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

                                   Form 10-KSB

              [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)
              OF THE SECURITIES EXCHANGE ACT OF 1934 [Fee Required]

                   For the fiscal year ended December 31, 1996

             [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)
            OF THE SECURITIES EXCHANGE ACT OF 1934 [No Fee Required]

                        For the transition period from to
                         Commission File Number 0-14793

                             TEKNOWLEDGE CORPORATION
           (Name of small business issuer as specified in its charter)

              Delaware                                             94-2760916
(State or other jurisdiction of                                (I.R.S. Employer
incorporation or organization)                               Identification No.)

1810 Embarcadero Road, Palo Alto, California                          94303
--------------------------------------------                          -----

(Address of principal executive offices)                            (Zip Code)

Issuer's telephone number (415)424-0500

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

Securities registered pursuant to Section 12 (g) of the Act:

                                          Common Stock, $.01 par value per share

Check  whether the issuer (1) filed all reports  required to be filed by Section
13 or 15(d) of the  Exchange  Act during the past 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

     Check if there is no disclosure  of  delinquent  filers in response to Item
405 of  Regulation  S-B  contained  in  this  form,  and no  disclosure  will 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-KSB
or any amendment to this Form 10-KSB. [X]

State issuer's revenues for its most recent fiscal year. $7,158,763

The aggregate  market value of Common Stock,  $.01 par value per share,  held by
non-affiliates of the registrant was $13,675,134 on March 20, 1997 (based on the
average  bid and ask price per  share of Common  Stock on that date as  reported
over-the-counter by the National Quotation Bureau).

On March 20, 1996, there were 26,205,643  shares of Common Stock, $.01 par value
per share, of the registrant outstanding.

Documents Incorporated by Reference:
Proxy Statement for 1997 Annual Meeting of Stockholders                 Part III

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                                     PART I

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Item 1.       Description of Business

         Teknowledge Corporation (the "Company") is in the distributed knowledge
processing  business.   Teknowledge  is  leveraging  its  core  competencies  in
knowledge based systems and large scale,  distributed  object-oriented  software
with the  expanding  opportunities  presented by the Internet and the World Wide
Web.  The  Company  provides  software  products  and  consulting  services  for
commercial  and government  applications.  The Company's key business lines are:
Sales Associate Product,  Education & Training Technologies,  Command & Control,
Situation Assessment and Data Fusion, and Distributed Systems  Engineering.  The
Company  was  incorporated  on July 8,  1981  under  the  laws of the  State  of
Delaware.  The  Company's  principal  executive  offices  are  located  at  1810
Embarcadero Road, Palo Alto, California 94303.

         The Company is the surviving  corporation  of the merger (the "Merger")
of American Cimflex Corporation and Teknowledge,  Inc., which was consummated in
1989. Since the Merger,  the Company has discontinued or divested certain of its
business  units.  Ongoing  operations  of the Company  consist  primarily of the
former  operations of Teknowledge's  Knowledge  Systems Division located in Palo
Alto and three satellite  engineering  offices located in San Diego,  California
(1995), Washington, D.C.(1995), and Orlando, Florida (1996).

         The  Company's   commercial   software  products  can  be  operated  on
individual computers and integrated into the Internet or intranets.  The Company
maintains an active  intellectual  property  program,  and currently holds eight
U.S.  software  patents.  The  application  software  developed  by the  Company
includes the Sales Associate(a) which interviews  customers and configures sales
orders on the Internet,  knowledge-based  expert systems,  and systems to manage
webs of networked information. The Company's products and services are primarily
marketed to domestic  commercial  companies  and the United  States  Government,
although the Company has several international customers.

Overview

         Knowledge-based  systems are computer  software  programs that capture,
represent,  distribute,  and  apply  knowledge  to solve  specific  applications
problems. The Company develops software architectures,  designs, and operational
systems  that  integrate   conventional   software  and  knowledge   systems  in
distributed,   heterogeneous  network  applications.   These  architectures  are
embodied in products and  services to support  distributed  intelligent  systems
integration and applications.

          Computer software  applications  provide maximum value when integrated
into networked operations, both within and between enterprises.  Integration of
these various functions is facilitated if object-oriented software is designed
with an "open  architecture."  This  allows  the  same  applications software
and user interfaces to be distributed via a client-server  protocol across many
different types of  computers.  The  Company's  products  and  services  are
designed to maximize the value of distributing and activating  application
knowledge within flexible frameworks for software integration.

         Since the U.S. Department of Defense and many commercial businesses are
now conducting  large-scale operations over international computer networks such
as the Internet,  much of the Company's  current and future business focus is on
providing associate systems to make it possible to delegate  knowledge-intensive
tasks to network-enabled  computer software associates systems.  These associate
systems  may  accomplish  routine  tasks,   accelerate   information  gathering,
disseminate  knowledge over computer networks,  or improve resource utilization.
Teknowledge's  strategic plans include  commercializing  software that amplifies
human productivity  through the use of these associate systems.  Teknowledge has
built six associate  systems and  commercialized  one.  These  systems  include:
Briefing Associate, the Parent's Associate, the Student's Associate, the Project
Center Associate, the Desktop Associate, and the commercial Sales Associate.
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Operations

         Teknowledge  headquarters  is  located in Palo  Alto,  California.  The
Company  continues to expand its technical staff at its  headquarters and in the
Washington  DC, San Diego,  and  Orlando  branch  offices.  The Company has five
program areas that provide  interrelated but distinct lines of business from the
commercial Sales Associate product to R&D on distributed object oriented systems
as discussed below.

         Sales Associate Product

         The Sales  Associate is a  commercial  software  product for  providing
unassisted  sales  over the  Internet.  It  incorporates  rules of  selling  and
utilizes  specific  product  knowledge to emulate the best practices of the most
productive  sales person in a firm. The product goes beyond the typical browsing
interaction  on the World Wide Web by engaging  the  customer in an  interactive
dialog about  products.  The Sales  Associate  creates a unique profile of every
customer and  specializes  the sales  presentation  to each  prospect.  It never
forgets  a  customer's  profile  and  preferences,  and the  Associate  uses all
available  information  towards  the next sale.  The system can  specialize  its
visual form to match the user's profile,  selecting among web text, audio, or 3D
renditions.  The Sales Associate  incorporates both generic and  domain-specific
"rules of selling"  to guide the sales  process.  It matches a customer  profile
with the products in a product  knowledge  base.  The Sales  Associate  delivers
up-to-the minute  information on product features and  availability,  as well as
news of special discounts and other promotions.  Sales are processed immediately
on-line through  electronic credit or digital cash.  Customer  fulfillment comes
via mail or local delivery. The Sales Associate is a new product in a new market
category.  There are uncertainties and risks associated with the introduction of
any new  software  product,  but the  Company is  committed  to making the Sales
Associate a commercial success.

         The Company has also developed application software systems for several
customers  to  design  and check  hardware  configurations.  This  configuration
software is in daily use at Applied  Materials  and  Motorola  Corporation.  The
Company  has been  building  configuration  systems  for over a decade,  and has
codified some of that experience in reusable configuration software.

         M.4 is a commercial  software  tool produced by the Company and sold to
customers who want to build their own knowledge-based  problem-solving  systems.
M.4 and its  predecessors  have  been  sold  and  supported  by  Teknowledge  as
shrink-wrapped  software since 1985. M.4 is used primarily as a tool that allows
users to embed expertise within other software systems.  M.4 is sold principally
on PC platforms,  and it includes interfaces to Visual BasicTM1,  Visual C++TM1,
and  ToolbookTM2.  The market  for  expert  systems  tools is  limited,  but M.4
provides a useful  infrastructure  for developing  knowledge  based  application
systems.

1 Visual Basic(a) and Visual C++(a) are trademarks of Microsoft Corporation.
2 Toolbook(a) is a trademark of Asymetrix Corporation.

         Education and Training Technologies

         The Internet and the World Wide Web have created a new  opportunity for
formerly isolated desktop systems that provided computer-aided instruction.  Not
only have the techniques of computer aided instruction improved  dramatically in
recent  years,  but the means to  distribute  them have  undergone  a  veritable
revolution.  Now it is possible to provide distance  learning via an interactive
course  delivered  through a  standard  World  Wide Web  browser  or  associated
application  system.  There are  opportunities  to  deliver  in-house  corporate
training over  intranets,  K-12  education over the Internet,  and  just-in-time
adult  training  on the job or in the home.  Teknowledge  has been  involved  in
education  and  training  since 1981,  and in 1996 it created a program  devoted
entirely to this growing  opportunity.  Teknowledge  has served for the past two
years as the Cluster  Leader for the US's largest  multi-institution  project on
Intelligent  Tutors  and  Associates.  The  DARPA  sponsored  Computer  Assisted
Education and Training Initiative is sponsoring  Teknowledge's Parents Associate
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to enable  parents  to get advice on  parenting  and  access to  Internet  based
educational resources,  and a Center Associate to provide a computer-based coach
or peer to help  guide  users in  getting  the  most  from  education  resources
available  to  them.   Teknowledge  is  actively  developing  distance  learning
technology to provide cost effective  industrial  strength  courseware  over the
Internet.

         Command and Control

         Teknowledge's   Command,   Control,   Communications,   Computer,   and
Intelligence  ("C4I")  program is focused on  intelligent  use of computers  and
communications in command and control  applications.  These  applications may be
used in times of natural  disasters such as floods or  hurricanes,  humanitarian
interventions into war torn areas such as Bosnia, or external conflicts, such as
the Gulf War. A keystone  of C4I  systems is that they use all of the  available
information  provided by web servers,  situation servers,  and other specialized
servers.  The resulting  digital  planning  space is used to assess  alternative
courses of action,  to select  action  plans,  and to monitor  and  control  the
results of those plans.  Teknowledge has contracts to provide  architectures and
systems implementations for several command and control applications.

         The Briefing  Associate  developed in this program supports briefers in
constructing  Internet  accessible command and control briefings and customizing
them for specific audiences.

         Situation Assessment and Data Fusion

         Complex  problem solving in emergencies,  competitive  enterprises,  or
external conflicts,  typically requires the problem solver to access and combine
data from multiple sources,  and to develop a dynamic  assessment of an evolving
situation. Teknowledge's Situation Assessment and Data Fusion program focuses on
providing  distributed  tools  and  systems  infrastructure  to fuse  data  from
multiple  sources  and  combine  those  data  into a  cogent  and  often  shared
perception of a situation.  An example of a project in this program includes the
DARPA sponsored  HIBURST project which focuses on the design and  implementation
of high performance  information bases using real-time  scaleable  technology in
time critical applications. This project will produce a situation server, and an
accelerator  to improve access to information  distributed  throughout  computer
networks.

         Distributed Systems Engineering

         Operations  that  are  globally  distributed  over  the  globe  require
extensive object-oriented systems infrastructure.  Currently, the World Wide Web
provides  little  of this  systems  infrastructure,  and  instead  relies on the
distribution of multimedia documents. In the future, complex webs of objects and
knowledge will have to be distributed systematically.  This requires the ability
to provide  high  performance,  security  of  operations,  maintainability,  and
distribution by intelligent "push" and "pull" techniques. In addition, the types
and quantity of knowledge  distributed  will require new conceptual  schemas and
new  software  for  distributed   knowledge   processing  tasks.   Teknowledge's
Distributed Systems Engineering program focuses on providing precisely this type
of infrastructure.

Sales and Marketing

         Company  systems and products are marketed  primarily by the  Company's
employees,  including  the Chief  Executive  Officer,  the  President,  and five
experienced  program  managers,  supported by senior technical  engineers.  Each
program area offers  consulting  services to help  prospective  customers define
their problems and projects.  Some of these consulting assignments are funded by
customers and others are performed at the Company's  expense.  Except for funded
consulting assignments, customers do not fund proposal work, unless agreement is
reached in advance.

         The customer  base for the  Company's  products  and  services  consist
primarily of government related projects and large industrial corporations.  For
the year  ended  December  31,  1996,  the  Company's  direct  revenue  mix from
continuing  operations  by industry  was  approximately  98%  government  and 2%
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commercial  products and services.  In 1995, the Company's mix was approximately
95%  government  and 5% commercial  products and other  services.  The Company's
business is currently  concentrated  in the United  States.  Less than 1% of the
Company's sales in 1996 and 1995 were to customers outside the United States.

Backlog

         At December 31,  1996,  the expected  order  backlog was  approximately
$18.5  million,  which  consisted  of (i) new  orders for which work has not yet
begun, and (ii) revenue remaining to be recognized on work in progress.  100% of
the December 31, 1996 backlog is from government customers. Approximately 76% of
the backlog consists of  government-sponsored  programs that are awarded but not
yet  authorized  for  funding.  The  government  normally  funds a  contract  in
incremental  amounts for the tasks that are currently in production.  Backlog is
an  estimate  and is  subject  to a number of risks  (see  Item 6.  Management's
Discussion  & Analysis or Plan of  Operation - Certain  Factors  That May Affect
Future  Results of Operations  and/or Stock  Price).  The portion of the overall
backlog that is reasonably  expected to be fulfilled in the current  fiscal year
is approximately 38%.

Research and Development

         Almost all of the Company's  research and  development  activities were
funded  externally,  mostly by the Federal  Government.  Generally,  the Company
retains the exclusive right to market the government sponsored R&D commercially.

         In  accordance  with SFAS 86,  "Accounting  for the  Costs of  Computer
Software  to be Sold,  Leased  or  Otherwise  Marketed,"  the  Company  incurred
software  development costs which were capitalized.  These capitalized  software
development  costs were $59,485 and $103,676 for the periods ended  December 31,
1996 and 1995, respectively.

Competition

          A number of companies  provide  consulting  services and software that
compete with aspects of the  Company's  business.  Many of these  companies  are
substantially  larger and have  greater  financial  resources  than the Company.
Sales and  configuration  systems  are  provided by Trilogy  Development  Group,
Calico, Concentra, and others.  Knowledge-based systems are provided by Carnegie
Group, Inference Corp., Neuron Data Corp., Intellicorp,  Inc., and Trinzic Corp.
Distributed systems  engineering,  data fusion, and C4I services are provided by
Bolt,  Beranek,  Newman, ISX, ISI, Battele Labs,  Perceptronics,  Pacific Sierra
Research, and SAIC.  Internet-based distance education and training technologies
are mostly in the R&D stage,  with competitors  still emerging in the commercial
marketplace.

         The  major  part  of the  Company's  business  consists  of  performing
cost-plus-fixed-fee  contracts.  The Company also offers licenses for the use of
its  software  products  with  installation,  maintenance  and support  services
offered  separately.  The sales process is  traditionally  characterized by long
lead times from first  contact to sale,  substantial  up-front  sales  costs and
significant competition.  Contract awards are generally made on the basis of the
concept and quality of the technical  proposal,  the track record of the bidder,
the quality and experience of project  management and technical  personnel,  and
price.

 Proprietary Rights

         The Company has relied on a  combination  of patent,  copyright,  trade
secret and trademark  laws, as well as  contractual  provisions,  to protect its
proprietary technology. The Company has required employees,  customers, vendors,
and others  who have  access to  proprietary  technology  to sign  nondisclosure
agreements.  The Company retains a proprietary right to market commercially most
of the development that was sponsored by government agencies. The government may
not distribute proprietary  information that was developed by the Company to any
third party for commercial purposes without first receiving  permission from the
Company.
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         The  Company  provides  its  software   products  to  end  users  under
non-exclusive,  non-transferable  licenses which typically have a perpetual term
unless  terminated  for  breach.  The  Company  protects  the source code of its
software   products  as  trade  secrets  and  unpublished   copyrighted   works.
Additionally, the Company holds patents for the knowledge processing and systems
engineering  technologies  that  form the  basis  for many of the  products  and
configuration services that the Company markets.

         The Company has  registered  Sales  AssociateTM  as a trademark  in the
United States. The COPERNICUSTM  trademark is also registered in the US and many
foreign  jurisdictions.  As use of  any  product  name  becomes  consistent  and
established, the Company intends to apply for formal registration of the product
name  as  a  trademark  in  the  United  States  and  any   applicable   foreign
jurisdictions.

Government Contracts

         In  1996,  approximately  98%  of  the  Company's  revenues  were  from
cost-type  government  contracts,  and 100% of its December 31, 1996 backlog was
from government contracts. Accordingly, the Company's business is dependent upon
successful bidding for government  contracts.  The Company applies for contracts
in the form of a proposal by  responding  to Requests  for  Proposals  and Broad
Agency  Announcements issued by the United States Federal Government or by prime
contractors  under  contract  to  the  Federal  Government.   Proposals  include
discussion of the technical  approach to be taken to satisfy the government's or
the  prime  contractor's  requirements  and a  detailed  presentation  of  costs
expected to be incurred. The proposal is reviewed and evaluated by technical and
administrative personnel employed by the government or the prime contractor.  If
the  procurement  method is  "competitive  bid," the  contract is awarded to the
company  which would best  satisfy the  government's  or the prime  contractor's
requirements.  If the procurement method is a "negotiated award," the government
or the prime contractor  would enter into  negotiations to determine a price for
the contract; upon successful conclusion of negotiations, a contract is awarded.
Government   contracts  contain   termination   clauses  which  permit  contract
termination upon the Company's default or at the government's discretion.

         Currently,  agencies  of  the  U.S.  Government  sponsor  most  of  the
Company's technical work. In recent years, the portion of the Company's revenues
attributed  to  government  business  has risen from 95% in 1995 to 98% in 1996.
Government  contracts  are  potentially  more  risky than  commercial  contracts
because  they  are  subject  to  agency   funding   limitations,   congressional
appropriation,  and  the  political  agenda  of the  current  administration  in
Washington,   D.C.  However,  the  particular  government  customers  that  have
sponsored  Teknowledge contract work have been unusually stable in recent years.
While there is no  guarantee  that this will  continue to be the case,  it is an
indication of the priority that the government has  historically  placed on this
type of contract R&D work.

         The typical cost-type  government contract performed by the Company has
a regulated  fixed fee limit which  inhibits the Company from  improving  profit
margins on the government contract part of the business beyond what is permitted
in the government  regulations.  Federal  Acquisition  Regulations (FAR) exclude
from  reimbursement  some  "unallowable"  expenses which the Company considers a
regular part of the business.  Additionally,  almost all the Company's contracts
contain termination clauses which permit contract termination upon the Company's
default  or  at  the  contracting  party's  discretion.   The  Company  has  not
experienced  any  material  cancellations  to  date;  however  there  can  be no
assurance that such cancellations will not occur in the future.

         The  indirect  costs and expenses  accumulated  in the  performance  of
government  contracts  are  allocated  to the  customer  in the form of overhead
(indirect)  rates.  These rates,  which are periodically  reviewed by government
auditors,  fluctuate  based on the  relationship  between the overhead costs and
direct costs incurred in the  performance  of the contract.  Excluded from these
rates,  and not subject to  reimbursement,  are  certain  costs (less than 5% of
total costs in `96) which are prescribed as unallowable by the government,  such
as  entertainment  and  advertising,   and  a  considerable  portion  of  patent
litigation  costs.  In addition,  the  government has  established  compensation
limits for  employees  which  expressly  reduce the amount of  compensation  and

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related  expenses,  such as bonuses and stock options,  that can be passed on to
the  government  through the overhead  rates.  In recent years,  the Company has
experienced a decline in the fees on new government  contracts due to government
cost  saving  efforts.  Some new  contracts  may not  suffer  this fee  erosion.
However,  the overall limitation on potential  government  contract fees coupled
with some  increase in the  expenses not  eligible  for  reimbursement  from the
government  combine to limit the Company's  ability to improve profit margins on
government  contracts in the future. The Company's  government-sponsored  R&D is
most valuable as a technology incubator,  development  laboratory,  and testbed.
The best  software from this work becomes  candidates  for  commercial  software
products.   This  helps  the  government   amortize  the  considerable  cost  of
maintenance,  and it provides  Teknowledge with the opportunity to compete in an
growing commercial marketplace.

Employees

         Including contract  engineers and temporaries,  the Company had a total
of 49 full time  employees at December 31, 1996. All the employees were employed
in the  continental  United  States.  The majority of  employees,  including top
management,  are technical.  They perform  direct  billable work on contracts or
develop and support  software  products.  A core group of  administrative  staff
performs  general  and  administrative  functions.  A  large  percentage  of the
employees hold advanced degrees in technical disciplines.  The future success of
the  Company  will  depend,  in part,  on the  Company's  ability to continue to
retain,  attract,  and  motivate  highly  qualified  technical,  marketing,  and
management  personnel.  This has become a  particular  challenge  as  increasing
demand for top quality software  professionals has exceeded supply.  The Company
has never had a work stoppage,  and it is not a party to a collective bargaining
agreement with any of its employees.

Item 2. Description of Property

         The Company's  executive  offices are located at 1810 Embarcadero Road,
Palo Alto,  California.  On  December  1, 1995 a new lease was  signed  with the
landlord for 12,919  square feet of office space at an average  price of $1.40 a
square foot for a period of three years  commencing  April 5, 1996.  The Company
has an option to extend the new lease for an additional  three years at the same
terms and conditions.

         On  February  19,  1996,  the Company  signed a  five-year  lease for a
business  office  located in Washington,  D.C. Over the term of the lease,  base
rent is scheduled to rise approximately 3% per annum on the 3,014 square feet of
leased space. Over the term of the lease the Company will pay an average rent of
$1.95 a square foot per month.

         In January 1994, The Company  entered into a settlement  agreement with
the landlord for the Company's former Franklin,  Massachusetts  location.  Under
the  terms of this  agreement,  the  lease  scheduled  to expire in May 1999 was
terminated for a total  consideration,  including accrued interest,  of $131,760
which is to be paid in escalating payments over a five-year period. Payments are
due January 31 of each year.  As of  December  31,  1996,  a total of $43,056 in
payments have been made and the  remaining  liability was included in "Long-term
liabilities - Provision for discontinued  operations" and "Current liabilities -
Other" (see Part II Item 7: Financial Statements).

         In September 1993, the Company entered into a settlement agreement with
the landlord at the former Bridgeville,  Pennsylvania location.  Under the terms
of the agreement,  the Company will avoid an annual settlement amount of $18,306
unless there exists a differential  in rent between what the new tenant pays and
what the Company was expected to pay during the term of the original lease.  The
settlement  agreement  provides for a maximum  payment of $18,306 by the Company
per annum until 1998.  There have been no such rent  assessments  to date. As of
December 31, 1996,  current and long-term future possible  assessments  totaling
$36,610  were  included  in  "Current   liabilities  -  Other"  and   "Long-term
liabilities   Restructuring   obligation"   (see  Part  II  Item  7:   Financial
Statements).
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Item 3. Legal Proceedings

         On or about August 2, 1994,  Daniel R. Robusto,  a former  executive of
  the Company,  filed a suit in the Court of Common  Pleas of Allegheny  County,
  Pennsylvania,  pursuant  to  Pennsylvania  Wage  Payment and  Collection  Law,
  alleging breach by the Company of an employment  settlement  agreement and the
  nonpayment of severance wages of $107,307 plus liquidated  damages of $26,827,
  attorney fees and other court costs.  The Company has responded to the initial
  complaint and asserted  certain  counterclaims  against Mr. Robusto based upon
  his actions while in office. The litigation process is continuing.

         On December 8, 1994, a lawsuit was filed in the United States  District
  Court for the Northern  District of California by Trilogy  Development  Group,
  Inc.  ("Trilogy") against the Company. The subject matter of the case involves
  a  configuration  systems  patent  owned by the  Company  (Bennett et al. U.S.
  Patent  4,591,983) and a sales  configuration  product of Trilogy.  Trilogy is
  seeking a judgment against  Teknowledge that it does not infringe any claim of
  the Bennett et al.  patent,  and for actual and punitive  damages and attorney
  fees for alleged  unfair  competition  under the Lanham Act and common law for
  misrepresenting  Teknowledge  and  Trilogy's  products.  The Company has filed
  counterclaims   against  Trilogy  for  patent   infringement  and  for  unfair
  competition  under  the  Lanham  Act and  common  law for  alleged  false  and
  misleading statements disparaging the Bennett et al. patent.

         On August 27, 1996,  Teknowledge and Trilogy  Development  Group,  Inc.
  agreed to a  settlement  of their  disputes.  On August  29,  1996,  Trilogy's
  attorneys provided written notification to the Federal District Court that the
  companies had reached a settlement. Under the agreement, Trilogy would provide
  consideration to Teknowledge and Teknowledge  would grant a license to Trilogy
  to use the  technology  covered  by the  patent-in-suit.  The  agreement  also
  provided that all lawsuits between the parties would be dismissed and that all
  previously  existing  debt between the parties  would be  canceled.  The other
  details of the agreement are to be kept confidential by both parties.

         Nevertheless,  on August 30, 1996,  before formal  documentation of the
  settlement  agreement was finalized,  but after Trilogy's lawyers confirmed to
  the Court in writing that the case had been settled,  the U.S.  District Court
  entered an order granting  Trilogy's motion for summary judgment  invalidating
  the patent. In view of the Court's order,  Trilogy has taken the position that
  no settlement  yet exists and that it need not abide by the terms to which the
  parties agreed and represented to the Court.  The Company has informed Trilogy
  that the Company  intends to enforce the  settlement  agreement,  and believes
  that Trilogy has breached the settlement agreement.  Accordingly, on September
  20,  1996,  the Company  filed a motion to vacate the judgment in light of the
  prior settlement. The Company and Trilogy engaged in discussions regarding the
  settlement  agreement in light of the Court's judgment;  however,  there is no
  assurance that the parties will be able to resolve the issues without  further
  litigation,   that  the  Company's  motion  to  vacate  and  dismiss  will  be
  successful,  or that  the  Company  will be able  to  enforce  the  settlement
  agreement.

         On September 19, 1995,  Trilogy  filed a suit in the Delaware  Superior
  Court  alleging  breach of  contract by the Company in relation to $125,000 in
  deferred payments under a 1987 agreement between BMW Vision Associates Limited
  Partnership ("BMW") and American Cimflex Corporation ("ACC"), a predecessor to
  the Company.  The agreement  provided for the sale of technology by BMW to ACC
  for a consideration including certain deferred payments. In July 1995, Trilogy
  acquired by  assignment  for $276,786  BMW's right to the  remaining  deferred
  payments and then demanded payment of $525,000 from the Company.  In September
  1995, the Company paid Trilogy $400,000 in full  satisfaction of the $525,000,
  disclaiming  the  obligation to pay the balance of $125,000  which the Company
  believes to be barred by statute of  limitation.  Trilogy filed a suit seeking
  the $125,000,  subsequent  deferred  payments,  interest and attorney fees. On
  August 20, 1996,  the Court denied the  Company's  motion for partial  summary
  judgment on the choice of law issue,  deciding that California law, instead of
  Pennsylvania  law, should apply to the issue of accord and  satisfaction.  The
  Company  is  preparing  a  motion  for  summary  judgment  on its  statute  of
<PAGE>
                                   - Page 9 -


  limitations  defense.  However,  the final outcome of this  litigation  may be
  decided by the ultimate enforceability of the settlement agreement between the
  Company and Trilogy described in the preceding  paragraph,  which provides for
  the dismissal of this lawsuit and the settlement of the underlying claim.

         Management  of the Company  believes the above suits are without  merit
and  intends to defend  itself  vigorously.  Management  believes  the  ultimate
resolution of the above matters will not have an adverse  material impact on the
Company's financial position and 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 1996.


<PAGE>
                                  - Page 10 -


                                     PART II
--------------------------------------------------------------------------------

Item 5.  Market for Common Equity and Related Stockholder Matters

         The Common Stock of  Teknowledge is traded under the symbol TEKC on the
"Bulletin  Board," an  over-the-counter  ("OTC") listing service provided by the
National Quotation Bureau. The price of the stock is updated periodically when a
trade is made.  On March 25, 1997,  the listed  closing "bid" price of the stock
was $.51 a share.

          The  following  table  sets  forth  the  range  of  high  and  low bid
information  for the Common  Stock on the OTC Bulletin  Board for the  quarterly
periods indicated.  The bid information reflects  inter-dealer  prices,  without
retail   mark-up,   mark-down  or  commission  and  may  not  represent   actual
transactions. The Company has never paid dividends on its capital stock.

                  1996                      High             Low

First quarter, ended March 31, 1996       $ .55            $ .25
Second quarter, ended June 30, 1996         .86              .46
Third quarter, ended September 30, 1996     .86              .56
Fourth quarter, ended December 31, 1996     .72              .40


                  1995                      High             Low

First quarter, ended March 31, 1995        $ .25           $ .11
Second quarter, ended June 30, 1995          .35             .10
Third quarter, ended September 30, 1995      .72             .10
Fourth quarter, ended December 31, 1995      .38             .10

     As of December 31, 1996 there were 1,992  holders of record of Common Stock
of the Company.


<PAGE>
                                  - Page 11 -


Item 6.  Management's Discussion and Analysis or Plan of Operation

Overview of Significant Matters

         Forward looking  statements made in this section relating to recruiting
of additional employees, expected growth and revenues,  competition for expected
new government  contracts,  development and announcement of commercial products,
and expected legal  expenditures are made pursuant to the safe harbor provisions
of the Private  Securities  Litigation  Reform Act of 1995. All forward  looking
statements  involve  risks and  uncertainties,  and actual  results could differ
materially  from those set forth in the  forward  looking  statements  contained
herein as a result of  competition,  agency funding  limitations,  other factors
relating to government contracting,  ability to attract and retain technical and
management  personnel,  and other factors described in "Certain Factors That May
Affect Future Results of Operations and/or Stock Price."

                          Year Ended December 31, 1996
                            Quarterly Results Summary
                    (in thousands except for per share data)

                            First     Second      Third    Fourth     Total
Revenues                   $1,671     $1,662     $1,847    $1,979    $7,159
Costs and Expenses          1,554      1,551      1,705     1,882     6,692
Other and Tax Provision        55         42         47        61       205
Net Income                    172        153        189       158       672
Net Income per share          .01        .00        .01       .00       .02


         The Company's  revenues for the year ended  December 31, 1996 increased
to $7,158,763, a 29% improvement over 1995. Sales to Federal Government entities
contributed  98% of total revenues for the year.  Total revenues are expected to
increase  further due to the 76% increase in backlog of $18.5M  versus $10.5M as
of December 31, 1995. Of the $18.5M, $12.0M in new contracts were awarded to the
Company in late 1996 and are expected to  contribute  to an increase in revenues
by  mid-1997,  provided  the  Company is able to attract  and retain  additional
software engineers. The Company competes for software engineering  professionals
in a highly dynamic industry  against  companies which often have more resources
and a higher  visibility  than the  Company.  Recruiting  software  engineers in
Silicon Valley has become  particularly  difficult in recent years as demand has
outpaced supply. However, the Company has had moderate success in recruiting new
technical employees for its branch facilities, particularly in Washington, D.C.,
and management  believes future development of the technical staff may favor one
or more of the branch office locations.

Certain Factors That May Affect Future Results of Operations and/or Stock Price:

         The Company  recognizes  that the continued  success of the business is
dependent on key management and technical personnel,  the loss of one or more of
whom could  adversely  affect aspects of the Company's  business.  The hiring of
five senior program  managers in the past two years will mitigate this risk. The
Company  relies on its  executives  and program  managers for the attainment and
negotiation  of government  awards,  preparation  of proposals,  and the general
direction and  management of the Company.  The Company  believes that its future
success depends on attracting and retaining highly skilled  technical  personnel
and other employees.

         Management  believes  that  the  market  for  Internet  software  is  a
significant new opportunity for growing the Company rapidly. Further, management
believes  that  Teknowledge  is in an  excellent  position  to utilize  software
developed  under R&D contracts into new  commercial  products.  However,  if the
Internet  market fails to develop,  develops more slowly than expected,  becomes
saturated with competitors, or if the Company's products for the Internet market
<PAGE>
                                  - Page 12 -


do not achieve market acceptance,  the Company's business,  financial condition,
and results of operation may be materially and adversely affected.  There can be
no assurance that commerce over the Internet or the demand for associate systems
will grow as quickly as expected,  or that any products developed or marketed by
the Company will achieve  market  acceptance for these  purposes.  The Company's
products may be subject to price erosion and marketing  risks due to free client
software  distributed by on-line service  providers,  Internet access providers,
and others.  There can also be no assurance  that any products  developed by the
Company for such new markets,  even if accepted,  will generate any  significant
profits for the Company.

         The  Company's  operating  results are  affected  by a wide  variety of
factors,  including  successful  commercialization  of the  Company's  products,
competition  from  larger  companies,  ability to staff and  recruit  employees,
general economic conditions,  and the possibility of an unfavorable or favorable
outcome in pending litigation (see Part I Item 3. Legal Proceedings).


Results of Operations

         1996 compared to 1995

         Revenues  increased  $1,592,710,  or 29%,  to  $7,158,763  in 1996,  as
compared to a 63% growth in revenues in the  previous  year.  This  increase was
attributable  primarily  due  to  increased  service  revenues  from  additional
government  contracts awarded in 1996 and ongoing service revenues on previously
awarded  contracts.  The  Company  continues  to recruit  and employ  additional
technical  employees  to meet the needs of  awarded  contracts.  Future  revenue
growth  is  expected  in 1997 due to the  addition  of  several  new  government
contracts in the fourth quarter of 1996.

         Cost of revenues were  $4,541,823  and  $3,409,703 in 1996 and 1995, to
63% and 61% of revenues, respectively, primarily due to an increase in the costs
associated with the growth in the technical workforce which support both new and
existing projects.

         Combined  selling and  marketing  costs and general and  administrative
costs for 1996 were $2,150,659, or 30% of revenues, versus $1,930,239, or 35% of
revenues in 1995.  The decrease is primarily due to a reduction in  compensation
expenses of $120,000  associated  with the grant of options to executives  which
were fully vested in 1996, as well as overall cost control efforts.

         The Company recorded no charges for research and development ("R&D") in
either 1996 or 1995. Much of the Company's research and development  efforts are
funded through government  projects,  and the Company may transform results from
these efforts into Company-sponsored products at a later date.

         Interest  income  was  $57,612 in 1996  versus  $41,747  for 1995.  The
increase was primarily due to increased  cash  balances  during the year.  Other
income  decreased by $25,606 to $173,131 in 1996.  Other income in 1996 and 1995
primarily  resulted  from the cash  receipts  for the sale in 1990 of a  product
line. In 1996, the Company received the final payment and there will be no other
income from this sale in the future.

         Net income in 1996 was  $672,374  versus  $450,670 in 1995.  Income per
common share was $.02 for each year.

Inflation

         During the  foregoing  periods,  the  Company  did not  experience  any
significant effect from inflation.

Liquidity and Capital Resources

         As of December  31,  1996,  unused  sources of liquidity of the Company
were $1,797,892 in cash and cash  equivalents,  an increase of $835,168 over the
previous year.  Cash totaling  $1,148,976 was provided by operating  activities.

<PAGE>
                                  - Page 13 -


Cash was  reduced  by  $317,713  in  capital  expenditures,  which was  invested
primarily in the development of the Sales Associate system,  and the purchase of
computer  equipment and other  improvements for the new branch office located in
Washington D.C.

         The  Company   believes  that  the  present  level  of  cash  and  cash
equivalents  is adequate to service the liquidity  needs of the Company in 1997.
The Company  relies  principally  on the  collection of  receivables to generate
internal cash reserves.

         The  Company  has  an  unsecured   line  of  credit  from  a  financial
institution in the amount of $1,000,000.  The Company may borrow up to a maximum
of 60% of the  receivable  base or $1,000,000,  whichever is lower.  The line is
subject to  certain  covenants  and  maintenance  requirements,  which have been
fulfilled.  The line expires on May 10, 1997 but is expected to be renewed.  The
Company did not utilize the credit line in 1996.

Item 7.  Financial Statements

         The  response to this item is  incorporated  by reference in a separate
section of this report.  See Exhibits and Reports on Form 8-K, Item 13(a)(1) and
(2).

     Item 8. Changes in and  Disagreements  with  Accountants  on Accounting and
Financial Disclosure

         Not applicable.


                                    PART III


Item 9. Directors, Executive Officers, Promoters and Control Persons;Compliance
With Section 15(a) of the Exchange Act
-------------------------------------------------------------------------------

         The  information  required by Item 9 regarding  directors and executive
officers of the Company is  incorporated  herein by  reference  to the  sections
entitled  "Election of Directors" and  "Executive  Compensation - Employment and
Consulting  Agreements"  included  in the  definitive  proxy  statement  for the
Company's  1997 Annual Meeting of  Stockholders  (the "1997 Annual Meeting Proxy
Statement").

Item 10. Executive Compensation

         The information required by Item 10 is incorporated herein by reference
to the section  entitled  "Executive  Compensation"  included in the 1997 Annual
Meeting Proxy Statement.

Item 11. Security Ownership of Certain Beneficial Owners and Management

         The information required by Item 11 is incorporated herein by reference
to the section entitled "Security Ownership" included in the 1997 Annual Meeting
Proxy Statement.

Item 12. Certain Relationships and Related Transactions

         The information required by Item 12 is incorporated herein by reference
to the sections  entitled  "Election of Directors" and "Executive  Compensation"
included in the 1997 Annual Meeting Proxy Statement.

Item 13. Exhibits and Reports on Form 8-K

(a)(1) and (2):  Financial Statements and Financial Statement Schedules.

         Reference is made to the Index to Financial  Statements  preceding  the
consolidated  financial  statements  included  in response to Part II, Item 7 of
this annual report for a list of all financial statements filed.

(a)(3):  Exhibits
<PAGE>
                                  - Page 14 -


         Set  forth  below  is  a  list  of  all  exhibits   filed  herewith  or
incorporated by reference as part of this Annual Report on Form 10-KSB.

Exhibit No.        Description

           3.1 Amended and Restated Certificate of Incorporation of Teknowledge
               Corporation (6)

           3.2 Amended and Restated Bylaws of Teknowledge Corporation (8)

           3.3 Certificate of Designation, Preferences and Rights of the Terms
               of the Series A Preferred Stock (8)

           4.1 Rights Agreement dated January 29, 1996 between the Company and
               Registrar and Transfer Company as Rights Agent (8)

Exhibit No.    Description

          10.1 Cimflex Teknowledge Corporation 1989 Stock Option Plan

          10.2 Development Agreement Amendment, dated December 22, 1987, between
               American Cimflex Corporation and Ford Motor Company (1)

          10.3 License  Agreement,  dated  February 11, 1987,  between  American
               Cimflex Corporation and BMW Technologies, Inc. (1)

          10.4 Technology Sale and Stock Purchase Agreement,  dated February 11,
               1987,  between  American  Cimflex   Corporation  and  BMW  Vision
               Associates Limited Partnership (1)

          10.5 Stock  Option  Agreement,  effective  as of  September  1,  1988,
               between American Cimflex Corporation and Romesh T. Wadhwani (1)

          10.6 Amendment to Stock  Option  Agreement,  dated  November 30, 1988,
               between American Cimflex Corporation and Romesh T. Wadhwani (1)

          10.7 Lease,   dated  March  30,  1989,   between  American   Automated
               Factories, Inc. and Third Copley-Franklin Trust (2)

          10.8 Purchase and Sales Agreement,  dated September 13, 1990,  between
               Cimflex  Teknowledge  Corporation,  PaineWebber R&D Partners L.P.
               and Applied Diagnostics, Inc. (3)

          10.9 Employment  Agreement,  dated as of December  13,  1990,  between
               Cimflex Teknowledge Corporation and Daniel R. Robusto (3)

          10.10Asset  Purchase  Agreement,  dated  December  14,  1990,  between
               American Automated Factories,  Inc. and Control Automation,  Inc.
               (3)

          10.11Lease, dated  June  10,  1991,   between  Cimflex   Teknowledge
               Corporation and Pittsburgh Great Southern Company (3)

          10.12Amended  Employment  Agreement,  dated as of  January  21,  1992,
               between Cimflex Teknowledge Corporation and Daniel R. Robusto (3)

          10.13Settlement  Agreement,  General  Release,  and  Waiver of Claims,
               dated  November 21, 1992,  between  Daniel R. Robusto and Cimflex
               Teknowledge Corporation (4)

          10.14Settlement  Agreement,   dated  May  21,  1993,  between  Cimflex
               Teknowledge Corporation and Third Copley-Franklin Trust (5)

          10.15Settlement  Agreement,  dated September 1, 1993,  between Cimflex
               Teknowledge Corporation and Pittsburgh Great Southern Company (5)
<PAGE>
                                  - Page 15 -


          10.16Settlement  Agreement,  dated December 15, 1993,  between Cimflex
               Teknowledge   Corporation   and   Heitman   Michigan   Trustee  I
               Corporation (5)

Exhibit No.    Description
----------     -----------

          10.17Change of Control  Agreement,  dated  November 21, 1994,  between
               Teknowledge   Corporation  and  Frederick   Hayes-Roth  and  Neil
               Jacobstein (7) 27 Financial Data Schedule

          23.1 Consent of Arthur Andersen LLP, independent public accountants

          27   Financial Data Schedule

References

          (1)  Filed as an Exhibit to the  Company's  Annual Report on Form 10-K
               for the fiscal year ended December 31, 1989.

          (2)  Filed as an Exhibit to the  Company's  Annual Report on Form 10-K
               for the fiscal year ended December 31, 1990.

          (3)  Filed as an Exhibit to the  Company's  Annual Report on Form 10-K
               for the fiscal year ended December 31, 1991.

          (4)  Filed as an Exhibit to the  Company's  Annual Report on Form 10-K
               for the fiscal year ended December 31, 1992.

          (5)  Filed  as an  Exhibit  to the  Company's  Annual  Report  on Form
               10-KSB, as amended, for the fiscal year ended December 31, 1993.

          (6)  Filed as an Exhibit  to the  Company's  Quarterly  Report on Form
               10-QSB for the quarter ended June 30, 1994.

          (7)  Filed  as an  Exhibit  to the  Company's  Annual  Report  on Form
               10-KSB, for the fiscal year ended December 31, 1994.

          (8)  Filed as an Exhibit to the Company's  Current  Report on Form 8-K
               dated  February  12,  1996,  related to the  adoption  of a 12(g)
               Shareholder Rights Agreement dated January 29, 1996.

(b)      Reports on Form 8-K

         None.

(c)      Exhibits

         Reference is made to the response to Item 13(a)(3)  above for a list of
all exhibits filed herewith or  incorporated by reference as part of this Annual
Report on Form 10-KSB.  Reference is also made to the Exhibit Index forming part
of this Annual Report on Form 10-KSB.

(d)      Financial Statement Schedules

         Reference is made to the  response to Item  13(a)(1) and (2) above with
regard to the financial  statement schedules filed as part of this Annual Report
on Form 10-KSB.

         For  the  purposes  of  complying  with  the  amendments  to the  rules
governing Form S-8  (effective  July 13, 1990) under the Securities Act of 1933,
the undersigned registrant hereby undertakes as follows, which undertaking shall
be incorporated by reference into registrant's  Registration  Statements on Form
S-8 Nos. 33-27291, 33-77874, 33-78984, 33-82720, and 333-00261.

         Insofar as indemnification for liabilities arising under the Securities
Act of 1933 may be permitted to directors,  officers and controlling  persons of
the  registrant  pursuant  to  the  foregoing  provisions,   or  otherwise,  the
registrant  has been advised that in the opinion of the  Securities and Exchange
<PAGE>
                                  - Page 16 -


Commission  such  indemnification  is against  public policy as expressed in the
Securities  Act of 1933 and is,  therefore,  unenforceable.  In the event that a
claim for  indemnification  against such liabilities  (other than the payment by
the  registrant  of  expenses  incurred  or  paid  by  a  director,  officer  or
controlling  person of the registrant in the  successful  defense of any action,
suit or proceeding) is asserted by such director,  officer or controlling person
in connection with the securities being registered,  the registrant will, unless
in the  opinion  of its  counsel  the matter  has been  settled  by  controlling
precedent,  submit to a court of appropriate  jurisdiction  the question whether
such  indemnification by it is against public policy as expressed in the Act and
will be governed by the final adjudication of such issue.

<PAGE>
                                  - Page 17 -



                                   SIGNATURES

         In  accordance  with 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.

                                                 Teknowledge Corporation


Date:  March 27, 1997                   By:      /s/ Frederick Hayes-Roth
                                                ------------------------
                                                  Frederick Hayes-Roth
                                                  Chairman  of  the
                                                  Board of Directors

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

              Name                       Capacity             Date

/s/ Frederick Hayes-Roth            Chairman of the Board     March 27, 1997
---------------------------
Frederick Hayes-Roth                of Directors and
                                    Chief Executive Officer
                                    (Principal Executive
                                    Officer)

/s/ Neil A. Jacobstein              President, Chief          March 28, 1997
--------------------------
Neil A. Jacobstein                  Operating Officer and
                                    Director

/s/ Dennis A. Bugbee                Director of Finance,      March 28, 1997
--------------------------
Dennis A. Bugbee                    Treasurer and Secretary
                                    (Principal Financial and
                                    Accounting Officer)

/s/ General Robert T. Marsh
---------------------------         Director                  March 28, 1997
General Robert T. Marsh

/s/ William G. Roth                 Director                  March 28, 1997
---------------------------
William G. Roth

/s/ James C. Workman                Director                  March 28, 1997
---------------------------
James C. Workman


<PAGE>
                                  - Page 18 -



                          ANNUAL REPORT ON FORM 10-KSB

                   ITEM 7, ITEM 13(a)(1) and (2), (c) and (d)

                          LIST OF FINANCIAL STATEMENTS

                                CERTAIN EXHIBITS

                              FINANCIAL STATEMENTS

     AS OF DECEMBER 31, 1996 AND FOR THE TWO YEARS ENDED DECEMBER 31, 1996

                            TEKNOWLEDGE CORPORATION

                             PALO ALTO, CALIFORNIA



<PAGE>
                                  - Page 19 -




                            TEKNOWLEDGE CORPORATION

                      FORM 10-KSB - ITEM 13(a)(1) and (2)

                   LIST OF CONSOLIDATED FINANCIAL STATEMENTS



The following consolidated  financial statements of Teknowledge Corporation are
included in Item 7:

Page

Report of Independent Public Accountants                         20

Consolidated Balance Sheet - December 31, 1996                   21 - 22

Consolidated Statements of Operations - Years ended
December 31, 1996 and 1995                                       23

Consolidated Statements of Stockholders' Equity - Years ended
December 31, 1996 and 1995                                       24

Consolidated Statements of Cash Flows - Years ended
December 31, 1996 and 1995                                       25

Notes to Consolidated Financial Statements                       26 - 33





<PAGE>
                                   - Page 20 -

                    Report Of Independent Public Accountants



To Teknowledge Corporation:


We have  audited the  accompanying  consolidated  balance  sheet of  Teknowledge
Corporation (a Delaware Corporation) and subsidiary as of December 31, 1996, and
the related consolidated statements of operations, stockholders' equity and cash
flows for the years ended December 31, 1996 and 1995. These financial statements
are the  responsibility of the Company's  management.  Our  responsibility is to
express an opinion on these financial statements based on our audit.

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 financial  statements  referred to above present fairly, in
all material  respects,  the financial  position of Teknowledge  Corporation and
subsidiary  as of December 31,  1996,  and the results of their  operations  and
their cash flows for the years ended  December  31, 1996 and 1995 in  conformity
with generally accepted accounting principles.







San Jose, California
February 11, 1997

<PAGE>
                                   - Page 21 -

                             TEKNOWLEDGE CORPORATION
                           CONSOLIDATED BALANCE SHEET
                             As of December 31, 1996


                                     ASSETS



Current assets:
     Cash and cash equivalents                            $        1,797,892
                                                           -----------------
     Receivables
         Customer - billed, net of allowance of $10,000            1,198,488
         Customer - unbilled                                          80,695
         Others                                                       10,220
                                                           -----------------

             Total receivables                                     1,289,403

     Deposits and prepaid expenses                                    61,452
                                                           -----------------

         Total current assets                                      3,148,747

Capitalized software, net of accumulated
     amortization of $675,209                                        126,001

Equipment and improvements, at cost
     Computer and other equipment                                  2,429,888
     Leasehold improvements                                          766,545
                                                           -----------------
                                                                   3,196,433
     Less accumulated depreciation and amortization               (2,877,020)
                                                           -----------------
     Net equipment and improvements                                  319,413
                                                           -----------------
Total assets                                              $        3,594,161
                                                           =================


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



<PAGE>
                                   - Page 22 -

                             TEKNOWLEDGE CORPORATION
                       CONSOLIDATED BALANCE SHEET (CONT'D)
                             As of December 31, 1996

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable                                            $          209,762
     Accrued liabilities                                               693,882
     Other                                                             423,510
                                                             -----------------
     Total current liabilities                                       1,327,154
                                                             -----------------

Long-term liabilities:
     Provision for discontinued operations                              54,432
     Restructuring obligation                                           18,305
                                                             -----------------

     Total long-term liabilities                                        72,737
                                                             -----------------

         Total liabilities                                           1,399,891
                                                             -----------------

Commitments and contingencies (Notes 4 and 11)

Stockholders' equity:
     Preferred stock, $.01 par value, authorized 2,500,000
         shares, Series A convertible, none issued                         -
     Common stock, $.01 par value, authorized 50,000,000
         shares, issued 26,096,770                                    260,963
     Additional paid-in capital (after (i) reduction of
     $57,962,379 for elimination of accumulated deficit
     at December 31, 1992 as a result of quasi-reorganization;
     and (ii) increase of $18,306, $18,306, $105,706 and $1,001,310
     in 1996, 1995, 1994 and 1993, respectively as a result
     of reversals of portions of 1992 loss provisions)              1,992,798

     Accumulated deficit since January 1, 1993
         (following quasi-reorganization)                             (56,491)
                                                            -----------------
                                                                    2,197,270
     Treasury stock, at cost, 24,000 shares                            (3,000)
                                                            -----------------
         Total stockholders' equity                                 2,194,270
                                                           ------------------
Total liabilities and stockholders' equity                 $        3,594,161
                                                           ==================

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


<PAGE>
                                   - Page 23 -

                             TEKNOWLEDGE CORPORATION
                      CONSOLIDATED STATEMENTS OF OPERATIONS



                                                 Years ended December 31,
                                                1996                 1995

Revenues                          $        7,158,763   $        5,566,053
                                   -----------------    -----------------

Costs and expenses:
     Cost of revenues                      4,541,823            3,409,703
     Selling and marketing                    95,961               53,049
     General and administrative            2,054,698            1,877,190
                                   -----------------    -----------------

         Total costs and expenses          6,692,482            5,339,942
                                   -----------------    -----------------

         Operating income                    466,281              226,111

Interest income                               57,612               41,747
Other income, net                            173,131              198,737
                                   -----------------    -----------------

Income before tax                            697,024              466,595
Provision for income tax                      24,650               15,925
                                   -----------------    -----------------

Net income                        $          672,374   $          450,670
                                   =================    =================


Net income per share              $             0.02   $             0.02
                                   =================    =================

Weighted average common and common
     equivalent shares outstanding        30,275,473           29,901,487
                                   =================    =================



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

<PAGE>
                                   - Page 24 -
<TABLE>
                             TEKNOWLEDGE CORPORATION
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<CAPTION>
                                   Common Stock           Additional
                             Shares            Par         Paid-in         Deferred     Accumulated        Treasury
                             Issued            Value       Capital         Compensation Deficit            Stock         Total
                            ------            -----        -------         -----------  -------            -------       -------
<S>                         <C>              <C>          <C>              <C>         <C>                 <C>           <C>
Balance,
     January 1, 1995        25,716,871       $ 257,164    $ 1,947,397      $ (360,518) $(1,179,535)        $(3,000)      $  661,508

Exercise of
    stock options              206,803           2,068          3,016               -            -               -            5,084

Net income                          -                -              -               -      450,670               -          450,670

Stock compensation expense          -                -              -         240,345            -               -          240,345

Reversal of portions of
provisions made prior to
quasi- reorganization for:

       Restructuring
          reserve                   -                -           18,306             -           -                -           18,306

                            ----------       ---------      -----------     ----------   ----------        -------      -----------
Balance,
    December 31, 1995       25,923,674       $  259,232     $ 1,968,719    $ (120,173)  $ (728,865)        $(3,000)     $ 1,375,913

Exercise of
    stock options              173,096            1,731           5,773             -            -               -            7,504

Net income                           -                -               -             -      672,374               -          672,374

Stock compensation expense           -                -               -       120,173            -               -          120,173

Reversal of portions of provisions
made prior to quasi- reorganization for:
       Restructuring
          reserve                    -                -          18,306             -            -               -           18,306

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

Balance,
    December 31, 1996       26,096,770          260,963     $ 1,992,798    $        -    $ (56,491)  $      (3,000)    $  2,194,270
                            ==========       ==========     ===========    ===========   =========   =============     ============

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


<PAGE>
                                   - Page 25 -

                             TEKNOWLEDGE CORPORATION
                      CONSOLIDATED STATEMENTS OF CASH FLOWS


                                                Years ended December 31,
                                                   1996              1995

Cash flows from operating activities:
    Net income                        $          672,374  $        450,670
    Adjustments to reconcile net
    income to net cash provided by operating
    activities:
      Depreciation and amortization              296,590           459,021
      Stock compensation expense                 120,173           240,346
      Gain on sale of equipment                     (100)           (4,559)
      Changes in assets and liabilities:
         Receivables                              65,975          (423,261)
         Deposits and prepaid expenses            (4,748)            2,067
         Accounts payable                         28,255           (14,197)
         Accrued liabilities                     (29,543)         (285,025)
                                         -----------------   ----------------

    Net cash provided by operating activities  1,148,976           425,062
                                         -----------------   ----------------

Cash flows from investing activities:
    Capitalization of software costs             (59,485)          (103,676)
    Purchase of equipment and improvements      (258,328)          (165,460)
    Proceeds from sale of equipment                  100              4,559
                                         -----------------   ----------------

    Net cash used for investing activities      (317,713)          (264,577)
                                         -----------------   ----------------

Cash flows from financing activities:
    Proceeds from issuance of common stock         7,504              5,084
    Payments of capital lease obligations         (3,599)           (12,014)
                                         -----------------   ----------------

    Net cash provided by (used for)
     financing activities                          3,905            (6,930)
                                         -----------------   ----------------

Net increase in cash and cash equivalents        835,168            153,555

Cash and cash equivalents at beginning of year   962,724            809,169
                                         -----------------   ----------------

Cash and cash equivalents at end
of year                               $        1,797,892  $         962,724
                                         =================   ================

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



<PAGE>
                                   - Page 26 -

                             TEKNOWLEDGE CORPORATION
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1996


1.       History and Business

                  Teknowledge  Corporation  (the  "Company")  is  the  surviving
         corporation of the merger of American Cimflex  Corporation  ("Cimflex")
         and Teknowledge  Inc.,  which was  consummated in 1989.  Prior to 1993,
         Cimflex restructured and divested a significant part of its operations.
         Reserves for discontinued operations and restructuring obligations were
         established for those events.  In December 1992, the Board of Directors
         approved a  quasi-reorganization,  which had the effect of  eliminating
         the  accumulated  deficit at  December  31, 1992 of  approximately  $58
         million  by  reducing   paid-in-capital.   Adjustments   to  previously
         established  reserves and realization of tax benefits subsequent to the
         quasi-reorganization  will be recorded  as  adjustments  to  additional
         paid-in-capital  in the future. As of December 31, 1996, there remained
         approximately   $125,000  of  accrued   liabilities  for   discontinued
         operations  and  restructuring  obligations,  which are scheduled to be
         paid over the next two years.

                  The  Company  is  in  the  distributed   knowledge  processing
         business.  Teknowledge is leveraging its core competencies in knowledge
         based  systems and large scale,  distributed  object-oriented  software
         with the  expanding  opportunities  presented  by the  Internet and the
         World Wide Web. The Company provides  software  products and consulting
         services for commercial and government applications.  The Company's key
         business  lines are:  Sales  Associate  Product,  Education  & Training
         Technologies,  Command & Control, Situation Assessment and Data Fusion,
         and Distributed  Systems  Engineering.  The Company was incorporated on
         July 8, 1981 under the laws of the State of Delaware.

                  The  Company  recognizes  that the  continued  success  of the
         business is dependent on key  management and technical  personnel,  the
         loss of one or  more  of whom  could  adversely  affect  the  Company's
         business. The Company is also subject to risks inherent in companies at
         a   similar   stage   of   development,    including   the   successful
         commercialization  of the Company's  products,  competition from larger
         companies  with  financial  resources  greater  than the  Company,  the
         ability to retain and attract  employees,  capital and financing needs,
         and the  possibility  of an  unfavorable  resolution of the  litigation
         matters discussed in Note 11.

2.       Summary of Significant Accounting Policies

         Use of Estimates in the Preparation of Financial Statements

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

         Consolidated Financial Statements

                  The consolidated  financial statements include the accounts of
         Teknowledge  Corporation and its wholly owned  subsidiary,  Teknowledge
         Federal  Systems,  Inc. All significant  intercompany  transactions and
         balances have been eliminated.

                  For certain income statement amounts, prior year balances have
         been reclassified to conform to the current year presentation.
<PAGE>
                                  - Page 27 -


         Cash and Cash Equivalents

                  The Company  considers  all highly  liquid  investments,  with
         original maturity dates of less than 90 days, as cash  equivalents.  As
         of December 31, 1996, the Company's funds were invested almost entirely
         in money market instruments at various institutions.

         Unbilled Receivables

                  Unbilled  receivables  represent  differences between billings
         and revenues  recognized on cost-type  contracts.  The unbilled amounts
         primarily represent (i) amounts which are recognized as revenue but not
         billed pending receipt of the next funding  authorization,  (ii) timing
         differences between incurred costs and billed costs, or (iii) a portion
         of the  earned  fee  held  back as  retention  until  the  contract  is
         completed and the final indirect overhead rates have been determined. A
         substantial portion of the retained fee may be billed to the government
         after  the  final  indirect  rates  are  submitted  to the  government;
         however,  they are subject to future review and approval by the Defense
         Contract  Audit Agency.  The Company has received  final  overhead rate
         approval for costs incurred through December 31, 1993.

         Concentration of Credit Risk

                  The  Company  performs  periodic  credit  evaluations  of  the
         financial  condition of commercial  customers  and  generally  does not
         require  collateral.  Historically,  the Company has  experienced  only
         minimal  write-offs  from commercial  receivables.  The Company has not
         experienced  a  credit  loss  from a  government  customer  nor does it
         anticipate such losses.

         Capitalized Software

                  Teknowledge  capitalizes  software  development costs from the
         point  technological  feasibility  is  determined  through  the general
         availability of the product. During 1996 and 1995, software development
         costs  of  $59,485  and  $103,676   were   capitalized,   respectively.
         Amortization costs were $114,458 in 1996 and $330,510 in 1995.

                  The Company's policy is to amortize capitalized software costs
         by the  greater  of (a) the ratio that  current  gross  revenues  for a
         product  bear to the total of  current  and  anticipated  future  gross
         revenues for that  product,  or (b) the  straight-line  method over the
         remaining  estimated  economic life of the product including the period
         being  reported on. It is reasonably  possible that those  estimates of
         anticipated  future gross revenues,  the remaining  estimated  economic
         life of the product, or both will be reduced  significantly in the near
         term due to competitive pressures.  As a result, the carrying amount of
         the  capitalized  software costs may be reduced  materially in the near
         term.

         Equipment and Improvements

                  Equipment and improvements, which include assets under capital
         leases,  are  depreciated  using the  straight-line  method  over their
         estimated  useful lives  ranging from three to five years.  Maintenance
         and repairs are charged to expense as incurred.  Leasehold improvements
         are  amortized  over the  shorter of the useful  life or the  remaining
         lease term.

         Revenue Recognition

         (a)      Government Contracts

                  The  Company's  revenues  are  primarily  generated  from U.S.
         Government  contracts  where  the  Company  may  be  either  the  prime
         contractor  or  a  subcontractor.  The  Company  principally  uses  the
         percentage-of-completion  method of accounting  for contract  revenues.
         The percentage-of-completion method is based on total costs incurred to
         date compared with estimated  total costs upon completion of contracts.
         The Company charges all losses on contracts to operations in the period
         when the loss is known.
<PAGE>
                                  - Page 28 -


                  In 1996,  approximately  98% of the  Company's  revenues  were
         recorded  in  connection  with  cost-type  U.S.  Government  contracts,
         principally  cost-plus-fixed-fee.  These  contracts  are  predominantly
         funded  by  the  Defense   Advanced   Research   Projects   Agency  and
         administered  by  various  government   agencies.   In  1995  cost-type
         government contracts represented approximately 95% of the revenues.

         For the year ended December 31, 1996, the Naval Command,  Control and
         Ocean Surveillance  Center was the sponsor of the Company's  three
         largest  government contracts,  accounting for approximately  85% of
         total revenues.  They were also the  sponsor  of the  Company's  thre
         largest  government  contracts  in 1995,accounting for approximately
         74% of the Company's revenues in that year.

         (b)      Commercial Contracts

                  Revenues  earned under software  license  agreements  with end
         users are generally  recognized  when the software has been shipped and
         there  are  no   significant   obligations   remaining.   Revenue  from
         post-contract  customer  support is recognized  ratably over the period
         the customer  support  services  are  provided  and  software  services
         revenue is recognized as services are performed.

                  Revenues from professional services provided principally under
         technology  contracts are recognized  when costs for time and materials
         are incurred.


         Net Income Per Share

                  The number of shares of common  stock used in the  computation
         of per share earnings for the years ended December 31, 1996 and 1995 is
         the  weighted  average  number of common and common  shares  equivalent
         outstanding during the applicable  periods.  Common stock options which
         are common stock equivalents are included in 1996 and 1995 because they
         are dilutive. The difference between primary and fully diluted earnings
         per share is immaterial,  therefore only primary  earnings per share is
         presented in the financial statements.

         SFAS 123 Accounting for Stock-Based Compensation


                  Effective  January 1, 1996, the Company adopted the disclosure
         provisions  of Financial  Accounting  Standards  No. 123 ("SFAS  123"),
         "Accounting for Stock-Based  Compensation." The adoption did not have a
         significant  effect  on the  Company's  results  of  operations  as the
         Company  continues  to apply the  principles  of APB Opinion No 125 and
         related  interpretations  in accounting for the Company's  stock plans.
         Note 9 to the Consolidated  Financial  Statements contains a summary of
         the pro forma effects on reported net income and earnings per share for
         1996 and 1995 based on the fair value of the  options  granted at grant
         date as prescribed by SFAS 123.


3.       Accrued Liabilities

                  Accrued  liabilities  as of December  31, 1996  consist of the
         following:

                     Payroll and bonuses                               $516,941
                     Provision for contract charges                     142,567
                     Provision for discontinued operations               34,374
                                                                       --------
                                                                       $693,882
                                                                       ========

<PAGE>
                                  - Page 29 -


4.       Commitments

                  Teknowledge  leases its facilities and certain equipment under
         operating  leases.  As of  December  31,  1996,  only the Palo Alto and
         Washington,  D.C.  locations had active facility leases.  The remaining
         obligations under these leases are as follows:

                                                Year Ending
                                                December 31,
                                                ------------
                            1997                $  282,000
                            1998                   292,000
                            1999                   130,000
                            2000                    74,000
                            2001 & After            37,000
                                                  --------
                                                  $815,000
                                                  ========

         Net rental expense for the years ended December 31, 1996 and 1995
         totaled $326,720 and $279,844, respectively.


5.       Line of Credit

                  The  Company  has  a  $1,000,000   unsecured  line  of  credit
         agreement  with a bank.  The line  expires  on May 10,  1997 and can be
         extended  from year to year.  The  Company  can borrow up to 60% of the
         eligible  receivables  base or  $1,000,000,  whichever  is  lower.  The
         maximum  rate that may be charged is prime plus  1.25%.  The  agreement
         includes certain financial  reporting and disclosure  requirements that
         were met during the year.  The line was not utilized in 1996 but may be
         utilized in the future.

6.       Tax Loss Carryforwards

                  The  Company  accounts  for income  taxes in  accordance  with
         Statement  of  Financial  Accounting  Standards  No. 109 ("SFAS  109"),
         "Accounting  for  Income  Taxes."  SFAS 109 is an asset  and  liability
         approach for computing  deferred income taxes based on enacted tax laws
         and rates applicable to the period in which the taxes become payable.

                  The provision for income taxes differs from the statutory U.S.
         Federal income tax rate due to the following:
                                                             1996        1995
                                                           ------       -----
         Provision at U.S. statutory rate                    34.0%       34.0%
         State income taxes, net of Federal benefit           6.1         6.1
         Permanent differences                                7.0        20.6
         Deferred tax assets and use of loss carryforwards  (43.6)      (57.3)
                                                           ------       -----
         Provision for income taxes                           3.5%        3.4%
                                                           ======       =====

                  At December  31,  1996,  the Company  had net  operating  loss
         carryforwards of approximately  $85 million  available to offset future
         Federal taxable  income.  These loss  carryforwards  expire through the
         year 2009. The availability and timing of the amount of prior losses to
         be used to offset  taxable income in future years may be limited due to
         various  provisions,  including any change in ownership interest of the
         Company resulting from significant stock transactions.

                  The  components  of the net  deferred  income  tax asset as of
         December 31, 1996 was as follows:

         Net operating loss carryforwards              $29,100,000
         Cumulative temporary differences                  451,000
         Tax credit carryforwards                        1,758,000
                                                        31,309,000
         Valuation allowance                           (31,309,000)
                                                       -----------
         Net deferred income tax asset                 $        -
                                                       ===========
<PAGE>
                                  - Page 30 -


                  The valuation  allowance  consisted of net  operating  losses,
         cumulative temporary differences and tax credit carryforwards which may
         expire  before  they  can be  used.  The  Company  believes  sufficient
         uncertainty  exists  regarding the  realizability  of these items,  and
         accordingly, a valuation allowance has been established.

7.       401(k) Plan

                  Teknowledge  has a 401(k) plan  covering all of the  Company's
         regular employees.  Participants in the plan may make a contribution as
         a percentage of their gross wages subject to the applicable  government
         limits.  Effective  January 1, 1996, the Board of Directors amended the
         Plan to include a matching  provision  whereby the Company  would match
         dollar-for-dollar  up to 3 percent of employee gross wages. During 1996
         the Company contributed $80,629 to the plan.

8.       Executive Compensation Plan

                  The Chief  Executive  Officer and the President of the Company
         each  have an  employment  agreement  that  provides  for  annual  base
         salaries  and an  incentive  compensation  plan with target  objectives
         established  in the five strategic  areas of cash flow,  profitability,
         bookings,  new commercial lines, and recruiting,  which were determined
         and assessed by the Board of  Directors to a maximum  payout of 100% of
         base  salary.   As  of  December   31,  1996,   $168,098  in  incentive
         compensation  was  accrued  for these  executives  and was  included in
         accrued liabilities.

9.       Stock-Based Compensation Plans

                  The Company has a stock option plan for  employees  called the
         Teknowledge  Corporation 1989 Stock Option Plan (the "1989 Plan").  The
         Company accounts for this plan under APB Opinion No. 25, under which no
         compensation cost has been recognized.

                  Had compensation cost for this plan been determined consistent
         with SFAS 123, the Company's net income and earnings per share would
         have been reduced to the following pro forma amounts:

                                                1996                     1995
         Net Income   As Reported           $672,374                 $450,670
                      Pro Forma             $575,043                 $437,541

         Primary EPS  As Reported               $.02                     $.02
                      Pro Forma                 $.02                     $.01


                  Because the SFAS 123 method of  accounting  has not been
         applied to options  granted prior to January 1, 1995, the resulting pro
         forma  compensation  cost  may  not be  representative  of  that  to be
         expected in future years.


                  The Company  may grant  options  for up to  10,250,000  shares
         under the 1989 Plan. The Company has granted  options on 459,022 shares
         ($.25 - $.86 per share) and 521,000  shares ($.19 - .$.50 per share) in
         1996 and 1995,  respectively,  and has reserved for issuance a total of
         6,046,828  shares through December 31, 1996. The Board of Directors has
         granted  options to employees that are either  incentive  stock options
         ("ISO") or non-statutory  stock options ("NSO").  For ISO, the exercise
         price of the common stock  options  granted under the 1989 Plan may not
         be less than the fair market  price on the date of grant.  For NSO, the
         exercise price of the common stock may not be less than 85% of the fair
         market  price of the common  stock on the date of grant.  Options  that
         have been granted normally vest in quarterly  increments over a term of
         two to three years and expire ten years after the grant date.
<PAGE>
                                  - Page 31 -


<TABLE>
                  A summary of the status of the  Company's  fixed stock  option
         plan as of  December  31, 1996 and 1995,  and changes  during the years
         ending is presented below:
<CAPTION>
                                                                   1996                             1995
                                                      ----------------------------      --------------------------
                                                             Shares      Wtd Avg              Shares     Wtd Avg
                                                                         Ex Price                         Ex Price
                                                       ---------------- -----------     ---------------- -----------
           <S>                                         <C>              <C>             <C>              <C>
           Outstanding at beg. of year                      5,880,902       .30              5,719,872       .29
           Granted                                            459,022       .55                521,000       .32
           Exercised                                         (173,096)      .04               (206,803)      .02
           Forfeited                                         (120,000)      .17               (131,229)      .29
           Expired                                                  -                          (21,938)     1.15
                                                       ---------------                  --------------
           Outstanding at end of year                       6,046,828       .32              5,880,902       .30
                                                       ---------------                  ---------------


           Exercisable at end of year                       5,520,453       .31              4,336,087       .36

           Weighted average fair value
            of options granted                                  $0.39                            $0.22


</TABLE>

                 The following table summarizes  information  about fixed stock
           options outstanding at December 31, 1996:
<TABLE>
<CAPTION>
                                             Options Outstanding              Options Exercisable
                                       -------------------------------      ------------------------
                                     Number      Wtd Avg    Wtd Avg. Ex        Number      Wtd Avg
           Range of Ex Prices     Outstanding    Remaining    Price        Excercisable at Ex Price
                 ($'s)              12/31/96     Plan life    ($'s)            12/31/96     ($'s)
                                       #          (years)                         #
           ------------------- --------------    ---------  ----------    ---------------- -----------
           <S>                 <C>               <C>        <C>           <C>              <C>
                   .01 -  .03       4,236,952      7.5        $.03             4,205,702   $ .03
                   .13 -  .86       1,017,397      8.6         .40               522,272     .32
                  1.00 - 3.53         792,479      1.8        1.80               792,479    1.80
                                -------------                              -------------
                   .01 - 3.53       6,046,828      6.9         .32             5,520,453     .31
                                -------------                              -------------
</TABLE>

                  The fair value of each option  grant is  estimated on the date
         of  grant  using  the  Black-Scholes  option  pricing  model  with  the
         following  weighted-average  assumptions  used for  grants  in 1996 and
         1995, respectively; risk-free interest rates of 6.1 and 6.2  percent;
         expected lives of 3.4 and 3.8 years; expected  volatility of 100% for
         each year; and an expected dividend yield of 0%.

                  The  Company  has  a  stock   option  plan  for   non-employee
         directors. The aggregate number of shares which may be issued under the
         plan may not exceed 250,000 shares of Common Stock. 120,000 shares were
         available  for future grant as of December  31, 1996.  Under this plan,
         non-employee  directors are entitled to receive annual option grants to
         purchase 15,000 shares of Common Stock on their initial election to the
         Board and thereafter on the  anniversary  date of their election to the
         Board. Options, which are granted at fair market value, are exercisable
         one year  after the grant  date and  expire  ten years  after the grant
         date. Options to purchase a total of 130,000 shares were outstanding as
         of December  31, 1996 at $.15 to $.86 per share and a weighted  average
         of $.49 per share.  Options for 85,000 shares at $.15 to $.66 per share
         and a weighted  average of $.35 per share were vested at  December  31,
         1996. No options have been exercised.

                  As of December 31,  1996,  the  following  number of shares of
         Common Stock have been reserved for future issuance under both Plans:

         Teknowledge Corporation 1989 Stock Option Plan             6,769,201
         Stock Option Plan for Non-Employee Directors                 250,000
                                                                    ---------
                                                                    7,019,201
                                                                    =========
<PAGE>
                                  - Page 32 -


10.      Other Income

                  The composition of other income is as follows:

                                                              1996        1995
                                                          --------    --------
         Income from sale of product line                 $148,998    $141,530
         Other                                              24,133      57,207
                                                          --------    --------
              Total                                       $173,131    $198,737
                                                          ========     =======

11.      Contingencies

         Litigation

                  On  December  8,  1994,  a  lawsuit  was filed in the
         United States District Court for the Northern District of California by
         Trilogy Development Group, Inc.  ("Trilogy")  against the Company.  The
         subject  matter of the case  involves a  configuration  systems  patent
         owned by the Company (Bennett et al. U.S. Patent 4,591,983) and a sales
         configuration product of Trilogy. Trilogy is seeking a judgment against
         Teknowledge  that it does not  infringe any claim of the Bennett et al.
         patent,  and for actual and  punitive  damages  and  attorney  fees for
         alleged  unfair  competition  under the  Lanham  Act and common law for
         misrepresenting  Teknowledge  and Trilogy's  products.  The Company has
         filed  counterclaims  against Trilogy for patent  infringement  and for
         unfair  competition  under the Lanham  Act and  common law for  alleged
         false and misleading statements  disparaging the Bennett et al. patent.
         On August 27, 1996,  Teknowledge and Trilogy  Development  Group,  Inc.
         agreed to a settlement of their disputes. On August 29, 1996, Trilogy's
         attorneys  provided written  notification to the Federal District Court
         that the  companies  had  reached a  settlement.  Under the  agreement,
         Trilogy would provide  consideration  to  Teknowledge  and  Teknowledge
         would grant a license to Trilogy to use the  technology  covered by the
         patent-in-suit.  The agreement also provided that all lawsuits  between
         the parties  would be dismissed and that all  previously  existing debt
         between  parties would be canceled.  The other details of the agreement
         are to be kept confidential by both parties.

                  Nevertheless,  on August 30, 1996, before formal documentation
         of the settlement agreement was finalized,  but after Trilogy's lawyers
         confirmed to the Court in writing that the case had been  settled,  the
         U.S.  District  Court entered an order  granting  Trilogy's  motion for
         summary judgment invalidating the patent. In view of the Court's order,
         Trilogy has taken the position that no  settlement  yet exists and that
         it need  not  abide  by the  terms  to which  the  parties  agreed  and
         represented  to the Court.  The Company has  informed  Trilogy that the
         Company intends to enforce the settlement agreement,  and believes that
         Trilogy  has  breached  the  settlement  agreement.   Accordingly,   on
         September  20, 1996,  the Company filed a motion to vacate the judgment
         in light of the prior  settlement.  The Company  and Trilogy  have been
         engaged in discussions  regarding the settlement  agreement in light of
         the Court's judgment;  however,  there is no assurance that the parties
         will be able to resolve the issues without further litigation, that the
         Company's motion to vacate and dismiss will be successful,  or that the
         Company will be able to enforce the settlement agreement.

                  In December 1994,  the Company  entered into an agreement with
         its legal counsel which was engaged for the Trilogy  litigation.  Under
         the terms of the  agreement,  should the  litigation be terminated as a
         result of a change in control of the  Company,  then the Company or its
         successor  would  become  liable  for four  times the  legal  counsel's
         ordinary and customary hourly rates plus all expenses incurred.

                  The  Company is also  subject to other legal  proceedings  and
         claims,  either  asserted or  unasserted,  which arise in the  ordinary
         course  of  business.  While  the  outcome  of these  claims  cannot be
         predicted with certainty,  management does not believe that the outcome

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         of any of these legal  matters will have a material  adverse  effect on
         the  Company's  consolidated  results  of  operations  or  consolidated
         financial position.

         Change of Control - Severance Benefits

                  In  the  event  of  a  change  of  control,   defined  as  any
         consolidation  or merger of the Company in which the Company is not the
         continuing or surviving  corporation,  the Chief Executive  Officer and
         the President of the Company will be entitled to severance  benefits to
         include:  (i) full  accrued  salaries and  vacation  pay,  (ii) accrued
         incentive compensation awarded or determined to be awarded by the Board
         of Directors, (iii) insurance coverage, (iv) retirement benefits, (v) a
         lump  sum  severance  payment  equal to two  times  their  most  recent
         respective annual salaries and (vi) accelerated  vesting of their stock
         options to purchase a total of 4,005,760 shares of Common Stock at $.03
         per share.

         Rights Agreement

                  On January 29, 1996 the Company's Board of Directors  approved
         a Rights  Agreement (the "Plan").  The adoption of the Plan is intended
         as a means to guard against  takeover  tactics designed to gain control
         of Teknowledge without paying all stockholders full and fair value.

                  Under the Plan,  stockholders will receive a Right to purchase
         one  one-hundredth  of a share of a new series of  Preferred  Stock for
         each  outstanding  share of Teknowledge  Common Stock of record held at
         the close of business on February 12, 1996.

                  The Rights,  which will initially trade with the Common Stock,
         become  exercisable to purchase one one-hundredth of a share of the new
         Preferred  Stock,  at $2.00 per Right,  when a third party  acquires 15
         percent or more of Common Stock or announces a tender offer which could
         result in such person owning 15 percent or more of Common  Stock.  Each
         one  one-hundredth  of a share of the new  Preferred  Stock  has  terms
         designed to make it substantially the economic  equivalent of one share
         of Common  Stock.  Prior to a third party  acquiring  15  percent,  the
         Rights can be  redeemed  for $.001  each by action of the Board.  Under
         certain circumstances,  if a third party acquires 15 percent or more of
         Common  Stock,  the Rights  permit the holders to purchase  Teknowledge
         Common Stock  having a market value of twice the exercise  price of the
         Rights,  in lieu of the Preferred  Stock. In addition,  in the event of
         certain business combinations, the Rights permit purchase of the Common
         Stock of an acquirer at a 50 percent  discount.  In either case, Rights
         held by the acquirer will become null and void.