PairGain") and Alcatel Network
Systems, Inc. ("Alcatel"); (ii) vendors of alternative ADSL technologies, such
as Globespan Technologies, Inc. ("Globespan"), which is currently marketing its
CAP-based ADSL technology, (iii) OEMs and other systems integrators, such as
Ericsson, Northern Telecommunications, Westell, Cisco, 3Com, and Pairgain, and
(iv) Regional Bell Operating Companies ("RBOCs") and other telcos, who are no
longer prohibited from manufacturing telecommunications equipment as a result of
deregulation

    The Company's success will depend on telcos' willingness to invest in
broadband digital services based on xDSL technologies. The Company expects that
its xDSL technology and products will compete not only with other products that
increase the efficiency of digital transmission technologies over copper wire,
such as ISDN for Internet access, but also with other broadband transmission
technologies, such as HFC, fiber optic cable, digital broadcast satellite and
other wireless technologies. The Company believes its current and future
broadband products will permit telcos to upgrade their networks in a flexible
and cost effective way, but telcos may choose to deploy products using better
established technologies to upgrade their networks including fiber optic cable,
which many telcos favor. To the extent that telcos choose to install fiber optic
cable or other transmission media between central offices and end users, the
Company's business, financial condition and results of operations will be
materially adversely affected.

    The Company believes that, in the ADSL market, its DMT-based products are
more flexible and will enjoy greater potential for deployment than products
using the CAP technique, which is a non-standard, proprietary, single-source
technology. However, CAP-based ADSL products were introduced prior to the
Company's products and are more readily available than the Company's products.

    To date, there has been only limited commercial deployment of the Company's
competitors' DMT-based ADSL products. Therefore, the Company is uncertain how
its products will compare with products sold by Alcatel, Amati/TI, Orckit and
PairGain, each of whom manufactures DMT-based ADSL products. Each of these
competitors have made claims in their sales literature and elsewhere suggesting
that their products provide data transmission rates that are equal to or faster
than that of the Company's products. However, the Company does not have access
to these products, and therefore has no independent means by which it can
corroborate these claims.

    The markets for the Company's wavelet image compression technology are
competitive, and are expected to become increasingly so in the near future. In
addition, the Company's WSQ Finger Print Compression product is an
implementation of an open standard and is therefore subject to competition.

    Many of the Company's competitors and potential competitors, including the
RBOCs, Alcatel, and Amati/TI have significantly greater financial,
technological, manufacturing, marketing and personnel resources than the
Company. There can be no assurance that the Company will be able to compete
successfully or that competition will not have a material adverse effect on the
Company's business, financial condition and results of operations. (See Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations FACTORS THAT MAY AFFECT FUTURE RESULTS.)




                                       13

<PAGE>   14
                              INTELLECTUAL PROPERTY

    In the field of telecommunications technology, the Company holds eight
patents for applying wavelet mathematics to communications systems. The Company
has two pending patent applications that pertain to the application of
multi-carrier technology to broadband communications. The Company has also filed
multiple provisional patents that pertain to its splitterless DSL techniques.
The Company also holds six patents for image compression and processing, three
patents for video compression, one patent for audio compression, one patent for
certain optical applications and one pending patent for seismic data
compression.

    Although the Company has patented certain aspects of its technology, the
Company relies primarily on know-how and trade secrets to protect its
intellectual property. The Company attempts to protect its trade secrets and
other proprietary information through agreements with its customers, suppliers,
employees and consultants, and through security measures. Each of the Company's
employees is required to sign a nondisclosure and non-competition agreement.
Although the Company intends to protect its rights vigorously, there can be no
assurance that these measures will be successful. In addition, the laws of
certain countries in which products incorporating the Company's technology may
be developed, manufactured or sold may not protect the Company's products and
intellectual property rights to the same extent as the laws of the United
States.

    While the Company's ability to compete may be affected by its ability to
protect its intellectual property, the Company believes that, because of the
rapid pace of technological change in the telecommunications industry, its
technical expertise and ability to introduce new products on a timely basis will
be more important in maintaining its competitive position than protection of its
existing intellectual property and that patent, trade secret and copyright
protections are important but must be supported by other factors such as the
expanding knowledge, ability and experience of the Company's personnel, new
technology and products, and product enhancements. Although the Company
continues to implement protective measures and intends to defend vigorously its
intellectual property rights, there can be no assurance that these measures will
be successful.

    Many participants in the telecommunications industry have an increasing
number of patents and have frequently demonstrated a readiness to commence
litigation based on allegations of patent and other intellectual property
infringement. Third parties may assert exclusive patent, copyright and other
intellectual property rights to technologies that are important to the Company.
If the Company is found to have infringed any of such patents, the Company could
be subject to substantial damages and/or an injunction preventing it from
conducting its business, and the Company's business could be materially and
adversely affected.

    The Company may also receive notices from third parties regarding the
pendency of various patent applications which may be pertinent to the design and
operation of xDSL telecommunications equipment. Unless and until patents
actually issue, there can be no infringement, and the Company has not examined
any such patent applications.

    Although third parties may offer to license their patents and their patent
applications to the Company, there can be no assurance that any license would be
available on acceptable terms should the Company choose to pursue such license
or be found to infringe such patents. In addition, there can be no assurance
that third parties will not assert infringement claims against the Company in
the future, that these assertions will not result in protracted and costly
litigation, or that the Company would prevail in any such litigation or be able
to license any valid patents from third parties on commercially reasonable
terms. Further, such litigation, regardless of its outcome, could result in
substantial costs to and diversion of effort by the Company. Litigation may also
be necessary to enforce the Company's 




                                       14

<PAGE>   15


intellectual property rights. Any infringement claim or other litigation against
or by the Company could have a material adverse effect on the Company's
business, financial condition and results of operations. (See Item 7.

Management's Discussion and Analysis of Financial Condition and Results of
Operations - FACTORS THAT MAY AFFECT FUTURE RESULTS.)




                                    EMPLOYEES

    At December 31, 1997, the Company employed 77 people, including 47 in
research and development, 15 in sales and marketing, 3 in manufacturing, and 12
in finance, information systems and administration. All of these employees were
based in Massachusetts. As necessary, the Company supplements its regular
employees with temporary and contract personnel. At December 31, 1997, the
Company had engaged 10 temporary and contract personnel primarily working in
research and development. The Company believes that its future success will
depend in large part on the continued service of its technical and senior
management personnel and upon the Company's continuing ability to attract and
retain highly qualified technical, sales and marketing, and managerial
personnel. Competition for highly qualified personnel is intense, and there can
be no assurance that the Company will be able to retain its key managerial and
technical employees or that it will be able to attract and retain additional
highly qualified personnel in the future. None of the Company's employees is
represented by a labor union. The Company considers its employee relations to be
good.




                                       15

<PAGE>   16


I
TEM 2.  PROPERTIES

         The Company houses its headquarters and entire business operations in a
72,000 square foot office building that is located in Bedford Massachusetts. The
Company purchased, renovated and moved into this facility in the second half of
1997. Under the terms of the building purchase agreement, the Company has sublet
approximately 24,000 square feet of space in the building to the seller of the
building. The term of the sublease agreement is for an eighteen-month period
commencing in July 1997 and expiring in January 1999.

         The Company believes that the space within the facility that is
available to the Company is substantially utilized, well maintained and suitable
for the products and services offered by the Company, and that suitable space
will be available as needed.



ITEM 3.  LEGAL PROCEEDINGS

         There are no pending legal proceedings to which the Company is a party
or to which any of its properties are subject which, either individually or in
the aggregate, are expected by the Company to have a material adverse effect on
its business, financial position or results of operations.



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

         No matters were submitted to a vote of security holders during the
fourth quarter of 1997.





                                       16

<PAGE>   17


                                     PART II



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

    The Company has one class of stock outstanding, its common stock, which has
a par value of $.01 per share. The Company's common stock is traded on the
Nasdaq National Market under the symbol AWRE. The following table sets forth the
high and the low sales prices as reported on the Nasdaq National Market from
August 9, 1996, the date of the Company's initial public offering, to December
31, 1997.


<TABLE>
<CAPTION>
                           FIRST         SECOND        THIRD        FOURTH
                          QUARTER       QUARTER       QUARTER      QUARTER
    ----------------------------------------------------------------------
    <S>                   <C>           <C>           <C>        <C>   
    1997
       High               14 7/8        16 7/8        15 1/8       14 15/16
       Low                 8 5/8         8 1/2         9 5/8        9 1/8

    1996
       High                  n/a           n/a        19           17 1/2
       Low                   n/a           n/a        10 1/2        8 1/2

</TABLE>



    As of February 17, 1998, the Company had approximately 131 shareholders of
record. This number does not include shareholders from whom shares were held in
a "nominee" or "street" name. The Company has never paid cash dividends on its
common stock and anticipates it will continue to reinvest any earnings to
finance future operations.

    The Company did not sell any equity securities that were not registered
under the Securities Act during the three months ended December 31, 1997.

    The Company sold 3,910,000 shares of the Company's Common Stock, par value
$.01 per share, on August 14, 1996 and September 9, 1996, pursuant to a
Registration Statement on Form S-1 (File No. 333-06807), which was declared
effective by the Securities and Exchange Commission on August 8, 1996 (the
"Effective Date"). The managing underwriters of the offering were BancAmerica
Robertson Stephens and Furman Selz LLC. The aggregate gross proceeds of the
offering were $39,100,000. The Company's total expenses in connection with the
offering were $3,937,000, of which $2,737,000 was for underwriting discounts and
commissions and $1,200,000 was for other expenses paid to persons other than
directors or officers of the Company, persons owning more than 10 percent of any
class of equity securities of the Company, or affiliates of the Company
(collectively, "Affiliates"). The Company's net proceeds from the offering were
$35,163,000. From the Effective Date through December 31, 1997, the Company used
(i) approximately $11,401,000 of such net proceeds to purchase and renovate a
commercial office building, which the Company now uses as its headquarters, and
to acquire computers, software and other equipment and (ii) approximately
$2,601,000 of such net proceeds for working capital. None of these payments were
made to Affiliates. As of December 31, 1997 the Company had approximately
$21,161,000 of proceeds remaining from the offering, and pending use of the
proceeds, the Company intends to invest such proceeds primarily in short-term,
interest-bearing, investment-grade securities, including money market
instruments.






                                       17

<PAGE>   18


ITEM 6.  SELECTED FINANCIAL DATA

    The following selected historical financial data has been derived from the
Company's audited consolidated financial statements. The historical financial
data should be read in conjunction with the Company's consolidated financial
statements and notes thereto included in Item 8.


<TABLE>
<CAPTION>

(in 000's, except per share data)
Year Ended December 31,                         1997        1996        1995        1994       1993
- ---------------------------------------------------------------------------------------------------
<S>                                           <C>           <C>         <C>       <C>        <C>    
Statements of Operations Data
- -----------------------------
Revenue                                      $ 6,198      $5,301      $3,260     $ 3,827    $ 3,172
Loss from operations                          (6,157)       (538)       (454)     (1,095)    (1,028)
Net income (loss)                             (4,448)        259        (343)     (1,012)      (992)
Net income (loss) per share - basic          $ (0.23)     $ 0.02      $(0.29)    $ (0.88)   $ (0.87)
Net income (loss) per share - diluted        $ (0.23)     $ 0.01      $(0.29)    $ (0.88)   $ (0.87)

Balance Sheet Data
- ------------------
Cash and short-term investments              $26,104     $36,719      $2,154     $ 2,566    $   186
Working capital                               26,774      38,280       2,516       2,877        281
Total assets                                  39,281      40,123       3,228       3,930        978
Total liabilities                              1,661         676         309         684        493
Total stockholders' equity                    37,620      39,446       2,920       3,246        485
- ---------------------------------------------------------------------------------------------------
</TABLE>





                                       18

<PAGE>   19


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


RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, certain line items
from the Company's consolidated statements of operations as a percentage of
total revenue:


<TABLE>
<CAPTION>

     Year ended December 31,                    1997         1996        1995
     --------------------------------------------------------------------------
     <S>                                       <C>          <C>         <C>   
     Revenue:
        Product                                 15.7 %       12.3%       12.5 %
        License and royalty                     48.9         56.0        31.8
        Research and development                35.4         31.7        55.7
     --------------------------------------------------------------------------
          Total revenue                        100.0        100.0       100.0

     Costs and expenses:
        Cost of product revenue                 20.2         15.7         7.4
        Research and development               110.9         61.0        71.6
        Sales and marketing                     36.9         14.5        12.6
        General and administrative              31.4         18.9        22.3
     --------------------------------------------------------------------------
           Total costs and expenses            199.4        110.1       113.9

     Loss from operations                      (99.4)       (10.1)      (13.9)
     Interest income                            27.6         15.0         3.4
     --------------------------------------------------------------------------

     Net income (loss)                         (71.8)%        4.9%      (10.5)%
     ==========================================================================

</TABLE>



PRODUCT REVENUE

     Product revenue in 1997 and 1996 consisted primarily of revenue from the
sale of Asymmetric Digital Subscriber Line ("ADSL") modems, transceiver modules,
and development systems. Product revenue increased by 49.9% from $649,000 in
1996 to $974,000 in 1997. Product revenue as a percentage of total revenue was
15.7% and 12.3% in 1997 and 1996, respectively. The product revenue increase in
1997 was primarily attributable to revenue from the sale of transceiver modules
and development systems, which began shipping in the second quarter of 1997.
Higher revenue from the sale of these new products was partially offset by
modestly lower revenue from the sale of modems. The decline in revenue from the
sale of modems in 1997 was primarily due to decreased demand for the Company's
modems for ADSL technology trials while the market for ADSL products remained in
an early stage of development.

     Product revenue increased by 60% from $406,000 in 1995 to $649,000 in 1996.
A year to year comparison of product revenue for these years is not meaningful
due to differences in the composition of product revenue. Product revenue in
1996 consisted primarily of revenue from the sale of ADSL modems, which were
introduced in early 1996. Product revenue in 1995 consisted primarily of revenue
from the sale of video editing chipset products, which the Company discontinued
in 1995.




                                       19

<PAGE>   20

LICENSE AND ROYALTY REVENUE
         License and royalty revenue consisted primarily of revenue from the
sale of intellectual property, such as hardware and software technology
licenses, compression software licenses, and royalties from the sale of chipsets
by customers who have licensed the Company's technology. As such revenue has
only a nominal cost of sale associated with it, the Company does not report a
separate cost of license and royalty revenue line in its Statements of
Operations.

         License and royalty revenue increased by 2% from $2,971,000 in 1996 to
$3,031,000 in 1997. License and royalty revenue as a percentage of total revenue
was 48.9% and 56.0% in 1997 and 1996, respectively. The dollar increase in
license and royalty revenue in 1997 was primarily attributable to higher revenue
from the sale of compression software licenses, which was partially offset by
lower telecommunications license and royalty revenue. The increase in
compression software license revenue was primarily due to a significant customer
sale in the second quarter of 1997. The decrease in telecommunications license
and royalty revenue was primarily attributable to a decline in revenue from
royalty advances, which fell from $350,000 in 1996 to nothing in 1997.
Approximately 63% of license and royalty revenue in 1997 was received from three
customers.

License and royalty revenue increased by 187% from $1,037,000 in 1995 to
$2,971,000 in 1996. The increase in 1996 was primarily attributable to an
increase in the sale of ADSL and other broadband technology licenses to
telephone company equipment suppliers. Revenue from the sale of compression
software licenses also contributed to the increase in license and royalty
revenue in 1996. Approximately 51% of license and royalty revenue in 1996 was
received from three customers.

RESEARCH AND DEVELOPMENT REVENUE
         Research and development revenue consisted primarily of revenue from
commercial contract engineering and development, and government research
contracts. Research and development revenue as a percentage of total revenue was
35.4% and 31.7% in 1997 and 1996, respectively. Research and development revenue
increased by 30.5% from $1,680,000 in 1996 to $2,193,000 in 1997. Higher
research and development revenue in 1997 was primarily due to an increase in
commercial engineering projects as well as a modest increase in U.S. government
projects. The increase in commercial engineering projects is primarily driven by
telecommunications customers, who have engaged the Company to assist them with
the integration of the Company's technology into their products.

         Research and development revenue decreased by 8% from $1,817,000 in
1995 to $1,680,000 in 1996. The decrease was primarily due to lower revenue from
commercial research and development contracts as well as slightly lower revenue
from U.S. government research contracts.


COST OF PRODUCT REVENUE
         Cost of product revenue consisted primarily of: (i) direct material,
direct labor, and overhead costs to produce the Company's products, (ii) cost of
goods for purchases of finished inventory from third party suppliers, and (iii)
provisions for excess and obsolete inventory.

         Cost of product revenue as a percentage of product revenue was 129% in
1997 as compared to 128% in 1996. The cost of product revenue as a percentage of
product revenue in 1997 and 1996 primarily reflects high material, labor, and
fixed manufacturing costs due to relatively low production volumes, and
provisions for excess and obsolete inventory of $275,000 in 1997 and $365,000 in
1996. The provisions for obsolete inventory recorded in 1997 and 1996 were
primarily driven by the environment in which the Company operates. This
environment was and continues to be characterized by rapid technological
advances, evolving industry standards, changes in end-user requirements,
frequent new product introductions, and evolving telco offerings. Consequently,
the Company's products have




                                       20

<PAGE>   21

relatively short life cycles. Excluding obsolete inventory provisions, cost of
product revenue as a percentage of product revenue was 100% in 1997 and 72% in
1996.

         In the third quarter of 1997, the Company entered into an agreement
with a third party contract manufacturer that will supply substantially all
finished goods products to the Company. The Company anticipates that this
arrangement will reduce per unit cost of sales if and when product volumes
increase.

         Cost of product revenue increased by 242% from $243,000 in 1995 to
$831,000 in 1996. As a percentage of product revenue, cost of product revenue
increased from 60% in 1995 to 128% in 1996. Such percentages primarily reflect
the cost of modem revenue and obsolete inventory provisions in 1996 and the cost
of video editing chipset revenue in 1995. Accordingly, a comparison of cost of
product revenue on a year to year basis is not meaningful due to differences in
the composition of product revenue.


RESEARCH AND DEVELOPMENT
         Research and development expense consisted primarily of salaries for
engineers, and expenses for consultants, recruiting, supplies, equipment,
depreciation and facilities. Research and development expense increased by 113%
from $3,235,000 in 1996 to $6,874,000 in 1997. The increase in research and
development expense is primarily due to increased spending on projects related
to the Company's x200 Access Router, DSL Lite technology, and SDSL technology.
Spending related to these projects was partially offset by lower spending on the
Company's Hybrid Fiber Coaxial (HFC) project, which was temporarily suspended in
1997. The Company anticipates that research and development spending will
continue to grow in future periods.

         Research and development expense increased by 39% from $2,333,000 in
1995 to $3,235,000 in 1996. The increase in research and development expense was
primarily attributable to higher spending on projects to develop, enhance, and
commercialize the Company's ADSL, VDSL, SDSL, and HFC broadband technologies.
Higher spending on these projects was partially offset by lower spending as a
result of the discontinuance of research involving audio compression technology
and lower facilities costs as a result of the relocation of the Company's
facilities in June 1995.


SELLING AND MARKETING
         Selling and marketing expense consisted primarily of salaries for sales
and marketing personnel, travel, advertising and promotion, recruiting, and
facilities expense. Selling and marketing expense increased 197% from $769,000
in 1996 to $2,286,000 in 1997. The increase was primarily due to: (i) the
addition of sales staff to establish channels of distribution for the Company's
products and technology, (ii) the addition of marketing staff, and (iii)
increased levels of advertising and promotion to create awareness for the
Company's products, including participation in major industry tradeshows. The
Company anticipates that selling and marketing spending will continue to grow in
future periods.

         Selling and marketing expense increased 87% from $412,000 in 1995 to
$769,000 in 1996. The increase was primarily due to the addition of sales
personnel and increased product advertising related to the Company's ADSL modem.

GENERAL AND ADMINISTRATIVE
          General and administrative expense consisted primarily of salaries for
administrative personnel, facilities costs, expenses related to being a public
company, and professional services, such as legal and audit expenses. General
and administrative expense increased by 94% from $1,004,000 in 1996 to
$1,943,000 in 1997. The increase was primarily due to: (i) additions to the
Company's finance,




                                       21

<PAGE>   22

information systems and administrative organizations to support organizational
growth, and (ii) expenses related to investor relations and being a public
company.

         General and administrative expense increased by 38% from $726,000 in
1995 to $1,004,000 in 1996. The increase was primarily attributable to additions
to the Company's management team and administrative infrastructure, and expenses
associated with becoming a public company.

INTEREST INCOME
         Interest income increased 114% from $798,000 in 1996 to $1,708,000 in
1997 primarily as a result of higher average cash balances due to the investment
of net proceeds from the Company's initial public offering for the full year, as
opposed to approximately five months in 1996. Interest income increased 621%
from $111,000 in 1995 to $798,000 in 1996 primarily as a result of higher
average cash balances due to the investment of net proceeds from the Company's
initial public offering.

PROVISION FOR INCOME TAXES
         The Company has made no provision for income taxes as it has a history
of net losses, which has resulted in tax loss carryforwards. At December 31,
1997, the Company had available federal net operating loss carryforwards of
approximately $16,586,000, which expire in 2003 through 2012, and federal
research and development credit carryforwards of approximately $791,000, which
expire in 2003 through 2012. At December 31, 1997, the Company also had
available state net operating loss carryforwards of approximately $9,261,000,
which expire in 1998 through 2002 and state research and development and
investment tax credit carryforwards of approximately $395,000, which expire in
2006 through 2012. Of the total net operating loss carryforwards, approximately
$1,906,000 was attributable to the exercise of stock options and the tax benefit
from these losses, when utilized, will be credited to additional paid in
capital.

OTHER INFORMATION
         In 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per
Share." Among other requirements, SFAS No. 128 requires restatement of prior
period earnings per share to comply with the provisions of this pronouncement.
Upon adoption of SFAS No. 128 in December 1997, the Company restated earnings
per share by applying the provisions of the standard. As a result of this
restatement, earnings per share for certain prior periods changed from the
amounts previously reported.










                                       22

<PAGE>   23





LIQUIDITY AND CAPITAL RESOURCES

         At December 31, 1997, the Company had cash, cash equivalents and
short-term investments of $26,104,000, a decrease of $10,615,000 from the prior
year. The Company has funded its operations primarily from sales of common
stock, including an initial public offering in August 1996, which generated net
proceeds of $35,200,000. In 1997, the Company used approximately $2,656,000 of
cash to fund operating losses, which was essentially offset by $2,622,000 of
proceeds from the issuance of common stock in connection with its stock option
plans.

         Accordingly, the decrease in cash, cash equivalents and short-term
investments in 1997 was primarily due to purchases of property and equipment.
Cash invested in property and equipment of $10,581,000 was primarily related to:
(i) the purchase and renovation of a 72,000 square foot commercial office
building for $8,224,000, and (ii) the acquisition of computers, software,
furniture, and other equipment primarily used in research and development
activities.

         While there can be no assurance that the Company will not require
additional financing, or that such financing will be available to the Company,
the Company believes that its financial resources are adequate to meet its
liquidity requirements over the next twelve months.




                                       23

<PAGE>   24


FACTORS THAT MAY AFFECT FUTURE RESULTS

         Certain statements contained in this Annual Report, including
statements regarding the anticipated development and expansion of the Company's
business, the intent, belief or current expectations of the Company, its
directors or its officers, primarily with respect to the future operating
performance of the Company, and other statements contained herein regarding
matters that are not historical facts, are "forward-looking" statements. These
forward-looking statements represent the Company's present expectations or
beliefs concerning future events, however the Company cautions that such
statements are qualified by important factors. Such factors, which include, but
are not limited to, the risk factors identified below, could cause actual
results to differ materially from those indicated in this Annual Report on Form
10-K.

         The Company believes that the occurrence of any one or some combination
of the following risk factors could have a material adverse effect on the
Company's business, financial condition and results of operations.

History of Operating Losses

         The Company has incurred operating losses in every fiscal year since
inception. Substantial additional research and development expenses to enhance
the performance and reduce the manufacturing costs of the Company's products
will be required before market acceptance of these products can be determined.
Also, the Company anticipates that substantial selling and marketing expenses
will be required to establish sales channels for the Company's products and
technology. There can be no assurance that the Company will achieve profitable
operations in any future period.

Dependence on Acceptance of ADSL Technology

         The Company's future success is substantially dependent upon whether
ADSL technology gains widespread commercial acceptance by the telephone
companies ("telcos") and end users of telco services. The Company has invested
substantial resources in the development of ADSL technology implemented through
the Discrete Multi-Tone ("DMT") modulation technique. Telcos continue to
evaluate DMT-based ADSL technology, and there can be no assurance that the
telcos will pursue the deployment of such ADSL technology. The Company believes
that volume deployment of ADSL technology and equipment will not commence before
the second half of 1998, if at all.

Reliance on Telcos; Dependence on a Limited Number of Customers

         Even if telcos adopt policies favoring full-scale implementation of
ADSL technology, there can be no assurance that sales of the Company's ADSL
products will become significant. The Company's customers, including Regional
Bell Operating Companies ("RBOCs"), OEMs and other telcos, are relatively few in
number and have significantly greater resources than that of the Company. The
Company has limited ability to influence or control decisions made by these
customers. There can be no assurance that these customers will not use their
size and bargaining power to demand unfavorable terms and conditions (including
price), seek alternative suppliers, or undertake internal development of
products comparable to those of the Company's.


Substantial Dependence on Analog Devices, Inc.

         The Company and Analog Devices, Inc. ("ADI") have entered into a series
of agreements to develop integrated chipsets based on the Company's technology.
The inability or refusal of ADI to 



                                       24

<PAGE>   25

manufacture, market and sell such chipsets in substantial quantities would
prevent telcos from adopting the Company's technology and would have a material
adverse effect on the Company's business. There can be no assurance that the
Company's relationship with ADI will be successful or, in the event that the
relationship is not successful, that the Company would be able to find a
substitute chipset manufacturer without significant delays.

Proprietary Technology; Risk of Third Party Claims of Infringement

         The Company's ability to compete effectively will depend to a
significant extent on its ability to protect its proprietary information and to
operate without infringing the intellectual property rights of others. Despite
the precautions the Company has taken to protect its intellectual property,
there can be no assurance that such steps will be adequate to prevent the
misappropriation of its technology. In addition, third parties may assert
exclusive patent, copyright and other intellectual property rights to
technologies that are important to the Company. There can be no assurance that
other third parties will not assert such claims against the Company in the
future.

Rapid Technological Change; Dependence on New Products

         The markets for the Company's products are characterized by rapid
technological advances, evolving industry standards, changes in end-user
requirements, frequent new product introductions, and evolving telco offerings.
The Company's business will be materially adversely affected if technologies or
standards on which Company's products are based become obsolete, or if the
Company is unable to develop and introduce new products in a timely manner in
response to changing market conditions. In such an environment, product cycles
tend to be short, and therefore, the Company may need to write-off excess and
obsolete inventory from time-to-time. The Company recorded provisions for excess
and obsolete inventory of $275,000 and $365,000 in 1997 and 1996, respectively.

Competition

         The markets for the Company's products are intensely competitive and
the Company expects competition to increase in the immediate future. Many of the
Company's competitors and potential competitors have significantly greater
financial, technological, manufacturing, marketing and personnel resources than
the Company. There can be no assurance that the Company will be able to compete
successfully or that competition will not adversely affect the Company's
business.

Manufacturing

         The Company has limited experience in manufacturing or in supervising
the manufacture of its products, including its ADSL modems, modules, and
development systems. In 1997, the Company entered into an agreement with a third
party contract manufacturer that will supply substantially all finished goods
products to the Company. There can be no assurance that the Company's
relationship with its contract manufacturer will be successful or, in the event
that the relationship is not successful, that the Company would be able to find
a substitute contract manufacturer without significant delays. Furthermore,
there can be no assurance that the Company or its contract manufacturer will not
encounter significant difficulties in manufacturing or controlling the quality
of its products, or that its products will be reliable in the field.


Dependence on Hiring and Retaining Personnel

         The Company believes that its future success will depend significantly
on its ability to attract, motivate and retain additional highly skilled
technical, managerial and marketing personnel. During



                                       25

<PAGE>   26
1997, the Company experienced difficulty in hiring the additional engineers it
had contemplated in its business plans. Competition for such personnel is
intense, and there can be no assurance that the Company will be successful in
attracting, assimilating and retaining the personnel required to grow and
operate profitably.



Year 2000

         The Company is in the process of assessing the impact of the transition
to the year 2000 on its computer and software applications. The Company does not
believe that any material year 2000 issues exist with software contained within
its product offerings. The Company is in the process of attempting to obtain
confirmation from vendors of certain purchased software that current releases or
upgrades, if installed, will not have any material year 2000 issues. To the
extent necessary to address material year 2000 issues, the Company plans to
obtain current releases or upgrades from software vendors prior to the end of
1998. Failure to obtain and implement such releases or upgrades, or the failure
of such software vendors to have eliminated year 2000 issues, could materially
and adversely affect the Company.





                                       26

<PAGE>   27


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



                        REPORT OF INDEPENDENT ACCOUNTANTS


We have audited the accompanying consolidated balance sheets of Aware, Inc. (the
"Company") as of December 31, 1997 and 1996, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the
three years in the period ended December 31, 1997. Our audits also included the
financial statement schedule listed in the Index at Item 14. These financial
statements and the financial statement schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and the financial statement schedule based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Aware, Inc. at
December 31, 1997 and 1996, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1997, in conformity
with generally accepted accounting principles. Also, in our opinion, such
financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, present fairly, in all
material respects, the information set forth therein.




/s/  Deloitte & Touche LLP


Boston, Massachusetts
January 27, 1998






                                       27

<PAGE>   28

AWARE, INC.
CONSOLIDATED BALANCE SHEETS


<TABLE>
<CAPTION>


December 31,                                                                  1997             1996
- -----------------------------------------------------------------------------------------------------
<S>                                                                       <C>             <C>        
ASSETS
Current assets:
     Cash and cash equivalents                                            $23,496,508     $31,092,273
     Short-term investments                                                 2,607,411       5,626,725
     Accounts receivable (less allowance for doubtful
        accounts of $50,000 in 1997 and $35,000 in 1996)                    1,824,119       1,654,980
     Unbilled accounts receivable                                                  --         110,722
     Inventories                                                              215,622         447,534
     Prepaid expenses                                                         290,847          23,426
- -----------------------------------------------------------------------------------------------------
           Total current assets                                            28,434,507      38,955,660
- -----------------------------------------------------------------------------------------------------

Property and equipment, net of accumulated depreciation and
     amortization of $1,330,281 in 1997 and $557,901 in 1996               10,846,025       1,166,928
- -----------------------------------------------------------------------------------------------------
           Total assets                                                   $39,280,532     $40,122,588
=====================================================================================================



LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities:
     Accounts payable                                                      $1,075,126        $337,339
     Accrued expenses                                                         185,676          60,091
     Accrued compensation                                                     326,558         173,692
     Accrued professional                                                      73,370          65,000
     Deferred revenue                                                              --          40,000
- -----------------------------------------------------------------------------------------------------
           Total current liabilities                                        1,660,730         676,122
- -----------------------------------------------------------------------------------------------------

Commitments and contingent liabilities

Stockholders' equity:
     Preferred stock, $1.00 par value; 1,000,000 shares                            --              --
          authorized, none outstanding
     Common stock, $.01 par value; 30,000,000 shares 
          authorized; issued and outstanding, 19,646,024 
          in 1997 and 18,959,897 in 1996                                      196,460         189,600
     Additional paid-in capital                                            52,640,360      50,025,548
     Accumulated deficit                                                  (14,764,056)    (10,315,720)
     Treasury stock                                                          (452,962)       (452,962)
- -----------------------------------------------------------------------------------------------------
           Total stockholders' equity                                      37,619,802      39,446,466
- -----------------------------------------------------------------------------------------------------
           Total liabilities and stockholders' equity                     $39,280,532     $40,122,588
=====================================================================================================

</TABLE>


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






                                       28

<PAGE>   29

AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>


Year Ended December 31,                                1997           1996         1995
- -----------------------------------------------------------------------------------------
<S>                                               <C>            <C>           <C>     
Revenue:
    Product                                       $   973,782    $   649,422   $  406,459
    License and royalty                             3,031,483      2,971,238    1,036,615
    Research and development                        2,192,786      1,680,449    1,816,820
- -----------------------------------------------------------------------------------------
        Total revenue                               6,198,051      5,301,109    3,259,894
- -----------------------------------------------------------------------------------------

Costs and expenses:
    Cost of product revenue                         1,251,677        831,241      242,983
    Research and development                        6,874,137      3,234,799    2,333,200
    Selling and marketing                           2,285,726        769,395      411,777
    General and administrative                      1,943,187      1,003,948      725,511
- -----------------------------------------------------------------------------------------
         Total costs and expenses                  12,354,727      5,839,383    3,713,471
- -----------------------------------------------------------------------------------------

Loss from operations                               (6,156,676)      (538,274)    (453,577)
Interest income                                     1,708,340        797,656      110,615
- -----------------------------------------------------------------------------------------
Net income (loss) before provision 
for income taxes                                   (4,448,336)       259,382     (342,962)
Provision for income taxes                                 --             --           --
- -----------------------------------------------------------------------------------------

Net income (loss)                                 $(4,448,336)   $   259,382   $ (342,962)
=========================================================================================


Net income (loss) per share - basic               $     (0.23)   $      0.02   $    (0.29)
Net income (loss) per share - diluted             $     (0.23)   $      0.01   $    (0.29)
=========================================================================================


Weighted average shares - basic                    19,328,252     10,841,919    1,162,717
Weighted average shares - diluted                  19,328,252     17,991,446    1,162,717
=========================================================================================
</TABLE>



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




                                       29

<PAGE>   30

AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>


Year ended December 31,                                                 1997             1996           1995
- -------------------------------------------------------------------------------------------------------------
<S>                                                                <C>             <C>             <C>        

Cash flows from operating activities:
   Net income (loss)                                               $(4,448,336)    $   259,382     $ (342,962)
   Adjustments to reconcile net income (loss) to net cash
      provided by (used in) operating activities:
      Depreciation and amortization                                    901,976         352,715        200,701
      Increase (decrease) from changes in assets and
liabilities:
      Accounts receivable                                             (169,139)     (1,154,152)        94,168
      Unbilled accounts receivable                                     110,722           5,539        187,840
      Inventories                                                      231,912        (407,821)       (18,044)
      Prepaid expenses                                                (267,421)         (8,955)        59,071
      Accounts payable                                                 737,787         225,820         14,757
      Accrued expenses                                                 286,821         151,492       (350,150)
      Deferred revenue                                                 (40,000)        (10,000)       (39,720)
- -------------------------------------------------------------------------------------------------------------
           Net cash used in operating activities                    (2,655,678)       (585,980)      (194,339)
- -------------------------------------------------------------------------------------------------------------

Cash flows from investing activities:
   Purchases of property and equipment                             (10,581,073)     (1,116,238)      (234,131)
   Net sales (purchases) of short-term investments                   3,019,314      (5,626,725)            --
- -------------------------------------------------------------------------------------------------------------
           Net cash used in investing activities                    (7,561,759)     (6,742,963)      (234,131)
- -------------------------------------------------------------------------------------------------------------

Cash flows from financing activities:
   Proceeds from issuance of common stock, net of
        issuance costs                                               2,621,672      36,267,535         16,023
- -------------------------------------------------------------------------------------------------------------
           Net cash provided by financing activities                 2,621,672      36,267,535         16,023
- -------------------------------------------------------------------------------------------------------------

Increase (decrease) in cash and cash equivalents                    (7,595,765)     28,938,592       (412,447)
Cash and cash equivalents, beginning of period                      31,092,273       2,153,681      2,566,128
- -------------------------------------------------------------------------------------------------------------

Cash and cash equivalents, end of period                           $23,496,508     $31,092,273     $2,153,681
=============================================================================================================



- -------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL NONCASH DISCLOSURES:
   Conversion of preferred stock to common stock                            --        $127,998             --
    Repurchase of Series D preferred shares for
        cancellation of notes                                               --              --       $457,062
- -------------------------------------------------------------------------------------------------------------

</TABLE>


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


                                       30

<PAGE>   31

AWARE, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY



<TABLE>
<CAPTION>

                                                                                                                   
                        Convertible Preferred Stock                Additional                   Notes                     Total
                  --------------------------------------  Common    Paid-In     Accumulated  Receivable For Treasury  Stockholders'
                  Series B  Series C  Series D  Series E   Stock    Capital       Deficit    Issued Stock    Stock       Equity
- ----------------------------------------------------------------------------------------------------------------------------------
<C>                 <C>      <C>      <C>      <C>      <C>       <C>          <C>            <C>         <C>           <C>
Balance,             
December 31, 
1994                $15,875  $13,525  $73,266  $29,432  $ 11,501  $13,792,091  $(10,232,140)  $(457,062)  $      --     $3,246,488
- ---------------------------------------------------------------------------------------------------------------------------------- 
 Exercise of 
  common stock 
  options, 16,867        --       --       --       --       169       15,854            --          --          --         16,023 
  shares
 Repurchase of 
  Series D 
  preferred stock, 
  4,100 shares           --       --   (4,100)      --        --           --            --     457,062    (452,962)            --
 Net loss                --       --       --       --        --           --      (342,962)         --          --       (342,962)
- ----------------------------------------------------------------------------------------------------------------------------------
Balance,  
December 31, 
1995                 15,875   13,525   69,166   29,432    11,670   13,807,945   (10,575,102)         --    (452,962)     2,919,549
- ----------------------------------------------------------------------------------------------------------------------------------
 Issuance of 
   common stock 
   in initial 
   public 
   offering, 
   net of 
   issuance costs, 
   3,910,000 shares      --       --       --       --    39,100   35,123,900            --          --          --     35,163,000
 Exercise of 
   common stock 
   options, 
   1,083,162 
   shares                --       --       --       --    10,832    1,093,703            --          --          --      1,104,535
 Conversion of 
   preferred 
   stock  to 
   common stock,    (15,875) (13,525) (69,166) (29,432)  127,998           --            --          --          --             --
   12,799,800 
   shares 
 Net income              --       --       --       --        --           --       259,382          --          --        259,382
- ----------------------------------------------------------------------------------------------------------------------------------
Balance,  
December 31, 1996        --       --       --       --   189,600   50,025,548   (10,315,720)         --    (452,962)    39,446,466
- ---------------------------------------------------------------------------------------------------------------------------------- 
 Exercise of common 
   stock options,
   686,127 shares        --       --       --       --     6,860    2,614,812            --          --          --      2,621,672
 Net loss                --       --       --       --        --           --    (4,448,336)         --          --     (4,448,336)
- ---------------------------------------------------------------------------------------------------------------------------------- 
Balance,  
December 31, 1997   $    --  $    --  $    --  $    --  $196,460  $52,640,360  $(14,764,056)  $      --   $(452,962)   $37,619,802
==================================================================================================================================

</TABLE>



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


                                      31

<PAGE>   32

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.   NATURE OF BUSINESS

     Aware, Inc. (the "Company") designs, develops and markets
     telecommunications software, hardware designs, chipsets and products that
     incorporate Asymmetric Digital Subscriber Line (ADSL), splitterless lite
     Digital Subscriber Line (DSL Lite), Very High Speed Digital Subscriber Line
     (VDSL), and Symmetric Digital Subscriber Line (SDSL) technologies. These
     broadband technologies are designed to increase the speed of data
     communications over conventional copper telephone lines. The Company's
     products are designed to allow telephone companies to utilize their
     installed bases of dedicated copper lines to provide both residential and
     business customers with interactive data transmission at speeds much higher
     than currently available. The Company also offers image compression
     software products.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     BASIS OF PRESENTATION - The consolidated financial statements include the
     accounts of Aware, Inc. and its subsidiary. All significant intercompany
     transactions have been eliminated.

     CASH AND CASH EQUIVALENTS - Cash and cash equivalents consist primarily of
     demand deposits, money market funds, commercial paper, and discount notes
     in highly liquid short-term instruments with original maturities of three
     months or less from the date of purchase and are stated at cost, which
     approximates market.

     SHORT-TERM INVESTMENTS - The Company follows Statement of Financial
     Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments
     in Debt and Equity Securities. At December 31, 1997, the Company had
     categorized all securities as "available-for-sale," since the Company may
     liquidate these investments currently. At December 31, 1996, the Company
     had categorized all investments with maturities of less than one year as
     "held-to-maturity", because of the Company's intent and ability to hold
     such securities to maturity. In calculating realized gains and losses, cost
     is determined using specific identification. Held-to-maturity securities
     are carried at amortized cost. SFAS No. 115 requires that unrealized gains
     and losses on available-for-sale securities be excluded from earnings and
     reported in a separate component of stockholders' equity. As of December
     31, 1997 and 1996, unrealized gains and losses were not material.

     The amortized cost of securities, which approximates fair value, consists
     of the following at December 31, 1997 and 1996:


<TABLE>
<CAPTION>
     -----------------------------------------------------------------------
                                                 MATURITY
                                         LESS THAN     ONE TO
     TYPE OF SECURITY                    ONE YEAR    FIVE YEARS      TOTAL
     -----------------------------------------------------------------------
     <S>                                <C>                       <C>       
     1997
       Corporate debt securities        $1,574,474           --   $1,574,474
       U.S. agency securities            1,032,937           --    1,032,937
     -----------------------------------------------------------------------
         Total                          $2,607,411           --   $2,607,411
     -----------------------------------------------------------------------
     1996
       Corporate debt securities        $3,040,072   $1,602,023   $4,642,095
       U.S. agency securities              984,630           --      984,630
     -----------------------------------------------------------------------
         Total                          $4,024,702   $1,602,023   $5,626,725
     -----------------------------------------------------------------------
</TABLE>




                                       32

<PAGE>   33
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     ALLOWANCE FOR DOUBTFUL ACCOUNTS - Accounts are charged to the allowance for
     doubtful accounts as they are deemed uncollectible based on a periodic
     review of the accounts. Bad debt expense was approximately $26,000,
     $20,000, and $5,000 for 1997, 1996, and 1995, respectively.

     INVENTORIES - Inventories are stated at the lower of cost or market with
     cost being determined by the first-in, first-out ("FIFO") method.

     PROPERTY AND EQUIPMENT - Property and equipment are stated at cost.
     Depreciation and amortization of property and equipment is provided using
     the straight-line method over the estimated useful lives of the assets
     ranging from three to thirty years.

     The Company accounts for the impairment of long-lived assets in accordance
     with the provisions of SFAS No. 121, "Accounting for the Impairment of
     Long-Lived Assets and for Long-Lived Assets to Be Disposed Of."

     REVENUE RECOGNITION - Product revenue consists primarily of revenue from
     the sale of tangible products, such as modems, transceiver modules,
     development systems and compression chipsets. Revenue is recognized upon
     shipment.

     License and royalty revenue consists primarily of revenue from the sale of
     intellectual property, such as hardware and software technology licenses,
     compression software licenses, and royalties from the sale of chipsets by
     customers who have licensed the Company's technology. Revenue from the sale
     of technology licenses for the initial transfer of hardware and software
     designs is recognized when a definitive agreement is reached, the transfer
     has been effected, and no contingent factors are present. Revenue from the
     sale of compression software licenses is recognized upon shipment. Royalty
     revenue is recognized based upon sales reports from customers.

     Research and development revenue is comprised of revenue from government
     and commercial research and development contracts. Revenue on government
     contracts is generally recognized when services are performed. Revenue on
     commercial contracts is generally recognized as research is performed and
     milestones are achieved under the terms of the respective agreements.

     Unbilled accounts receivable are stated at estimated realizable value.
     These amounts will be billable to customers based on the terms of contracts
     which include achievement of milestones or completion of the contract.

     INCOME TAXES - The Company accounts for income taxes under SFAS No. 109,
     "Accounting for Income Taxes." SFAS No. 109 requires the Company to compute
     deferred income taxes based on the differences between the financial
     statement and tax basis of assets and liabilities using enacted rates in
     effect in the years in which the differences are expected to reverse. SFAS
     No. 109 also requires the Company to establish valuation allowances to
     offset temporary deductible differences, net operating loss carryforwards
     and tax credits, which are not likely to be realized.

     CAPITALIZATION OF SOFTWARE COSTS - The Company capitalizes certain
     internally generated software development costs after technological
     feasibility of the product has been established. Capitalized software costs
     also include amounts paid for purchased software, which has reached
     technological feasibility. Such costs are amortized, on a
     product-by-product basis, on a straight-line basis over their useful
     economic lives (generally two to four years), or the ratio of current gross
     revenues to total gross current and future revenues, whichever is greater.
     There were no capitalized software 



                                       33

<PAGE>   34
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     costs at December 31, 1997 and 1996, because such costs incurred subsequent
     to the establishment of technological feasibility, but prior to commercial
     availability, were immaterial.

     CONCENTRATION OF RISK - At December 31, 1997 and 1996, the Company had bank
     cash balances and money market investments, in excess of federally insured
     deposit limits of approximately $26,004,000 and $36,619,000, respectively.

     Concentration of credit risk with respect to accounts receivable is limited
     to $524,000, $400,000, and $154,000 with three customers at December 31,
     1997 and to $549,000, $275,000 and $155,000 with three customers at
     December 31, 1996.

     In 1997, the Company entered into an agreement with a third party contract
     manufacturer that will supply substantially all finished goods products to
     the Company.

     STOCK-BASED COMPENSATION - The Company grants stock options for a fixed
     number of shares to employees with an exercise price equal to the fair
     value of the shares at the date of grant. As permitted by SFAS No. 123, the
     Company accounts for stock option grants in accordance with Accounting
     Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
     Employees." Accordingly, the Company recognized no compensation expense for
     stock option grants.

     NET INCOME (LOSS) PER SHARE - In 1997, the Company adopted SFAS No. 128,
     "Earnings Per Share." SFAS No. 128 establishes standards for computing and
     presenting earnings per share and applies to entities with publicly held
     common stock or potential common stock. Prior to 1997, the Company computed
     earnings per share in accordance with APB Opinion No. 15, "Earnings per
     Share." As a result of implementation of SFAS No. 128, net income (loss)
     per share for the years ended December 31, 1996 and 1995 has been restated.

     USE OF ESTIMATES - The preparation of the Company's financial statements in
     conformity with generally accepted accounting principles necessarily
     requires management to make estimates and assumptions that affect the
     reported amounts of assets and liabilities and to disclose contingent
     assets and liabilities at the balance sheet date. Significant estimates
     include reserves for doubtful accounts, reserves for excess and obsolete
     inventory, useful lives of fixed assets, valuation allowance for deferred
     income tax assets, and accrued liabilities. Actual results may differ from
     these estimates.

     FAIR VALUE OF FINANCIAL INSTRUMENTS - The carrying amounts of cash and cash
     equivalents, short-term investments, accounts receivable, accounts payable
     and accrued expenses approximate fair value because of their short-term
     nature.

     FUTURE ADOPTION OF ACCOUNTING PRONOUNCEMENTS - In 1997, the Financial
     Accounting Standards Board issued SFAS No. 130, "Reporting Comprehensive
     Income", and SFAS No. 131, "Disclosure About Segments of an Enterprise and
     Related Information."

     SFAS No. 130 requires that all items that are required to be recognized
     under accounting standards as components of comprehensive income (revenues,
     expenses, gains and losses) be reported in a financial statement that is
     displayed with the same prominence as other financial statements. The
     provisions of SFAS No. 130 are effective for fiscal years beginning after
     December 15, 1997. The Company believes that changes made to comply with
     this statement will not have a material effect on the Company's
     consolidated financial position or results of operations. 




                                       34

<PAGE>   35
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     SFAS No. 131 requires public business enterprises to report financial and
     descriptive information about its operating segments. The provisions of
     SFAS No. 131 are effective for periods beginning after December 15, 1997.
     The Company believes that implementation of this statement will not have a
     material effect on the Company's consolidated financial position or results
     of operations, but may impact the level of disclosure of its segment
     information.

     In October 1997, the American Institute of Certified Public Accountants
     issued Statement of Position (SOP) No. 97-2, "Software Revenue
     Recognition." SOP No. 97-2 provides guidance on applying generally accepted
     accounting principles in recognizing revenue on software transactions. The
     provisions of SOP No. 97-2 are effective for periods beginning after
     December 15, 1997. The Company believes that implementation of this
     statement will not have a material effect on the Company's consolidated
     financial position or results of operations.



3.   INVENTORIES

     Inventories consisted of the following at December 31:


<TABLE>
<CAPTION>
                                                            1997          1996
     ---------------------------------------------------------------------------
     <S>                                                  <C>           <C>     
     Raw materials                                        $163,555      $408,643
     Work-in-process                                            --        38,891
     Finished goods                                         52,067            --
     ===========================================================================
            Total                                         $215,622      $447,534
     ===========================================================================
</TABLE>



4.   PROPERTY AND EQUIPMENT

     Property and equipment consisted of the following at December 31:


<TABLE>
<CAPTION>
                                                             1997         1996
     ---------------------------------------------------------------------------
     <S>                                            <C>           <C>     
     Land                                               $1,080,000    $       --
     Building                                            7,144,656            --
     Computer equipment                                  1,996,164       983,819
     Furniture and fixtures                                401,979       124,677
     Office equipment                                      142,313        83,917
     Manufacturing equipment                               262,610       118,998
     Purchased software                                  1,148,584       375,467
     Leasehold improvements                                     --        37,951
     ---------------------------------------------------------------------------
     Total                                              12,176,306     1,724,829
     Less accumulated depreciation and amortization    (1,330,281)     (557,901)
     ---------------------------------------------------------------------------
     Net                                               $10,846,025    $1,166,928
     ===========================================================================


</TABLE>







                                       35

<PAGE>   36
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



5.   INCOME TAXES

     Deferred income tax assets at December 31 are attributable to the
     following:


<TABLE>
<CAPTION>
                                                             1997        1996
     ---------------------------------------------------------------------------
     <S>                                                <C>          <C>       
     Federal net operating loss carryforwards           $5,641,000   $3,367,000
     Research and development and other tax credit 
       carryforwards                                     1,526,000      761,000
     State net operating loss carryforwards                880,000      518,000
     Depreciation                                           41,000       69,000
     Accrued expenses                                       88,000      187,000
     Prepaid expenses                                      (94,000)           -
     Deferred revenue                                            -       22,000
     Alternative minimum tax credit                              -        6,000
     ---------------------------------------------------------------------------
     Total                                               8,082,000    4,930,000
     Less valuation allowance                           (8,082,000)  (4,930,000)
     ---------------------------------------------------------------------------
     Net                                                $       --   $       --
     ===========================================================================

</TABLE>


     A valuation allowance is provided against temporary deductible differences,
     net operating loss carryforwards and tax credits, which are not likely to
     be realized. During 1997 and 1996, the net valuation allowance was
     increased to fully reserve gross deferred tax assets.

     A reconciliation of the U.S. federal statutory rate to the effective tax
     rate is as follows:


<TABLE>
<CAPTION>
                                                      1997      1996     1995
     --------------------------------------------------------------------------
     <S>                                              <C>        <C>      <C>  
     Federal statutory rate                           (34)%      34 %     (34)%
     State rate, net of federal benefit                (6)        6       (6)
     Tax credits                                      (17)      (69)      (10)
     Operating losses and tax credits with no 
     current tax enefit                                57        69        50
     Tax benefit from the utilization of net
        operating loss carryforwards                   --       (40)       --
     ==========================================================================
     Effective tax rate                                -- %      -- %      -- %
     ==========================================================================
</TABLE>



     The Company has made no provision for income taxes as it has a history of
     net losses, which has resulted in tax loss carryforwards. At December 31,
     1997, the Company had available federal net operating loss carryforwards of
     approximately $16,586,000, which expire in 2003 through 2012, and federal
     research and development credit carryforwards of approximately $791,000,
     which expire in 2003 through 2012. At December 31, 1997, the Company also
     had available state net operating loss carryforwards of approximately
     $9,261,000, which expire in 1998 through 2002 and state research and
     development and investment tax credit carryforwards of approximately
     $395,000, which expire in 2006 through 2012. Of the total net operating
     loss carryforwards, approximately $1,906,000 are attributable to the
     exercise of stock options and the tax benefit from these losses, when
     utilized, will be credited to additional paid-in capital.



                                       36

<PAGE>   37
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



6.   STOCKHOLDERS' EQUITY

     COMMON STOCK - In 1996, the Company increased the number of shares of
     authorized common stock from 18,650,000 to 30,000,000.

     In August 1996, the Company completed an initial public offering of its
     common stock consisting of 3,910,000 shares at $10.00 per share. Proceeds
     to the Company, net of issuance costs, were approximately $35,163,000
     (issuance costs were approximately $3,937,000).

     In accordance with the terms of the underlying agreements, all outstanding
     shares of Series B, C, D, and E convertible preferred stock were
     automatically converted into common stock upon completion of the initial
     public offering.

     PREFERRED STOCK - In 1996, the Company authorized 1,000,000 shares of $1.00
     par value preferred stock.

7.   STOCK COMPENSATION PLANS

     At December 31, 1997, the Company has three stock-based compensation plans,
     which are described below. The Company adopted SFAS No. 123, but, as
     permitted, applies APB Opinion No. 25 and related Interpretations in
     accounting for its plans. Accordingly, no compensation cost has been
     recognized for its fixed stock option plans and its employee stock purchase
     plan. The Company has no performance-based stock option plans. Had
     compensation cost for the Company's three stock-based compensation plans
     been determined based on the fair value at the grant dates for awards under
     those plans consistent with the method of SFAS No. 123, the Company's net
     income (loss) and per share amounts would have been adjusted to the pro
     forma amounts indicated below:


<TABLE>
<CAPTION>
     YEAR ENDED DECEMBER 31,                                    1997            1996         1995
     ----------------------------------------------------------------------------------------------
     <S>                                   <C>             <C>                <C>         <C>       
     Net income (loss)                     As reported     $(4,448,336)    $   259,382    $(342,962)
                                           Pro forma       $(8,531,745)    $(4,403,824)   $(580,611)

     Basic earnings (loss) per share       As reported     $     (0.23)    $      0.02    $   (0.29)
                                           Pro forma       $     (0.44)    $     (0.41)   $   (0.50)

     Diluted earnings (loss) per share     As reported     $     (0.23)    $      0.01    $   (0.29)
                                           Pro forma       $     (0.44)    $     (0.24)   $   (0.50)
</TABLE>



     The fair value of options on their grant date was measured using the
     Black-Scholes option pricing model. Key assumptions used to apply this
     pricing model are as follows:


<TABLE>
<CAPTION>
     YEAR ENDED DECEMBER 31,                             1997          1996         1995
     -----------------------------------------------------------------------------------

     <S>                                              <C>          <C>           <C>  
     Average risk-free interest rate                     6.48%        6.25%         6.25%
     Expected life of option grants                   5 years      4 years       4 years
     Expected volatility of underlying stock               96%          97%           97%
     Expected dividend yield                               --           --            --

</TABLE>




                                       37

<PAGE>   38
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     FIXED STOCK OPTION PLANS - The Company has two fixed option plans. Under
     the 1990 Incentive and Nonstatutory Stock Option Plan, the Company may
     grant incentive stock options or nonqualified stock options to its
     employees and directors for up to 2,873,002 shares of common stock. Under
     the 1996 Stock Option Plan, the Company may grant incentive stock options
     or nonqualified stock options to its employees and directors for up to
     3,000,000 shares of common stock. Under both plans, options: are granted at
     an exercise price as determined by the Board of Directors; have a maximum
     term of ten years; and generally vest either: (i) on a monthly basis over
     three years, or (ii) 40% two years from the date of grant with the
     remaining 60% vesting on a monthly basis over the next three years.

     A summary of the status of the Company's two fixed stock option plans as of
     December 31, 1997, 1996, and 1995, and changes during the years ending on
     those dates is presented below:



<TABLE>
<CAPTION>
                                           1997                        1996                           1995
                                 ------------------------   -------------------------   ---------------------------
                                               Wgtd. Avg.                  Wgtd. Avg.                    Wgtd. Avg.
                                  Shares      Exer. Price     Shares      Exer. Price    Shares         Exer. Price
                                -------------------------   -------------------------   ---------------------------
<S>                             <C>             <C>         <C>              <C>        <C>                 <C>
Outstanding at
  beginning of year             3,396,408        $5.01      2,757,500        $1.21      2,481,948           $1.45
Granted                           913,186        12.20      1,818,250         9.10      1,139,750            1.30
Exercised                         686,127         3.82      1,083,162         1.02         16,867             .95
Forfeited                          69,296         9.10         96,180        14.54        847,331            1.90
                                ---------                   ---------                   ---------
Outstanding at
   end of year                  3,554,171        $7.01      3,396,408        $5.01      2,757,500           $1.21
                                =========                   =========                   =========

Options exercisable at 
year end                        1,754,552                   1,343,617                   1,447,474

Weighted-average grant date
fair value of options
granted during the year         $    9.28                   $    6.07                   $    0.92

</TABLE>


      The following table summarizes information about stock options outstanding
at December 31, 1997:


<TABLE>
<CAPTION>
                                        Options Outstanding                           Options Exercisable
                     ------------------------------------------------------   -------------------------------
                         Number          Weighted-Avg.                           Number
 Range of Exercise   Outstanding at  Remaining Contractual    Weighted-Avg.    Exercisable      Weighted-Avg.
       Prices           12/31/97             Life            Exercise Price   At 12/31/97      Exercise Price
 -----------------   ------------------------------------------------------   -------------------------------
  <S>                 <C>                   <C>                 <C>           <C>                  <C>    
  $ 1 to 2             1,222,329             7.1 years           $ 1.30        1,046,230            $ 1.31
    8 to 9             1,178,406             8.4                   8.25          613,075              8.25
  10 to 11               450,000             9.2                  10.29           87,387             10.31
  12 to 13               703,436             9.4                  12.75            7,860             12.75
                     ------------------------------------------------------   -------------------------------
                       3,554,171             8.3                 $ 7.01        1,754,552            $ 4.23
                     ======================================================   ===============================

</TABLE>





                                       38

<PAGE>   39
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     EMPLOYEE STOCK PURCHASE PLAN - In June 1996, the Company adopted an
     Employee Stock Purchase Plan (the "ESPP Plan") under which eligible
     employees may purchase common stock at a price equal to 85% of the lower of
     the fair market value of the common stock at the beginning or end of each
     six-month offering period. Participation in the ESPP Plan is limited to 6%
     of an employee's compensation, may be terminated at any time by the
     employee and automatically ends on termination of employment with the
     Company. A total of 100,000 shares of common stock have been reserved for
     issuance. During 1997 and 1996, no shares of common stock were issued under
     this plan, as the Company had not commenced implementation of the plan.



8.   COMMITMENTS AND CONTINGENT LIABILITIES

     LEASE COMMITMENTS - In 1995, the Company entered into a three-year
     noncancelable operating lease for its principal office and research
     facilities commencing June 1, 1995. In November 1996, the Company entered
     into a twelve-month operating lease for additional space for its research
     facilities commencing December 1, 1996. In November 1997, both of these
     leases were either terminated or allowed to lapse at no cost to the
     Company, and the Company moved into a new building that it had purchased.

     At December 31, 1997, the Company has no material operating leases.

     Rental expense was approximately $308,000, $143,000, and $283,000 in 1997,
     1996 and 1995, respectively.

     LITIGATION - There are no material pending legal proceedings to which the
     Company is a party or to which any of its properties are subject which,
     either individually or in the aggregate, are expected by the Company to
     have a material adverse effect on its business, financial position or
     results of operations.



9.   TRANSACTIONS WITH RELATED PARTIES

     CONSULTING AGREEMENTS - In prior years, the Company had paid consulting
     fees for scientific research and development services provided by certain
     stockholders. The total charges from related parties approximated $8,000,
     and $66,000 in 1996 and 1995. There were no amounts due to related parties
     at December 31, 1997 and 1996.



                                       39

<PAGE>   40
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


10.  MAJOR CUSTOMERS

     The portion of total revenue that was derived from major customers was as
     follows:


<TABLE>
<CAPTION>

     YEAR ENDED DECEMBER 31,                            1997     1996     1995
     --------------------------------------------------------------------------
     <S>                                                 <C>      <C>      <C>                 
     Customer A                                          16%      --       --
     Customer B                                          13%      12%      12%
     Customer C                                          12%      17%      23%
     Customer D                                           7%      22%      --
     Customer E                                          --       10%      --
     Customer F                                          --       --       18%
     Customer G                                          --       --       10%
</TABLE>



11.  EMPLOYEE BENEFIT PLAN

     In 1994, the Company established a qualified 401(k) Retirement Plan (the
     "Plan") under which employees are allowed to contribute certain percentages
     of their pay, up to the maximum allowed under Section 401(k) of the
     Internal Revenue Code. Company contributions to the Plan are at the
     discretion of the Board of Directors. There were no Company contributions
     in 1997, 1996 and 1995.

12.  NET INCOME (LOSS) PER SHARE

     A reconciliation of weighted average shares used for the basic computation
     and that used for the diluted computation is as follows:


<TABLE>
<CAPTION>

     YEAR ENDED DECEMBER 31,                       1997          1996         1995
     --------------------------------------------------------------------------------
     <S>                                         <C>          <C>           <C>      
     Weighted average shares - basic             19,328,252   10,841,919    1,162,717
     Dilutive effect of:
         Convertible preferred stock                     --    5,467,106           --
         Options                                         --    1,682,421           --
     --------------------------------------------------------------------------------
     Weighted average shares - diluted           19,328,252   17,991,446    1,162,717
     ================================================================================

</TABLE>



     For the years ended December 31, 1997 and 1995, potential common shares are
     not included in the per share calculations for diluted EPS, because the
     effect of their inclusion would be antidilutive. For the year ended
     December 31, 1996, options to purchase 1,737,750 shares of common stock at
     an average weighted price of $8.57 per share were outstanding, but were not
     included in the computation of diluted EPS because the options' exercise
     prices were greater than the average market price of the common shares.





                                       40

<PAGE>   41
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



13.  QUARTERLY RESULTS OF OPERATIONS - UNAUDITED

     The following table presents unaudited quarterly operating results for each
     of the Company's eight quarters in the two-year period ended December 31,
     1997:


<TABLE>
<CAPTION>
                                                                        1997
                                                 -------------------------------------------------
         Quarters ended                            March 31     June 30      Sept. 30     Dec. 31
         -----------------------------------------------------------------------------------------
         <S>                                     <C>          <C>            <C>        <C>       
         Revenue                                 $1,801,085   $1,870,417     $722,500   $1,804,049
         Loss from operations                      (724,586)    (748,143)  (2,569,699)  (2,114,248)
         Net loss                                  (276,302)    (275,398)  (2,145,946)  (1,750,690)
         -----------------------------------------------------------------------------------------

         Net loss per share - Basic                  ($0.01)      ($0.01)      ($0.11)      ($0.09)
         Net loss per share - Diluted                ($0.01)      ($0.01)      ($0.11)      ($0.09)
         =========================================================================================

<CAPTION>

                                                                         1996
                                                 -------------------------------------------------
         Quarters ended                            March 31      June 30     Sept. 30     Dec. 31
         -----------------------------------------------------------------------------------------
         <S>                                     <C>          <C>            <C>        <C>       
         Revenue                                   $962,003   $1,128,475   $1,505,820   $1,704,811
         Income (loss) from operations               17,651       18,300        4,250     (578,475)
         Net income (loss)                           41,151       48,668      261,683      (92,120)
         -----------------------------------------------------------------------------------------

         Net income (loss) per share - Basic          $0.04        $0.01        $0.02        $0.00
         Net income (loss) per share - Diluted        $0.00        $0.00        $0.01        $0.00
         =========================================================================================

</TABLE>





I
TEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

        None.




                                       41

<PAGE>   42



                                    PART III



ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

    Information with respect to Directors and Executive Officers and compliance
with Section 16(a) of the Exchange Act may be found in the sections captioned
"Directors and Executive Officers" and "Section 16(a) Beneficial Ownership
Reporting Compliance" appearing in the Company's definitive Proxy Statement to
be delivered to shareholders in connection with the Annual Meeting of
Shareholders to be held on Wednesday, May 27, 1998. Such information is
incorporated herein by reference.

EXECUTIVE OFFICERS OF THE REGISTRANT

         The executive officers of the Company as of February 28, 1998 are:

        NAME            AGE   POSITION
        ----            ---   --------
James C. Bender .......  45   President, Chief Executive Officer, and Director
David C. Hunter .......  42   Senior Vice President, Product Development
Richard P. Moberg .....  42   Chief Financial Officer and Treasurer
Edmund C. Reiter ......  34   Vice President, Advanced Products
Michael A. Tzannes ....  36   Chief Technology Officer, General Manager of
                              Telecommunications, and Director


James C. Bender has been President, Chief Executive Officer and a director of
the Company since October 1994. From April 1992 to February 1994, Mr. Bender
served as President and Chief Executive Officer of Logicraft, Inc., a network
service provider. From 1986 to April 1992, Mr. Bender served as Logicraft's
President and Chief Operating Officer. Mr. Bender received an M.B.A. from the
Harvard Graduate School of Business Administration and a B.S. from Lowell
Technological Institute.

David C. Hunter joined the Company in May 1996 as Senior Vice President, Product
Development. From 1982 to April 1996, Mr. Hunter served as Vice President,
Research and Development of I.D.E. Corporation ("IDEA"), a manufacturer of data
communications equipment. Mr. Hunter was a founder and director of IDEA. Mr.
Hunter received an M.B.A. with high distinction from the Harvard Graduate School
of Business Administration and a B.S. with distinction from Cornell University.

Richard P. Moberg joined the Company in June 1996 as Chief Financial Officer and
Treasurer. From December 1990 to June 1996, Mr. Moberg held a number of
positions at Lotus Development Corporation, a computer software developer,
including Corporate Controller from June 1995 to June 1996, Assistant Corporate
Controller from May 1993 to June 1995, and Director of Financial Services from
December 1990 to May 1993. Mr. Moberg received an M.B.A. from Bentley College
and a B.B.A. in accounting from the University of Massachusetts at Amherst.

Edmund C. Reiter has been the Company's Vice President, Advanced Products since
August 1995. Prior to that, he served as the Company's Manager of Product
Development for still image compression products from June 1994 to August 1995,
as a Senior Member of the Company's Technical Staff from November 1993 to June
1994, and as a Member of the Technical Staff from December 1992 to November
1993. Dr. Reiter served as Senior Scientist at New England Research, Inc. from
January 1991 to October 1992. Dr. Reiter received a B.S. from Boston College and
a Ph.D. from the Massachusetts Institute of Technology.



                                       42

<PAGE>   43

Michael A. Tzannes has been the Company's Chief Technology Officer and General
Manager of Telecommunications since September 1997, and a director since March
1998. Dr. Tzannes served as the Company's Senior Vice President,
Telecommunications from April 1996 to September 1997, as the Company's Vice
President, Telecommunications from December 1992 to April 1996, as a Senior
Member of the Company's Technical Staff from January 1991 to November 1992, and
as a consultant to the Company from October 1990 to December 1990. From 1986 to
1990, he was a Staff Engineer at Signatron, Inc., a telecommunications
technology and systems developer. Dr. Tzannes received a Ph.D. in electrical
engineering from Tufts University, an M.S. from the University of Michigan at
Ann Arbor, and a B.S. from the University of Patras, Greece.



ITEM 11.  EXECUTIVE COMPENSATION

    Information with respect to this item may be found in the section captioned
"Compensation of Directors and Executive Officers" appearing in the Company's
definitive Proxy Statement to be delivered to shareholders in connection with
the Annual Meeting of Shareholders to be held on Wednesday, May 27, 1998. Such
information is incorporated herein by reference.



ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

    Information with respect to this item may be found in the section captioned
"Security Ownership of Certain Beneficial Owners and Management" appearing in
the Company's definitive Proxy Statement to be delivered to shareholders in
connection with the Annual Meeting of Shareholders to be held on Wednesday, May
27, 1998. Such information is incorporated herein by reference.



ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    Information with respect to this item may be found in the section captioned
"Certain Transactions" appearing in the Company's definitive Proxy Statement to
be delivered to shareholders in connection with the Annual Meeting of
Shareholders to be held on Wednesday, May 27, 1998. Such information is
incorporated herein by reference.





                                       43

<PAGE>   44


                                     PART IV



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

(A)(1) INDEX TO FINANCIAL STATEMENTS

     The following consolidated financial statements are included in Part II,

Item 8:


                                                                            Page
                                                                            ----
     Report of the Independent Accountants.................................. 27
     Consolidated Balance Sheets as of December 31, 1997.................... 28
     Consolidated Statements of Operations for each of the three
         years ended December 31, 1997...................................... 29
     Consolidated Statements of Cash Flows for each of the
         three years ended December 31, 1997................................ 30
     Consolidated Statements of Stockholders' Equity for each of
          the three years ended December 31, 1997........................... 31
     Notes to Consolidated Financial Statements............................. 32


     (2) INDEX TO FINANCIAL STATEMENT SCHEDULE

                                                                            Page
                                                                            ----
     Schedule II - Valuation and Qualifying Accounts........................ 46


     Schedules other than those listed above have been omitted since they are
     either not required or not applicable or the information is otherwise
     included.


     (3) INDEX TO EXHIBITS

       EXHIBIT NO.       DESCRIPTION OF EXHIBIT

       3.1          Amended and Restated Articles of Organization (filed as
                    Exhibit 3.2 to the Company's Registration Statement on Form
                    S-1, File No. 333-6807 and incorporated herein by
                    reference).

       3.2          Amended and Restated By-Laws (filed as Exhibit 3.3 to the
                    Company's Form 10-Q for the quarter ended June 30, 1996 and
                    incorporated herein by reference).

       10.1         1990 Incentive and Non-Statutory Stock Option Plan (filed as
                    Exhibit 10.2 to the Company's Registration Statement on Form
                    S-1, File No. 333-6807 and incorporated herein by
                    reference).

       10.2         1996 Stock Option Plan (filed as Exhibit 10.3 to the
                    Company's Registration Statement on Form S-1, File No.
                    333-6807 and incorporated herein by reference).

       10.3         1996 Employee Stock Purchase Plan (filed as Exhibit 10.4 to
                    the Company's Registration Statement on Form S-1, File No.
                    333-6807 and incorporated herein by reference).

       10.4         License Agreement with Analog Devices, Inc., dated September
                    25, 1993, together with appendices thereto (filed as Exhibit
                    10.5 to the Company's Registration Statement on Form S-1,
                    File No. 333-6807 and incorporated herein by reference).



                                       44

<PAGE>   45

       10.5        Development Contract with Analog Devices, Inc., dated
                   September 25, 1993, together with amendments thereto (filed
                   as Exhibit 10.6 to the Company's Registration Statement on
                   Form S-1, File No. 333-6807 and incorporated herein by
                   reference).

       10.8        Employment Agreement of James C. Bender, dated October 27,
                   1994, together with amendment thereto dated December 20,
                   1996 (filed as Exhibit 10.8 to the Company's Form 10-K for
                   the year ended December 31, 1997 and incorporated herein by
                   reference).


       10.9        Form of Director Indemnification Agreement (filed as Exhibit
                   10.13 to the Company's Registration Statement on Form S-1,
                   File No. 333-6807 and incorporated herein by reference).

       10.11       Agreement of Purchase and Sale by and between Aware, Inc.
                   and The Mitre Corporation dated as of June 6, 1997 (filed as
                   Exhibit 10.1 to the Company's Form 10-Q for the quarter
                   ended September 30, 1997 and incorporated herein by
                   reference).

       11.1*       Computation of basic and diluted net income (loss) per share.

       21.1*       Subsidiaries of Registrant

       23.1*       Consent of Independent Accountants

      * Filed herewith.


(B) Reports on Form 8-K

         No reports on Form 8-K were filed during the fourth quarter of 1997.




                                       45

<PAGE>   46

                                                                     SCHEDULE II

                                   AWARE, INC.

                        VALUATION AND QUALIFYING ACCOUNTS
                    YEARS ENDED DECEMBER 31, 1997, 1996, 1995


<TABLE>
<CAPTION>

- -------------------------------------------------------------------------------------------------
    COL. A                COL. B         COL. C(1)      COL. C(2)      COL. D            COL. E
- -------------------------------------------------------------------------------------------------
                                                  ADDITIONS
                                        -------------------------
                         BALANCE AT     CHARGED TO        CHARGED     DEDUCTIONS          BALANCE
                         BEGINNING       COSTS AND       TO OTHER     CHARGED TO           AT END
                         OF PERIOD       EXPENSES        ACCOUNTS      RESERVES         OF PERIOD
- -------------------------------------------------------------------------------------------------
<C>                      <C>              <C>                           <C>               <C>    
Allowance for 
doubtful accounts
receivable:

1997 ..................  $ 35,000         $25,923              --       $10,923           $50,000

1996 ..................  $  5,300         $19,698         $20,000        $9,998           $35,000

1995 ..................        --          $5,300              --            --            $5,300


Allowance for 
sales returns 
and allowances:

1997 ..................        --              --         $50,000            --           $50,000

1996 ..................        --              --              --            --                --

1995 ..................        --              --              --            --                --


Inventory reserves:

1997 ..................  $300,000        $275,000              --      $558,333          $ 16,667

1996 ..................        --        $365,000              --       $65,000          $300,000

1995 ..................        --              --              --            --                --

</TABLE>










                                       46

<PAGE>   47


                                   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.




                                     AWARE, INC.



                                     By:  /s/ James C. Bender
                                          -------------------------------------
                                          James C. Bender, Chief Executive 
                                          Officer & President

                                          Date: March 20, 1998


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 indicated on the 20th day of March 1998.



      SIGNATURE                              TITLE
      ---------                              -----

/s/ James C. Bender           Chief Executive Officer, President, and Director
- --------------------------    (Principal Executive Officer)
James C. Bender               


/s/ Richard P. Moberg         Chief Financial Officer, Treasurer
- --------------------------    (Principal Financial and Accounting Officer)
Richard P. Moberg             


/s/ Charles K. Stewart        Chairman of the Board of Directors
- --------------------------
Charles K. Stewart


/s/ David Ehreth              Director
- --------------------------
David Ehreth


/s/ Jerald G. Fishman         Director
- --------------------------
Jerald G. Fishman


/s/ John K. Kerr              Director
- --------------------------
John K. Kerr


/s/ John S. Stafford, Jr.     Director
- --------------------------
John S. Stafford, Jr.


/s/ Michael A. Tzannes        Chief Technology Officer, General Manager
- --------------------------    of Telecommunications, and Director
Michael A. Tzannes            





                                       47





<PAGE>   1

                                                                    EXHIBIT 11.1

                                   AWARE, INC.

                        COMPUTATION OF BASIC AND DILUTED
                           NET INCOME (LOSS) PER SHARE




<TABLE>
<CAPTION>
                                                                          YEARS ENDED DECEMBER 31,
                                                                ---------------------------------------------
                                                                    1997             1996             1995
                                                                -----------       -----------      ---------- 
<S>                                                             <C>               <C>              <C>        

Net income (loss) ............................................  $(4,448,336)      $   259,382      $ (342,962)
                                                                ===========       ===========      ========== 

Weighted average number of common shares outstanding:
  Common stock ...............................................   19,328,252        10,841,919       1,162,717
  Other ......................................................           --                --              --
                                                                -----------       -----------      ---------- 
      Common shares outstanding for purpose of
           calculating basic net income per share ............   19,328,252        10,841,919       1,162,717

Common stock equivalents to reflect dilution:
      Convertible preferred common stock equivalent shares ...           --         5,467,106              --
      Option common stock equivalents shares .................           --         1,682,421              --
                                                                -----------       -----------      ---------- 

  Total shares for purpose of calculating diluted net
       income per share ......................................   19,328,252        17,991,446       1,162,717
                                                                ===========       ===========      ========== 

Basic net income (loss) per share ............................  $     (0.23)      $      0.02      $    (0.29)
                                                                ===========       ===========      ========== 

Diluted net income (loss) per share ..........................  $     (0.23)      $      0.01      $    (0.29)
                                                                ===========       ===========      ========== 

</TABLE>









<PAGE>   1
                                                                    EXHIBIT 21.1


                           SUBSIDIARIES OF REGISTRANT




          NAME OF ORGANIZATION                              JURISDICTION
          --------------------                              ------------

          Aware Security Corporation ....................   Massachusetts











<PAGE>   1

                                                                    EXHIBIT 23.1


                       CONSENT OF INDEPENDENT ACCOUNTANTS



We consent to the incorporation by reference in Registration Statement No.
333-15805 of Aware, Inc. on Form S-8, of our report dated January 27, 1998,
appearing in this Annual Report on Form 10-K of Aware, Inc. for the year ended
December 31, 1997.





/s/  Deloitte & Touche LLP

Boston, Massachusetts
March 20, 1998






<TABLE> <S> <C>

<ARTICLE> 5
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
       
<S>                             <C>
<PERIOD-TYPE>                   YEAR
<FISCAL-YEAR-END>                          DEC-31-1997
<PERIOD-START>                             JAN-01-1997
<PERIOD-END>                               DEC-31-1997
<EXCHANGE-RATE>                                      1
<CASH>                                          26,104
<SECURITIES>                                         0
<RECEIVABLES>                                    1,874
<ALLOWANCES>                                        50
<INVENTORY>                                        216
<CURRENT-ASSETS>                                28,435
<PP&E>                                          12,176
<DEPRECIATION>                                   1,330
<TOTAL-ASSETS>                                  39,281
<CURRENT-LIABILITIES>                            1,661
<BONDS>                                              0
<PREFERRED-MANDATORY>                                0
<PREFERRED>                                          0
<COMMON>                                           196
<OTHER-SE>                                      37,424
<TOTAL-LIABILITY-AND-EQUITY>                    39,281
<SALES>                                            974
<TOTAL-REVENUES>                                 6,198
<CGS>                                            1,252
<TOTAL-COSTS>                                        0
<OTHER-EXPENSES>                                11,103
<LOSS-PROVISION>                                     0
<INTEREST-EXPENSE>                                   0
<INCOME-PRETAX>                                (4,448)
<INCOME-TAX>                                         0
<INCOME-CONTINUING>                            (4,448)
<DISCONTINUED>                                       0
<EXTRAORDINARY>                                      0
<CHANGES>                                            0
<NET-INCOME>                                   (4,448)
<EPS-PRIMARY>                                   (0.23)
<EPS-DILUTED>                                   (0.23)
        

</TABLE>






<TABLE> <S> <C>

<ARTICLE> 5
<RESTATED> 
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
       
<S>                             <C>
<PERIOD-TYPE>                   6-MOS
<FISCAL-YEAR-END>                          DEC-31-1996
<PERIOD-START>                             JAN-01-1996
<PERIOD-END>                               JUN-30-1996
<EXCHANGE-RATE>                                      1
<CASH>                                           2,694
<SECURITIES>                                         0
<RECEIVABLES>                                      959
<ALLOWANCES>                                        15
<INVENTORY>                                        504
<CURRENT-ASSETS>                                 4,545
<PP&E>                                           2,067
<DEPRECIATION>                                   1,595
<TOTAL-ASSETS>                                   5,017
<CURRENT-LIABILITIES>                              976
<BONDS>                                              0
<PREFERRED-MANDATORY>                               48
<PREFERRED>                                          0
<COMMON>                                           102
<OTHER-SE>                                       3,892
<TOTAL-LIABILITY-AND-EQUITY>                     5,017
<SALES>                                            150
<TOTAL-REVENUES>                                 2,090
<CGS>                                               99
<TOTAL-COSTS>                                      491
<OTHER-EXPENSES>                                 1,563
<LOSS-PROVISION>                                    10
<INTEREST-EXPENSE>                                   1
<INCOME-PRETAX>                                     90
<INCOME-TAX>                                         0
<INCOME-CONTINUING>                                  0
<DISCONTINUED>                                       0
<EXTRAORDINARY>                                      0
<CHANGES>                                            0
<NET-INCOME>                                        90
<EPS-PRIMARY>                                      .02
<EPS-DILUTED>                                      .01
        

</TABLE>






<TABLE> <S> <C>

<ARTICLE> 5
<RESTATED> 
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
       
<S>                             <C>
<PERIOD-TYPE>                   9-MOS
<FISCAL-YEAR-END>                          DEC-31-1996
<PERIOD-START>                             JAN-01-1996
<PERIOD-END>                               SEP-30-1996
<EXCHANGE-RATE>                                      1
<CASH>                                          37,526
<SECURITIES>                                         0
<RECEIVABLES>                                    1,234
<ALLOWANCES>                                        15
<INVENTORY>                                        885
<CURRENT-ASSETS>                                39,712
<PP&E>                                           2,394
<DEPRECIATION>                                   1,675
<TOTAL-ASSETS>                                  40,431
<CURRENT-LIABILITIES>                              962
<BONDS>                                              0
<PREFERRED-MANDATORY>                                0
<PREFERRED>                                          0
<COMMON>                                           189
<OTHER-SE>                                      39,281
<TOTAL-LIABILITY-AND-EQUITY>                    40,431
<SALES>                                            530
<TOTAL-REVENUES>                                 3,596
<CGS>                                              365
<TOTAL-COSTS>                                      973
<OTHER-EXPENSES>                                 2,583
<LOSS-PROVISION>                                    10
<INTEREST-EXPENSE>                                   1
<INCOME-PRETAX>                                    352
<INCOME-TAX>                                         0
<INCOME-CONTINUING>                                  0
<DISCONTINUED>                                       0
<EXTRAORDINARY>                                      0
<CHANGES>                                            0
<NET-INCOME>                                       352
<EPS-PRIMARY>                                      .04
<EPS-DILUTED>                                      .02
        

</TABLE>






<TABLE> <S> <C>

<ARTICLE> 5
<RESTATED> 
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLLARS
       
<S>                             <C>
<PERIOD-TYPE>                   YEAR
<FISCAL-YEAR-END>                          DEC-31-1996
<PERIOD-START>                             JAN-01-1996
<PERIOD-END>                               DEC-31-1996
<EXCHANGE-RATE>                                      1
<CASH>                                          36,719
<SECURITIES>                                         0
<RECEIVABLES>                                    1,801
<ALLOWANCES>                                        35
<INVENTORY>                                        448
<CURRENT-ASSETS>                                38,956
<PP&E>                                           1,725
<DEPRECIATION>                                     558
<TOTAL-ASSETS>                                  40,123
<CURRENT-LIABILITIES>                              676
<BONDS>                                              0
<PREFERRED-MANDATORY>                                0
<PREFERRED>                                          0
<COMMON>                                           190
<OTHER-SE>                                      39,257
<TOTAL-LIABILITY-AND-EQUITY>                    40,123
<SALES>                                            649
<TOTAL-REVENUES>                                 5,301
<CGS>                                              831
<TOTAL-COSTS>                                        0
<OTHER-EXPENSES>                                 5,008
<LOSS-PROVISION>                                    20
<INTEREST-EXPENSE>                                   1
<INCOME-PRETAX>                                    259
<INCOME-TAX>                                         0
<INCOME-CONTINUING>                                259
<DISCONTINUED>                                       0
<EXTRAORDINARY>                                      0
<CHANGES>                                            0
<NET-INCOME>                                       259
<EPS-PRIMARY>                                      .02
<EPS-DILUTED>                                      .01
        

</TABLE>